No, I am not referring to plans under way in the U.S. Congress to slap punitive tariffs on U.S exports. What I have in mind is a proposal that is suggested by the underlying economics of the situation, but which no-one has yet put forward. It entails granting China an exemption from WTO rules that prohibit subsidization of its export industries in return for a commitment by the Chinese government to let its currency appreciate. Crazy? Perhaps, but read on.
First, let's agree that China's currency is part of the problem. China's large external surplus (and its corresponding huge bilateral surplus vis-a-vis the U.S.) is driven partly by the undervaluation of the remninbi. Here is one estimate (from my ongoing work), which suggests an undervaluation of the remninbi of the order of 50% in real terms.
The precise extent of the undervaluation is a matter of debate, and that particular question need not detain us here.
Second, while Chinese currency policies may seem purely mercantilist, let's also understand that there are sound economic reasons behind it. Chinese economic growth for the last 10-15 years has been driven by a policy of encouraging tradable (and mainly export-oriented) industries. As these modern industries expand, they draw labor from significantly less productive rural and other economic activities, generating an increase in overall labor productivity and GDP per head. An undervalued currency is the linchpin of this growth strategy, as it provides the incentive needed by investors (foreign and domestic) to establish and expand exportable industries. Why would the incentives be inadequate without a hyper-cheap currency? Because market and institutional barriers prevent modern industries from getting started in poor countries without extra inducements. Using economics jargon, currency undervaluation is a second-best mechanism for overcoming market failures.
The trouble is that an undervalued currency also taxes consumption of tradables at home, and this combination of subsidizing output and taxing consumption of traded industries results in a trade surplus for China and a trade deficit elsewhere. (The only exception are commodity exporters, who benefit from increased demand from China.) The U.S deficit is particularly worrisome, as it has spawned a backlash against China that is growing in importance and political salience. Let's not forget that macroeconomic imbalances have often been at the root of rising protectionism.
Hence the current dilemma: Pushing China to revalue its currency is damaging to China's economic growth, and ultimately to its social and political stability. But doing nothing on the currency front risks dangerous unilateralism on the part of the U.S.
But there is a way to de-couple China's trade balance from its need to encourage exportable industries, and that is to allow China to subsidize its industries directly, instead of through the exchange rate. In fact, China can provide any and all inducements it wants to its modern industries through fiscal instruments and still run a balanced trade account. A subsidy on tradables in conjunction with currency appreciation enables precisely that, as it generates more imports alongside more exports.
(This might seem puzzling at first, because it appears that the appreciation would offset the effect of the subsidy on the profitability of tradables. But the offset is necessarily partial since an appreciation reduces the trade surplus through a second channel, namely by encouraging consumption of importables. To use a numerical example, a 20% subsidy would require, say, a 10% appreciation to offset its effect on the current account, still leaving a roughly 10% increase in the relative profitability of exportables. The actual numbers will depend on elasticities of demand and supply.)
Subsidies are of course costly to the budget, but China can easily afford them. In any case, it is not clear which is the more expensive strategy for China: outright subsidies or accumulating costly reserves to stem the appreciation of the currency?
WTO rules currently do not allow countries to subsidize their industries when these subsidies have an effect on export levels. This prohibition has little economic logic behind it in any case. So exempting China (or any other country for that matter) from these rules will hardly do any damage. And it would have the big advantage of creating the policy space to overcome one of the most important policy challenges of our time. The quid pro quo would be this: you can subsidize your industries as much as you like; but you cannot let the currency stray too far from where it needs to be to generate (rough) external balance. This will allow China to pursue its highly-successful growth strategy without imposing large current account deficits on other countries.