My Blog

December 19, 2007

According to the Commerce Department, the U.S. current account deficit fell to $178.5 billion in the third quarter, the equivalent of 5.1% of GDP.  This is happening at the same time that Europe’s trade deficit is surging.  Part of this reduction in the trade deficit may be caused by a slowdown in the growth of US demand, but it seems pretty clear that relative currency values do matter to a country’s trade balance.

In today’s International Herald tribune there is a piece by Behzad Yaghmaian, a US-based academic, on why, regarding US-China trade, “the yuan is not the problem.”  Yaghmaian makes the argument that a revaluation of the RMB would not fix the US trade imbalance with China.  Part of the argument is pretty standard.  In his words:

The revaluation of the yuan would have had the desired effect were the goods imported from China also produced in the United States. Facing the rising prices of imports caused by the revaluation, some American consumers would have switched to domestic substitutes.  

But that is not the situation with most Chinese imports, for which there are few American substitutes. The Chinese apparel, computer parts, electronics, furniture, toys and many other things in the lengthening list of imports no longer compete with similar American products. If not from China, the United States would have to buy them from elsewhere. The deficit would remain; it would only be with other countries.

Yaghmaian adds the point, however, that a significant and growing component of the trade relationship between the US and China is the value of subcontracted imports.  This component tends to be priced in US dollars, and he argues that if the RMB were revalued it would not affect the relative value of the goods sold into the US, so it would not affect the trade balance.  He adds:

However, the revaluation hurts the profitability of the subcontractors that face a reduction in their income after conversion to the local currency. To make matters worse, many American firms have been demanding lower prices from their subcontractors, threatening to move to India, Vietnam or elsewhere

I don’t fully agree with this point for two reasons.  First, if Chinese companies were not able to absorb the lower value of the dollar by reducing profits, a revaluation would force them to charge higher prices on their contracts in the future.  This might not be soon enough to help many of them from avoiding bankruptcy, but it would nonetheless affect the price of Chinese goods in the US.  

Second, many countries in Asian are suffering, like China, from the monetary consequences of holding down the value of their currencies against the US dollar, and are only unwilling to allow their own currencies to appreciate because they fear losing out to cheaper Chinese production.  If China were to permit more flexibility in the value of the RMB, a number of other countries in Asian would also follow suit.

Still, I think he is right in pointing out that a revaluation would be painful for many small exporting companies who have not in the past been able to hedge the value of the dollar, and this must be at least part of the reason why Chinese financial authorities have dragged their feet for so long in adjusting the currency.  He agrees that streamlining the market and weeding out inefficient producers may be a welcome consequence in the longer term of the policy for China, but he still worries that such a policy would in the short-term effect pose greater hardship for Chinese workers

I don’t disagree at all with Yaghmaian’s argument as far as it goes, but I think he makes the same mistake that other American defenders of China’s foreign exchange policy make – he sees China’s RMB policy purely from the point of view of trade and only looks at the direct impact a revaluation will have on relative pricing.  But as I have argued many times before, the real reason China must revalue is to attempt to regain some control over its explosive monetary growth and, were it to do so, the trade relationship would indeed change, and change dramatically.  

It is not the cheapness of the RMB that is the primary cause of the huge and growing Chinese trade surplus.  It is the fact that China has locked itself into a monetary policy that forces excessive momentary expansion as the PBoC has to buy up the torrent of dollars that flow into the country via the trade and capital accounts.  Thanks to inefficiencies in its financial sector very easy money automatically forces industrial production to grow at unhealthy rates, and this growing industrial production has not and cannot be absorbed by rising domestic consumption.  The consequence is a currency regime that forces Chinese exports to grow more quickly than its imports, and so forces a rising trade surplus.  China’s trade surplus is basically a residual of the growing imbalance between Chinese production and consumption, and this imbalance is growing precisely because of the currency regime.

Comments (3) for "The value of the RMB DOES ma...

It is a game. While other Asian countries fear China's cheap goods. China is afraid that the other countries can take Chinese share too. The idea of rising domestic consumption is just a lip service since the wage rate in a labor-intensive economy is mostly flat. It probably will take at least another 10 years to establish a relatively complete capital-intensive economy to absorb workers and increase personal income. By fatbrick - 12/18/2007 10:04 PM

"... surplus is basically a residual of the growing imbalance between Chinese production and consumption..." I would have agreed if this is referring to a developed country. But in case of China, does this sound right? I always thought China's export-oriented productions are somewhat de-linked from its domestic consumptions... I must say I don't know the answer with certainty. Does this feel right? By zh - 12/19/2007 3:55 AM

ZH, it is mostly an accounting identity. If a country produces more than it consumes, it must run a trade surplus, and vice versa. In that sense faster nominal growth in production than in consumption implies a rising trade surplus. By Michael Pettis - 12/19/2007 1:13 PM