China and the US trade deficit

Last week saw a report that China had foreign exchange reserves of US$853.7 billion at the end of February, overtaking Japan as the largest in the world. Not surprising then that it has taken over Japan's place as the country with the most trade frictions with the United States.

The rise in China's foreign exchange reserves has come on the back of a rising trade surplus and possibly been boosted by capital inflows speculating on a revaluation of the renminbi. However, while China's trade surplus has been rising, so has the US trade deficit, much of it with China. In fact, the US trade deficit with China hit a record US$202 billion in 2005.

Little wonder that there have been moves recently by the US Congress to force China to revalue the renminbi or take steps to free its exchange rate. One such move, by senators Charles Schumer and Lindsey Graham, threatened tariffs on Chinese goods if China failed to take appropriate action on its currency, but the proposal was temporarily put on hold last week after the senators met Chinese officials in China. However, another proposal was raised last week by senators Charles Grassley and Max Baucus that would induce the Treasury Department to take action on countries with "fundamentally misaligned" currencies.

Not everyone agrees with such moves. Two publications -- both incidentally British-based -- have recently come out with reports saying that a yuan (or renminbi) revaluation would do little to correct the US trade deficit.

In a recent report for the Financial Times, Christopher Swann wrote that "even dramatic gestures by China would do surprisingly little to reverse the imbalance". He pointed out that "companies adjust price tags to keep in line with competitors, rather than according to fluctuations in the exchange rate". He cited the experienced with Europe, where a 44 percent rise in the value of the euro against the US dollar since July 2001 has not stopped the US deficit with the euro zone from rising 75 percent.

Swann cited Paul Donovan, a global economist at UBS, as saying that most of the goods China sells to the US are not widely produced in America. "If the US did not buy these goods from China it would have to buy them from abroad anyway," said Donovan.

Swann also wrote that many economists think that a significant reduction in the overall US deficit will not be possible without domestic reforms. With US imports so much bigger than exports, "even a dramatic surge in demand in Europe and Japan might have a surprisingly modest impact on the deficit". He cited the Institute for International Economics in saying that every one percentage point rise in real growth in the rest of the world only reduces the deficit by US$15 billion.

And yet, as Swann pointed out, "there are no signs the US government is willing to take politically unpalatable actions -- the current account is not seen as a sufficiently pressing issue to justify raising taxes or accelerating monetary tightening".

A recent article from The Economist essentially said the same thing.

"China's exchange rate is not to blame for America's huge current-account deficit," The Economist said. It thinks that the US "consumes too much and saves too little", but yet "has done little to boost national saving by addressing its reckless fiscal policy".

While the arguments in the two reports look essentially correct, I think the US trade deficit in general and the deficit with China in particular could perhaps be put in better perspective by distinguishing between long-term and short-term effects.

While cheap labour in China in general means that it is always likely to have a trade surplus in manufactured goods -- especially consumer goods -- with richer economies like the US, much of the recent increase in the US deficit with China has clearly been the result of overstimulation of the US economy relative to the Chinese economy, or indeed the rest of the world. However, the Federal Reserve has been raising interest rates for almost two years. As some of the stimulus is removed, especially on the monetary side, the trade imbalance should be reduced.

Over the long term, China's policy of allowing gradual appreciation of the renminbi could be optimal, at least from its point of view. Supplemented with domestic price changes in both China and the US to reduce price differentials between the two countries, it could help reduce the trade imbalances in the two countries without being overly disruptive to exporters and importers.

Over the short term, though, a more flexible renminbi exchange rate would probably be helpful in damping cyclical fluctuations, allowing the US to stimulate its economy more without spillover overheating in China. The emphasis here, however, should be on exchange rate fluctuation, not so much on renminbi appreciation.

In other words, the US trade deficit with China is indeed more than just about exchange rates -- and much more about US government policies than it would like to admit -- but a flexible renminbi is a good thing nevertheless.

Ultimately, if China is to reduce its trade surplus, it needs to do more than just tinker with its currency; it needs to increase domestic demand as well. There are signs that the Chinese government is already taking steps in that direction. Its latest five-year plan for the period 2006-2010 shifts the economic focus from high growth rates towards more balanced growth, including greater rural and social development.

And yet, because of its rapidly ageing population, it needs to be careful not to drive up today's consumption to the extent that it cannot pay for tomorrow's. It needs to increase investment without exacerbating overcapacity. And it needs to do all of this without further degrading its environment.

These are big challenges, even for a big country.