[Article] The History and Future of US-China trade: How rocky will the road get?

[agamemnus]

In 1978, China's government formally decided on an economic path called the "Four Modernizations". China aimed to develop both economically and militarily through trade; in terms of US relations, China would put its massive labor force to work in producing things Americans wanted in exchange for US currency, US technology, and industrial production know-how. A peg on the powerful US dollar allowed China's economy and government to grow and remain stable. The high Chinese private and public savings rate caused by this pegging policy promoted stability in the Chinese economy at the expense of both private and public consumption of goods and services.

With this trade policy, US inflation remained low, and public and private spending was encouraged on the guarantee that China would simply trade paper currency for goods. With the immense 20-fold increase in US-China trade between 1990 and 2008, the trade deficit also expanded from $10.5 billion to $273 billion. Both countries' governments knew that this trade arrangement was unsustainable; in the past several years China, partly influenced by U.S. prodding, partly by official government concerns of economic/political/environmental stability, and partly by the growth of the middle class in its cities, increased its imports, increased domestic consumption, and increased the value of its currency (to reduce exports and further reduce imports).

With economic problems in the US that were most clearly visible in late 2008, imports from China abruptly fell; there was immense pressure on the Chinese government to allow its currency, the yuan, to appreciate; its price has been widely seen, by both economists and the public, as an unfair trade advantage that impeded the growth (and now threatened the survival of) all kinds of US-based manufacturing businesses, thus helping to prevent the US economy from recovering.

China's government knows that an unraveling of the historic US-China trade (and deficit) threatens economic instability in its own country, but it fears raising the value of the yuan too quickly will also cause economic instability (and sharply increase inflation in the US). Thus, it has tried alternatives such as dramatically raising the salaries of state-owned companies. These measures have been unable to counteract the falling savings rate in China, caused by a rapidly growing (and consuming) middle class.

Thus, China has been suffering from increased inflation, caused partly by more money in the hands of the private sector and partly by increasing raw materials prices from the rest of the world. (China imports a large amount of raw materials to feed its factories) To curtail inflation, China's government has raised the effective country-wide interest rate through a variety of means. The yearly inflation rate has so far been modest, at 5% (compared with 28% in late 1994 and 7% to 8% in 2008), but there is a risk that it will rise significantly if the US-China trade dynamic changes. On a yearly basis, from 2008 to 2010, US exports to China rose 31.8%, while imports rose only 1.9%.

Inflation, Money Supply, and Debt

In China, the concern is about political, social, and economic stability due to rising inflation. The same could be said of the US, not because of rising inflation, but because of rising debt. Does this inflation and the interest rate changes in China have some connection to US debt?

The effect of the recent Chinese interest rate change on US government debt is three-fold. (These effect depend on several other important factors to stay constant -- and they are unlikely to do so.) First, an interest rate hike curtails Chinese domestic spending; this will cause the trade deficit to increase, which will also increase US government deficit (and debt) because of lower taxes generated from manufacturers. Second, an interest rate hike means that the US government will have to raise its own interest rate to attract buyers in the US federal bonds market, or risk being unable to borrow sufficient funds. If interest rates are raised, any significant economic recovery in the US would be dampened because increased interest rates would make it harder and more expensive for businesses to borrow money in order to expand. This will cause taxes and the deficit to further decrease.

Some factors which will make these effects unlikely or very minimal are: (1) the yuan will likely continue to slowly be re-pegged higher against the dollar (an effort halted in mid-2008 and restarted in mid-2010), lowering domestic Chinese inflation. (2) the interest rate rise of .8%, from 5.3% to 6.1%, is not significant; this pales in comparison with the fluctuations between 2004 and the end of 2008: 5.3% in Jan. 2004, to 7.5% in Jan.-Aug. 2008, and back to 5.3% in Jan. 2009.

The Restructuring of Global Trade

More significant factors affecting US debt are the changes and restructuring in the world economy as the United States slowly recovers from a severe recession and economic stagnation, and the North African and Middle East countries struggle with immense unemployment and changes of government.

Lower supply and higher demand of basic commodities, including energy and food, will dampen economic growth everywhere, including the most vulnerable and unstable developing countries. The cost of ocean shipping will increase substantially in the medium term, and with it the cost of US-China trade. A necessary re-alignment from high deficit spending to much lower deficit spending in the US (both private and public [government]) will help balance trade and maintain economic stability -- in the past 10 years, imports have gone from 135% of exports in 2000 to 127% in 2010. A re-valuation of the yuan upward to shorten the trade deficit and cope with increased Chinese consumption necessarily means a weaker dollar, which will mean that US debt will effectively be lower and exportable products-based jobs will increase, reducing US unemployment. It will also mean, however, that US consumers will find many goods relatively more expensive than before.

As the mutual benefit from US-China trade has been shifting from one of cheap goods in exchange for technology to one of all kinds of goods and services in exchange for all kinds of other goods and services, both countries and governments have struggled to keep up. This shift in trade is not over by far; the road to a more balanced trade is riddled with potential price shocks that governments must try to prevent and private companies and individuals must carefully monitor.


Sources:
US Census Bureau:
http://www.census.gov/foreign-trade/...ical/gands.txt
http://www.census.gov/foreign-trade/...5700.html#2010

Google Finance:
http://www.google.com/finance?hl=en&...ed=0CCQQ5QYwAA

TradingEconomics.com (primary source: National Bureau of Statistics of China):
http://www.tradingeconomics.com/Econ...spx?Symbol=CNY

TradingEconomics.com (primary source: People's Bank of China):
http://www.tradingeconomics.com/Econ...spx?Symbol=CNY

[wiggin]

An interesting and well-thought out article, agamemnus, but as you probably expected I have some doubts about your projections and explanations.

With economic problems in the US that were most clearly visible in late 2008, imports from China abruptly fell; there was immense pressure on the Chinese government to allow its currency, the yuan, to appreciate; its price has been widely seen, by both economists and the public, as an unfair trade advantage that impeded the growth (and now threatened the survival of) all kinds of US-based manufacturing businesses, thus helping to prevent the US economy from recovering.

I agree that the yuan is undervalued, but I question how much that affects US manufacturing. Put simply, we don't make the same stuff that the Chinese do. Thus, Chinese manufacturers are not really benefiting at the expense of US manufacturing, but rather of other countries with cheap labor who cannot hold down their currencies as well against the dollar.

Furthermore, while you don't say it outright, there seems to be a mistaken public impression that American manufacturing is imperiled. This is far from the truth; America makes more stuff more efficiently than ever before, and we export a truly prodigious amount of goods. It's just that certain sectors are in trouble (generally those relying on cheap labor, since cheaper labor can be found in lots of places). More generally, manufacturing jobs are in trouble because the American worker has gotten much more productive, so we need fewer people to make the same (or larger) amount of stuff. I think that might lead to some structural unemployment problems in the US, but that will only be temporarily alleviated by decreasing the trade deficit and global imbalances.

The effect of the recent Chinese interest rate change on US government debt is three-fold. (These effect depend on several other important factors to stay constant -- and they are unlikely to do so.) First, an interest rate hike curtails Chinese domestic spending; this will cause the trade deficit to increase, which will also increase US government deficit (and debt) because of lower taxes generated from manufacturers. Second, an interest rate hike means that the US government will have to raise its own interest rate to attract buyers in the US federal bonds market, or risk being unable to borrow sufficient funds. If interest rates are raised, any significant economic recovery in the US would be dampened because increased interest rates would make it harder and more expensive for businesses to borrow money in order to expand. This will cause taxes and the deficit to further decrease.

This is where I start to get skeptical. I don't believe that a Chinese rate hike is likely to have a dramatic effect on US manufacturers or the US government deficit. Chinese consumers don't buy that much of our goods (US total exports to China are quite low against our total exports), and most of our big ticket export goods that are more dependent on corporate and government spending.

Secondly, I think saying a yuan rate hike will lead to the US having to pay more on debt is extremely suspicious. The US bond market is very deep and very liquid, and there are a lot of other factors affecting rates and auctions than the Chinese. Absent compelling investment opportunities elsewhere, US debt is going to continue to be a safe haven in poor economic times. I don't doubt that there might be some upward pressure on rates, but I doubt it will be significant absent really dramatic changes in China. One thing that Chinese policymakers are leery of is really dramatic changes, so I'm betting on gradual shifts.


All that aside, I agree that a rebalancing is both necessary and underway, and that it will probably negatively affect the US consumer in the short term.

[agamemnus]

I agree that the yuan is undervalued, but I question how much that affects US manufacturing. Put simply, we don't make the same stuff that the Chinese do. Thus, Chinese manufacturers are not really benefiting at the expense of US manufacturing, but rather of other countries with cheap labor who cannot hold down their currencies as well against the dollar.

Furthermore, while you don't say it outright, there seems to be a mistaken public impression that American manufacturing is imperiled. This is far from the truth; America makes more stuff more efficiently than ever before, and we export a truly prodigious amount of goods. It's just that certain sectors are in trouble (generally those relying on cheap labor, since cheaper labor can be found in lots of places).

Of course we mostly don't make the same stuff... because American factories that made the same stuff, even if they were more automated, went quickly out of business. In the past decade, China no longer makes cheap stuff, either. They are making more and more advanced stuff, leaving the rest to poorer developing countries. The argument made is not of specific sectors but more of the idea that having an artificial exchange rate does unfairly cheapen your products in the US market... it makes us more dependent on China for both goods and fiscal policy. The more dollars they hold, the more leverage they have.

You're right that other countries (like Taiwan?) might not have it as good as Chinese manufacturers, a certain rigidity in access to yuan (since it's not floating, you can't really get as much of it as you want) and inflation pressures (it's not really worth what the government says it is) do counteract that.

More generally, manufacturing jobs are in trouble because the American worker has gotten much more productive, so we need fewer people to make the same (or larger) amount of stuff. I think that might lead to some structural unemployment problems in the US, but that will only be temporarily alleviated by decreasing the trade deficit and global imbalances.

Productivity is important, but you can't compete against unfair trade practices.

This is where I start to get skeptical. I don't believe that a Chinese rate hike is likely to have a dramatic effect on US manufacturers or the US government deficit. Chinese consumers don't buy that much of our goods (US total exports to China are quite low against our total exports), and most of our big ticket export goods that are more dependent on corporate and government spending.

The interest rate hike won't have a big effect (5.7% between China's official interest rate of 6% and US 1-year bond rates), and I said as much in the following paragraph. :P You're right that most of the exports seem to be big-ticket stuff like aircraft, but the Chinese consumer has made enormous strides in the past decade. US exports to China rising 32% in 2 years is a big deal, although in my opinion some of that is just currency inflation.

All that aside, I agree that a rebalancing is both necessary and underway, and that it will probably negatively affect the US consumer in the short term.

Separately, what do you think of the massive difference here? It's just unreal. 6% versus .3%. Could mortgage yields (currently at ~4.25% for 15-year mortgages) be a better indicator of economy-wide interest rates than treasury bonds?