Hamish McRae: Why China has given a chilly reception to Snow's pressure on revaluing its currency

John Snow is, as Americans would say, mad. The US Treasury Secretary is angry at China's under-valuation of its currency and the effect this is having on the US/China trade balance and US manufacturing jobs. But do not expect his visit to Beijing this week to bring any significant change in Chinese policy. And expect US inflows of investment capital to grow larger.

The easiest way to catch a feeling for the scale of the under-valuation is to look at the difference between US and Chinese GDP at market exchange rates and at purchasing power parity. If you do that, the Chinese economy moves from being one-tenth the size of the US to half the size (see graph), with China becoming the world's second largest economy. That purchasing power comparison overstates China's significance in the world league because the low cost of unexportable domestic services - haircuts and the like - pushes up the ppp rate. Still, as a working assumption, the US claim that the renminbi is 40 per cent undervalued cannot be far out.

The effect has been to cause a flood of inward investment into China, with the country displacing the US as the world's largest recipient of investment funds (next graph) - though this is largely because of the collapse of inward investment into the US.

With investment has gone jobs. John Snow's estimate that 2.5 million jobs have been lost by the US to China may not be right as to detail, but the broad numbers will be about right. As for the trade balance, China has a surplus of more than $100 billion with the US alone.

It is not only the US that is suffering. Other countries that have up to now been big, low-cost suppliers to the US market are also being damaged. China looks like displacing Mexico as the second largest exporter to the US this year (Canada is the largest).

Last year Chinese exports were up some 20 per cent on 2001, while Mexico's exports were flat. Mexico, host to the World Trade Organisation talks in Cancun later this month, is as upset as the US about this. In some ways the Mexican predicament is worse than the US one, for the US finds it easier to move upmarket and shift still further into services. Mexico, by contrast, has built its own boom on exporting manufactured goods to the US and finds it harder to replace the jobs being lost.

You can see the effect on Chinese manufacturing in the third graph. US industrial production has not done at all badly through the 1990s. There were of course the twin recessions at the beginning of the decade and in 2001, but the US growth in production has been much better than that of continental Europe or the UK. But it is dwarfed by growth in China, much of which has of course been financed by US firms, who have responded to costs pressures at home by outsourcing more of their production.

So what will happen? If it is right that the Chinese will not revalue their currency - and every report seems to be confident that they won't - the inflow of capital is likely to continue and the trade imbalance to grow still larger. Changing the value of its currency is not at the top of the Chinese leadership's priorities. Those are to maintain growth and to continue rebalancing the economy further towards the market system.

However the imbalances - and the inflows of capital - are causing problems. China is suffering from deflation in goods prices and inflation in asset prices. It is a similar predicament to the one we have here but on a vastly larger scale.

One of the reasons for the surge in asset prices is China's policy of printing money to mop up the dollars that are coming in - a policy that has the effect of increasing asset prices. It is increasing its reserve requirements on banks later this month as part of plan to curb excessive spending.

This excessive lending is another of the reasons for the surge in asset prices. At the moment the banks have huge debts and one way of diluting those bad loans is to make more good loans. Foreign capital is now starting to move into the banking and life assurance sectors, as well as into manufacturing. (The Pru is the first foreign insurer to operate in Beijing and is currently expanding its stake in a joint venture.)

There will be trimming at the edges. Thus China may allow the bands in which the renminbi trades to widen, in effect allowing a very modest revaluation. But as there will not be much, the issue then becomes what will the US do?

I think the political issue is the number of jobs being lost rather than the more abstract one of a currency being under-valued. One of the profound concerns of the US right now is that the quite decent economic recovery is not generating many new jobs. Job-wise it is the weakest recovery since the Second World War. One US senator, Charles Schumer, said he may introduce a bill that would raise "legitimate trade barriers" to China's exports. Certainly the gut instinct of Americans under these circumstances is to go for import controls. But we will see. Since the imbalance has in large measure been driven by the actions of US companies, it is tricky to see what can or should be done.

My guess is that the US will gradually try to increase pressure, just as it did on Japan 30 years ago. Japan, similarly, manipulated its exchange rate to make it super-competitive, building up huge stocks of dollars, which it then invested spectacularly badly. Japan still has a huge trade surplus now but was gradually forced to export its own jobs by building plants in the US.

China is a long, long way from that. But Chinese policy will change when the country's leaders feel it is in its self-interest to change. My guess is that it will all be fairly messy. There will be some restrictions on Chinese imports into the US because, politically, the Bush Administration will have to be seen to do something. These measures will be ineffective, just as measures to curb Japanese imports were pretty ineffective. But China will want help in rebuilding its banking system and that will give the US a lever on policy. China, too, will see that while it needs to remain competitive, it does not need to be super-competitive. So gradually the tourniquet will be eased.

From a UK perspective, the issue seems less pressing than it appears in the US. Trade with China is a smaller proportion of the total and investment there is much more modest. We are more likely to lose service industry jobs to India than manufacturing ones to China. Our self-interest is damaged, however, if hostility in the US to China spills out into more general US hostility to the multilateral trading system.

But there is one thing from which there is no escape. China will play an ever-greater economic role in the world over the next decade, maybe the next two or three decades. We have to think about our own comparative advantage and ask the tough question: what can we do that Chinese people on one-tenth of our wages can't?