Friday, October 25, 2013

Dealing with China

In 2012 the US had a trade deficit with China of $315.0B.  That is, the US exported $110.6 to China while importing $425.6B of goods and services[1].  This is an extraordinary imbalance and constitutes the largest single contributor to the total trade deficit of $735B that same year.

Why would China want to run such a huge trade surplus with the US? And why would the US allow such a situation to continue so long?  There has been much speculation about these reasons.  Mainly because in politics the announced reasons are often not the real reasons.  So, I will also speculate about these as well.

For the first question, the Chinese have been growing their economy at a furious rate of about 8-10%/year in a bid to become a technologically advanced, developed nation.

In order to do this they need to spur domestic development at a level that is much higher than in the developed countries.  To do so using only domestic resources and investment mechanisms would likely proceed at a slower rate simply due to the inherent difficulties in growing that quickly.  Instead, the Chinese are supplementing growth by exporting the excess production, mainly to the US.  Thus, the US provides the demand to spur growth that would not generally come at home in China so quickly.  The other reason, which may be the more important one, is that China wants to import advanced technology that is only available in the west, and in the US in particular.  Many of the deals China now makes are not to purchase goods and services from the US with its vast holdings of USD, but to buy US companies with technologies that they need.  Or, to enter into production agreements with US firms which requires the US company to share their technology with their Chinese counterpart.

Why the US would allow this?  From a national perspective this ongoing deficit is bad as it adds to the total deficit and reduces employment in manufacturing in the US.  Worse, it transfers important technology from US companies to Chinese ones, or transfers the whole company to China.  Who benefits from this situation?  Well, US companies that move manufacturing to China can reduce their manufacturing costs to generate larger profits, as long as the Chinese Yuan (CNY) remains low relative to the USD.  That's the key for US companies, a low Yuan.  If the Yuan rises in value relative to the USD then the advantages of manufacturing in China drop and will eventually disappear, and so will their out-sized profits.

China, it is well known, intervenes in the currency market to keep the Yuan low against the dollar.  This keeps their exports up and technology flowing in.  It also pleases US companies that import from China, as they can continue to generate large profits.  But this creates the trade imbalance that doesn't allow market forces to bring trade into balance, and continues all the dislocations to the economy that have occurred.  One would think that the advocates of free trade would be furious at this and vociferous in their demands for market exchange rates for the Yuan.  But, hardly a peep.  The US sends some trade delegates, and even the President, to ask for a floating Yuan, but nothing happens.  In response, Washington does nothing.  Why would the Chinese change anything if there are no consequences to their policies?

The traditional solution to this is again the tariff.  Imposing a tariff is the needed consequence to not allowing the Yuan to float.  To be clear, a tariff for this reason has nothing to do with trade imbalances that exist for reasons other than China's intervention in the Yuan currency market.  The sole reason is that the currency market is designed to work only when exchanges of currencies are due to market forces alone.  Intervention breaks this system, so either China needs to play by the rules or we need a new system.  Now, I'm not a fan of floating market currency systems, as they have many problems that have be previously discussed.  But, at a minimum, if we're going to use this system then all participants need to play by the rules.  Or else face consequences.

A significant tariff (in a previous post I suggested ~60% for general trade) should be applied to imports from China.  The Chinese might not like this, as it thwarts their plan for growth and technology acquisition, and US companies which import would certainly not like the immediate hit to their bottom line.  So, imposing a tariff would largely be a political fight.  But with such powerful foes like China and US corporations on one side, who will represent America's interests in this fight?


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