Revaluing Chinese yuan won't solve trade deficit and indebtedness

Vijay K. Mathur

Published in Standard-Examiner, September 23, 2010, Ogden, UT

We are hearing the call for protectionist policies from the political right and left in response to the manipulation of yuan (also called renminbi) by China. An academic study by Thomas Oatley in Business and Politics, 2010, argues that trade politics and exchange rate politics are interrelated. He finds that as the exchange rate, adjusted for price, appreciates beyond some optimum level, a large share of businesses competing with imports support protectionist policies. Undervaluation of the currency by China makes U.S. exports more expensive than Chinese imports. This situation is partly due to our rising trade deficit with China, which increased 171 percent from 2000 to 2009.

As our trade deficit with China worsens and our debt to China increases, concern about currency manipulation becomes more worrisome because it weighs down the economic recovery process.

Trade deficit and international debt of the US are related. International accounting teaches us that when exports are less than imports, causing a trade deficit, China will acquire more U.S. assets than Chinese assets held by U.S. (net debt to China). Hence more trade deficit implies more net debt to China. 

What can be done to reduce our debt to China? Decrease our imports and increase our exports. It will also help if we start consuming less and saving more. Reduced consumption reduces imports, allows a greater supply of our goods and services available for export, thus improving trade deficit. More saving will also provide more domestic capital for our investment projects and reduce Chinese ownership of public debt. In addition, when Chinese buy large amounts of our private or public bonds, prices of bonds increase and interest rates decrease, adversely affecting our retirees who are dependent on earnings from bonds.

Are Chinese manipulating their currency to keep the price of the yuan low against the dollar? The Wall Street Journal reported on Sept. 1 that in "mid-June, China rolled out a new currency policy that freed the yuan from its two-year defacto peg to the U.S. dollar." But in spite of this policy change, yuan has not appreciated much against the dollar. In fact the exchange rate of yuan with dollar has been fairly constant since 2008. However, it must be noted that even if yuan becomes expensive relative to dollar, our trade deficit may still not appreciably decrease. It all depends upon the sensitivity of our consumption to import-price increases, demand of our exports to price decreases in China and the response of our businesses to increase the supply of products demanded by Chinese consumers. Moreover if Chinese do appreciate their currency, they may switch to the exports of more high-end products which bring the same or more export revenue to China.

Some economists argue that over time Chinese labor will demand higher wages, thus increasing cost of production and consequently prices. This will favor our exports against imports from China. This expectation is based on the fact that China's workforce is aging and hence reduced labor supply will put upward pressure on wages, assuming that China continues to grow robustly in the future. That will help narrow the trade deficit in the long run, even without the appreciation of the yuan against the dollar. 

The empirical evidence of wage increase on prices and its affect on exports of a country is thin at best. If wages increase relative to the price of capital, China may respond by substituting capital for labor. This will reduce their cost and put downward pressure on wages and prices. China may also respond by producing high value-added products which directly compete with the U.S,; some evidence seems to suggest that China is already moving in that direction.

These actions may offset the effect of yuan appreciation. Yuan appreciation is not a panacea for fixing the trade deficit and indebtedness to China. Besides putting pressure on China to make the yuan flexible against the dollar, we also have to invest more in developing high level skills and accumulate human capital. We must innovate more, develop new technologies, produce more competitive products for the international markets using our own technologies and innovations, reduce outsourcing, and save more to generate more internal capital for investment in future technologies.

Former CEO and Chairmen of Intel, Andy Grove, remarks in his essay in Bloomberg Business that "the underlying problem isn't simply lower Asian cost. It's our own misplaced faith in the power of startups to create U.S. jobs. ... Equally important is what comes after that mythical moment of creation in the garage, as technology goes from prototype to mass production."

Mathur is former chair of the economics department and professor emeritus of economics at Cleveland Sate University, Cleveland, Ohio. He resides in Ogden. His articles also appear in vijaykmathur.blogspot.com.