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Why is currency just part of the solution?

In recent years, the discussion in Washington regarding the U.S.-China economic relationship has focused in large part on China’s currency policy. Some lawmakers assert that an undervalued yuan makes cheap Chinese exports even cheaper. This gives Chinese producers an unfair advantage over American companies. And it contributes to the 2010 U.S. trade deficit with China of $273 billion, up 21 percent from the year before.

For years, China has stated that its goal is to liberalize its exchange rate. On July 21, 2005, Chinese authorities revalued the yuan by 2.1 percent. In total, the yuan has appreciated more than 25 percent since 2005. Still, political pressure on China continues to mount. Legislation to impose a 27.5 percent tariff on imports from China unless the yuan is significantly re-valued has garnered bipartisan support in both chambers.

Progress toward a market-determined yuan is important. But the reality is that even if China dramatically re-valued the yuan against the dollar, or immediately allowed the yuan to float according to market forces — which it can’t, due to the underdeveloped state of its capital markets — the impact on the overall U.S. trade and current account deficits would be quite modest.  In fact, because a higher-valued yuan would mean that imported Chinese goods would be more expensive, the initial effect of a significant appreciation would likely be to make U.S. deficits worse.

Of far greater significance to the policy objective of reducing the U.S. trade deficit is helping to activate China’s 1.3 billion potential consumers. A simple example reveals why:

  • Last year, the United States exported $92 billion to China. 
  • Japan, with a population one-tenth that of China, consumed $61 billion worth of U.S. exports last year. 
  • The European Union, whose population is about a third of China’s, consumed two and a half times the exports from the United States ($240 billion) last year as China did. 
  • If China began consuming U.S.-produced goods and services at the rate that Japan and the European Union currently do, the U.S. would export about $640 billion to China annually — $540 billion more than we did last year.
  • This would turn a $273 billion trade deficit in 2010 into a $267 billion trade surplus.

Given the importance of our trade relationship with China to economic growth and job creation in the United States, policymakers should devote the same, or even greater, focus to expanding market access and continued financial modernization in China, as they have to other aspects of the bilateral relationship.