Trade Dispute Heats Up
Exchange Rate No Solution to U.S.-China Trade Deficit
by Li Jin and Shan Li
Tension is steadily mounting between the United States and China over trade issues. The U.S. trade deficit with China accounted for almost one-third of the record $765 billion U.S. trade deficit in 2006. Both sides agree that this large imbalance is unsustainable, but negotiations to reduce it are making little progress. If not managed properly, the trade imbalance could escalate into a trade war.
The solution provided by U.S. policymakers is to focus on the dollar-renminbi exchange rate. The Bush administration and Congress are pressing China to appreciate the renminbi rapidly relative to the dollar. We think this is at best a suboptimal solution, with three major flaws.
First, this solution is not mutually agreeable and therefore unenforceable. A sharp appreciation of the renminbi would endanger China’s export-dependent economy. The mainland is undergoing rapid industrialization to absorb over 300 million rural laborers into the industrial sector. An interruption to that process could cause social instability in China — something the leaders in Beijing want to avoid. If the United States pushes too hard, it could lead to a trade war.
Secondly, this solution fails to recognize the fact that the trade imbalance between the two countries is a multilateral, not a bilateral, issue. China serves as the final assembly point for a significant portion of the U.S.-bound exports of other Asian economies. In fact, China runs a substantial trade deficit with its Asian neighbors, suggesting that countries like Japan and Korea are using China to assemble goods, which they then export to the United States. China’s trade surplus with the United States actually represents the trade surplus of the region — a fact that undermines renminbi appreciation alone as a remedy for the trade imbalance. A unilateral appreciation of the renminbi would likely shift Asian countries’ assembly plants to other low-cost Asian countries, not back to America.
Last but not least, this solution may create huge risks for U.S. financial markets. It is widely believed that a unilateral appreciation of the renminbi against the dollar would not correct the U.S. trade deficit. For the exchange-rate adjustment to be effective in resolving the U.S. trade deficit, substantial dollar depreciation would be necessary. Such a move might trigger a massive exodus of foreign central bank reserve assets from the U.S. Treasury market, sharply reducing the demand for U.S. Treasury securities and increasing U.S. interest rates — at a huge cost to the U.S. economy and crucial elements in it, such as the housing market.
We think the fundamental problem of the exchange-rate-focused solution is that it addresses the terms of trade, rather than trade itself. If both the United States and China move one step back and focus their negotiation on trade rather than on the exchange rate, they may find ample room to restore the trade balance amicably.
Specifically, the United States may consider loosening restrictions on technology exports to China, where U.S. companies are losing out to their Japanese and European competitors. The United States harbors reasonable concerns about limiting military-use technology exports to China, but there are vast areas of nonmilitary-use technology exports — particularly environmental protection and energy-efficiency technologies that China desperately needs.
For its part, China might consider levying environmental and energy taxes on its exports to properly account for the burden of the export sector to the environment and energy consumption. This is consistent with its domestic policy to maintain sustainable economic growth.
China could also actively invest its newly generated trade surplus directly in the United States in the form of foreign direct investment (FDI), since this prevents the trade surplus from entering China’s financial markets and fueling the oversupply of domestic liquidity. It also helps create jobs in the United States and yields a potentially higher return than an investment in U.S. Treasury securities. Such direct investment would be welcomed by the United States: In 2005, FDI created jobs for over 5 million Americans and provided 4.5 percent of all private-sector jobs.
China aspires to be the world’s leading manufacturing center, while the United States wants to maintain its leadership position in R&D and financial markets. As such, the two economies are complementary rather than competitive, at least in the foreseeable future. Instead of shortsighted posturing, cautious policies on both sides should be able to sustain growth and enhance cooperation. Confrontation is in no one’s interest.
Jin is an associate professor at HBS. Li is vice chairman of the China Overseas-Educated Scholars Development Foundation and former CEO of Bank of China International. Reprinted from the Wall Street Journal Asia © 2007 Dow Jones & Company, Inc. All rights reserved. Edited for space.
