Posted by: Dirk | October 19, 2011

Trade with China: who is the protectionist?

The Economist reports on the undervaluation of the yuan:

The rules of the World Trade Organisation (WTO) generally do not recognise undervalued currencies as an illegal subsidy. Currencies are considered part of a country’s monetary sovereignty, to be dealt with, if at all, by the International Monetary Fund. The odds are that if America imposed tariffs on China under the bill’s provisions, China could successfully bring a complaint against America at the WTO.

Fred Bergsten at VoxEU has this to say:

Hopefully with a similarly broad coalition, the US should exercise its right to ask the WTO to constitute a dispute settlement panel to determine whether China has violated its obligations under Article XV (“frustration of the intent of the agreement by exchange action”) of the WTO charter and to recommend remedial action that other member countries could take in response. The WTO under its rules would ask the IMF whether the renminbi is undervalued, another reason why it is essential to engage the IMF centrally in the new initiative from the outset.

There can only be one winner in this dispute, and to my knowledge it is Fred Bergsten. The Economist continues to argue that the problem, if there ever was one, is being solved right now:

Since June last year the yuan has appreciated 7% against the dollar. The rise in China’s relative costs has been even greater given its higher inflation rate. With stimulative fiscal and monetary policy bolstering domestic demand, China’s current-account surplus has shrunk by two-thirds, from 10% of GDP in 2007. Meanwhile America’s trade deficit has narrowed, and manufacturing employment has stopped falling. All this means the yuan is far less undervalued than it was a few years ago—if at all.

There is some truth to it, but even the Chinese media reports an IMF study that says undervaluation is still between 3 and 23%. The question is, however, whether you can trust China not to re-peg its currency again when the next recession hits. It did so in July 2008 and ensured that its relative share of demand would not fall. This would shift more burden on the US and the rest of the world. Also, Chinese promises to make the yuan more expensive and to liberalize the capital account are not trustworthy, since these have been heard many times in the last decade. The Chinese authorities stick to ‘never change a winning team’ and are unsure how to recalibrate their economy.

On a side note, talk of free trade is off the point when speaking about China and the US. Free trade models assume no monetary frictions since they rely on barter. I give you this, you give me that, we are both better off, they imply. They stay silent on questions like I give you toxic toys, you give me toxic assets. Adam Smith and Ricardo and Heckscher/Ohlin all lack a monetary system, and their results cannot be generalized to imbalanced trade situation like that of the US and China.

In the end, undervaluing its currency it is China who is protectionist in the first place. Note that undervaluation not only makes your exports cheaper in foreign countries, but also makes foreign products more expensive in domestic currency at home. I often find reporting biased in the sense that the US are displayed as the country with protectionist ambitions – they are clearly not.

This does not mean that China should not undervalue, which is a strategy of development followed by many countries over time. Even Germany still does (through wage compression and with bad effects for the euro zone). After all, it is the real exchange rate that matters. In the Bretton Woods system, there was cooperation in the international monetary system.

Today, the relationship between China and the US seems to be in decline. There is much confusion on both sides over the issue, not like in the post-WWII period when the international monetary system was accepted by all players. We live in times of international monetary anarchy, and what is good for a single country might be bad for all when every country does it. Undervaluation in the international arena is a classic case of a fallacy of composition.


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