In recent years many of those jobs lost to Mexico have moved to Asia, and particularly to China. China’s accession to WTO in 2001 opened up new markets for China, and created huge challenges for countries like Mexico that compete in the low skill intensive export arena. But Mexico has continued to grow its trade with the United States even in the face of these challenges, with total exports to the US of more than US$215 billion in 2008, and a trade surplus with the US of US$64 billion. Interestingly, this bilateral trade surplus occurs despite Mexico’s floating exchange rate.

Today the major complaint from the US on the international trade front concerns “currency manipulation” by China. China fixed its exchange rate against the US dollar at 8.28 Yuan to US$1 from 1995 until mid-2005, since which time China has allowed the exchange rate to appreciate to around 6.8 today. But many in the US complain that this appreciation is too slow, artificially improving China’s competitiveness and leading to very large trade surpluses with the US – amounting to US$266 billion in 2008. Paul Krugman this week suggested in the New York Times that this artificially sustained demand in China at the expense of other countries, including the US.

But the problem with US trade deficits has little to do with the value of the Chinese currency. This year the US trade deficit with China, as with Mexico and most other countries, has narrowed significantly. The US trade deficit to the end of September was “only” US$165 billion with China, and US$32 billion with Mexico. The closing of the trade gap has little to do with exchange rate movements but is due to weakness in demand in the US, with consumers in particular buying far fewer imported goods. It is these trends in overall demand in the US economy that have been the major driver of US trade deficits.

 Growth in the US trade and current account deficits in recent years have been driven by strong growth in US demand relative to the ability of the US to produce output. Until the GFC consumer demand grew very strongly on the back of rising wealth, and large government deficits also raised demand. These factors were the major driver of the US trade deficit, and for the US to move towards balanced trade requires these demand and supply factors in the US to return to equality, rather than major exchange rate realignments.

Of course it must be true that an exchange rate realignment will move global trade between countries. But the point that is often missed about China’s trade is that China is a very large importer, as well as exporter of goods, with a lot of exported goods containing  high levels of imported content. After NAFTA was passed the production and assembly of televisions largely exited the US and moved to Mexico. Early in this decade much of this production moved to China. But most TVs are assembled in China with up to 90% imported components, mostly imported from other parts of Asia. The fact that relatively little value is added means that a lot of the cost of China’s exports is related to costs in other parts of Asia, rather than Chinese costs. For this reason even a very large further appreciation of the Yuan is likely to lead only to a much smaller increase in Chinese goods prices. A typical estimate suggests that a 20 percent appreciation of the Yuan leads only to about a 4 percent increase in Chinese export prices. The implication of this is that even a very large appreciation of the Chinese currency will have only a small impact on China’s competitiveness, and on China’s trade surplus with the United States. For the United States to start producing TVs again even a Yuan appreciation towards zero isn’t going to be enough!

In the end the US trade deficit is about factors that US policymakers can address directly, and little about the value of the Yuan. Ensuring that demand is consistent with supply is the major factor. As the US economy recovers the budget deficit must be reduced in a manner consistent with continued economic growth, and consumers need to save as well as spend. This internal rebalancing in the US will not be easy, but if a reduced trade deficit is a priority then this is the means to that end.