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Economics Essays

“Let China sleep, for when she wakes the world will shake,” said Napoleon some 200 years ago. If China’s economic growth rate and its foreign reserves are any measure, then Napoleon’s prophecy already stands validated. China’s rapid rise has once again raised the debate on a bi-polar world, which had previously ended with the fall of the Soviet Union in 1991.

Some political economists are optimistic about America’s robust economy and believe that China lags far behind the U.S. both in military might and economic prosperity, and talks of a bi-polar world are exaggerated. While others are skeptical of this view and refer to the miraculous Chinese growth in all areas of competition which is rising fast to challenge the U.S.

This essay reviews the intricate US-China relationship in the new world order with respect to their trade pattern, and the impact of the exchange rate policy on the U.S. trade deficit, and on the U.S. economy at large.

Earlier this year, China overtook Germany to become the world’s largest exporter and the world’s second largest economy. [1] Not surprisingly, the America’s trade deficit with China – a staggering $227 billion – was the largest between any two countries. [2] It makes obvious economic sense that the two countries trade so heavily with each other.

After all, U.S. is the wealthiest country in the world and also the biggest consumer nation, while China is the most populous country, hence having a clear cost advantage in the production of labor intensive goods. A cursory understanding of the theory of comparative advantage can demonstrate how both economies can command mutual gains from trade.

The U.S. consumers gain from importing low cost Chinese goods, while the U.S. producers lose as they have to compete with cheap Chinese labor and production costs. In China, the producers gain as they can sell Chinese goods at higher prices to foreign markets, while the Chinese consumers lose as they pay higher prices for these goods. Thus, the US-China trade bond has flourished because of their complementary economic structures and their shared gains from trade.

Many Americans are skeptical of an ever increasing reliance on China for cheap consumer goods. What they overlook is that America still enjoys a massive technological advantage over China. Moreover, most of the goods imported from China are outsourced there by American companies, so ultimately it is American corporations who profit and benefit domestic shareholders.

And lastly, India, Brazil, East Asia, and even Russia are other emerging economies which have a reservoir of skilled labor and vast potential to become export giants. In short, American consumerism can attract other economies to cater to American needs and choose an export led path to growth, just like China. On the other hand, China cannot find a bigger market for its goods than America and thus, it has a relatively weaker position in this trade relationship.

This brings us to the second issue discussed in this paper. Economic theory suggests that a trade deficit leads to a depreciation of the exchange rate, thus initiating a self-adjusting mechanism through which a deficit or a surplus will tend to move towards the balance of payments equilibrium. A natural question then arises, that why has the U.S. had a consistent deficit with China over the last decade?

The answer is because China does not have a free-float exchange rate. China manages its currency. Some analysts even argue that China manipulates its currency and keeps it undervalued so it does not lose competitiveness. If and when the dollar loses value relative to the Yuan, the Chinese authorities intervene by supplying more Yuan and buying U.S. government treasuries to keep the dollar-Yuan parity within a certain favorable range.

Last fall, the U.S. Secretary of Treasury, Timothy Geithner raised this issue with the Chinese authorities, only to his disappointment. The Chinese authorities maintain that a stable Yuan is in the interest of both countries, and by allowing a completely free-float exchange rate they will risk a crisis similar to the Asian Crisis that hit the East Asian economies in 1997, or the Mexican Peso Crisis in 1993.

Further, they argue that the Yuan has gained steadily against the dollar over the last decade, and a gradual adjustment of exchange rate is the only feasible option in the mutual interest of both countries.

For many Americans, this is an irksome area in the relationship between the two countries. As China attempts to keep its exports cheap by continuously buying U.S. treasuries, it has ultimately become the biggest lender to the U.S. government and holds as much as $1 trillion in treasury bills.

Americans are concerned that this gives China a political leverage over the U.S. because it could start selling off the government bonds to appropriate its loan at any time. In reality, as the recent literature on this issue reveals, the American position is not that grotesque. Let us review some recent literature to get a clearer picture of this complicated relationship.

For instance, Andrew Nathan, a Professor of Political Science at Columbia University, and a specialist in Chinese foreign policy, expounds that the American concerns are overstated.

He contends, even if China becomes the wealthiest country in the world, it will not have the technological advantage, it will only account for 6 percent of the world GDP, equal to that of two Californians, and on a per capita basis, it will still be 100th in world rankings; neither will it have yuan as the world’s reserve currency, nor will it set parameters for commodity prices etc, and will not have political clout over the World Bank or IMF (McKinsey & Company 2009).

Stephen Cohen, a Professor at the University of California at Berkeley, in his recent book, ‘The End of Influence’, writes that China holds $2.5 trillion in reserves. Chinese reserves are so huge, he asserts, that China cannot sell this amount without hurting its own economic interests, and there is nothing else it can sell so much dollar for, not at such a large scale (Foreign Policy 2010).

The positive aspect of the US-China trade relationships is not just appreciated by Americans, but also by the Chinese scholars and politicians alike. More recently, Chinese Commerce Minister, Zhong Shan writing for the Wall Street Journal focused on how the world economy has benefitted during the recession from China’s resilient growth.

He further pointed out that it is because of cheap Chinese goods that have kept down the cost of living in America. Addressing the undervalued yuan issue he said ‘[f]rom 2005 to 2008, the renminbi appreciated by 21% against the dollar but China’s trade surplus with the U.S. increased by 20.8% annually’ (Wall Street Journal 2010).

After reviewing the recent literature on the subject, the complexities of the relationship become more apparent, but that does not necessarily mean that this relationship skewed against America’s disadvantage. Americans should remind themselves that America will stay the wealthiest country per capita for a long time.

Secondly, America is the only country to lend, borrow, and trade in its own currency and have the benefit of a global reserve currency. And lastly, in the words of John Paul Getty, if you owe the bank $100 that’s your problem, if you owe the bank $100m, that’s the bank’s problem, and it appears that the huge US debt is China’s problem.