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China's Currency and the Trade Deficit

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Wednesday, 22 September 2010 01:59

David Leonhardt examines the prospective impact of a rise in China's currency on the U.S. trade deficit with China. He concludes that the impact might be limited for two reasons.

First he argues that much production might be transferred to countries with even lower cost labor, like Vietnam. Second, he notes that much of the value-added of goods that we import from China actually comes from third countries. The items are simply assembled in China. The rise in the value of the yuan would only affect the cost of assembly, not the cost of the other inputs, which may account for most of the value.

While both of these points are valid, there are important qualifications to each. Many other developing countries also peg their currency, either formally or informally, to the dollar. If China were to substantially raise the value of its currency, they would likely follow suit, since they are trying consciously to maintain the same competitive position vis-a-vis China. This was the experience the last time China substantially raised the value of its currency in 2007.

The point about China assembling items that involve inputs from other countries ignores the flip side of this story: there are many goods imported from countries like Japan and Germany that have substantial inputs from China. If the value of the yuan rises relative to the dollar, then these imports would be more expensive in the United States, making people here more likely to buy domestically produced goods. This will help the U.S. trade balance even though it will not be picked up in the trade balance with China.

Finally, the discussion of the relationship of the yen and the dollar is inadequate since it ignores the huge difference in relative inflation rates in the two countries. Since 1990 prices in Japan have fallen by more than 10 percent. They have risen by more than 50 percent in the United States. This means that to keep the trade situation from changing, the yen should have risen by more than 60 percent over this period.

Comments (10)Add Comment
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written by izzatzo, September 22, 2010 6:25
Many other developing countries also peg their currency, either formally or informally, to the dollar. If China were to substantially raise the value of its currency, they would likely follow suit, since they are trying consciously to maintain the same competitive position vis-a-vis China.


Price leadership is the highest virtue of economic competition. It beats branding any day. Ask not what your country's currency can do for you. Ask what you can do for your country's currency.

*This message is from The Multinational Moralistic Society of Freedom
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written by skeptonomist, September 22, 2010 8:59
Is it time yet to bring back Bretton Woods? The U.S. did well under that regime and so did most other countries. Was it abandoned for real reasons or because monetary-policy fanatics thought they knew how to run things better?
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written by Ed Dolan, September 22, 2010 9:50
You are right, relative inflation rates are of key importance--but why did you shift attention from the Chinese yuan to the Japanese yen in the last paragraph? The Japanese yen mostly floats, like you want the Chinese yuan to do, with only rare intervention by the Japanese government, and over the last 10 years, it has appreciated by 46% relative to the dollar, almost enough to wipe out the effects of the inflation differential.

Now, look at the inflation differential with China. The annual inflation rate in China right now is about 4 percent, and rising, whereas the US inflation rate is flat, and falling. That means that the real exchange rate of the Chinese yuan vs. the dollar is appreciating already even if the nominal rate stands still. That is movement in the right direction.

What would happen if China speeded up its nominal appreciation? If so, the Chinese central bank would have to buy fewer US bonds as part of its exchange market intervention, and as a result, the speed of Chinese money growth would slow and inflation pressure would be taken off China. The inflation differential would narrow, thus offsetting part of the nominal appreciation.

I agree with you, for a lot of reasons, that allowing the Chinese yuan to float more freely would be good for the US economy. It would be good for China, too. But don't expect such a change to fundamentally transform the economic relationship between the two countries.
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written by jcb, September 22, 2010 2:41
"Since 1990 prices in Japan have fallen by more than 10 percent. They have risen by more than 50 percent in the United States. This means that to keep the trade situation from changing, the yen should risen by more than 60 percent over this period."

I'm not sure I understand this reference to the rate of Japanese deflation and the appreciation of the yen. Surely the two are not unconnected, and in fact it is the yen appreciation that has influenced, if not caused, price deflation. In an export oriented economy you might expect deflation when cheaper labor from other Asian countries gained export shares in the same markets. This suggests a structural decline, not merely a demand decline -- comparable to the decline in agricultural prices in Europe in the late 19th century -- that has been masked by deflation.

So, instead of: "to keep the trade situation from changing, the yen should risen by more than 60 percent over this period."

This: "the Japanese trade balance would have increased much less had Japanese prices not fallen by 10% since 1990."
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written by Gho, September 22, 2010 2:50
Ed Dolan - Aren't most of China's intervention purchases sterilized by issuing PBoC debt to domestic banks? I think the intervention linkage to domestic money supply is significantly less than 1.
off the subject, but dead on the issue
written by phillip nelson, September 23, 2010 12:06
*** author's message ***

The missing piece that will hopefully ruin this gouge will be quality and IP theft. At some point - I hope - the people in the US and around the world will stop buying anything made in China and we need to force an RMA mechanism with China. Now it is easier to throw Chinese junk away then to go down to the store and demand a refund. They have billions in our cash, because we haven't demanded a refund on junk delivered! They owe us way more than the US bond reserves they hold.

*** we need a General Purpose RMA against China ***
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About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.

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