International Herald Tribune
Bowring: Free trade under threat
Monday, December 22, 2008

HONG KONG: China, almost as much as the U.S., may hold the key to whether the global recession leads to a vicious cycle of protectionism and contracting trade.

The world is unlikely to experience anything approximating the two-thirds shrinkage in trade seen between 1930 and 1933. For one, manufacturing systems are now much more integrated across borders and international investments so important that there is scant large corporate interest in protectionism. Another is that Smoot-Hawley, the mother of self-defeating protectionist measures that proliferated in the 1930s, is still viewed across the globe as a warning.

Nonetheless, the recent arrival of China as a major player in global trade raises new issues. We do not need a Smoot-Hawley to bring about a sustained contraction in trade any more than that legislation was solely to blame in the 1930s.

China's role now is probably even more important than its trade volumes - large as they are - suggest. Here is why.

Just like the U.S. in 1930, China has massive foreign-exchange reserves and starts the recession in a very strong trade position. Thus, at the broadest level, Beijing has least excuse for measures to protect local employment by artificially curtailing imports. Indeed, China has, in theory at least, the most leeway to stimulate domestic demand and imports.

So far, such stimulation appears to be its principle response - but that will not be easy for structural reasons. Failure to get quick results could easily lead to protectionist responses, of which some glimpses have already emerged.

Competitive devaluations are perhaps the most dangerous. These measures start in Asia and eventually lead to formal trade barriers as protection against "unfair" trade practices. The post-September rise of the dollar against the Chinese yuan and most other Asian currencies (excluding the yen) caused concerns that the region would attempt to sustain exports with currency manipulation. In an unusually tart comment, the Asian Development Bank warned countries against buying dollars to depreciate domestic currencies. Some Asian currency declines have reversed, nonetheless the Asian instinct for currency undervaluation to boost exports is alive and well. China matters particularly because other countries such as Malaysia, Thailand and Taiwan have taken to following its lead.

China also has an effect on other developing countries. China hitherto has been willing to cut tariffs unilaterally rather than on a horse-trading basis. But one result is that many actual levels are below the maximum under its World Trade Organization agreements. Thus it can increase them without breaking rules. Other countries are in a similar position but China is crucial because its liberalization went too fast and far.

India, Brazil and Russia have to greater or lesser degrees followed China on the liberalization path but now find that commodity exports are dropping dramatically while their domestic industries remain under pressure from Chinese imports. For the time being, protectionist measures by such nations have been isolated and industry-specific but more barriers will probably rise, particularly if China continues to run massive surpluses with them. In turn, these may provoke copy-cat moves by trade partners in regional arrangements.

Pressures from China's own companies are another danger. China's leadership and senior bureaucrats recognize how much it has benefited from trade and investment liberalization - 30 years of which were celebrated last week. But much of the benefit is perceived to have gone to foreign-invested firms that account for about 50 percent of exports rather than to the big quasi-state enterprises catering largely to the domestic market. They have more inclination toward protectionism and are also the recipients of cheap credit and subsidies that make them targets for foreign anti-dumping actions.

Support for freer trade is also waning at the political level. Worker layoffs have been particularly acute in low-tech manufacturing industries in southern China. A government that places social stability above all else will give the back seat to the longer-term benefits of foreign trade. Meanwhile, Chinese losses on its investments in once revered U.S. financial houses have soured the Chinese on Western-made rules and foreign advice. China is also understandably reluctant to see the yuan value of its dollar holdings continue to fall.

China may even have to rethink the value of its trade relations with Asian neighbors. The collapse in Western demand has exposed the fact that much intra-regional trade was in components for finished products sold in the West. Questions will be asked about whether it really makes sense to invest much political capital in regional trade liberalization.

These dangers to free trade do not add up to a repeat of the 1930s, but they all need watching.