The Two Sides of the Chinese Currency Question

A common theme in much of the political rhetoric during both this election cycle and the last four years has been complaining about China as a "currency manipulator." The truth is that China has kept the value of its currency artificially low, thereby increasing the cost of U.S. exports to China and decreasing the costs of U.S. imports from China. Just like a coin has two sides, it is clear that changes in value of the Chinese currency simultaneously helps some groups while it hurts others. The novelty is that much of the media and political focus has been on the U.S. groups that get hurt by this policy, while stories about the benefits are neglected. And it is likely that the benefits outweigh the costs--possible by a landslide.
Costs to the United States

When China keeps the value of its currency--the yuan--low in terms of dollars, it means that one yuan equals fewer dollars. The yuan buys fewer U.S. exports to China, the cost of U.S. exports increases, and U.S. exports to China decline. The Chinese policy of keeping the value of the yuan low clearly hurts U.S. exporters to China. In 2012, U.S. exports to China are on track to being just over $100 billion. That is only 0.6% percent of all U.S. output (just over half a percent of $16 trillion nominal GDP). U.S. exporters seem to have a loud political voice relative to their economic size.

Another potential cost of China's low currency value policy is that decreasing exports and increasing imports raises the trade deficit with China, which represents U.S. obligations or debt to China. Suppose that you are the United States and your neighbor is China. You both have different currencies. If you trade one Dell laptop (made in USA) for one of your neighbor's equally valued Lenovo laptops (made in China), you have balanced trade. No dollars or yuan need to change hands because exports equal imports. Now suppose that you want to buy some of your neighbor's clothing and toys (made in China), but you don't have any goods that he wants. This currency trading is similar to trading forex online as explained in this top10forex.net forex trading website. For this transaction, you pay your neighbor dollars and he gives you clothing and toys that you wear and play with. Now your imports are larger than your exports--a trade deficit.

Why does this U.S. trade deficit represent a U.S. international debt? It is because your neighbor (China) is holding a handful of dollars that he can neither play with nor wear. These dollars are only good for buying some of your goods, U.S. exports, when he chooses to cash them in. These dollars that your neighbor, China, is holding represent goods that you eventually have to give to him--goods that he can both play with and wear. It is this accumulated debt to China from both persistent U.S. trade deficits and Chinese currency manipulation that amounts to nearly $1.2 trillion dollars held primarily by the Chinese government. It is true that these balances of dollar-denominated assets would wreak havoc on the U.S. economy if China were to abruptly change course and start using them to buy U.S. goods. But it is also true that this course is highly unlikely because it would drastically increase the value of the yuan and decrease Chinese exports to the U.S. and to the rest of the world, which exports have been the sole driver of Chinese growth. 

Benefits to the United States

Less well known are the benefits to the United States from China's low-currency-value policy. A cheap yuan means that one dollar trades for more yuan. One dollar buys more Chinese imports or the cost of Chinese imports decreases. The shirts and toys that we buy from our neighbor become cheaper. This benefits everyone who wears clothes or plays with toys. In terms of U.S. imports from China, this group is nearly four times bigger than the U.S. exporters to China (about 2.5% of U.S. nominal GDP). On this dimension, the benefits seem to outweigh the costs.

In addition, China's policy of keeping the value of the yuan artificially low means that they must sell the U.S. more wearable and playable goods in exchange for little green pieces of paper that can neither be worn nor played with. China's policy has made them a consistently willing recipient of U.S. dollars. A comfortable home for these dollars has been particularly important for the U.S. over the last four years during the Great Recession which has seen the U.S. Congress and Federal Reserve borrowing trillions of dollars to finance stimulus spending and monetary intervention. China's role as an ever-ready purchaser of dollars has helped keep U.S. interest rates and inflation low, thereby stimulating U.S. investment and growth. The $3 trillion expansion of the Federal Reserve balance sheet and the $5 trillion Federal deficit over the last four years has not raised interest rates or inflation, in large part, because the U.S. has always had a ready buyer of those dollars in China. In a forthcoming paper in the Journal of Macroeconomics, I show that the U.S. actually can tax foreign countries that hold dollar-denominated assets by expanding the supply of dollars in this way.

The benefits to the U.S. from China's low-currency-value policy seem to outweigh the costs. Were the U.S. to make good on some of the threats to punish China for holding down the value of the yuan, the damage to the United States could be tremendous. Like it or not, the trade incentives of the both the United States and China have been aligned for a long time and any large changes in trade policy would be damaging to both.