Pressuring China On Exchange Rate Policy: Even When You Win, You Lose

China is dominating the financial news this week. The Chinese government announced a $3 billion investment in The Blackstone Group (BX) private equity firm in an effort to boost the return on the $1.2 trillion Chinese foreign exchange reserves.

Most of those reserves are in U.S. Treasury bonds as a result of the strict Chinese exchange regimen. With the Chinese representatives in Washington, D.C. to discuss economic issues impacting China and the U.S., there is a keen focus on the exchange rate between the dollar and the yuan.

Ahead of the negotiations China announced a new level of flexibility in the exchange rate and other monetary measures. Protectionist policy makers will push for further and faster changes in the Chinese exchange policy.

The outcome of the U.S. - Chinese talks are uncertain, but one thing is very clear. Pressuring the Chinese to float their currency is like jousting at windmills; even if you win, you achieve nothing. The protectionists are ignoring a basic law of trade: one cannot change the terms of trade by altering the unit of account. The China bashers are on an intellectual par with Count de Monet.

In yesterday's WSJ, Matthew J. Slaughter offers more proof:

To demonstrate this critical point, look to Europe. The yuan floats against European currencies such as the euro and the pound. If nominal exchange rates were driving trade flows as commonly alleged, then Chinese exports to the U.S. should have been growing faster than to Europe. The data show something completely different, however. In 1995, monthly Chinese exports to both destinations averaged about $2 billion. By 2006, monthly Chinese exports to both destinations were still the same, at about $17 billion. Plotted together over that entire decade, these two series look nearly identical. This is because the same real economic forces -- e.g., China's relative abundance of less-skilled labor -- have been driving both sets of trade flows

Put it this way: In a counter-factual world where over the past decade China allowed the yuan to float against the dollar, the U.S. would still have run a large and growing trade deficit with China. The real economic forces of comparative advantage that drive trade flows operate regardless of which nominal prices central banks choose to fix.

We've covered the cause of the trade deficit before. It is simply a result of our superior treatment of capital which attracts capital from all over the world. As a result, other nations must run a trade surplus with the U.S. in order to invest capital here. More importantly, China and other nations (like Kuwait) should alter their currency pegs when it is in their best interests. Small and emerging countries often benefit from a currency peg to the world's reserve currency, as it adds needed stability. However, when U.S. policy makers devalue the dollar as rapidly as they have since 2004, these same countries may need to abandon their currency pegs in order to seek stability.

Comments

[Eric Balkan:]

Attracting capital causes a trade deficit? Then China, the country attracting the most capital worldwide -- an estimated 70% of their economy is due to FDI -- should have the largest deficit.

I agree that changing the yuan-dollar rate won't change much. The trade deficit we have with nearly everyone is because we no longer make very much that other people want to buy: airplanes, movies, packaged software... that's about it. Pretty much everything else, from medical care to computers to fuel is better/cheaper overseas.

2007 May 24 06:33 PM

[dlj_canada:]

It's always interesting -- and annoying -- to see people using the term "comparative advantage," when what they mean is "advantage."

It's a sure sign that the guy is on autopilot.

2007 May 25 12:09 PM