No Pain, No Gain: Yuan Float Leads to Fairer Trade -- at a Cost to U.S. Consumers

May 10, 2006

Until July 2005, the Chinese currency, the yuan, had been pegged to the U.S. dollar for a decade, prompting complaints that the undervalued currency gave the Chinese an unfair trade advantage -- evidenced most concretely by the fact that Wal-Mart merchandise went from being touted as being all-American to being about 80 percent made in China.

Since China began floating its currency 10 months ago, allowing it to fluctuate in value against the U.S. dollar, the yuan has appreciated by about 3 percent. Most forecasters say it will strengthen to the 5 to 7.5 percent mark by the end of 2006. As the yuan floats higher, the United States' trade deficit with China -- bigger than its shortfall with any other nation -- could go lower as China imports more American-made goods and Americans buy less Chinese goods.

The upside is fairer trade, but the downside of the yuan float is that American consumers will tend to pay more for Chinese-produced textiles and electronics, and the float could lead to higher inflation and interest rates.


The yuan float comes amid continuing pressure by U.S. politicians to protect U.S. jobs, but experts at the W. P. Carey School of Business caution against an excess of protectionism as the U.S., population 300 million, trades with China, population 1.3 billion. They say job losses in the U.S. will be low-tech and that they will be replaced by higher-paying jobs higher up the technology food chain.


Bipartisan concerns


Daniel Brooks, director of the W. P. Carey MBA-Executive Program, says Washington, D.C. decision-makers on both sides of the aisle are worried about a related issue: the fact that the Chinese government holds some $800 billion in U.S. funds, much of it invested primarily in U.S. Treasury bonds. The U.S.–China Economic and Security Review Commission warns that when the total of Chinese-held bonds hits $1 trillion, the Chinese may begin acquisition of American manufacturing resources. Taiwan, Korea and Japan could follow suit.

"The picture that Warren Buffet has used recently to describe this unfolding scenario is that the U.S. is the rich family on the hill that no longer makes enough money to sustain its lifestyle, so it begins selling off parts of its estate to keep the revenue flow going. The result is that they no longer own the estate but get to live there so long as they work well for the owners," Brooks says. "There are many who feel that the Asian countries, in particular China and Japan, have a major input in managing the value of the dollar in the international market place and they are keeping it stable because we are an important customer of theirs and they want us able to continue buying and sending dollars their way."

China has been criticized for failure to comply with World Trade Organization requirements, including intellectual-property rights.

"While China now has 35,000 people employed in monitoring the Internet in China to make sure no undesired connections are made," Brooks notes, "they have very few monitoring protection of IP rights."

International pressure is being put on China to end piracy, says Herbert Kaufman, professor of finance.

"You see a DVD on sale in China before a movie is even released in the U.S., and this is not appropriate and frankly not in the long-term interest of the Chinese," Kaufman says, adding however that it cannot be thwarted by passing protectionist legislation. "You do it though negotiation and through pressure between bargaining partners. You build coalitions so it becomes not just bilateral but multilateral, as appears to be happening with our joint efforts with the European Union."



The economics of comparitive advantage

Despite inexpensive, compliant labor in China, trade with that nation is not necessarily a losing battle for U.S. workers or companies, Kaufman says.

First, he notes, "The Chinese are experiencing some shortages and worker resistance as well, and competition from lower-wage workers in Vietnam and other emerging economies."

Also, trade with China is a great deal for U.S. consumers.

"I would prefer that if the Chinese want to continue to subsidize American consumers, they be allowed to do that," Kaufman says. "You should not discourage American consumers from buying Chinese products -- if Americans find these products attractive enough to buy because of price, quality or some other metric, this increases consumer welfare."

Kaufman says he is confident the U.S. economy can move to the next stage of development, just as it did when shifting from agriculture to manufacturing and then increasingly to a services economy.

"We can continue to benefit from China's comparative advantage in manufacturing and still compete, innovate, and grow," Kaufman says. "If we're going to allow the continuation of these free markets, we do have a responsibility to have some safety net in place, in terms of retraining and transitional support. Lost U.S. jobs are replaced by higher-technology and other more value-added jobs and higher-yielding, more efficient enterprises."

"This is simply the economics of comparative advantages," explains Lin Zhou, W. P. Carey professor of economics. "Of course, this is not good news for some American workers who have lost or will lose their jobs. They have to improve their skills and make themselves employable for jobs that are not easily filled by foreign labor."

Zhou says many U.S. companies, particularly large companies, benefit tremendously through trade with China, in two ways.

"First, they can sell more of their products when China opens up its market to foreign
companies; second, they can also make their products at lower costs by either outsourcing or moving their manufacturing facilities to China or other developing countries," Zhou says. "The truth is that the overall U.S. economy is still growing and corporate profits are growing even faster."

Zhou says it is a "huge exaggeration" when politicians say the United States is being de-industrialized.

"America is still the leading industrialized country in the world," Zhou says. "We are at the leading edge in many goods, from supersonic jets to agriculture products -- you name it. It is true that we no longer make toys or clothing since we can buy them cheap from other countries. But so what? In fact, many Chinese are also complaining about U.S.-China trade. They have to sell hundreds of millions of sweaters, enough to dress every single American, just to make as much money as Boeing can make by selling one 747."

The U.S. trade deficit with China is about a quarter of the overall trade deficit, Zhou notes.


"When the rest of world saves more than they spend and we spend more than we save, the trade deficit is unavoidable," Zhou says. "We have to change our buying and saving behavior to reduce the trade deficit. Picking an easy target will not solve anything. It was Japan some 20 years ago, it is China now, and it might be India down the road."



Benefits of an unencumbered capital market

The yuan float will help address concerns about fair trade and U.S. jobs, says Dennis Hoffman, associate dean of research and doctoral programs and director of the the Seidman Institute at the W. P. Carey School. He says exchange rates should be allowed to find their own relative value in the world market.

"Freely fluctuating exchange promotes a healthy capital market," Hoffman says. "The threat to the world economy and to the U.S. in particular is the imposition of trade and financial barriers. That would be a real loser. As boomers retire and begin to sell assets, we will need to turn to the world to look for buyers."

Kaufman agrees. "We have been through periods of protectionism before with ill effect," he says. "For example, the Smoot-Hawley tariff act exacerbated what became the worldwide depression of the 1930s by interfering with free trade."

China, Hoffman says, "may be just the catalyst we need ... to turn our attention to the production of high-margin products and services. Phasing out the old manufacturing options just provides more natural incentives for people to pursue knowledge-economy employment opportunities."

Is the proportion of the U.S. national debt held by China a threat to the U.S. economy?

"The Chinese hold $800 billion in total foreign currency reserves, probably three-quarters of it in dollars," Kaufman says. "The danger is that they can make a decision to get out of the dollar. If they did that quickly, it would put substantial upward pressure on U.S. interest rates. I don't expect any of that. The Chinese are smart business people. I think the economics would win out over the politics. Incremental movement as China diversifies its currency reserves is manageable."

"In a world economy, financial capital will seek its most productive use," Hoffman says. "The U.S. is still seen as a sound investment."

"You may worry about the impact of the size of the national debt on the economy and you may want to reduce it," says Zhou. "But we should be grateful that someone is there to lend us money when we need it. Unfortunately, it just will not last forever."

Meanwhile, Kaufman urges moderation regarding the strengthening of the Chinese currency.

"I would not be putting the kind of pressure that is being put on China to float, because at the current rates, they provide a pretty good subsidy to the U.S. consumer, and they put downward pressure on inflation," Kaufman says. "If the Chinese accede to that pressure, from a political point of view, the balance of payment looks better, but the current subsidy is to the American consumers' advantage."



Bottom line:

  • Since China began floating its currency 10 months ago, the yuan's value has appreciated by about 3 percent.
  • Most forecasters say it will strengthen to the 5 to 7.5 percent mark by the end of 2006.
  • The upside is fairer trade, but the downside of the yuan float is that American consumers will tend to pay more for Chinese-produced textiles and electronics, and the float could lead to higher inflation and interest rates.