Comment 76: U. S. Trade Deficit with China and the Impact of Chinese Yuan Revaluation (July 12, 2010)

Recently the revaluation of Chinese Yuan has become a focal point of interest again since U. S. trade deficit with China has started to move up anew after a short hiatus during the global economic crises. On one extreme some claim that Chinese Yuan needs to appreciate 50 to 60% vs. U. S. Dollar to bring the trade imbalance under control. At the other extreme some insist that the gradual appreciation of Chinese Yuan from the middle of 2005 to the middle of 2008 failed to dent the trade deficit so no pressure on Chinese Yuan should be applied from the side of The United States. Here we will treat economics like a real science, and will start from actual data, derive the existing relations between the trade deficit and the valuation of Yuan, and then analyze the future course of U. S. trade deficit with China. Before going into the actual analysis of the relevant data, we need to discuss some general characteristics of the relation between currency movements and trade imbalances.

The misalignment of currencies is usually a potent force to cause runaway trade imbalances. There is a time delay between a major realignment of currencies and for the effect to appear in the trade balances. The reason of the time delay is as follows: Suppose the currency of an exporting country suddenly devaluates by a significant amount against the currency of an importing country. The exporters in the former country naturally want to expand their exports and make more profits. But the exporters need to draw up plans, raise capital, construct factories, install machines, hire workers, and then can produce and export more. All those processes take time and thus the time delay. On the other hand if the currency movement is adverse for the exporters, they will try to keep their market shares by cutting back their profit margins instead of immediately raising the prices of their products to drive away their customers until some weak exporters are shaken out, the supply and demand balances and the trade imbalance improves. A typical time delay from the currency movement to its reflection on the trade imbalance is like two years. However, this time delay depends on the level of added-value of the product involved. Higher value-added goods display longer time delay from currency movements due to the sophistication of the manufacturing processes and higher profit margins. Labor intensive and low value-added goods can move much faster following the currency movements. In case of China, the typical time delay is less than one year as will be shown below.

In the graph at the right-hand side, the monthly average of Chinese Yuan per U. S. Dollar is plotted as the red curve. The monthly average is obtained from the website of The Federal Reserve. The green curve in the graph is the 12 month running sum of U. S. trade deficit with China plotted in log-10 scale. The 12 month running sum is calculated as follows: Let us take the 12 month running sum of December, 2009 as an example. The monthly US-China trade deficits from January, 2009 to December, 2009 are summed to form the 12 month running sum of December, 2009. The 12 month running sum at December, 2009 does not describe the condition at December, 2009, but describes the average condition of the whole year of 2009; it is more fitting to consider the 12 month running sum of December, 2009 as the average condition in the middle of 2009 so the data point is plotted at the time scale of June, 2009, and so on. The monthly data of U. S. trade deficit with China is obtained from the website of The Census Bureau. We should also note that in a logarithmic curve, a straight line implies a constant rate of growth or decline. Thus by looking at the slope of the green curve, we can immediately see whether the growth rate of U. S. trade deficit with China is changing or not.

The most prominent feature of the red Chinese Yuan-U. S. Dollar curve is the drastic devaluation of Yuan vs. Dollar in the transition from year 1993 to year 1994. Yuan plunged from about 5.83 per Dollar level of December, 1993 to 8.79 Yuan per Dollar by January of 1994. Promptly the slope of the green trade deficit curve steepened. Considering that the green curve is shifted toward left by six months, this correlation between the drastic devaluation of Yuan and the acceleration of the growth rate of U. S. trade deficit with China means that the time delay factor as discussed in the previous paragraph is less than one year for the case of China. The drastic 1993-1994 devaluation of Yuan caused U. S. Government to label China as a "currency manipulator" in 1994, and that label forced Chinese Government to let Yuan appreciate a little from its drastically devalued level. The small retracement of Yuan caused the slope of the green curve to moderate somewhat in the middle of 1994. The continued small retracement of Yuan in combination with the economic slowdown of The U. S. in 1995 induced the flattening of the green trade deficit curve in 1995. During the U. S. economic slowdown, Chinese Government stopped the gentle retracement of Yuan and had kept Yuan at the level slightly above 8.2 Yuan/Dollar until the middle of 2005. As U. S. economy picked up speed from 1995 slowdown, the green trade deficit curve surged up rapidly again. It was the vastly undervalued Yuan that enabled China to weather the storm of Asian financial crises of 1996 that was induced by Japan’s near zero interest rate policy as discussed in article 1. The prolonged stagnation to slight downward pattern of the green trade deficit curve from the middle of 2000 to 2001 was due to the 2000-2001 recession in The United States. After the recession U. S. trade deficit with China grew briskly anew until the middle of 2005 when Yuan was forced to appreciate under the pressure from U. S. Congress. It is worthy to note that after the 2000-2001 recession China has overtaken Japan as the number one contributor to the runaway U. S. trade deficit. By the middle of 2005, annual U. S. trade deficit with China was more than double of U. S. trade deficit with Japan, and by the middle of 2008 the size of US-China trade deficit had ballooned to three time of US-Japan trade deficit.

The 2005 appreciation of Chinese Yuan was sharp in the first month and then proceeded with a gentler pace, but the speed of appreciation quickened toward the end of 2007 to 2008 as the red curve shows. In response the slope of the green trade deficit curve moderated immediately from the middle of 2005 and flattened out further as the appreciation of Yuan quickened its pace. The decline of the green trade deficit curve from the middle of 2008 was due to the escalation of the financial crises and the full blow of the recession caused by massive default of debt ridden U. S. consumers and the self-destruction of Wall Street. It was also at that time Chinese Government stopped the appreciation of Yuan so that Yuan stayed at the level of about 6.83 Yuan per Dollar until near the end of June, 2010. However, Yuan at the level of 6.83 Yuan/Dollar is still undervalued so that once the U. S. economy has started to recover, U. S. trade deficit with China has started to rise again, creating new pressure from U. S. Congress on Yuan to appreciate. From the timing of the green and the red curves in the graph, we can see that even if the recently announced appreciation of Yuan is substantial, it will not suppress the renewed rise of the trade deficit for another six months to a year. If the appreciation of Yuan is nominal, then we should expect the rise of U. S. trade deficit with China to continue much longer and the anger of U. S. Congress will literary boil over.

As has been pointed out in article 13, the "globalization" was proposed by a group of clever economists tailored to the taste of Wall Street in order to let The United States run uncontrollable trade deficits. As The United States runs trade deficits, U. S. dollars are handed out to foreigners. Foreigners must return those dollars to U. S. financial market through Wall Street to be lent out to U. S. consumers so that U. S. consumers will have money to buy more foreign made goods and sustain the "globalization" scheme. Serving as the middlemen between foreign dollars and U. S. consumers, Wall Street makes huge amounts of profits. That is why Wall Street has been the champion supporter of the runaway U. S. trade deficit and routinely labels any attempt to curtail the trade deficit as "protectionist". Unfortunately this kind of bogus scheme cannot continue for long. U. S. consumers under this scheme must pile up their borrowing year after year to sustain the runaway trade deficit. Eventually U. S. consumers will not be able to service the debt load anymore and start to default. With massive consumer defaults, the middlemen, that is, Wall Street will be wiped out. That was exactly what had happened in the financial firestorms after financial firestorms that scorched the global economy from the middle of 2007 to early 2009. Now the global economy is under the life support with massive amount of fiat money printed by the governments around the globe, and is bewildered and lost in the search of new directions. Even the monetary and fiscal policy makers of The United States and international monetary organizations have belatedly become aware of the enormous danger of letting the global trade imbalance to runaway. That is why U. S. Congress and the administration have no mood to let the trade deficit to get out of hand again. On the other hand China’s phenomenal growth has been the result of huge influx of dollars. In order to prevent the appreciation of Yuan, Chinese Government has bought up those inbound dollars and swollen its foreign currency reserve. In the process of dollar buying, Chinese Government must release matching amount of Yuan into the domestic financial market. The enormous amount of released Yuan eventually falls into the hands of national banks and are lent out to related parties to engage in massive infrastructure building and thus to induce China‘s rapid economic growth. To force Yuan to appreciate and to cut down China’s trade surplus is tantamount to deny China the most important source of economic growth. For China to switch from export to domestic consumption is easy said than done. Thus the confrontation around the pace of appreciation of Yuan will be the focal point of global economy for the time being. The outcome of this keen confrontation will shape the direction of the global economy even with the possibility that whatever still left of the "globalization" will be swept away entirely.