The United States has a major problem contained within its economic relationship with China, as highlighted by the recent presidential debates. Trade deficits, outsourcing, currency manipulation and government subsidies are all factors that riddle our often contentious affair with Asia’s largest economy.
In 2011, the U.S. maintained a $295 billion trade deficit with China, and millions of jobs have moved overseas as companies look for ways to lower overhead by taking advantage of lower costs of living abroad. As bad as this trend is for the U.S., China is hurt even more by other effects of this situation.
The crux of this dilemma is the Chinese government’s artificial devaluation of their national currency, the yuan. In order to maintain huge trade imbalances, the Chinese government pegs the currency artificially low against the dollar, thus ensuring that their domestic manufactures possess a competitive advantage against other nations’ relatively more expensive products.
To maintain currency disparity, the People’s Bank of China must buy dollars and sell yuan, since currencies naturally balance as a result of trade in an international free market.
For example, if an American construction company buys a million dollars worth of steel, the Chinese producer must then trade those dollars for yuan, thus increasing the supply of dollars while increasing the demand for yuan in currency markets. Because dollars are now more abundant and yuan less so, dollars will depreciate against the scarcer yuan, and the yuan will grow closer in parity to the dollar. Thus products from America become comparatively less expensive, while Chinese products more so.
However, since the Chinese government actively seeks to maintain a trade imbalance, they rig the system by buying up dollars and selling yuan, thus making the yuan artificially cheap, allowing Chinese products to be inexpensive and unfairly competitive on the world market.
This system ultimately hurts the Chinese people while enriching Americans with cheap products.
In currency trading, value is neither created nor destroyed, but currencies’ values are transferred to each other through fluctuating levels of supply and demand. By pegging the yuan low against the dollar, the Chinese government is adding value to American currency and standard of living by subtracting it from its people. With the yuan artificially inexpensive, products made in China but destined for export are out of reach for the Chinese workers who produce them and earn their wages in artificially devalued yuan.
If the yuan were allowed to rise, this would give the Chinese people more purchasing power, and make their products more widely available on their domestic market. However, trade imbalances enrich the Chinese state as massive dollar reserves are built up and reloaned to the U.S. government for its annual budgetary blowouts.
A cheap yuan also encourages the U.S. economy by enriching it with products that would otherwise be more expensive, thus raising Americans’ standard of living by lowering product prices. The Chinese government also consumes inflation pressure by purchasing excess dollars brought about by the trade imbalance, thus helping tamp down on the monetary excesses of the quantitative easing sessions.
The dilemma for the U.S. is how to coerce the Chinese from manipulating their currency, but despite the rhetoric, this will be a problem that the Chinese, not Americans, will solve. At a certain point, the Chinese government will decide that the dollar is no longer a viable reserve currency in the wake of lax American monetary and fiscal policy.
Chinese officials are already voicing concerns over the Fed’s quantitative easing, and if the dollar begins to lose value, China could decide to sell much of its vast dollar reserves and thus appreciate its currency. Instead of exporting their products, this action would allow an unprecedented rise in prosperity for the average Chinese citizen and encourage a massive domestic market for their products. Perhaps they would even create a new reserve currency in league with other emerging economic powerhouses in order to avoid the mercurial manipulated dollar.
For the U.S., deep recession would be inevitable as cheap goods become expensive and economic activity reacts accordingly. Inflation could also increase, both from higher consumer prices and the flooding of currency markets with hoarded dollars.
Chinese currency manipulation is a problem with few satisfactory solutions. One thing is clear; the U.S. needs China more so than vice-versa. Despite my personal sympathies, China monetary hawks who advocate an end to yuan manipulation should be careful what they wish for; they just might get it.