While Western companies see China as a potential market of one billion customers, there is a downside to the China trade: the U.S. deficit grew faster in the final months of 2005 than ever before, swelling to 7 percent of national income, with the balance of payments with China a key factor. Some U.S. and U.K. leaders call angrily for trade action against China unless it opens its markets and allows another revaluation of the yuan
These days the United States and other Western nations feel China breathing down their necks in the world marketplace. While the Western nations appreciate the potential that the Chinese market offers in a global economy, they object to how China is playing the game, especially when it comes to currency valuation. As in Japan and other Asian countries, Chinese monetary authorities have intervened in foreign-exchange markets, consistently buying dollars, U.S. Treasury securities, and other reserve currency assets to maintain an undervalued currency, thereby assuring that Chinese exports remain cheap in their destination countries whereas imports to China remain expensive.
China ’s Currency Policy
Annually, Chinese monetary authorities purchase about $200 billion in foreign, mostly U.S., currency and securities, which equal about 10 percent of Chinese GDP and 25 percent of its exports. By lowering the price of Chinese products on world markets and raising the cost of foreign products in China, these currencypurchases distort global trade, artificially boosting Chinese exports and stunting Chinese imports. This process also increases U.S. imports and reduces U.S. exports and is a major contributor to large U.S. trade deficits.
Given rapid productivity growth and foreign investments in China, we would expect the dollar value of the Chinese currency to rise with its development progress. However, in 1995, the Chinese government began pegging the yuan (the primary unit of the Chinese currency, the renminbi) at 8.28 per dollar. In July 2005, China adjusted this peg to 8.11 and announced the yuan would be aligned to a basket of currencies. However the yuan still tracks the dollar quite closely, with little day-to-day variation, and in March 2006 stood at 8.04.
At this level, the demand for yuan exceeds the supply in currency markets, creating upward pressure on its value; however, Chinese authorities buy dollars and sell yuan to keep the value of the yuan from rising against the dollar. Hence, the yuan is “undervalued” and the dollar is “overvalued.” Other Asian governments follow China’s policy to avoid having products face a competitive disadvantage in U.S. markets. Hence the dollar is broadly overvalued against Asian currencies.
The U.S. trade deficit with China has grown from $38 billion in 1995 to $162 billion in 2004, and was about $200 billion in 2005. The overall U.S. current account deficit has grown from $105 billion to about $800 billion. Back in 1980, when the U.S. Congress granted China most-favored-nation trading status, the U.S. bilateral trade and global current accounts were in surplus at $2.8 billion and $2.3 billion, respectively. The causes of U.S. trade deficits are many and interrelated, but the undervalued yuan and China’s trade surpluses play a critical role. Reduced sales and layoffs in U.S. import-competing industries caused by Chinese and other foreign competition have not been matched by increased sales and new jobs in U.S. export industries at the scale a market-driven outcome would require. The free-trade benefits of higher productivity and growth to the U.S. economy have been frustrated by currency market intervention.
Consequences for U.S. Productivity and Growth
Increased trade with China and other Asian economies should shift U.S. employment from import-competing to export industries. Since the latter create more value added per employee and undertake more R&D, this process would be expected to immediately raise U.S incomes and consumption and boost long-term productivity and GDP growth.
Instead, growing trade deficits with China and other Asian economies have increased U.S. imports more than exports and caused more Americans to seek employment in nontradable, service-producing activities.Import-competing and export industries create about 50 percent more value added per employee and spend more than three times as much R&D per dollar of value added than the overall average for the private business sector. An econometric model constructed for the Economic Strategy Institute, a nonpartisan public-policy research institute in Washington, D.C., indicates that by reducing investments in R&D, the overvalued dollar and resulting trade deficits are reducing U.S. economic growth by at least one percentage point a year, or about 20 percent of potential GDP growth. China accounts for almost half of this lost growth.
Importantly, this one percentage point of growth has not been lost for just one year. The trade deficit has been taxing growth for most of the last two decades, and the cumulative consequences are enormous. Had foreign-currency market intervention and large trade deficits not robbed the United States of this growth, U.S. GDP would likely be at least 10 percent greater—and perhaps 20 percent greater—than it is today. GDP and tax revenues would be higher, and the Congress would not be facing large federal deficits. We would not be enduring a crisis in manufacturing and nearly 5 percent unemployment four years into an economic recovery, and the Congress would not be facing the difficult task of trimming Medicare benefits.
Nor are China’s artificially large trade surpluses detrimental to the United States alone. They impose similar costs on European Union economies, and they crowd out exports from Latin America to the United States, hampering growth in that region. Mexico, for example, has not enjoyed all of the potential benefits of NAFTA, and this has made U.S. efforts to promote free trade in the Western Hemisphere more difficult.
Revaluing the Yuan
An obvious solution to the United States’ current predicament would be for China to revalue the yuan to reflect its true economic strength. Several arguments have been made against letting the yuan rise to a value that balances its external trade, but the underpinnings of these arguments are questionable.
For example, permitting the yuan to rise 30 or 40 percent would impose difficult adjustments on Chinese state-owned enterprises, disrupt Chinese labor markets, and further stress the balance sheets of Chinese banks. However, adjustments of these kinds will only be larger if China delays revaluing the yuan. To avoid making such adjustments and sustain its current development model, China will have to purchase ever-larger amounts of dollars, and sell ever-greater quantities of products to U.S. consumers. At some point, political and social pressures within China will require a change in policy, and that change will prove more difficult the longer China delays.
Interestingly, revaluing of the yuan would actually benefit China because removing some of the protection its industries now enjoy would stimulate a productivity burst. This would reduce the competitive gains for U.S. import-competing and exporting business. However, to the extent that a 30 or 40 percent jump in the dollar value of the yuan did not wipe out China’s trade surplus and the excess demand for yuan in currency markets persisted, the dollar value of the yuan could be further adjusted without imposing additional hardships. Productivity gains in China would cushion inflationary effects all around, and Chinese living standards would rise dramatically.
Currently, the United States depends on Chinese and other foreign-government purchases of treasury securities (currency market intervention) to finance part of the federal budget deficit. However, absent this intervention, the exchange rate for the dollar and trade deficits would be lower, and GDP and tax revenue would be higher. To the extent that additional tax revenue did not close the federal financing gap, the Federal Reserve could purchase additional treasury securities to maintain interest rates—something it routinely does to expand and regulate the money supply. In other words, instead of Chinese and other foreign monetary authorities purchasing treasury securities, the Fed itself could make those purchases.
Given the long-term benefits not only to the U.S. economy but also to the Chinese economy, U.S. policy makers should press harder for yuan revaluation. Failing Chinese cooperation, the U.S. should implement trade measures, specifically directed at China, to reduce the deficit.
Bo Zhiyue. (2004). The politics of cooling China’s overheated economy. Singapore: East Asian Institute, National University of Singapore.
Lardy, Nicholas R. (2002). Integrating China into the global economy. Washington, DC: Brookings Institution Press.
Prasad, Eswar. (Ed.). (2004). China’s Growth and Integration into the World Economy: Prospects and Challenges (Occasional Paper 232). Washington, DC: International Monetary Fund. Retrieved from http://www.imf.org/external/pubs/ft/op/232/op232.pdf
Source: Morici, Peter. (2006). China trade: threat and opportunity. Guanxi: The China Letter, 1, 1.