China’s Exchange Rate Policy and Trade Imbalances

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Chairman Brown, Ranking Member DeMint and members of thesubcommittee, I am Daniel Ikenson, associate director of the Centerfor Trade Policy Studies at the Cato Institute. I appreciate theinvitation to share my thoughts about the Chinese currency, itsrelationship to the bilateral trade deficit, the impact on U.S.jobs, and what, if anything, Congress should consider doing. Theviews I express are my own and should not be construed asrepresenting any official positions of the Cato Institute.

Introduction

Many economists believe that the Renminbi is undervalued, butthere is disagreement about the magnitude. Disagreement is to beexpected. After all, nobody can know the true value of the RMBunless, and until, it is allowed to float freely and restrictionson China's capital account are removed.1 Short of that,economists produce estimates of undervaluation - and thoseestimates vary widely. So that begs a practical question: How willwe know when we are there?

That question is important because Congress is once againconsidering legislation to compel the Chinese government to allowRMB appreciation under the threat of sanction. Regardless ofwhether sanctions take the form of an across-the-board surcharge orare the product of a countervailing duty investigation or aremanifest in exchange rate conversions in antidumping calculations,a precise estimate of the market value of the Renminbi would haveto serve as the benchmark. But respected economists from reputableinstitutions have produced a range of undervaluation ofapproximately 10 to 40 percent. So what should be thebenchmark?

Of course the sanctions approach is fraught with dangers. Notonly would it amount to a tax on U.S. producers and consumers -felt particularly acutely by lower- and middle-income families -but it could spark retaliation from China and run afoul of U.S.World Trade Organization obligations at a time when the Obamaadministration is planning to hold our trade partners moreaccountable to their own WTO commitments, as part of its NationalExport Initiative.

Many in Washington blame the undervalued Renminbi for the tradedeficit with China, and blame the deficit for U.S. job losses. Butthose relationships are weak. Before doing something unnecessary orcounterproductive, Congress should consider whether, and to whatextent, RMB appreciation would even lead to more balanced bilateraltrade. Recent evidence casts plenty of doubt.

Laser-like Focus on the Trade Deficit

For many in Washington, it seems the issue is not that theChinese currency is undervalued per se, but that the United Stateshas a large bilateral trade deficit with China, which is popularlyattributed to the undervalued RMB.2 Currency revaluationfor many policymakers is just a proxy for reducing the tradedeficit to zero - or better still, turning it into a surplus. Thereshould be little doubt that many will take the position that theRMB is undervalued as long as U.S. imports from China exceed U.S.exports to China.

Leaving aside the question of whether bilateral deficitreduction should even be an explicit objective of policymaking inthe first place, there is reason to be skeptical that currencyrevaluation would have the "desired" effect. It is assumed thatAmericans will reduce their purchases of Chinese products and thatthe Chinese will increase their purchases of American products ifthe value of the RMB increases against the dollar. But whetherthose trends would work to reduce the U.S. deficit with Chinadepends on the extent to which consumers in both countries areresponsive to the relative price changes.

What matters for the trade account is how muchAmericans reduce their purchases of Chinese goods and howmuch the Chinese increase their purchases of U.S. goods.Import value equals price times quantity, so if the percentincrease in price (appreciation of the RMB) exceeds the percentreduction in quantity of imports consumed (in absolute value), thenimport value will increase. For example, if the RMBappreciates by 25 percent and U.S. consumers reduce consumption ofChinese imports by only 10 percent, then the value of U.S. importsfrom China will be greater than before (adding to thetrade deficit). The same 25 percent increase in RMB value, however,should lead to an unequivocal increase in U.S. exports to Chinabecause the dollar price charged (the price used to measure U.S.exports) remains the same, while the quantity sold to Chinaincreases because Chinese consumers, by virtue of RMB appreciation,face lower relative prices, and demand more goods. Thus, RMBappreciation should unambiguously increase U.S. export value,reducing the trade deficit. But its effect on U.S. import valueis ambiguous.

Whether the aggregate change in U.S. import and export valueresults in a lower trade deficit depends on the relativeresponsiveness (price elasticity) of American and Chinese consumersto the price changes they face. If U.S. consumers are responsive(they reduce the quantity of their purchases by a percentagegreater than the price increase), then the trade deficit willdecline, regardless of the degree of Chinese responsiveness. IfU.S. consumers are not responsive (they reduce the quantity oftheir purchases by a smaller percentage than the price increase),then import value will rise and Chinese consumers would have toincrease their purchases of American goods by a large enoughpercentage to offset the increased U.S. import value, if the U.S.trade deficit is to be reduced.3

Weak Link between Currency Values and TradeFlows

Recent evidence suggests that RMB appreciation will not reducethe U.S. trade deficit and undermines the common political argumentfor compelling China to revalue. Between July 2005 and July 2008,the RMB appreciated by 21 percent against the dollar - from a valueof $.1208 to $.1464.4 During that same period (betweenthe full year 2005 and the full year 2008), the U.S. trade deficitwith China increased from $202 to $268 billion.

U.S. exports to China increased by $28.4 billion, or 69.3percent. But how much of that increase had to do with RMBappreciation is very much debatable. The nearby chart shows thatU.S. exports to China were already on an upward trajectory,increasing by $3 billion in 2001, $3 billion in 2002, $6.2 billionin 2003, and $6.1 billion in 2004, when the exchange rate wasconsistently at 8.28 RMB per dollar. Natural sales growth from theconfluence of market penetration and cultivation of Chinese demandwas already evident.

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In 2005 - the first year in which there was a slight RMBappreciation - the value of exports increased by $6.8 billion.Exports jumped another $12.5 billion in 2006, a year in which theRMB appreciated by 2.8 percent. But in 2007, despite an evenstronger 4.7 percent RMB appreciation, the increase in exports wasonly $9.3 billion. And in 2008, the RMB appreciated by asubstantial 9.5 percent, but the increase in exports fell to $6.8billion. If currency value were a strong determinant, then exportgrowth should have been much more robust than it was in 2007 and,especially, in 2008. Other factors, such as Chinese incomes andChinese savings propensities, must have mitigated the lowerrelative price effects.

On the import side, recent experience is even more troubling forthose who seek deficit reduction through currency revaluation. Theevidence that an appreciating RMB deters the U.S. consumption ofChinese goods is not very compelling. During the period of astrengthening RMB from 2005 to 2008, U.S. imports from Chinaincreased by $94.3 billion, or 38.7 percent. Not only did Americansdemonstrate strong price inelasticity, but they actuallyincreased their purchases of Chinese imports. One reasonfor continued U.S. consumption of Chinese goods despite therelative price increase is that there may be a shortage ofsubstitutes in the U.S. market for Chinese-made goods. In somecases, there are no domestically produced alternatives.5Accordingly, U.S. consumers are faced with the choice of purchasinghigher-priced items from China or foregoing consumption of the itemaltogether.

It is doubtful that members of Congress, who support action tocompel Chinese currency appreciation, would proudly announce totheir constituents that they intentionally reduced their realincomes. But that is the effect of relative dollardepreciation.

Globalization Mutes the Effect of CurrencyChanges

Something else is evident about the relationship from those 2005to 2008 data. The fact that a 21 percent increase in the value ofthe RMB was met with a 38.7 percent increase in import value meansthat the quantity of Chinese imports demanded after the pricechange increased by nearly 15 percent.6 Higher pricesbeing met with greater demand would seem to defy the law ofdemand.

Chinese exporters must have lowered their RMB-denominated pricesto keep their export prices steady. That would have been acompletely rational response, enabled by the fact that RMBappreciation reduces the cost of production for Chinese exporters -particularly those who rely on imported raw materials andcomponents. According to a growing body of research, somewherebetween one-third and one-half of the value of U.S. imports fromChina is actually Chinese value-added.7 The other halfto two-thirds reflects costs of material, labor, and overhead fromother countries. China's value-added operations still tend to below-value manufacturing and assembly operations, thus most of thefinal value of Chinese exports was first imported into China.

RMB appreciation not only bolsters the buying power of Chineseconsumers, but it makes China-based producers and assemblers evenmore competitive because the relative prices of their importedinputs fall, reducing their costs of production. That reduction incost can be passed on to foreign consumers in the form of lowerexport prices, which could mitigate entirely the effect desired byCongress, which is to reduce U.S. imports from China. That processmight very well explain what happened between 2005 and 2008, and isprobably a reasonable indication of what to expect goingforward.

A 2006 Cato paper on the topic of exchange rates and trade flowsfound that despite considerable dollar depreciation between 2002and 2005 against the Canadian dollar, the Euro, the Japanese yen,the Korean won, and the Brazilian real, the U.S. trade deficitexpanded during that period with Canada, Europe, Japan, Korea, andBrazil.8 Factors other than currency movements, such asincome and the availability of substitutes, influence trade flows,particularly when exporters are willing to absorb the costs ofthose currency changes.

In a recently published paper from the U.S. International TradeCommission, economist Cathy L. Jabara observes a weak relationshipbetween exchange rates and U.S. import prices, particularly withrespect to imports from Asia. Exchange rate pass-through is quitelow because exporters often "price to market" to absorb costs andmaintain market share. She notes that the economic literaturesupports her findings of low exchange rate pass-through,particularly for consumer goods. Ironically, she also notes thateconomist Paul Krugman, who is among the most outspoken advocatesof U.S. intervention on the currency issue, was one of the first toexplore and describe the potential for exchange-rate pass-throughto mitigate the impacts on trade flows.9

Economic Benefits

Although it may be fashionable to think of China as the countryto which the U.S. manufacturing sector was offshored in exchangefor tainted products and a mountain of mortgage debt, the fact isthat the bilateral relationship has produced enormous benefits forpeople in both countries, including most Americans. China isAmerica's third-largest export market, and has been ourfastest-growing market for a decade, providing 20.2 percent annualsales growth for U.S. businesses between 2000 and 2008, whenoverall annual export growth to all countries stood at just 6.8percent.10

American businesses, portfolio investors, and 401(k)participants also have benefited handsomely from China's high rateof sustained economic growth. Likewise, American consumers havebenefited from their access to Chinese goods. Imports from Chinahave helped keep prices in check, raising real incomes and easingthe strain on family budgets.

What is perhaps less well known - because they are oftenportrayed as victims - is that large numbers of American producersand workers benefit from the bilateral relationship, as well. Thisis the case because the U.S. economy and the Chinese economy arehighly complementary. U.S. factories and workers are more likely tobe collaborating with Chinese factories and workers in productionof the same goods than they are to be competing directly. Theproliferation of vertical integration (whereby the productionprocess is carved up and each function performed where it is mostefficient to perform that function) and transnational supply chainshas joined higher-value-added U.S. manufacturing, design, andR&D activities with lower-value manufacturing and assemblyoperations in China. The old factory floor has broken through itswalls and now spans oceans and borders.

Though the focus is typically on American workers who aredisplaced by competition from China, legions of American workersand their factories, offices, and laboratories would be idledwithout access to complementary Chinese workers in Chinesefactories. Without access to lower-cost labor in places likeShenzhen, countless ideas hatched in U.S. laboratories - whichbecame viable commercial products that support hundreds ofthousands of jobs in engineering, design, marketing, logistics,retailing, finance, accounting, and manufacturing - might neverhave made it beyond conception because the costs of productionwould have been deemed prohibitive for mass consumption. Justimagine if all of the components in the Apple iPod had to bemanufactured and assembled in the United States. Instead of $150per unit, the cost of production might be multiple times thatamount.11

Consider how many fewer iPods Apple would have sold; how manyfewer jobs iPod production, distribution, and sales would havesupported; how much lower Apple's profits (and those of theentities in its supply chains) would have been; how much lowerApple's research and development expenditures would have been; howmuch smaller the markets for music and video downloads, caraccessories, jogging accessories, and docking stations would be;how many fewer jobs those industries would support; and the lowerprofits those industries would generate. Now multiply that processby the hundreds of other similarly ubiquitous devices and gadgets:computers, Blu-Ray devices, and every other product that isdesigned in the United States and assembled in China fromcomponents made in the United States and elsewhere.

The Atlantic's James Fallows characterizes thecomplementarity of U.S. and Chinese production sharing as followingthe shape of a "Smiley Curve" plotted on a chart where theproduction process from start to finish is measured along thehorizontal axis and the value of each stage of production ismeasured on the vertical axis. U.S. value-added comes at the earlystages - in branding, product conception, engineering, and design.Chinese value-added operations occupy the middle stages - someengineering, some manufacturing and assembly, primarily. And moreU.S. value-added occurs at the end stages in logistics, retailing,and after-market servicing.12 Under this typicalproduction arrangement, collaboration, not competition, is whatlinks U.S. and Chinese workers.

Economic Frictions

Despite the enormous benefits of the bilateral relationship,Americans are more likely to be familiar with the sources offriction. Americans have heard that underhanded Chinese policieshave had a deleterious impact on U.S. manufacturing. They have beentold that China manipulates its currency to secure an unfair tradeadvantage; "illegally" dumps and sells government-subsidizedproducts in U.S. markets; maintains policies that discriminateagainst imports and favor domestic industries; steals Americanintellectual property; treats its workers poorly; degrades theenvironment; sells us tainted products; and even caused the U.S.financial crisis by lending America too muchmoney.13

There is some truth in some of those claims. But there is also agood deal of exaggeration, misinformation, and hypocrisy in them.Some ring hollow because the U.S. government - usually at thebehest of the same interests clamoring for action against China -commits the same sins.

Manufacturing the Myth ofDecline14

Nefarious Chinese trade practices are often blamed for thedecline of U.S. manufacturing. But the first problem with thatpresumption of causation is that U.S. manufacturing is simply notin decline. Until the onset of the recent recession (when virtuallyevery sector in the economy contracted), U.S. manufacturing wassetting new performance records year after year in all relevantstatistical categories: profits, revenues, investment returns,output, value-added, exports, imports, and others. In absoluteterms, the value of U.S. manufacturing has been growingcontinuously, with brief hiccups experienced during recessions overthe past several decades. As a percentage of our total economy, thevalue of manufacturing peaked in 1953 and has been declining since,but that is the product of rapid growth in the services sectors andnot - as evidenced by its absolute growth - an indication ofmanufacturing decline.

The preponderance of Chinese and other imported goods on retailstore shelves may give the impression that America does not makeanything anymore. But the fact is that American factories make lotsof things - in particular, high-value products that are less likelyto be found in retail stores - like airplanes, advanced medicaldevices, sophisticated machinery, chemicals, pharmaceuticals, andbiotechnology products. American factories are, in fact, theworld's most prolific, accounting for 21.4 percent of globalmanufacturing value-added in 2008, while China accounted for 13.4percent.15 The main reason for continued Americanindustrial preeminence is that the U.S. manufacturing sector hascontinued its transition away from labor-intensive industriestoward higher value-added production.

Regardless of manufacturing's operating performance, the metricthat matters most politically is the number of jobs in the sector.That figure reached a zenith of 19.4 million jobs in 1979 and hasbeen trending downward along roughly the same trajectory eversince. China's entry into the WTO and the subsequent increase inbilateral trade did nothing to accelerate the decline.Manufacturing job loss has very little to do with trade and a lotto do with changes in technology that lead to productivity gainsand changes in consumer tastes. China has also experienced adecline in manufacturing jobs. In fact, many more jobs have beenlost in Chinese manufacturing and for the same reasons -productivity gains. According to a 2004 study published by theConference Board, China lost 15 million manufacturing jobs between1995 and 2002, a period during which 2 million U.S. manufacturingjobs were lost.16

Policymakers in Washington have been citing a figure from theEconomic Policy Institute that attributes 2.4 million manufacturingjob losses between 2001 and 2008 to the bilateral trade deficitwith China. But that figure approximates job gains from exportvalue and job losses from import value, as though there were astraight line correlation between the figures. And it assumes thatimports do not create or support U.S. jobs. But U.S. producers -purchasing raw materials, components and capital equipment -account for more than half of the value of U.S. imports annually,according to the U.S. Bureau of Economic Analysis. Those importssupport U.S. jobs in a wide range of industries.

Furthermore, according to the results from a growing field ofresearch, only a fraction of the value of U.S. imports from Chinarepresents the cost of Chinese labor, materials and overhead. Mostof the value of those imports comes from components and rawmaterials produced in other countries, including the U.S.

In a 2006 paper, Stanford University economist Lawrence Laufound that Chinese value-added accounted for about 37% of the totalvalue of U.S. imports from China.17 In 2008, using adifferent methodology, U.S. International Trade Commissioneconomist Robert Koopman, along with economists Zhi Wang andShang-jin Wei, found the figure to be closer to 50%.18In other words, despite all the hand-wringing about the value ofimports from China, one-half to nearly two thirds of that value isnot even Chinese. Instead, it reflects the efforts of workers andcapital in other countries, including the U.S. In overstatingChinese value by 100% to 200%, the official U.S. import statisticsare a poor proxy for job loss.

The fact that China surpassed Germany to become the world'slargest exporter last year - a milestone that prompted a string of"end-of-Western-civilization" newspaper commentaries - says lessabout Chinese economic might than it does about the extent ofglobal economic integration. The global division of labor enabledby intricate transnational production and supply chains stillassigns to China primarily lower-value production and assemblyoperations.19 That alone speaks to the complementarynature of the U.S. and Chinese economies, underscores themeaninglessness of bilateral trade accounting, and magnifies theabsurdity of predicating policy on the goal of reducing a bilateraltrade deficit.

Despite occasional fireworks, both governments have mutualinterest in harmonious economic relations. Our economies areextremely interdependent. U.S. economic performance will continueto be a determinant of Chinese economic performance - and viceversa - and barring destructive policies, the pie should continueto grow larger. Much more can be done to cultivate our areas ofagreement using carrots before seriously considering the use ofsticks.

Less Provocative Alternatives

Another reason the Chinese government worries about RMBappreciation is that Chinese investors owns about $800 billion ofU.S. debt. A 25 percent appreciation in the RMB would reduce thevalue of those holdings to approximately $640 billion. That's ahigh price for China to pay, especially in light of the fact thatU.S. inflation is expected to rise in the coming years, which willfurther deflate the value of those holdings (and ease the burden ofrepayment on U.S. taxpayers). Likewise, mass dumping of U.S.government debt by Chinese investors - the much ballyhooed"leverage" that China allegedly holds over U.S. policy - wouldprecipitate a decline in the dollar as well, which also woulddepress the value of Chinese holdings. The assertion that Chinaholds U.S. debt as a favor to America, and would withdraw thatfavor on a whim, is a bit far-fetched.

China, it seems, is guilty of a failure to heed the first law ofinvestment: it failed to diversity its portfolio adequately. Theoverwhelming investment focus on U.S. public debt has left Chinaexposed to heavy losses from dollar inflation and RMB appreciation.The fact that the inflation rate is in the hands of U.S.policymakers makes China even more reluctant to allow large-scaleor, at least, precipitous, RMB appreciation.

As of the close of 2008, Chinese direct investment in the UnitedStates stood at just $1.2 billion - a mere rounding error at about0.05 percent of the $2.3 trillion in total foreign directinvestment in the United States. That figure comes nowhere close tothe amount of U.S. direct investment held by foreigners in otherbig economies. U.S. direct investment in 2008 held in the UnitedKingdom was $454 billion; $260 billion in Japan; $259 billion inthe Netherlands; $221 billion in Canada; $211 billion in Germany;$64 billion in Australia; $16 billion in South Korea; and even $1.7billion in Russia.20

If it is desirable that China recycle some of its estimated $2.4trillion in accumulated foreign reserves, U.S. policy (and thepolicy of other governments) should be more welcoming of Chineseinvestment in the private sector. Indeed, some of China's pastefforts to take equity positions or purchase U.S. companies or buyassets or land to build new production facilities have been viewedskeptically by U.S. policymakers - and scuttled - ostensibly overill-defined security concerns.

A large inflow of investment from China would have a similarimpact as a large increase in U.S. exports to China on the value ofboth countries' currencies, and on the level of China's foreignreserves. In light of China's large reserves and its need anddesire to diversify, America's need for investment in the realeconomy, and the objective of creating jobs and achieving sustainedeconomic growth, U.S. policy should be clarified so that thebenchmarks and hurdles facing Chinese investors are betterunderstood. Lowering those hurdles would encourage greater Chineseinvestment in the U.S. economy and a deepening of our mutualeconomic interests.

To reduce bilateral tensions and foster greater cooperation fromChina with respect to market access, intellectual property theft,and other legitimate U.S. concerns, the United States should offerto reform its punitive trade remedies practices toward China.Ending the practice of treating China as a non-market economy inantidumping cases would probably do more to improve bilateraleconomic relations than just about any other possible reform.

China has made no secret of its desire to be designated a marketeconomy. In essence, China's NME status is an asset to U.S.policymakers - but a rapidly depreciating one. In accordance withthe terms of its WTO accession, China's economy cannot be treatedas an NME after 2016, so U.S. policy will have to change in sixyears anyway. If U.S. policymakers want anything of value fromChina in exchange for designating it a market economy, thatdesignation has to come soon. The longer this inevitable reform isdelayed, the less valuable it becomes.

Short of graduating China to market economy status, U.S.policymakers could reduce bilateral tensions by addressing anothersystemic, methodological problem that results in Chinese exportersbeing penalized twice for the same alleged infraction. Since theCommerce Department resumed applying the countervailing duty law tonon-market economies in 2007 (after a 22-year moratorium), it hasfailed to account for the problem of "double-counting" in caseswhere imports are subject to both the antidumping andcountervailing duty laws.

Under NME methodology, a Chinese exporter's U.S. prices arecompared to a surrogate value based on costs in a third country,such as India. Any difference between the U.S. price and thatsurrogate accounts for both the dumping and subsidy margin becausethe surrogate represents a non-dumped, non-subsidized price.However, U.S. practice has been to treat that difference asreflecting only the margin of dumping, while calculating anadditional margin to reflect the subsidy only. Both the dumpingmargin (which already reflects the amount of the subsidy) and thesubsidy margin are applied as duties on Chinese imports, resultingin a double counting of the countervailing duty.

Some Hypocrisy in U.S. Allegations

Claims are numerous that China maintains discriminatory policiesthat impede imports and foreign companies. Indeed, some of thoseclaims have been substantiated and remedied. Others have only beensubstantiated. And still many more have been merely alleged.

The United States maintains formal and informal channels ofcommunication with the Chinese government through the Strategic andEconomic Dialogue, the Joint Commission on Commerce and Trade, andother venues, through which sources of economic and trade frictionare discussed and often defused. On eight occasions, the UnitedStates decided that bilateral process alone was insufficient, andlodged official complaints with the WTO Dispute Settlement Bodyabout various Chinese practices. Outcomes in two of the cases arestill pending, but six of the eight cases produced satisfactoryoutcomes from the perspective of the U.S. government: either Chinaagreed during consultations to change its rules or practices, or adispute panel affirmed most of the U.S. complaints and issuedopinions requesting that China bring its practices into conformitywith the relevant WTO agreements.

It is difficult to find merit in the suggestion that U.S. tradepolicy toward China should change tack and become moreunilateralist or provocative, when the WTO dispute settlementsystem has worked well as a venue for resolving U.S. complaints.The United States has brought 19 cases against Europe in the WTO,but there is not much talk about adopting a more strident tradepolicy toward the EU.

The fact is that China has made substantial progress sincebeginning its reforms to join the WTO. Nevertheless, some tradebarriers and subsidy programs still exist or have emerged that, ifchallenged, likely would be found to violate China's various WTOcommitments. And China should be held accountable to its marketliberalizing commitments. Still, it is up to the USTR, inconjunction with other stakeholders, to evaluate the evidence andweigh the costs and benefits before deciding whether and when tolodge official WTO complaints.

One of the costs of bringing cases against Chinese marketbarriers or policies that favor domestic firms would be theexposure of U.S. hypocrisy. The U.S. government subsidizes chosencompanies and industries, too. The past 18 months is littered withexamples, such as General Motors and Chrysler. Though the U.S.business community is concerned about the emergence of technicalmarket barriers in China favoring local companies, the U.S.government maintains opaque technical barriers in a variety ofindustries, which hampers and precludes access to the U.S. marketfor foreign food products, in particular. Mexican trucks cannoteven operate on U.S. highways. There is an element of the potcalling the kettle black in U.S. allegations.

By and large, though, the Office of the U.S. TradeRepresentative, in its December 2009 report to Congress about theimplementation of China's WTO commitments, strikes the right toneand reassures that the economics can and should be shielded fromthe vicissitudes of politics:

China has taken many impressive steps over the last eight yearsto reform its economy, while implementing a set of sweeping WTOaccession commitments that required it to reduce tariff rates, toeliminate non-tariff barriers, to provide national treatment andimproved market access for goods and services imported from theUnited States and other WTO members, to protect intellectualproperty rights, and to improve transparency. Although it stilldoes not appear to be complete in every respect, China'simplementation of its WTO commitments has led to increases in U.S.exports to China, while deepening China's integrations into theinternational trading system and facilitating and strengthening therule of law and the economic reforms that China began 30 yearsago.21

Conclusion

The world would be better off if the value of China's currencywere truly market-determined, as it would lead to more optimalresource allocations. The impact on the bilateral trade account -meaningless as that statistic is in a globalized economy - would beimpossible to predict. But compelling China to revalue under threatof sanction could produce adverse consequences - includingreductions in Americans' real incomes and damaged relations withChina - leaving us all worse off without even achieving theunderlying policy objectives.

For now, it would be better to let the storm pass and allowChina to appreciate its currency at its own pace.


1 To float its currency and letmarkets determine the value, China would have to removerestrictions on its capital account, so that investment can flow inand out of the country freely. If China did this, it is notentirely clear that the value of the RMB would appreciate. It ispossible that there would be more capital flight than inflow, asdomestic savings are able to pursue investment options outside ofChina. This capital flight would have a depreciating effect on thevalue of the RMB.
2 Of course, there are many other important determinantsof the trade account besides relative currency values.
3 There is also an "income effect" from the change incurrency values. When the dollar declines in value, U.S. consumersexperience a decline in real income, which affects theirconsumption choices. Even though Chinese imports might berelatively more expensive than they were before the currency rise,they may still be less expensive than the alternatives.Accordingly, U.S. consumers with lower real incomes might beinclined to purchase more Chinese imports.
4 Federal Reserve Board, Federal Reserve StatisticalRelease G5.A, Foreign Exchange Rates (Annual), release datesJanuary 4, 2010 and January 2, 2009. Since July 2008, the value ofthe Yuan against the dollar has not changed measurably.
5 The dearth of substitutes is probably a function ofretailers not wanting to incur the costs of having to reconfiguretheir supply chains. If the cost of reconfiguring and sourcingproducts from other countries is similar to the cost of maintainingChinese suppliers with their exchange-induced higher prices, thenretailers may be more likely to stick with the status quo and passon their higher costs to consumers.
6 Assume that the price of imports is $1 and thequantity demanded is one unit. The import value is then $1. If a15.2 percent increase in price leads to a 38.7 percent increase invalue, then quantity must increase by 20.4 percent because : (1.152x price) * (1.204 x quantity) = 138.7. 7 Robert Koopman,Zhi Wang, and Shang-jin Wei, "How Much of Chinese Exports Is ReallyMade in China? Assessing Foreign and Domestic Value-Added in GrossExports," U.S. International Trade Commission, Office of Economics,Working Paper no. 2008-03-B, March 2008.
8 Daniel J. Ikenson, "Currency Controversy: Surplus ofControversy, Deficit of Leadership," Cato Free Trade Bulletin no.21, May 31, 2006.
9 Cathy L. Jabara, "How Do Exchange Rates Affect ImportPrices? Recent Economic Literature and Data Analysis," U.S.International Trade Commission, Office of Industries Working Paperno. ID-21 (revised), October 2009.
10 U.S. Department of Commerce, Bureau of the Census,Foreign Trade Statistics,http://www.census.gov/foreign-trade/balance/c5700.html#2009. Chinawas the fastest-growing market among America's top 25 largestexport markets between 2000 and 2008. In 2009, overall U.S. exportsdeclined 12.9 percent, but exports to China held steady, decliningby just 0.23 percent.
11 Production of Apple iPod's is the quintessentialexample of the benefits of transnational production and supplychains. The degree of international collaboration embedded in thevalue of an iPod has been described in a few other Catopublications, including: Daniel Ikenson, "Made on Earth: How GlobalEconomic Integration Renders Trade Policy Obsolete," Cato TradePolicy Analysis no. 42, December 2, 2009.
12 James Fallows, "China Makes, the World Takes,"Atlantic, July/August 2007,http://www.theatlantic.com/doc/200707/shenzhen.
13 It is particularly ironic to hear this lastaccusation from spendthrift members of Congress who overlook thefact that their own profligacy is what brought China to the U.S.debt markets in the first place.
14 For more comprehensive treatments refuting the mythof manufacturing decline in the United States, see: Daniel Ikenson,"Thriving in a Global Economy: The Truth about Manufacturing andTrade," Cato Trade Policy Analysis no. 35, August 28, 2007; DanielIkenson and Scott Lincicome, "Audaciously Hopeful: How PresidentObama Can Help Restore the Pro-Trade Consensus," Cato Trade PolicyAnalysis no. 39, April 28, 2009, pp. 12-16; and Daniel Griswold,"Trading Up: How Expanding Trade Has Delivered Better Jobs andHigher Living Standards for American Workers," Cato Trade PolicyAnalysis no. 36, October 25, 2007.
15 United Nations Industrial Development Organization,"National Accounts Main Aggregates Database, Value Added byEconomic Activity," (2008 data are the most recent available),http://unstats.un.org/unsd/snaama/resQuery.asp.
16 Yuan Jiang, Yaodong Liu, Robert H. McGuckin, III,Matthew Spiegelman, and Jianyi Xu, "China's Experience withProductivity and Jobs," Conference Board Report NumberR-1352-04-RR, June 2004,http://www.conference-board.org/publications/describe.cfm?id=809.
17 Lawrence J. Lau et al., Estimates of U.S.-ChinaTrade Balances in Terms of Domestic Value-Added, working paperno. 295 (Palo Alto, CA: Stanford University, October 2006; updatedNovember 2006).
18 Robert Koopman, Zhi Wang, and Shang-jin Wei, "HowMuch of Chinese Exports Is Really Made in China? Assessing Foreignand Domestic Value-Added in Gross Exports," U.S. InternationalTrade Commission, Office of Economics, working paper no. 2008-03-B,March 2008.
19 For a more comprehensive treatment of this topic, seeDaniel Ikenson, "Made on Earth: How Global Economic IntegrationRenders Trade Policy Obsolete," Cato Trade Policy Analysis no. 42,December 12, 2009.
20 Bureau of Economic Analysis, "Foreign DirectInvestment in the United States: Selected Items by DetailedIndustry of U.S. Affiliate," 2004-2008,http://www.bea.gov/international/xls/LongIndustry.xls.
21 United States Trade Representative, 2009 Reportto Congress on China's WTO Compliance, December 2009, p.4.

Daniel J. Ikenson

U.S. Senate Committee on Banking, Housing, and Urban Affairs Subcommittee on Economic Policy