Is a Trade War with China Brewing?

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A worker walks over steel bars at an iron and steel plant in Wuhan, Hubei province, on November 1, 2008

When the U.S. Senate last February introduced a clause requiring the purchase of U.S.-made steel and iron in Washington's $787 billion stimulus package, the Chinese government decried the "Buy American" measure as a dangerous step toward trade protectionism, stressing that Beijing would not respond in kind. "We won't practice Buy China," Vice Commerce Minister Jiang Zengwei vowed, according to the state-run China Daily newspaper.

But four months later, China's resolve to avoid a showdown over trade with the West appears to have weakened as the country struggles to keep its manufacturing sector growing during recession. Instead, China, the U.S. and the European Union may be sliding toward the kind of tit-for-tat trade battle that economists warn could impede commerce and stall a global economic recovery.

China since last August has boosted tax rebates for Chinese exporters seven times on thousands of items including shoes and toys; export duties will soon be eliminated entirely on some grains and steel wire. And last week, Beijing appeared to abandon its previous promise not to favor domestic producers over foreign manufacturers by directing government offices to buy Chinese goods when available.

While there may be no direct link to Beijing's recent action, the U.S. and the European Union this week brought a complaint against China at the World Trade Organization (WTO) for restricting exports by Chinese producers of raw materials such as coke, magnesium, and zinc that are used in making steel and aluminum. The U.S. and the E.U. argue this harms their manufacturers by making those raw materials more expensive. China's Ministry of Commerce said the restrictions were meant to protect the environment and not to give domestic producers an unfair advantage. Beijing also said this week that it objects to American efforts to limit Chinese poultry imports, and asked the WTO to investigate.

It's unclear whether the measures by both sides do much actual economic damage. "Buy American and Buy China, what kind of impact they have is debatable," says Michael Pettis, a professor of finance at Peking University. "But they are so visible and easy for people to focus on. They become rallying cries." The real danger is that retaliatory steps such as Beijing's order for the government to buy Chinese goods "will spur protectionist sentiment and is at odds with worries about the country's export sector," wrote Ben Simpfendorfer, the Hong Kong-based chief China economist for the Royal Bank of Scotland, in a recent report. Economists say tariffs enacted by the U.S. government in 1930 and subsequent retaliation by Europe curtailed trade and helped prolong the Great Depression.

The financial crisis has deeply affected Chinese manufacturers. The country's exports were down 26% last month compared with the same period last year. But imports have fallen even faster, and China's already massive trade surplus grew to $13.4 billion in May. China has ratcheted up imports of some raw materials such as iron ore. But because prices have dropped so much since last year's highs, the effect on its overall trade surplus has been small.

While China's aggressive stimulus efforts have helped stabilize its economy, there is a risk that if China continues to export more abroad than it takes in, it will undermine weakened manufacturers overseas. That could further provoke protectionist sentiment in the U.S. and elsewhere. "We're going to see a significant rise in protectionism. There's no way around it," says Pettis. "In order to avoid it we need real statesmanship from the U.S., China, Europe and Japan. So of course I'm pessimistic."