China, China, China
This post is the third in a three part series that attempts to dissect and evaluate popular lines of rhetoric surrounding trade. This article seeks to address the trading relationship the United States maintains with its largest trading partner, China.
Rhetoric Line 4: CHINA, CHINA, CHINA
As the administration continues to follow through on controversial trade policies, many households, businesses, and foreign entities are evaluating how to best position themselves for what lies ahead. To assess the short and long term ramifications of such policy, it is important to first understand the underlying intricacies of the US-China relationship. It is these intricacies that make wide sweeping legislation potentially dangerous.
Debt and Currency — Expansionary policy in the present and the past, coupled with escalating social program expenditures, has left the United States with a debt growth rate that is quickly becoming unsustainable. Excessive debt not only serves as a form of borrowing from the growth of tomorrow, it can also lead to an unintended reliance on foreign entities.
The hard reality of the United States’ debt situation is that as it escalates the United States becomes more reliant than ever on cheap interest rates and large purchasers of US debt. There is a significant amount of research being done on the ultimate impacts of China retaliating to the current trade war by selling off its US treasuries. This practice will also be referred to as “treasury dumping.” Conclusions vary in expected impact, and there are undoubtedly measures that could be taken to lessen the blow, both by the Federal Reserve and the Treasury department. The unescapable fact however is that China currently serves as the number one foreign holder of US debt and the largest incremental purchaser in the world.
Before exploring how China came to be the largest foreign holder of US debt, and the implications to trade and monetary policy, it is first important to understand the supply and demand dynamics that make the release of US treasuries potentially dangerous while considerably unlikely. The description that follows is meant to be simplistic and does not take into account reactions from US and foreign organizations. Nevertheless, this simplistic example will suffice in understanding the basic tenants of why treasury dumping is a subject of debate among economists and policy makers as they speculate how China might respond to new tariff threats from the United States.
Basic supply and demand economics teaches us that an over supply of a good results in lower prices. Lower prices serve to entice buyers to purchase more of a good. If more treasuries are available than purchasers would normally be enticed to buy, the issuer of the treasuries must make the prospect of purchasing treasuries increasingly advantageous to the buyer. If China begins to sell off the treasuries it holds, this will serve to increase supply. Thus, the next time the US treasury department goes to sell additional debt to pay for government expenditures, it will need to entice buyers by promising to pay higher interest rates. The interest paid on debt crowds out funds that would otherwise be used to cover government provided goods.
China making the decision to release its reserves of US treasuries into the market is not without repercussions to its own economic wellbeing. The US dollar being the reserve currency of the world means China will not entirely deplete its holdings of treasuries. Releasing treasuries into the market will serve to make remaining holdings less valuable. More important than the impact to China’s balance sheet, is the impact such actions would have on the value of the Chinese yuan. In simplified terms, if China sells off US treasuries it will hold more of its own currency. This results in a seesaw effect where there is now a greater supply of US dollars in the market and a smaller supply of Chinese yuan. As a result the dollar depreciates in value and the yuan appreciates. As will be discussed next, this negatively impacts China’s ability to export to the United States. China could attempt to lessen the appreciation of its currency by purchasing the debt of other countries, but the depreciation of the dollar still makes this a risky move.
China’s interest in keeping the value of its currency low relative to the dollar has been a source of controversy and has been the driver behind campaign rhetoric accusing China of being a currency manipulator. Currency manipulation is considered an unfair trade practice as a lower currency value makes a country’s exports more attractive. If your 1 dollar goes from buying 50 yuan of Chinese goods to 100 yuan, you will now be incentivized to purchase far more goods from China. Conversely, if 50 yuan goes from being worth 1 US dollar to half a dollar, Chinese consumers will be less incentivized to purchase US goods.
Emerging markets benefit from a lower currency valuation, and it is not uncommon for such markets to take actions to depress their currency as they continue to develop. Free market forces would typically serve to increase the value of a country’s currency as it develops and continues to export a greater number of goods. When countries undertake practices to manipulate the supply of their currency relative to trading partners, thus depressing its value, free market forces are not allowed to take effect.
It is true, in the past, China has practiced overt currency manipulation. From 1994 to 2005 the Chinese yuan stayed at absurdly low levels despite rapid growth in the country’s GDP. In a free market, such growth would have dictated an appreciated currency value. Since 2005 however the yuan has been allowed to appreciate and the stated goal has been to maintain the currency’s stability.
To ask China to truly float its currency, allowing the yuan to appreciate through free market forces, would most certainly send shock waves across the global economy. Firstly, consumer goods would become significantly more expensive. US consumers would see their spending power lessened and the risk of inflation would inevitably increase. Second, allowing the yuan’s value to be governed purely by free market forces would dictate a slow down, if not termination, of Chinese US treasury purchasing. If China stops buying US treasuries or starts to release its reserves into the market, US interest rates will likely have to rise.
With the above ramifications of debt and currency exchange rates in mind, it is important to consider how such dynamics play out in a trade war. For reasons discussed above, it is very unlikely China would retaliate by attempting to increase US debt interest rates by dumping reserves into the market. In fact, the exact opposite is significantly more likely. As the United States increases tariffs on Chinese goods, making them more expensive to US consumers, the Chinese central bank can offset these increased prices by devaluing the Chinese yuan. Take the simplified example of purchasing a Chinese-made t-shirt.
At a 1 dollar to 50 yuan exchange rate you are motivated to purchase a $5 made-in-China t-shirt. Your $5 purchased you a good worth 250 yuan. In the event of a 20 percent tariff, the t-shirt would now cost you $6 (assuming the manufacturer of your t-shirt increases the sales price by the full amount of the tariff). As a result, you may be persuaded to purchase an equivalent domestic t-shirt costing you $5.50. If China retaliates by devaluing its currency such that 1 US dollar is now worth 60 yuan, you can now purchase 250 yuan of Chinese goods with $4.17. After the 20 percent tariff the good once again costs you $5. As $5 is less than $5.50, you will once again be incentivized to purchase the made-in-China t-shirt.
The above example is clearly simplified and doesn’t account for comparative elasticities and the impact such elasticities have on how much of a tariff is ultimately passed on to the consumer. Nevertheless, the deadweight loss to GDP resulting from foregone transactions, and the costs passed on to consumers by way of higher sales prices, are consequences that have been proven out by economists dating back as far as Adam Smith. These issues, compounded by China’s willingness to devalue the yuan, makes room for serious market distortions to take shape as trade tensions intensify.
Inflation Stabilization — The globalization of trade is one reason, albeit among many, we have experienced notable inflation stabilization over the past decade. Starting in the earlier parts of the 21st century consumers became accustomed to the Made in China sticker found on the majority of household goods. The cheap and plentiful labor force in China was able to manufacture goods at a rate far lower than American companies. And this should not be scary. Economic prosperity in the United States has resulted in higher wages and higher costs of real estate. The country’s position in the world has forced a transition from low skill to high skill jobs.
This evolution is not unusual. Over time, assuming free market forces are allowed to govern, China will ultimately have to endure the same transition. Even now there are an increasing number of Made in Taiwan and Made in Indonesia stickers appearing on imported goods. As new and even lower cost countries have begun to build manufacturing infrastructure, companies have logically begun purchasing from and manufacturing within these areas. To maintain its “low cost everyday” guarantee Walmart must constantly look to where the best priced goods are being sourced.
This capacity to source from new markets has lowered the risks of inflation. If the cost of an imported good from a given country begins to escalate, buyers will begin the search for a lower cost alternative. Low cost goods have had remarkable impacts on the standard of living as they have guaranteed affordable prices on a wide range of consumer goods.
THE BOTTOM LINE
As the United States’ ability to adapt to a globalizing economy is put to the test over the coming decade, it will be increasingly important to thoughtfully devise a strategy that promises to keep the American people relevant and competitive abroad. The United States must learn from the successes and failures of countries around the world to retrain and retool their workforces. The United States must call upon subject matter experts in the academic, private, and public sectors to create a vision of what American competitiveness looks like in the years to come. Without thoughtful planning and strategic analysis, the appropriate foreign relations and policy decisions will not be possible.
