A Stronger Yuan: No Cure-All for an Ailing US economy

Apr 26 2010

A Stronger Yuan: No Cure-All for an Ailing US economy

 
Over the past several weeks a political war of words has been raging between the United States and China. At issue is the value of China’s currency, the yuan. Washington is accusing Beijing of effectively subsidizing its export industry by deliberately undervaluing its currency. In an attempt to shield itself from the global financial crisis, China has pegged its currency at 6.83 to the dollar since July 2008, which Washington says gives its economy an unfair trade advantage. The contention is that this has contributed to US job losses and is the root cause behind America’s huge trade deficit.
 
Faced with high unemployment and a fragile recovery, scores of US legislators are therefore pressuring the US Treasury Department to brand China as a ‘currency manipulator’ and, should China resist revaluing the yuan, for the Obama administration to take action and impose trade restrictions including higher tariffs on Chinese-made imports.
 
Not surprisingly, China’s President Hu Jintao has rejected these demands and has asserted that his country will not yield to outside pressure. The Chinese government’s position is that it alone will proceed with currency reforms based on its own economic and social-development needs. Thus, with the two big nations at loggerheads, the saber-rattling continues and, given all the rhetoric, the key question for investors is: will an appreciation of the yuan actually rectify the US’s trade imbalance with China?
 
China/US Trade – A Few Facts
To answer this question, a good starting point is to analyze the data on merchandise trade flows between China and the US. Table 1 highlights the trends in exports and imports between the two countries over the past five years and from this data a number of key points leap out.
 
First, US imports from China fell by 12.3% to $296.4 billion in 2009 as a result of declining US demand caused by the deep recession. However, despite the deceleration in China’s growth rate from 13.0% in 2007 to 8.7% last year, US exports to China have held their ground.
 
 
TABLE 1
US/CHINA TRADE IN GOODS
($ billions)
 
Year
US Exports to China
US Imports
from China
Trade Balance
Import/Export Ratio
2009
69.6
296.4
-226.8
4.3
2008
69.7
337.8
-268.0
4.8
2007
62.9
321.4
-258.5
5.1
2006
53.7
287.8
-234.1
5.4
2005
41.2
243.5
-202.3
5.8
Source: US Census Bureau; Chand Carmichael & Company Ltd
 
     
 
 
 
 
Second, US exports, although starting from a much lower base, have been rising at a faster pace than imports. This can be seen by examining the ratio between imports and exports (column 5). In 2005 for every dollar of goods that the US exported to China, it imported 5.8 dollars in return. However, by 2009 this ratio had fallen to 4.3 to 1 as the pace of exports accelerated.
 
Third, despite faster growth in exports, America’s trade deficit with China has continued to rise. What’s interesting to note is that for three of the five years during this period, the yuan strengthened and the dollar depreciated. One would have thought that the realignment of the dollar/yuan exchange rate would have had the intended effect of reducing the trade deficit. What gives?
 
The 2005-08 Revaluation of the Yuan
When China allowed the yuan to appreciate by 22% against the dollar from 2005 and 2008, the resulting lower prices of US goods did indeed boost US exports to China which surged by 69%. In contrast, with the dollar price of Chinese goods becoming more expensive, although US imports during this period also increased it was by ‘only’ 39%.
 
In dollar terms, over this three year period, US exports to China increased by $28.5 billion, rising from $41.2 billion in 2005 to $69.7 billion in 2008. US imports from China on the other hand increased by $94.3 billion, rising from $243.5 billion to $337.8 billion, and swamped the increase in US exports. Thus, although the 22% hike in the value of the yuan did alter the growth rates of exports and imports, because of the much lower base of US exports, the US trade deficit with China actually increased. In 2005, it was $202.3 billion but by 2008 it had jumped by nearly 33% to $268 billion.
 
A Stronger Yuan Will Not Bridge the Trade Gap
Certainly, a revaluation of the yuan, by lowering US export prices and raising import prices, will alter the two-way trade flows between China and the United States. But, because of the wide gap that exists between what the US exports to China and what it imports, a revaluation of the yuan will do little to correct the trade imbalance. In absolute terms China will still export more to the US and the trade deficit will continue to rise.
 
To put this in perspective, consider that from 2000 to 2009, US exports to China climbed by 18.2% a year while its imports increased by 13.7% annually during the last decade. Now, even if we assume that the US will be able to maintain these growth rates in exports and imports for the next 10 years, its trade defict with China would still increase. In fact, it would jump from $202.3 billion in 2009 to $700 billion by 2019. Moreover, even if US imports from China were to remain frozen at the 2009 level of $296.4 billion and US exports countinued rising at 18.2% a year, it would take nine years to achieve a balance in trade between the two countires.
 
Clearly, it is going to take a lot more than a currency revalution of the yuan to rectify the trade imbalance between China and the United States. Of course, a sharp appreciation of the yuan in the order of 50% or more would quickly change the relative prices of imports and exports and reduce China’s trade surplus with the US but this course of action is simply a non-starter.
 
China’s concern is that if it were to allow its currency to float freely on foreign exchange markets, a sharp and sudden appreciation of the yuan would rock its domestic economy and also de-stabilize the world economy. In China, millions of small-to-mid sized export-based companies that are already struggling with razor-thin profit margins would go under and send the unemployment rate soaring. Some estimates suggest that about 30 million Chinese workers could be thrown out of work.
 
Furthermore, and contrary to Washington’s claims, a sharply lower dollar would not lead to a resurgence in the US’s manufacturing sector or higher employment. Instead, it is more than likely that the scores of US corporations that have manufacturing facilities located in China will simply shift their plants to more lower cost locations such as India, Indonesia, or Vietnam. In addition, higher import prices would further squeeze the incomes of millions of US consumers who are struggling to stay afloat. Inevitably, this will lead to a slowdown in consumer spending and effectively put the nascent US recovery in jeopardy.
 
Bottom Line
Of course, China recognizes that it is in its self-interest to let the yuan rise in value. A stronger currency would increase the purchasing power of its citizens; falling import prices would help curtail rising inflation and give the central bank more leeway in conducting its monetary policy; and, by increasing dometic demand, a stronger yuan would help China rebalance its economy. But, China will manage the value of its currency on its own terms and it will do so in a deliberate and measured manner.
 
Letting the yuan appreciate against the dollar will certainly help ease the pressure between the two countries, but, as noted above, it will not solve the trade imbalance. For that to happen, the US needs to reduce its level of consumption and step up its savings rate. But with consumer spending accounting for 70% of GDP, reducing consumption risks pushing the US economy into a prolonged period of stagnation.
 
Ironically, the adjustment to a stronger yuan will be much more wrenching for the United States than it will be for China. Perhaps, Washington needs to reflect on the old adage: Be careful what you wish for….
 
 
© Copyright 2010 Chand Carmichael & Company Limited
 
About Ranga Chand
Ranga ChandRanga Chand is recognized both domestically and internationally as one of Canada's leading economists and mutual fund analysts. Professionally, he held senior positions with Canada's Department of Finance, then served as a director of the Conference Board of Canada, before joining a major stock brokerage firm. He has also taught economics at the University of Waterloo, published extensively in the field of economics, and represented Canada at numerous economic forums, including the OECD in Paris, the United Nations, and the World Institute of Economics in .
 
A media personality with a huge following, his popular television show "Talking Mutual Funds with Ranga Chand" aired weekly on Canada’s Report on Business Television (ROBTV) for three years from 2000 to 2003 and reached over 4.3 million viewers nationwide. Much in demand by organizations, industries, and associations throughout
  • Ranga Chand's Top 50 Mutual Funds
  • Ranga Chand's Getting Started with Mutual Funds
  • Best of the Best Mutual Funds, Featuring America's top 50 Heavy Hitter funds
Highly respected in the investment community, Ranga Chand is founder and President of the research and consulting firm Chand Carmichael & Company Limited, located in Ottawa, Ontario.

Back to Market Commentary Index