China and the Deficit

A tempest in the world's largest teapot.

Wilmington NC – [Click the LISTEN button to hear Dennis' commentary.]

China-bashing has become a political expediency of the day. Many of America?s economic ills have been blamed on our trade deficit with the Chinese, which now exceeds 100 billion dollars. This has affected, among others, unemployed workers who have seen Chinese products replace theirs in the market place.

To appease political criticism about jobs lost to China, politicians have accused the Chinese of a wide array of unfair trade practices. Not long ago, the Bush Administration imposed import tariffs on a range of Chinese textile goods, and threatened more.

But, the real economic lever behind China?s success in the US market is exchange rates. That is, the dollar price of the Chinese yuan. The yuan is relatively low-priced in terms of dollars. This means a few dollars can buy a lot of yuan, and thus a lot of goods priced in yuan. This makes Chinese goods relatively cheap to people who have dollars ? that is, Americans.

For quite some time, the US dollar had been the world?s strongest currency. A dollar would have purchased about 1.2 euros, 1.5 Canadian dollars, 120 Japanese yen, or eight Chinese yuan. In mid-2003 this began to change, and the dollar fell broadly. A dollar will now purchase less than 80 cents worth of a euro, a dollar thirty Canadian, or 110 yen. But it will still buy the same number of Chinese yuan.

Last fall the Bush Administration mounted an initiative to bring down the value of the dollar. The idea being that a lower-value dollar makes imports more expensive and exports less so, thus it should improve our trade balance. And for the most part, the initiative worked, as evidenced by the falling dollar vis-?-vis most other major currencies.

But, why not against the yuan? The answer is, the Chinese maintain a fixed exchange rate between the yuan and the dollar. Why? When China gained membership in the World Trade Organization several years ago, leading WTO members ? the US and the European Union ? insisted that China fix their currency so that wide fluctuations in the yuan?s value would not disrupt international trade. Now, despite America?s displeasure, China adheres to that policy. The Administration has tried ?jaw-boning? the Chinese into floating the yuan ? where it would appreciate against the dollar ? but with little success so far.

However, a floating yuan may not be in our overall best economic interest. The Chinese have maintained the relatively low-value yuan by selling all the yuan buyers want at a fixed price of 12 cents American. This means that they will buy all the US dollars offered, in return for yuan which can then be used to buy Chinese goods.

Now, America has lots of dollars looking for takers. Because of the large Federal budget deficit, the US is spending 500 billion dollars a year more than it produces. Someone abroad has to be willing to accept and hold this mounting debt. Until recently, Europeans did so, pouring an average of $28 billion a month into the US. But that stopped last fall as European economic recovery gained traction. At about the same time, the Japanese central bank eased its policy of dollar-buying, which had been done to mitigate the value of the yen and help prime Japan?s economic engine.

This leaves the Chinese as the principle buyers of US dollars. If the Chinese stop ? let the yuan float upward, as the Administration seems to desire ? the dollar will weaken even further. Then, to finance our deficit, the payment for holding dollars will have to increase. This payment is the interest rate. A sharp jump in the interest rate would deal the US a serious economic blow.