The European Commission's strategy to manage economic relations with China is based on delivering benefits to both sides. The Brussels view is that so far China has grabbed the lion's share of the returns and Trade Commissioner Peter Mandelson will seek dialogue and cooperation – and, failing that, the possibility of enforcement – to achieve equity.
Much of this strategy depends on achieving policy change in China that will reduce the flow of exports and open its markets to European companies. But the imbalances are in fact the result of a number of factors and, for the strategy to have an impact, change is required on a broad range of issues.
Based on Brussels' efforts so far, though, exchange rates are not one of them.
A key issue
Despite being one of the biggest factors in trade flows and investment, exchange rates have not figure greatly in European discussions of imbalances with China. And, worryingly, it is an issue that may continue to work against the Commission achieving its objectives.
It is hardly a coincidence that the dramatic rise in Chinese exports to Europe in recent years has followed the fall of the US dollar against the euro which began in early 2002.
The RMB, which was fixed against the dollar, naturally enough followed the US currency down against the euro. Although the dollar regained some ground in 2005, much of this has been since lost. The strength of the euro in the past five years undoubtedly was a factor in the sharp growth of European imports from China.
Of course, the pattern of parallel movements of the Chinese and US currencies against the Euro changed in July 2005, when the RMB was allowed to appreciate against the dollar. Between then and mid-January 2007, the RMB has fallen 1.7% against the euro. The dollar is down 7.9% against the European currency in the same period.
Thus, while the RMB has risen against the dollar, it has actually fallen against the euro.
Even if the economic benefits that many in America expect from an RMB rise against the dollar do not materialize, the US can at least congratulate itself on the apparent success of its diplomacy as the Chinese currency breaks one record high after another against the dollar.
Europe cannot even enjoy that illusion. Unlike senior American officials, Mandelson is not even paid the compliment of a sudden jump in the RMB against the euro just before his plane lands in Beijing.
The RMB exchange rate in itself is not the key factor. Given that the US dollar is the currency that really matters in international trade, its future will have a major impact on China-EU trade and investment flows. If the Chinese authorities follow their apparent policy of allowing the RMB to appreciate slowly against the dollar, the EU-China relationship to a significant extent will be hostage to the fate of the US currency.
Consequently, if the dollar pessimists are proved correct, Europe may find itself bearing the full burden of absorbing an ever increasing flow of imports from China.
For European investors, a RMB that is weak against the euro will help maintain China's attractiveness as an investment location. But the prospect of increased imports from China, and the continuing "delocalization" of jobs from Europe, will not make it any easier for the Commission to sell its policy of constructive engagement to what may be an increasingly skeptical audience.
The future of the dollar is something over which the Europeans and Chinese have minimal influence.
There are many Americans who blame China for the massive external imbalances in the US economy. But these external imbalances that are to a large extent the cause of pessimism over the dollar are primarily the result of domestic causes in which China has no part.
Even if China adopts policies that reduce exports and increases imports, as both the US and EU hope, and as Beijing has said it wishes to do, that will bring little impact on the future direction of the US dollar, especially in the short term.
The fate of trade balances between the EU and China and their efforts to manage economic relations may be determined as much by the view the exchange markets take of the US economy as it is by the policymakers in Brussels and Beijing.