Nov

19

The RMB and the US trade deficit

November 19, 2009 | 1 Comment | Mark Crosby

With Obama in China this week many have been calling again for the need for greater Yuan flexibility to address the problem of global imbalances – big US trade deficits and big Chinese trade surpluses in particular.  The problem is that a flexible RMB will not solve the US trade deficit – the US trade deficit is not about a lack of competitiveness with China, but rather about excessive demand inside the US. This excess of demand has been reduced due to the GFC, but is still the main game. I published the following piece in the Age in April 2005 – I will try to update in the next few days. Of course the numbers and facts have changed in 4 1/2 years – in particular the Yuan has depreciated by about 20% against the USD, and the US trade deficit has widened. As I say below, even another 20-30% appreciation of the RMB is likely to do little to close the US trade deficit…

George Bush has again yesterday called for the Chinese government to allow the Chinese currency, the Yuan, to float. Bush has argued that China’s fixed exchange rate, at 8.28 Yuan per US dollar, gives China an unfair advantage in trade and explains why China had a trade surplus with the US of US$162 billion in 2004. The argument is that China’s currency is undervalued, and if allowed to float freely would appreciate significantly. Any appreciation of the Yuan would reduce China’s international competitiveness and allow US (and Australian) manufacturers to compete fairly with China.

 

Unfortunately for George Bush, allowing the Yuan to float will do almost nothing to reduce the US-China trade imbalance. It is probably true that floating the Yuan will lead to Yuan appreciation, though perhaps not by very much. China’s overall trade is close to being in balance – like every country that trades internationally, China has a trade surplus with some countries (like the US and Australia) and a trade deficit with some others (mostly countries elsewhere in Asia). So it isn’t the case that a big Chinese trade surplus is pointing to appreciation of the currency because such a surplus doesn’t exist. What is true is that China has a lot of inward foreign direct investment (FDI), meaning that foreigners need to get hold of Yuan to buy Chinese businesses. It is this FDI that is the real source of excess demand for Chinese currency that might lead to appreciation of the currency. But until recently there were two reasons to believe that China’s capital account balance (including FDI and other forms of foreign money inflows) might be artificially high. Firstly, Chinese citizens and businesses have been restricted from investing overseas. So money can flow in, but little can flow out. In the past year some of these restrictions have been lifted and it may be that we will see more money flowing out of China to buy foreign assets. Secondly, some of the money flowing into China has been speculative – flowing in in the hope that the Yuan will then appreciate.

 

Taking these arguments aside, imagine that the Chinese government did float the Yuan and we saw significant appreciation. A good estimate is that a 20 percent appreciation of the Yuan will at most affect the prices of China’s exports by 4 percent! The reason is that in most categories of China’s exports, goods have a significant component of import content. These imported components are largely priced in US dollars (and often sourced from other Asian countries). A Chinese widget producer selling widgets to the US for $100, but with imported components costing US$80 can still sell widgets at close to $100 after a 20 percent appreciation of the Yuan because it is only the 20 percent margin that is affected by the appreciation. If margins are allowed to fall, then export prices will rise by less than 4 percent.

 

It is hard to know how far the Yuan might appreciate if it were allowed to float, but for sure there will not be an appreciation large enough to really push up China’s export prices, and so make US manufacturing competitive again. The real problem with the US trade deficits is that the level of demand inside the US is far too great to be satisfied by US production – meaning that this excess demand must be satisfied through imports. It is George Bush’s stimulus of demand through irresponsible fiscal policy in the past 4 years that has driven US trade deficits – the fixed value of the Yuan has little to do with it.


Comments

One Response to “The RMB and the US trade deficit”

  1. Pete Murphy on November 20th, 2009 9:04 am

    Our enormous trade deficit is rightly of growing concern to Americans. Since leading the global drive toward trade liberalization by signing the Global Agreement on Tariffs and Trade in 1947, America has been transformed from the wealthiest nation on earth – its preeminent industrial power – into a skid row bum, literally begging the rest of the world for cash to keep us afloat. It’s a disgusting spectacle. Our cumulative trade deficit since 1976, financed by a sell-off of American assets, exceeds $9.5 trillion. What will happen when those assets are depleted? Today’s recession is the answer.

    Why? The American work force is the most productive on earth. Our product quality, though it may have fallen short at one time, is now on a par with the Japanese. Our workers have labored tirelessly to improve our competitiveness. Yet our deficit continues to grow. Our median wages and net worth have declined for decades. Our debt has soared.

    Clearly, there is something amiss with “free trade.” The concept of free trade is rooted in Ricardo’s principle of comparative advantage. In 1817 Ricardo hypothesized that every nation benefits when it trades what it makes best for products made best by other nations. On the surface, it seems to make sense. But is it possible that this theory is flawed in some way? Is there something that Ricardo didn’t consider?

    At this point, I should introduce myself. I am author of a book titled “Five Short Blasts: A New Economic Theory Exposes The Fatal Flaw in Globalization and Its Consequences for America.” My theory is that, as population density rises beyond some optimum level, per capita consumption begins to decline. This occurs because, as people are forced to crowd together and conserve space, it becomes ever more impractical to own many products. Falling per capita consumption, in the face of rising productivity (per capita output, which always rises), inevitably yields rising unemployment and poverty.

    This theory has huge ramifications for U.S. policy toward population management (especially immigration policy) and trade. The implications for population policy may be obvious, but why trade? It’s because these effects of an excessive population density – rising unemployment and poverty – are actually imported when we attempt to engage in free trade in manufactured goods with a nation that is much more densely populated. Our economies combine. The work of manufacturing is spread evenly across the combined labor force. But, while the more densely populated nation gets free access to a healthy market, all we get in return is access to a market emaciated by over-crowding and low per capita consumption. The result is an automatic, irreversible trade deficit and loss of jobs, tantamount to economic suicide.

    One need look no further than the U.S.’s trade data for proof of this effect. Using 2006 data, an in-depth analysis reveals that, of our top twenty per capita trade deficits in manufactured goods (the trade deficit divided by the population of the country in question), eighteen are with nations much more densely populated than our own. Even more revealing, if the nations of the world are divided equally around the median population density, the U.S. had a trade surplus in manufactured goods of $17 billion with the half of nations below the median population density. With the half above the median, we had a $480 billion deficit!

    Our trade deficit with China is getting all of the attention these days. But, when expressed in per capita terms, our deficit with China in manufactured goods is rather unremarkable – nineteenth on the list. Our per capita deficit with other nations such as Japan, Germany, Mexico, Korea and others (all much more densely populated than the U.S.) is worse. My point is not that our deficit with China isn’t a problem, but rather that it’s exactly what we should have expected when we suddenly applied a trade policy that was a proven failure around the world to a country with one fifth of the world’s population.

    Ricardo’s principle of comparative advantage is overly simplistic and flawed because it does not take into consideration this population density effect and what happens when two nations grossly disparate in population density attempt to trade freely in manufactured goods. While free trade in natural resources and free trade in manufactured goods between nations of roughly equal population density is indeed beneficial, just as Ricardo predicts, it’s a sure-fire loser when attempting to trade freely in manufactured goods with a nation with an excessive population density.

    If you‘re interested in learning more about this important new economic theory, then I invite you to visit either of my web sites at OpenWindowPublishingCo.com or PeteMurphy.wordpress.com where you can read the preface, join in the blog discussion and, of course, buy the book if you like. (It’s also available at Amazon.com.)

    Pete Murphy
    Author, “Five Short Blasts”