Posted in Finance Articles, Total Reads: 3714
, Published on 12 June 2011
China’s rise as manufacturing giant has not only established its supremacy as one of the leading economy but also has made United States, largest economy in the world, totally dependent on it. In Feb 2011, US trade deficit with China was $270 billion. Deficit means United States imports from China were $270 billion greater than its exports to china.
China is able to produce low cost goods which has made itself manufacturing hub for almost all the global companies. Companies like Apple, HP have their manufacturing units set up in China. Reasons for china’s competitive pricing are lower standard of living which allows companies to pay them lower wages and exchange rate which is set by China’s central bank at a level always favorable for Chinese exports.
Question which comes to mind is how China manages to keep its exchange rate lower despite huge demand for Chinese goods. Whenever demand for yuan increases leading to appreciation, China’s central bank steps in, buying US dollars through US treasuries. At present, china holds approximately $1.3 trillion dollars of US’s debt. Lower value of Yuan not only makes US manufacturers less competitive but is also fueling inflation in China. In order to keep its currency at low value, china needs to buy more dollars releasing yuan in the market which increases money supply in the market leading to inflation. China’s central bank has taken inflation curbing measures by hiking interest rates but in the longer term china will have no other option but to let yuan appreciate. Also increasing interest rates will not help as increases in its interest rates would only increase demand for the RMB, forcing China to supply even more Yuan to maintain the peg with the dollar.
How does US trade deficit with China affect US economy?
China bought US treasuries to support the value of dollar. It is the biggest lender to the US government. By buying treasuries China helped US to keep off the interest rates. Until subprime crisis in 2008, low interest rates led to housing boom. Post recession, if China stops investing in US treasuries, then it would lead to interest rate hike leading to delay in recovery from the recession.
How can US reduce its overall trade deficit?
It will take continued international pressure, not just efforts by the U.S., to encourage China to let its currency appreciate faster. Naturally, China takes a different view of its fixed-band yuan exchange and the trade situation, arguing that it needs to keep the yuan at a low value to protect its nascent industries. Although china has indicated it plans to let the yuan appreciate slowly, policymakers in china suggest that the best way for the U.S. to reduce its trade deficit with China is for the U.S. to consume less and save more.
The Stats :
But can the appreciation of Yuan solve the problem? Definitely the china’s imports from US will increase reducing the overall trade imbalance with China. As the Yuan strengthens against the dollar, some US multinationals manufacturing there could shift production to lower cost countries, meaning the overall trade deficit would not be changed. Ten years ago most of the goods sold in US were made in Japan and after a decade later, it is “Made in China”. To suggest that if the item is not made in China, it will be made in USA is misleading.
So the revaluation of yuan may not have much effect on the US foreign trade as a whole. Moreover, if China has no more foreign trade surplus, it will not be able to lend huge sums of money to the US at low interest rates. Globally, the effect on the US economy would therefore be negative or even disastrous. How accurate is to blame low valued yuan for its high trade deficit? Is the only way for US to reduce trade deficit is to consume less and save more? Please leave your comments.
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