In a close election year, the easy option for politicians is to blame America’s economic woes on China. America’s bilateral deficit with China hit a record $295 billion for last year. Protectionist sentiments are running high with recent complaints filed with the WTO that China does not follow the rules. Passage of a countervailing tariff bill exemplifies the skirmishes that are coming. These efforts are bolstered by repeated calls for the renminbi to be revalued upwards to offset China’s alleged currency manipulation.
The problem is that this isn’t the real story.
From China’s perspective, admonitions that the renminbi is significantly undervalued seem devoid of logic. China’s current account surplus has declined from 10 percent of GDP five years ago to less than 3 percent last year and many project even further declines. Moreover, Beijing finds it perplexing that after steadily appreciating the renminbi by nearly 40 percent in real terms since 2005, critics say that the renminbi is still undervalued by the same 20 percent or more as if nothing has happened over the past five years.
Much of the confusion comes from focusing on the still huge US-China bilateral trade imbalances rather than looking at it from a global perspective.
Chinese policy-makers are reminded that the US took a similar approach in complaining decades ago that an undervalued yen was the major reason for Japan’s sustained trade surpluses. That the Japanese yen appreciated from 240 to 80 to a dollar in response to the 1985 Plaza Accord and yet continued to run a surplus until its recent nuclear disaster reminds the Chinese leadership that factors other than the exchange rate are far more important in shaping trade balances.
The truth is that China’s surpluses are not driving America’s deficits. This is illustrated by the differences in timing for when changes to both countries’ trade balances occurred. The US trade deficit began increasing rapidly around 1998 and peaked around 2005. China’s trade surpluses began increasing around 2005 and peaked in 2008. This pattern suggests that US deficits and China’s surpluses are not directly related but reflect global shifts and country specific circumstances.
Clearly “manipulating” the value of the renminbi had little to do with the emergence of China’s trade surplus since its value was pegged to the dollar until 2005. And only as the renminbi began to appreciate, did China’s surplus increase.
One could argue that China’s reluctance to allow the renminbi to appreciate even more rapidly after 2005 allowed surpluses to grow larger. However more rapid appreciation would likely not have reduced US trade deficits but only transferred some of the China specific surpluses to other Asian countries as long as the US continued to run major fiscal deficits.
The driving force behind the US deficits and China’s surpluses lies not in exchange rates but in structural factors that built up over time. Three factors largely explain the emergence of China’s trade surpluses: surging US consumption that fueled import demand, maturation of the East Asian production sharing network centered on China, and ratcheting up of China’s savings rates.
The story of the origins of the decline in US household savings rates which was then exacerbated by growing fiscal deficits and together led to the excessive demand for imports is well known and still unresolved. This part of the story has little to do with China but reflects the political gridlock in Washington.
The role of the Asian production sharing network did not just surface in the mid-2000s. It began much earlier as Japan moved portions of its production base to Southeast Asia decades ago. China’s central role took off only with its accession to WTO in 2001, giving it easier access to Western markets. This was supported by a massive infrastructure construction program that strengthened its competitive position.
Thus despite substantial real wage increases of around 12 percent annually, labor productivity increased even more rapidly at an estimated 15-20 percent, making it profitable for multinational firms to use China as the assembly plant for the world. Thus the US trade balance with China is really a regional rather than a bilateral issue and one which has been substantially shaped by the interests of firms like Wal-Mart in driving costs down.
Processing exports account for about half of China’s trade volumes but generate the entirety of its surplus. This trade – often exemplified by China’s exports of Apple’s I-Pads to the US – typically depends on the import of high technology components made elsewhere and then brought into China for assembly and export to the West. Eighty percent of the value added for these components is generated elsewhere with China’s contribution concentrated in the lower technology components and labor assembly.
The particular country mix in processing trade is shown by the jump in the trade surpluses of South Korea, Japan and Taiwan with China which went from $30 billion to over $200 billion in the decade up to 2010. Thus China’s trade surplus with the US originates largely from this North Asian trio. And rather than complain about China’s exports of low tech – labor intensive products, the real question is why America is not able to produce the high tech- capital intensive components coming to the US via China from the North Asian trio. These activities command the skills and salaries that would be more appropriate for American workers.
When President Obama welcomed his counterpart from South Korea to Washington last year, he commented approvingly that South Korea’s trade with the US was in balance – “as it should be”. What Obama should’ve done was congratulate Lee by noting that South Korea along with several others has been able to avoid US criticism by hiding its trade surpluses behind the Great Wall of China.
Studies such as one done recently by a Federal Reserve Bank have shown that appreciation of the renminbi by itself would do very little to curb China’s trades surplus with the West, since much of the impact is negated by the lower cost of imports into China. Since exchange rates for the major East Asian countries are now closely aligned in their movements, it would take a more coordinated approach of the major East Asian countries to a make a difference. Only the domestic labor content is affected and this is typically only a few percentage points of the cost.
More significant in its impact on trade balances has been the rise in household savings rates. Accounting identities tell us that the trade balance is the difference between what an economy saves and what it invests. The surge in China’s savings rates in excess of the rapid growth in investment explains the emergence of the huge trade surplus during 2005-08.
While many studies have suggested that Chinese household savings rates rose because of welfare concerns and demographics, the major factor has gone unrecognized. Rapid urbanization and the movement of some 250 million migrant workers into the major coastal cities have changed the savings dynamics in China. Restrictive policies have prevented these migrants from being given formal residency rights and thus repressed their consumption instincts. Consequently, migrant workers savings rates are as much as twice that of established residents in some cities, and as their incomes have soared, this has led to a sharp increase in household savings and in turn amplified China’s large trade surpluses.
These trade surpluses began to decline when China’s stimulus program drove up investment rates after 2008. But such high investment rates are not sustainable, thus consumption needs to increase as a share of GDP. For this to happen, the key is more rapid urbanization and lower household savings rates.
This has already begun. In the last two years there has been a modest increase in the share of consumption to GDP (which has not yet shown up in the official accounts). This has occurred because recently rural incomes have been increasing faster than urban. Since savings rates are lower for rural relative to urban households this is reversing the historic decline in consumption as a share of GDP. In addition, as migrant workers move inland because of lower living costs and better job opportunities, this is also boosting consumption.
This process of rebalancing in favor of more consumption would be given a big boost if migrants were given formal residency rights. Since their abnormally high savings amount to 2-3 percent of GDP, this would lead to a surge in consumption that would eliminate China’s trade surpluses even as investment rates decline in the coming years.
Financial markets typically focus on exchange rates in analyzing China growth and trade prospects. But in doing so they miss the power of these kinds of structural shifts which would moderate global trade imbalances in ways that are far more beneficial to both China and the US than the politically charged focus on appreciating the renminbi and actions that push both sides toward more protectionism.
Yukon Huang is a senior associate at the Carnegie Endowment and a former World Bank country director for China
(A shorter version of this paper was published by Bloomberg on April 19, 2012 with the title: “Don’t Blame China’s Currency for US Trade Deficit”.)
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