Bashing Beijing Will Not Help Our Trade Deficit

Robert C. Pozen

Pressured by the U.S. and other countries, China announced in June that it would adopt a “flexible” exchange rate for the
yuan. Yet to date there has been minimal appreciation against the dollar, so the pressure is back. Responding to reports on
China’s rising trade surplus in July, Sen. Charles Schumer (D., N.Y.) said last week: “These numbers show just how little
motive China has to end its currency manipulation.”

Many American politicians want the yuan to appreciate relative to the dollar in order to reduce the U.S. trade deficit—by
making Chinese exports more expensive, and encouraging Chinese consumers to buy more imports. However, the value of the
yuan is not the main driver of the U.S. trade deficit. The wages and social safety net of Chinese workers are more important.
Labor is the most significant component of most goods exported from China to the U.S. If wages go up in China, then the
prices of its exports will rise—absent a proportional increase in labor productivity. Wages are direct costs of producing
Chinese exports, which cannot be easily avoided by currency hedging.

The higher prices of exports from China should reduce the incentive of U.S. consumers to buy low-end goods from China like
toys and clothing. While higher prices for Chinese exports will also increase the prices of consumer goods in the U.S., a little
price inflation would be a welcome antidote to the dangers of potential deflation in the U.S.

And if wages rise in China, its workers would have more money to spend. Admittedly, Chinese workers are big savers, not
spenders, because of the weak social safety net there. Ironically, in the People’s Republic of China, most Chinese workers must
rely mainly on their own resources to pay for health care and retirement. Nevertheless, higher wages have been closely
correlated with higher private consumption in China, according to the World Bank.

Between 1993 and 1995, for example, wages rose to 54% of GDP from 50% as private consumption rose to 49% from 47% of
GDP. Conversely, between 1999 and 2006, wages declined to 40% from 52% of GDP as private consumption dropped to 37%
from 47% of GDP.

Over the last two months, the average minimum wage in China has increased by an average of 20% in at least 18 provinces,
including Beijing and Shenzhen. These increases in minimum wages reflect the smoldering labor disputes at many Chinese
plants. For instance, striking workers at the Honda plants in southern China recently accepted wage increases of 24% to end
their strikes. As higher wages are reflected in higher prices of Chinese-made goods, fewer of these goods will be purchased by
consumers in America and Europe.

By contrast, the value of the yuan is not closely correlated with the size of the U.S. trade deficit with China. Although the
relative value of the yuan to the dollar rose by 20% between 2005 and 2008, the U.S. trade deficit with China climbed to a
record $268 billion in 2008, from $202 billion in 2005. There are several reasons for this disconnect between currency values
and trade deficits.

First, many exports from China to the U.S. are only assembled in China; as with Apple’s iPod, most of the components are
made elsewhere. Since the Chinese input constitutes no more than 10% of such exports, even a 20% appreciation in the yuan
would at most increase the prices of these exports by 2%.

Second, the appreciation of the yuan relative to the U.S. dollar may cause China to lose low-end exports to countries like
Bangladesh and Vietnam—thus leading to job losses and lower imports by Chinese workers. However, such a shift in low-end
exports from China to other countries will not reduce the overall volume of exports to the U.S., just the country of origin.
Third, the volume of U.S. exports to China is primarily influenced by competition with countries such as Germany and Japan
on high-end capital goods like supercomputers and jet engines. The critical determinant in this high-end competition is not so
much the value of the yuan, but more the value of the dollar relative to the euro and yen.

In short, American politicians should not push so hard for yuan appreciation—which has, by provoking resistance in China,
been counterproductive. Instead, they should support higher wages and a stronger safety net for Chinese workers. These
measures would not only help reduce the U.S. trade deficit but also would be consistent with recent efforts of China’s officials
to improve the living standard of its workers.