The United States and China continue to bicker over trade issues. We criticize China for keeping its currency artificially cheap compared to the dollar. President Barack Obama made that point forcefully in various settings on his recent trip to Asia.
The Chinese response, typified in a recent speech by Premier Wen Jiabao, is that China’s currency policies are not a trade issue. Moreover, they say that China is the victim of unfair protectionist measures like the tariffs on cheap Chinese tires that the Obama administration imposed earlier this year. We respond that the tire tariffs are legal under existing trade agreements and apply only to a minuscule fraction of all that we import from them.
Who is right? In a narrow legalist sense, both sides are. The tire tariffs that the Obama administration imposed probably are legal under World Trade Organization rules as part of a general escape clause that allows trade restrictions in extraordinary cases. But these imports clearly posed little danger to the U.S. tire industry and the restrictions were clearly a sop to a specific set of Democratic Party stalwarts.
In an narrow legal sense, the Chinese also are right. Existing international trade law says little to limit the use of exchange rate manipulation as a trade tool. Indeed, this is one of the crying omissions of current agreements. So we have no legal basis to use trade agreement enforcement mechanisms to force the Chinese to change.
But in a broader sense, this is a dispute in which the Chinese are wrong and the magnitude of their policy actions dwarf the minor tariff increases imposed on Chinese exports. Moreover, what the Chinese are doing with the yuan has essentially the same effects as a tariff.
This is not obvious. But an import tariff changes the relative prices of imports relative to domestically produced products. It makes the imported good more expensive for buyers. Domestically produced products become relatively cheaper.
With imports more expensive, domestic producers can raise prices without losing as much in sales as they would if the tariffs were not in place.
Subsidizing domestic producers can have the same effect as imposing a tariff on imports. It makes the domestic goods cheaper relative to the unsubsidized imports. Consumers respond by buying more of the domestic products than they would if they weren’t subsidized, and hence they buy less of the imports. Historically, this did not violate agreements between nations to limit tariffs.
The European Union and many nations used subsidies for agricultural products in this manner for decades. These subsidies often supplemented import tariffs rather than replaced them. The two policies had similar effects, but subsidies were deemed domestic policies under trade agreements.
Limiting such subsidies was a contentious and unfinished issue in the Uruguay Round of trade negotiations that dragged on from 1986 to 1994 and gave birth to the World Trade Organization. Domestic subsidies remain an issue in the moribund Doha Round.
Exchange rates, the value of one currency in terms of other currencies, also affect the relative prices of imports and exports. This is true whether the rates are floating, that is, set by market forces, or determined by government policy.
Consider that a bushel of U.S. soybeans that costs $10. When the euro was first introduced in 1999 at $1.19 per euro, those soybeans cost a European buyer 8.4 euros. The value of the euro slid to $.83 by late 2000 and the beans cost more than 12 euros, nearly a 50 percent increase. But by late 2008, with the euro at $1.56, the price of a bushel to a euro-zone buyer was only 6.4 euros.
A cheap currency has the same effect as an import tariff or a subsidy to domestic producers. It makes domestic products cheaper relative to imported goods.
Countries can act, usually via their central banks, to manipulate the value of their currencies. If you want to discourage imports, promote exports and favor domestic producers over domestic consumers, you try to keep the value of your currency low relative to the currencies of your trading partners. Another way of saying this is that you act to increase the value of other currencies.
It is a simple matter of supply and demand. The greater the demand for anything, the higher its price. In this case, the central bank supplies the demand for a foreign currency by buying up whatever quantities are offered to it. The central bank often simply creates more money to make these purchases.
China has done precisely this. A 50-yuan Chinese-manufactured shirt would have cost $8.65 in 1993 when the exchange rate was 5.8 yuan to the dollar. It would have only cost $6 from 1995 through 2005 as the Bank of China bought up trillions of dollars so that it took 8.3 yuan. This, of course, would have kept $10 U.S. soybeans at 83 yuan instead of at 58.
After 2005, China let the yuan increase in value by some 20 percent. But since mid-2008, it is once again holding it at a fixed value that does not reflect market realities.
So Premier Wen Jiabao’s distinction between some minor tariffs imposed by the United States and his own country’s currency policy is pure poppycock. But there is as yet no international agreement that clearly bans what China is doing. And so all the United States can do is alternately beg and bluster.
© 2009 Edward Lotterman
Chanarambie Consulting, Inc.