The 'Strong' Yuan
After being pegged at a constant rate against the US$ for many years China's currency (the Yuan) has, over the past year or so, moved relentlessly higher against its US counterpart. This strength has gone a long way towards quieting the US politicians who were previously pointing to the US's large and growing trade deficit with China as evidence that China was achieving an unfair trade advantage by holding its currency at an unreasonably low level. The US trade deficit with China has continued to expand, but now the Chinese are doing something to fix the problem. At least, that's the way it seems. But as is often the case when politics and economics become intertwined, things are not what they seem.
For starters, the following long-term monthly chart of the US$/Yuan exchange rate shows that the gains made by the Yuan over the past year have been trivial compared to the losses it incurred over the preceding 20 years (a downward move on the chart indicates a lower number of Yuan per US$ and, therefore, a strengthening Yuan). The satisfaction -- if that's what it is -- that China is finally doing something to address the worrisome US trade deficit can be likened to the satisfaction felt by an American tourist after he/she has negotiated a 50% discount on the asking price of a trinket at an Asian marketplace, blissfully unaware that the local vendor tripled his asking price in anticipation of the negotiation.
As far as the Yuan is concerned, an 80% loss of value relative to the US$ between 1981 and 2005 has been followed by a one-year gain of around 4%. If a stock lost 80% of its value and then bounced by 4% nobody would be talking about how strong the stock was; and yet we keep reading about the "strong Yuan".
In any case, the main reason that things aren't what they seem is that the entire debate over US-China trade relations and currency exchange rates is based on a false premise. The false premise is that in a trade relationship between Country A and Country B, if Country A cheapens its exports by fixing its currency at an artificially low exchange rate then it will benefit at the expense of Country B.
The fact is that the US economy is a net BENEFICARY of the low Yuan; and the lower the Yuan becomes relative to its true value (the value at which it would trade in the absence of the Chinese Government's exchange rate manipulation) the greater the benefit to the US economy. Thanks to the under-valued Yuan, US consumers spend less of their hard-earned dollars in order to obtain the goods they want; and the difference between what they would spend in the absence of the subsidy -- an artificially low exchange rate is equivalent to a subsidy -- and what they actually spend becomes available for spending elsewhere or for investment. The US companies whose products are in direct competition with the subsidised Chinese imports are hurt, but the US economy as a whole gets a boost.
By the same token, China's economy gets hurt by an artificially low Yuan. Exporting companies will benefit, by everyone else will be stuck paying higher prices as a result of the cheapened currency.
All of which begs the question: why does China do it and why do some US politicians complain about it?
The general answer is: it's futile to look for economic logic in the interventionist decisions of governments. If most politicians were economically literate and strove to do what made the most sense from an economic perspective then when it came to the workings of the economy the government would do absolutely nothing. The fact is, however, that most politicians are neither economically literate nor motivated to do what makes the most sense from a purely economic perspective. They are, instead, primarily motivated by desires to serve special interests and to increase their own popularity amongst the voting public.
So even though subsidies and tariffs are guaranteed to hurt the economy as a whole, they are periodically advocated by politicians because the adverse effects on the overall economy of any single subsidy/tariff will potentially be small compared to the short-term positive effects -- the short-term being the only term that matters if your overriding goal is to win the next election -- on the targeted industry (group of voters). For example, a few years ago George Bush slapped hefty tariffs on steel imports in order to help US steel producers. It's likely that almost everyone in the US was hurt by this action because almost everyone buys things that contain some steel, but the amount by which the average consumer was 'out of pocket' due to higher steel prices was probably quite small relative to his/her total expenditure. And in any case, at any given time there will be a myriad of factors affecting prices so it will generally be impossible to prove a direct link between the imposition of any tariff -- Bush's steel tariff included -- and specific price rises elsewhere in the economy. The average steel-worker, on the other hand, might have perceived a huge benefit from the tariff. Therefore, the political logic behind the economically-indefensible tariff probably went something like: we won't lose any votes amongst the general population, but we'll pick up some votes amongst the steel-workers.
Getting to the specifics of the US-China trade/currency situation, the motives of the US politicians who have called for China to allow its currency to rise substantially or suffer the draconian consequences (a 27% tariff on Chinese imports) are easy to understand: they have advocated a 'solution' that would have the effect of pushing prices materially higher throughout the US economy in order to curry favour with a small section of the voting public. They might not understand the adverse effects of their recommended solution on the overall economy, but even if they did their approach would probably be the same. In contrast, the US Treasury Secretary seems to be reasonably comfortable with the Yuan's ultra-slow appreciation and the current China-US trade situation. He undoubtedly understands the benefits to the US economy of China's exchange rate policy: not just the benefits conferred by lower goods prices but also the benefits conferred by the process through which China keeps its currency at an artificially low level (China's central bank 'soaks up' the excess trade-related dollars and uses them to purchase US bonds, thus putting downward pressure on long-term interest rates in the US).
The motives of China's leaders are more difficult to fathom because they don't have to stay popular in order to stay in power. One possibility is that China's export-oriented businesses exert a disproportionately-large influence on the decision-making process. Another possibility is that the subsidy being provided to US consumers by the Yuan's under-valuation is perceived by China's leadership to be necessary, for now, in order to foster the rapid development of the country's manufacturing industry. A third possibility is that the enormous rises in the prices of natural resources over the past few years have made China's leaders aware that a fairly valued Yuan would be in their own best interest, but they are afraid to make a big move in that direction due to the unpredictable effects it might have. In this case, the Yuan's miniscule appreciation over the past year would be the first step in a long journey.
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