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.