The Contrived China Advantage

We all know what’s it’s like to have the odds stacked against us. Go to a casino, play a game when one of the players is cheating, marked playing cards – you get the picture, and you know what usually happens – you lose. This is exactly what’s happening with our trade with China. The U.S. is in a losing position. There is such a huge imbalance of what China exports to us and what we export to them, hence the large trade deficit with China that we hear about pretty regularly. In 2011 the deficit with China was nearly $300 Billion, 40% of our total deficit, and Apple’s ipads alone, assembled in Chinese factories, accounted for nearly $4 billion of the deficit, estimates The Economist.

Given, China has a cost advantage largely due to its cheaper labor, and this is a topic unto itself, the way the free market and supply and demand economics is supposed to work is: the more demand there is for a widget (be it a good or service) the higher the price should go until a new equilibrium level is found where supply and demand find a new balance at the higher price. Higher pricing, instituted sequentially, is meant to curtail demand until the point where a new balance of supply and demand is reached. What China has been doing for a long time is keeping their currency – the yuan, also called the renminbi artificially weak, bucking the natural forces of supply and demand, to perpetuate the Chinese price advantage relative to the U.S.. Cheaper prices for Chinese goods equate to a persistent pricing advantage of their goods, services and labor. This spells persistent and or growing trade deficits, more Chinese goods flooding our shores, less exports to China leaving our shores, and more challenges to the American workforce.

How does China do this? Let’s say a U.S. company buys assembled goods from a Chinese factory. The U.S. company pays in U.S. dollars. The Chinese factory receives U.S. dollars, but has to convert the U.S. dollars to their local currency the yuan, also called the renminbi. Off the factory goes to their bank and exchanges the dollars for yuan at the prevailing exchange rate. At this writing each U.S. dollar fetches about 6.3 yuan. Now the Chinese factory has their local currency and they’re happy, and the Chinese bank is holding dollars from the conversion transaction. Multiply this event exponentially, considering the enormous imbalance of goods we buy from China versus what we sell to them, as indicated from the huge trade deficit mentioned earlier, and this provides some insight into why China has nearly $3.2 trillion dollars – yes trillion – in U.S. dollar reserves! This is a simplification because there are other parties to this like the Chinese Central Bank where the reserves are actually held, but let this suffice to make my point.

Where China’s manipulation comes in is when China sells its own currency, the yuan (creating supply) and buys U.S. dollars, (demand for dollars) and the forces of supply and demand create an artificially weak yuan relative to the U.S. dollar, that is buffeting the natural forces of supply and demand on the currency that by all rights, considering the huge demand for China’s goods and services, not only from the US but the Euro Zone (China’s largest trading partner representing 20% of China’s exports) and many other countries as well, should be appreciating at a much faster clip than it is. Remember what that Chinese factory we used as an example is doing when they receive U.S. dollars for payment. They are selling U.S. dollars to buy their local currency the yuan creating demand for the yuan over and over again. If China’s currency appreciated relative to other currencies as the natural forces of supply and demand would dictate, China’s price advantage would be eroding, relative to its trading partners. We all know that China’s price advantage is still significant enough to be perpetuating the huge trade imbalance with us and its other trading partners.

To be continued

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