Currency Controversy: Surplus of Politics, Deficit of Leadership

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Earlier this month the U.S. Department of the Treasury issuedits much-anticipated, semiannual "Report to the Congress onInternational Economic and Exchange Rate Policies." The report'skey conclusion, that China is not a currency manipulator, was metwith incredulity on the part of a number of members of Congress,some of whom suggested that Treasury's inaction would move themcloser to enacting provocative legislation to compel China to allowthe yuan to rise.To them, it's simple. China's currency is purposely undervalued toencourage Chinese exports and discourage imports. Such"manipulation" explains much of the bilateral trade deficit, whichis costing U.S. jobs. Thus, appreciation of the yuan is a matter ofsuch urgency that any adverse consequences of compelling thatoutcome would be trivial by comparison.Leaving aside the facts that U.S. employment growth has been robustduring decades of rising Chinese imports and that today'sunemployment rate is well below historic averages, the fixation onChinese currency adjustment as a cure for the trade deficit ismisguided.1 Mosteconomists agree that China's currency is undervalued, but opinionsdiverge on the relationship between the yuan and the trade balance.Conceivably, the deficit could grow even larger, as has been thecase with nearly all of our major trading partners over the pastfour years despite a concurrent weakening of the dollar.At a minimum, supporters of the Schumer-Graham bill, which callsfor a 27.5 percent tariff on all imports from China unless anduntil the yuan appreciates by an amount deemed sufficient byCongress, should divert some of their energies from obsessing aboutthis issue to assessing whether appreciation of the yuan would evenaccomplish the objective of reducing the bilateral trade deficit.If they are so convinced, they should then weigh the prospectivebenefits of a smaller deficit against the costs of a stronger yuanand the costs of threatening or imposing sanctions to compel Chinato act on this matter. Americans deserve greater circumspection andless demagoguery from their elected officials--particularly whenthe economic stakes are so high.

Currency and Trade Flows--The Real Story

Many members of Congress have adopted the view that anintentionally undervalued yuan is the primary cause of the deficit with China. Accordingly, revaluation of the Chinesecurrency is the central component of an attempt to restore greaterbalance of trade. As the yuan appreciates, the relative prices ofChinese-produced goods to American businesses and consumers willrise, reducing U.S. demand for Chinese imports. Simultaneously, therelative prices of U.S. products to Chinese purchasers willdecrease, allowing U.S. exports to rise. At least, that is thetheory.But evidence suggests that the effects of other factors, such aschanges in relative incomes and wealth, the availability ofdomestic and other foreign substitutes, and the real costs andopportunity costs of finding new suppliers, might play a moresignificant role than relative price changes in predicting tradeflows. A review of the relationship between the dollar and tradewith our major partners suggests that currency values have hadlittle to do with changes in the trade balance in recentyears.The top 10 trade partners of the United States accounted for 75percent of all U.S. trade in goods during 2005.2 Eight of the 10 have free-floatingcurrencies, while China's and Malaysia's currencies have beentightly managed. In January 2002 the value of the U.S. dollarpeaked against the currencies of most major trading partners. Sincethen there has been a nearly continuous decline in the dollar'svalue against all of the major floating currencies with theexception of the Mexican peso. Thus, the dollar depreciated againstthe currencies of seven of our eight largest trade partners thatfloat their currencies. But with the exception of Taiwan, thebilateral U.S. deficits grew with each partner over the period.

Currency and Trade Flows

Table 1 shows that the U.S. dollar depreciated against theCanadian dollar by 23 percent between 2002 and 2005. But whathappened to the bilateral trade balance over this period? Thedeficit expanded from $48 billion to $76 billion, or by 58 percent.Yes, exports rose considerably, as theory might suggest, from $161billion to $211 billion, or 31 percent. But imports increased by aneven faster 38 percent, rising from $209 billion in 2002 to $288billion in 2005.The same is true for the 12 members of the European Union that haveadopted the Euro as their official currencies. In 2005 the U.S.dollar had declined against the euro by 24 percent from its 2002value. But did the trade deficit shrink? No, it increased by 39percent over the period to $90 billion. Again, U.S. export growth,which was 30 percent between 2002 and 2005, was outpaced by U.S.import growth of 33 percent.Of all of the other major U.S. trading partners whose currenciesappreciated against the dollar--Japan, the United Kingdom, Korea,Taiwan, and Brazil--only Taiwan had a trade surplus with the UnitedStates that declined over the period. And that decline was arelatively modest 8 percent. In contrast, the U.S. deficitincreased by 18 percent with Japan, 22 percent with Korea, 71percent with the United Kingdom, and 181 percent with Brazil.In each of those cases, foreign currency appreciation (in somecases quite substantial) was met by increased U.S. consumption. Andin every case but Taiwan's, U.S. import growth exceeded exportgrowth, leading to larger trade deficits over the period.Policymakers--in particular, those supportive ofSchumer-Graham--should consider this real-world experience beforecommitting to imposing sanctions against China.

Potential Consequences of an AppreciatingYuan

Much has been made of the Chinese trade surplus with the UnitedStates. That surplus reached $201 billion in 2005 and contributedto a record $100 billion Chinese trade surplus with the world. Butthese figures tell another relevant story, which has been largelyignored by policymakers and the media.Factoring out its surplus with the United States, China ran a $100billion trade deficit with the rest of the world in 2005. That factin itself is a fairly strong rebuttal to the premise that Chinesecurrency policy deters imports. But like manufacturers in theUnited States, Chinese producers rely on imported raw materials andcomponents to stoke their industrial machines. Appreciation of theyuan would only reduce the prices of those imported materials toChinese producers, enabling them to lower their costs ofproduction, and ultimately their selling prices, without dentingtheir profits. Conceivably, lower Chinese selling prices madepossible by cheaper inputs and higher U.S. prices caused by moreexpensive inputs could mitigate the impact of the yuan'sappreciation on the bilateral trade account that many U.S.policymakers seem to expect.Furthermore, increased Chinese purchasing power stemming fromappreciation of the yuan could inspire even greater demand forcommodities such as copper, iron ore, and oil as the relativeprices of those inputs decrease in China. That might be good forChina and for the companies around the world that export theproducts that Chinese businesses and consumers want to purchase.But increased demand in China--particularly for commodities proneto supply constraints--might also drive up U.S. prices beyondlevels normally associated with a depreciating dollar. And thatcould present serious problems for a U.S. economy that is trying todigest near-record oil prices without contracting.With investment in U.S. Treasury bills, bonds and notes in therange $262 billion to $321 billion, China is the second-largestholder of U.S. government debt.3 Any appreciation of the yuan vis-a-vis the dollarwill reduce the value of those holdings. By demanding that theChinese currency be allowed to rise, by say 27.5 percent, U.S.policymakers are effectively telling the Chinese that their loanswill be repaid at 72.5 cents on the dollar. That is clearly not inChina's interest.Furthermore, an abrupt shift in holdings by the Chinese from thedollar to the euro, for example, could cause a rapid decline in thevalue of the dollar and a steep increase in U.S. interest rates. Ifthe dollar declines dramatically, the value of Chinese holdings ofU.S. debt will drop commensurately. If the United States is forcedto raise interest rates precipitously, the economy could slow orcontract, reducing U.S. demand for Chinese products.This is a delicate issue that will require gradual adjustment.Ultimately, it is in China's interest to have a free-floatingcurrency and to remove controls on the flow of capital, but as thatprocess takes shape, U.S. policymakers should try to comprehendthat currency adjustments affect more than just bilateral tradeflows.In the grand scheme of things, the trade balance has preciouslittle to do with trade policy. It has everything to do with habitsof saving and consumption. Americans save very little--around 0percent at the household level--while Chinese savings rates areamong the highest in the world. Excess Chinese savings finds itsway into the U.S. Treasury, which must borrow from abroad to fundthe U.S. budget deficit. The willingness of the Chinese to investtheir savings in the United States helps to keep interest rateslower, the dollar higher, and American consumers feelingwealthier.If the objective of policy is balanced trade, then policymakersshould focus their attention on tax and fiscal policy toincentivize different patterns of savings and consumption. If U.S.policymakers exercised greater restraint in their own spendingdecisions, so that the government did not have to borrow so muchfrom abroad, and less time scapegoating the Chinese, the tradeaccount would likely move toward greater balance.


It is unclear how appreciation of the Chinese yuan would affectthe balance of trade between the United States and China. Yet, manyU.S. policymakers are so convinced--at least rhetorically--thatappreciation would reduce the U.S. trade deficit that they wouldeven support sanctions to compel that outcome. Not only does thatposition reflect ignorance of the factual record that shows risingU.S. deficits with nearly all of our major trade partners despite acontinuous decline in the dollar's value, but it fails to reflectadequate consideration of other likely consequences.A stronger yuan would reduce the relative prices of materials andcomponents imported by Chinese producers, thereby enabling them toreduce their own selling prices. And greater Chinese demand forcommodities would likely drive up prices for those products in theUnited States. That would constitute a double whammy for U.S.consumers and businesses, whose purchasing power will have alreadybeen reduced by the declining value of the dollar.Finally, if the sanctions that are being threatened were ever to beimposed, it would not take long before the economy felt the pain ofa 27.5 percent tax on imports from our second-largest foreignsupplier. And likely retaliation from China would make mattersworse.On matters of international trade, Americans should be concernedabout surpluses and deficits. We suffer from a surplus of politicsand a deficit of real leadership. Policymakers can start to remedythe imbalance by acting more fiscally responsible and carefullyreassessing their positions on the currency issue.

1. The CivilianUnemployment Rate, as tabulated by the Department of Labor, Bureauof Labor Statistics, was 4.7 percent in April 2006. That comparesfavorably to averages over the most recent five decades: 4.8percent in the 1960s; 6.2 percent in the 1970s; 7.3 percent in the1980s; 5.8 percent in the 1990s, and; 5.2 percent since 2000.

2. The top ten tradepartners in descending order of trade are Canada, the European-12(the 12 members of the European Union that use the Euro: Austria,Belgium, Finland, France, Germany, Greece, Ireland, Italy,Luxembourg, Netherlands, Portugal, and Spain), Mexico, China,Japan, the United Kingdom, Korea, Taiwan, Malaysia, and Brazil.

3. U.S. Department of theTreasury, "Major Foreign Holders of Treasury Securities," May 15,2006, indicates that China held $321 billion of U.S. governmentdebt at the end of March 2006. But in a speech before the SenateFinance Committee on March 29, 2006, Timothy Adams, under secretaryfor international affairs, U.S. Department of the Treasury,indicated that China's holdings amounted to about 3.2 percent ofthe total U.S. public debt of $8.2 trillion, which equals roughly$262 billion.