Krugman Is Still All Wrong About the Yuan

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by: Shaun Rein

This column originally appeared in Forbes

In his latest column in The New York Times Paul Krugman recommends that the US impose a 25% tariff on Chinese imports unless China appreciates the renminbi, its currency, whose principal unit is the yuan. As I've written before, the Chinese government can't risk revaluing its currency until world markets are more stable or it will risk driving Chinese exports back into a tailspin, which I estimate would result in another 5 million job losses. Far too many factories are running on the paper-thin margins that American companies like Target (NYSE:TGT) and Wal-Mart (NYSE:WMT) demand from their suppliers. An appreciation of the yuan would immediately put those factories out of business, just as many closed down when China appreciated the yuan 20% between 2005 and 2008.

Moreover, Krugman doesn't take into account the fact that rising labor costs are already helping fix the imbalance in the dollar-yuan exchange rate without an actual appreciation, and he fails to acknowledge that China's surplus is actually decreasing as China's domestic consumption grows. You don't have to change the exchange rate directly to make the yuan more fairly valued. Even Jim O'Neill, Goldman Sachs' chief economist, who has repeatedly criticized China's exchange rate policy, recently said that the yuan is no longer as underappreciated as it has been.

The reason? Rising labor costs and increasing Chinese consumption. In the last several months many provinces in manufacturing areas have raised the minimum wage and started to enforce the rules that companies must pay medical and social security costs for employees. In Shanghai the government finally equalized the medical and social security benefits for Shanghai residence permit holders and non-Shanghai residents working in Shanghai.

A year ago if a company paid a Shanghai resident $300 in salary, it also had to pay approximately $180 in benefits, while it only had to pay $60 in benefits for a nonresident working there. Now companies have to pay every worker the same amount. That not only is fairer to workers, it also increases companies' cost of doing business, which helps solve the exchange rate imbalance. Doing it this way rather than through an actual appreciation gives companies the ability to plan and make alterations to their business models--such as automating their production lines and creating their own brands, rather than simply being original equipment manufacturers--in a way that a sudden appreciation of the yuan would not.

Rising labor and real estate costs are causing factories to move to China's poorer neighbors like Vietnam, the countries that, unlike the US and Europe, are truly hurt by a weak yuan. Krugman suggests that the China-US trade imbalance would drop if the yuan appreciated, but such a case is also unlikely, as most companies would simply move production to lower-cost places rather than accept lower margins or move jobs back to the US, where workers are unlikely to accept $100 a month to make Nike sneakers (NYSE:NKE).

If China doesn't appreciate the yuan anytime soon--and Chinese Premier Wen Jiabao made clear last week that it won't--should the US impose a 25% tariff, as Krugman advocates? I don't think so. Such a course of action would not help anyone.

First, although globalization has become a popular whipping boy in the financial crisis, some level of globalization does help both American companies and consumers. One thing Krugman seems to forget is how much American companies benefit from production in China. Take Apple (NASDAQ:AAPL) and the iPhone, for example. Apple is a huge beneficiary of overseas production. Chinese workers assemble phones at factories in Guangdong owned by Foxconn (OTCPK:FXCNY), a Taiwanese company, but Apple is so good at squeezing all it can from its suppliers and manufacturers that most of the profits go to Apple.

Jason Dedrick, a professor at Syracuse University and co-author of the study Mapping the Value of an Innovation: An Analytical Framework, estimates that only 2% of the retail price of an iPhone goes to its Chinese assemblers, and 50% goes to Apple and the retailer in America. Imposition of a 25% tariff would hurt Apple, and Apple's workers in the US and shareholders, the most. American companies are scrounging for any profits they can get right now. Increasing their costs and consumers' costs will not get the economy back on track. Until companies start to generate more earnings, the employment picture will not brighten.

Furthermore, if product prices increase because of tariffs, there's greater danger of massive inflation. Increasing import duties while the Fed increases the money supply and keeps interest rates low would have an astronomical net cost to the American consumer. With consumers already paring down their spending, inflation is something the Fed needs to be very concerned about. The US needs to rebuild global confidence in the dollar. A weak dollar benefits no one right now.


What should the US do about the yuan? Instead of calling China a currency manipulator, as many in Congress want it to do, the Obama administration should continue to push for reforms, but through back channels, not public stridency. The reason is the situation within the Chinese government: Right now there is a lot of jockeying going on for spots that will open up on the Politburo Standing Committee when the current leadership retires in a few years. Reformers, trying to placate hardliners, are taking more hard-line positions, and hard-liners are becoming super-hard-line. Publicly putting China's leadership on the spot, as Google has done, makes the Chinese do the opposite of what you want. No one vying for power can be seen as soft or as giving in to foreigners.

The US should also ease its restrictions on technology transfers to China, so that China can buy more value-added goods from the US. Too many products and technologies are banned from export to China. Allowing American companies to sell their products to more markets would be a good thing for American companies and improve the trade imbalance.

If we were to follow Krugman's advice and ramp up protectionism, a trade war would break out, and both America's and China's growth would stop. Needless to say, that would badly damage business confidence in both the US and China. Global business confidence is improving precisely because emerging markets like China and Brazil are plowing ahead. Fear, more than anything else, made the current financial crisis as bad as it has been. We cannot let it reemerge.

Disclosure: No position