Trade, Currency and Why We're Mad at China
Updated: Nov 9, 2018
You’d be hard-pressed to read or watch the news without coming across a piece on an impending trade war with China, as collective resentment for the country seems to be climbing. It’s not hard to agree that shrinking our deficit couldn’t hurt, but that is really where the consensus ends. What the deficit signifies and what has caused it is somewhat controversial. Today's post attempts to unveil the backstory on how our relationship with the Asian superpower evolved and what the global implications are.
It's been no secret that US manufacturing employment has declined. Though it was steadily on a downward slope for almost 50 years, the industry's employment was about 17.6 million in 1987 and didn’t get far below 17 million throughout the 1990s. By 2010, however, it had plummeted by approximately 5.7 million, leaving just 11.5 million workers. Manufacturing accounted for 32% of employment in 1953 compared to just 8.5% around 2016.
Many say that rapid technological increases are the culprit for job losses as automation makes some jobs obsolete. It is certainly true that labor productivity has increased, despite significant employment decline. Still, even though technological innovation has taken off, manufacturing output as a percentage of the total US economy decreased from 23% in 1997 to just 18.5% last year in 2016. When looking at it from a global scale, it’s easy to see why we point fingers to China. The United States’ share of global manufacturing activity declined from 28% in 2002 to 16.5% in 2011, and in 2010, guess who displaced the United States as the largest manufacturing country? China’s value added in manufacturing exceeded $3 trillion, compared to $2.2 trillion for the United States that year.
China’s meteoric rise as an economic powerhouse and manufacturing hub has been quite astonishing. In the 1980s, when it was hard for foreign companies to sell directly to the Chinese due to their closed economic market, the country wanted to attract foreign manufacturers so that they could sell to the rest of the world at competitive prices. Once China joined the World Trade Organization (WTO) in 2001, they agreed to adhere to standard international law and business practices, as well as equal tariffs and regulations for everyone. The decision made themselves even more attractive to foreign investors as a manufacturing hub, and from then on, there's been no turning back.
With manufacturing hubs that crank out a lot of stuff for a small price, it comes as little surprise that our trade deficit with China reached a record high of $375 billion in 2017. A chief concern among Americans-and even European nations-is that Chinese companies are not abiding by intellectual property practices by mandating “technology transfers”. In essence, this means that China requires that, in order to have access to their lucrative market, foreign companies must provide the Chinese with their technology. They subsequently “steal” the company’s technology for their own advantage and businesses. These claims are not unfounded. The US Trade Representative estimated in 2017 that the US loses between $225 billion and $600 billion each year because of China’s intellectual property (IP) theft. It’s pretty hard to pin down the exact intellectual property appropriations and values, which explains the wide range of estimates; however, the consensus is that China has used deceitful practices that are a step beyond the counterfeit and piracy issues that have historically caused concern. Domestic controversy arises not because of conflicting views over whether this has negatively impacted American IP, but what the solution should be. According to a Q&A article with Stanford law professor Paul Goldstein, while the President does have authority to impose trade sanctions on violating countries, American IP owners have been increasingly successful within the Chinese legal system to protect their property. Going through the court system on a case-by-case basis may prove to be more successful than a large-scale punitive policy with unknown effects spanning various industries. “Addressing these discrete appropriations with trade sanctions is like performing microsurgery with a sledge hammer,” Goldstein said.
Another universal frustration is the Asian country’s currency-manipulation practices which keep their exports cheap thereby leaving US goods too pricey to compete. It works like this: Let’s say the Chinese export $500 worth amount of goods to the US, so $500 US dollars go back to China. Businesses go to their bank to exchange the $500 into the RMB (short for their national currency, renmibi), so that they can pay themselves and workers in their own currency. The local bank wants more of its own reserves in RMB, so it then goes to its central bank, the People’s Bank of China, to exchange the dollars it just got for RMB. The central bank takes the dollars, and uses it to buy mostly US Treasury bonds, or American debt. This keeps the the US dollar in high demand and therefore, more valuable. If the US dollar is more valuable, then the exchange rate becomes higher (if the exchange rate was 6 yuan to $1 and then the value of the dollar goes up, then the exchange rate may now be 8 or 9 yuan to the dollar). This allows Chinese-or foreign companies-to pay their workers less than American workers, and therefore they can charge much less for their products. It's something that American consumers love, but it puts American manufacturers out of business.
Because China has become an economic machine in the past couple of decades, their currency-manipulating practices are getting lots of attention, but they are not the only country to do this. Despite the potential negative long-term effects, many emerging markets take advantage of this practice, so that they can artificially keep export prices lower to stay competitive. In 1988, when Trade Act was passed, the US Treasury began conducting semiannual reviews of exchange rate policies with major trading partners. “According to the law, once a 'manipulator' is identified, the Treasury Secretary needs to undertake negotiations with the country to urge it to address the cause of currency undervaluation...If after one year the country continues to 'manipulate' its currency, the US may introduce penalty measures and bring the dispute to the IMF,” according to a research report conducted by China International Capital Corporation. The report, entitled “History of Currency-Manipulation and Challenges Facing China”, was conducted by one of the country’s leading investment banking firms. The first countries to be identified in the wake of the semiannual review were Taiwan and Korea and after negotiations with both countries, they were eventually removed from the “list” one and two years later respectively.
The IMF prohibits currency devaluations, but it doesn’t have the power to enforce the penalties, and the WTO does have an enforcement muscle, but its rules around exchange rates are not very clear. In addition, China also claims that currency devaluation is practiced not to gain unfair trade advantages-which would be against trade rules- but to stabilize its economic growth. This gives the US leeway to impose retaliatory tariffs to “protect” our own economy which would otherwise be considered in violation of international trade rules- hence the protectionist mentality that seems to be sweeping over several Western nations in recent years. Retaliatory tariffs could be the signs of an impending trade war, and while they may protect select industries, it is nearly impossible to predict the full weight of the economic ripple effect.
While currency devaluation and intellectual property theft can negatively impact our own manufacturing sector and therefore exports, there is much more to our trade deficit than just that. In fact, one of the biggest reasons has more to do with a fundamental way our global financial system works, which has nothing to with China being evil.
Because the US dollar is the global reserve currency, this comes with the responsibility of running a perpetual “account deficit”. A reserve currency is a currency foreign governments tend to keep in significant quantities, usually for international transactions. Other reserve currencies are the euro and the Japanese yen, but approximately 61.4% of the world’s foreign currency reserves are in dollars, and it is used in 86% of global currency transactions, according to a macroeconomic research series report conducted by Meketa Investment Group.
You may remember from history class that in 1944, leaders from the Allied nations held the Bretton Woods Conference to establish some sort of global financial system. The US dollar became the world’s reserve currency and would be backed by gold. After it was no longer backed by gold, the only real “backing” became the credibility of the issuing government. The dollar’s status as the largest-held reserve currency is still propped up by this confidence in economic stability and market liquidity. This basically means that other countries rely on the dollar to facilitate trade amongst each other, not just with the United States. Having a currency that is in high demand forces up the dollar’s value, allowing imports to be less expensive for American consumers. It also means that the dollar is considered an “exported” good. Essentially, Americans can consume more than what we produce because our currency is considered an export. The consequence, however, is that we run a continual account deficit. According to Meketa Investment report, “Because foreign countries need dollars to transact amongst themselves, a constant outflow of dollars from the United States (i.e., a current account deficit) is needed to facilitate global trade. Thus, while there are some negative consequences associated with continually running a current account deficit, the dollar’s reserve currency status doesn’t give us much of a choice.” Because the dollar is in high global demand, it becomes more valuable, and this often means that our exports have to be sold at a higher cost. This leads to a less competitive export sector, therefore leading to a loss of domestic manufacturing jobs.
According to a 2015 Foreign Policy magazine article (since then, China has received SDR status from the IMF), “Any country that wants its currency to actually function as an international reserve must supply the rest of the world with claims in that currency, either by running trade deficits or by providing large amounts of aid or investment capital. Until now, at least, China’s development model has been based on precisely the opposite: running trade surpluses and attracting foreign investment. In the process, rather than exporting its own currency, it has imported an astonishing $4 trillion in other countries’ currencies, which it holds as central bank reserves.”
While there is undeniable truth in our trade deficit with China and our loss in manufacturing employment, the global financial structure may prove to be just as much of a hurdle in shrinking our deficit than the Chinese stealing our technology-if not bigger. Ironically, the Chinese have proposed using a different, interconnected financial system to decrease reliance on the dollar, but that hasn’t gained significant traction, especially within the US government. After all, relinquishing the dollar as the dominant reserve currency may also mean relinquishing many of the advantages we have, such as the ability to consume more than we produce.
Sources (in order of appearance)
“The World is Flat: A Brief History of the 21st Century”, pages 115-120. Thomas Friedman.
“US Manufacturing in International Perspective.” Congressional Research Service. Summary page, page 2.
“Most Americans unaware that as U.S. manufacturing jobs have disappeared, output has grown”. http://www.pewresearch.org/fact-tank/2017/07/25/most-americans-unaware-that-as-u-s-manufacturing-jobs-have-disappeared-output-has-grown/
Trade in Goods with China. 2017: Trade in Goods with China.
”Intellectual Property & China. Is China Stealing American IP?” https://law.stanford.edu/2018/04/10/intellectual-property-china-china-stealing-american-ip/
The World’s Reserve Currency: A Gift and a Curse. pages 2-5. https://www.meketagroup.com/documents/Client%20-%20January%202014.pdf
History of “Currency-Manipulation” and Challenges Facing China. http://www.cicc.com/portal/business/rs/investweather///1482223027553F305043F2F436270244FD1426722690B.pdf
’Currency Manipulation’ and World Trade, pages 590-595. Robert Staiger, Alan O. Sykes.
”4 Trillions Reasons China’s Currency Isn’t Ready for Prime Time.” Patrick Chovanec. https://foreignpolicy.com/2015/06/16/yuan-renminbi-world-reserve-currency-special-drawing-rights-imf/
“Zhou Xiaochuan: Reform the International Monetary System”