Hamish McRae: The Chinese retreated from Unocal, but they will be back

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The Independent Online

It forced a revaluation - albeit a very modest one - in the Chinese currency, the renminbi. And now it has forced CNOOC, the Chinese state-controlled oil group, to abandon its bid for one of the few remaining independent US oil companies, Unocal Corporation.

At first sight this looks like a fairly straightforward example of the US reaping a reward for a tough stance. In the case of the revaluation the move was much smaller than the US Treasury had sought: it wanted a 10 per cent revaluation, not a 2.1 per cent one. But it was welcomed by several congressional members, including Senator Chuck Schumer, who has been leading the plan to impose a penal tariff on Chinese imports had the Chinese not moved. The Senator wants a revaluation of a few more percentage points by October and will otherwise still press forward with the tariff bill. But the Chinese move has certainly reduced the risk of protectionism.

In the case of the bid for Unocal, the Chinese openly admitted that it was political pressure that had forced them to abandon the bid.

A spokesman for CNOOC said that the opposition was "regrettable and unjustified" - but then it would say that, wouldn't it? This tussle is not about principles. It is about power.

You could see the past few days as the first of what will become a series of skirmishes between the two dominant economic powers of the world. The rest of us have to hope that the skirmishes will not develop into open warfare but inevitably the danger of that remains.

The background to all this is the growing awareness in the US that it is hugely affected by what happens in China. Of all its economic relationships in the world the one with China is the most important. Between them, the US and China accounted for more than half of the additional demand in the world last year. Unless there is some catastrophe, within five years China will have become the third largest economy in the world after the US and Japan, passing Germany and the UK. (The projections for GDP in 2009 from Goldman Sachs's famous BRICs study - Brazil, Russia, India, China - are shown in the top graph.)

The US political and economic establishment recognises this advance as inevitable and even desirable. Cheap imports of manufactured goods from China have enabled the long American boom to continue without any significant increase in inflation and has helped many US companies boost their profits.

But while American consumers seem happy enough to buy cheap Chinese products, they are less comfortable about the consequences of their action: increasing Chinese economic power. They have a constant reminder of the effect of the growth of Chinese demand for oil every time they fill up their vehicles, for it has been the Chinese boom that has driven the oil price above $60 a barrel.

But if it is easy to understand this growing concern it is harder to see its medium-term consequences. Tension between the US and China is nothing new. Taiwan has long been and will remain a source of concern. The US is putting pressure on the European Union not to resume arms sales to China. But up to now the US has not seen China as an economic rival - a political and military one of course, but not economic. That is now changing.

The obvious source of tension is the trade gap. But while it is perfectly correct that China does now have an overall trade surplus, and one that has risen sharply in the past few months, the fact remains that this gap is overwhelmingly with the US and to a much lesser extent the EU. As the graph shows, it is actually in deficit to Japan and to the rest of Asia. So you could see this as more a result of excessive US demand than unfair Chinese trade practices.

This leads to a discussion about the currency. From a US perspective the renminbi is and remains grossly undervalued. But that is largely because of the recent fall of the dollar, to which it was and still is pegged. If you look at the trade-weighted value of the currency, there was a long and sustained decline in its value from the end of 2002 (final graph), which has started to reverse with the recovery of the dollar at the beginning of this year.

The obvious point here is that a 2.1 per cent revaluation against the dollar makes a tiny change to its weighted value. Put another way, swings of the dollar itself have been much more important to the currency's value than this change in the dollar peg.

Given this, you can see why the Chinese authorities wanted to move from a dollar peg to a weighted currency one, a change that is expected to take place later this year. Once that has taken place, it will be much harder for US politicians to blame Chinese currency policy for the trade gap between the two countries, though I don't expect it will stop them trying to do so.

If the tension over the trade gap will, in the medium term, probably defuse itself, tension over Chinese financial power will almost certainly rise. The bid for Unocal was at one level a straightforward enough financial transaction. Had the bid come from BP or Shell it would have caused little controversy. But the UK and the Netherlands are not perceived as threats. China self-evidently is.

As the Chinese economy grows, so will Chinese international investment. Exactly that pattern happened with Japan in the 1980s. Japanese expansion provides some sort of model for what China will do, with the proviso that China will try to avoid Japan's mistakes.

On the narrow issue of trying to get control of oil supplies, China is already trying to avoid one mistake. Japan, faced with concerns about its ability to secure supplies, started a huge international exploration programme. Essentially it failed: the Japanese were very bad at finding oil. Hence China has sought to buy into known supplies rather than try and drill for new ones.

On the wider issue of investment policy, Japan made the mistake of buying trophy assets at the top of the market, paying far too much for them. China also seems to have some similar mistakes because it too has accumulated large blocks of US Treasury bonds.

It may well turn out that, like Japan, it has bought those at the wrong exchange rate and the wrong yield. But if it has made mistakes up to now, expect it to learn from them. It may well try and buy more US companies in less strategic areas and it will be hard legally to resist the purchases if there is no strategic significance. In other words, do not expect the retreat from Unocal to represent a change of direction. The Chinese will be back and will be harder to resist next time.

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