FXIS Market Insights

China has been the favored target of some politicians and an increasing number of high profile economists in recent months.  Talk of Chinese currency manipulation has become more widespread in the main-stream media too.  Ask someone about the name of the Norwegian currency for instance and you might get a blank stare. But the Chinese Renminbi a.k.a. Yuan has been part of the talk on the street these days.  And so is the common perception that it is the “artificially” low exchange rate which is to blame for the massive trade deficit between the US and China; better yet, blame China for every other challenge facing the US and global economy these days.

In his recent NY Times article Taking On China, Paul Krugman does some of that finger-pointing towards the East.  Call it a fool’s privilege, but I would like to “take on” the Nobel Laureate in Economics by reviewing the actual impact of currency exchange rates on international trade.  But first, let me clarify that I have the utmost respect for Mr. Krugman and that I am not out here to join the increasingly popular crowd bashing Keynesian economics, however convenient that may be at this time.  Keeping within the length restrictions of this short article, we have to simplify a few things. Realizing the limitations of a brief analysis, we cannot get into the complex historic circumstances that ended the Bretton Woods agreement which then lead to the current system of freely floating exchange rates among the major global currencies.  I simply question whether Mr. Krugman’s suggestion of a 25% tariff on Chinese Goods would convince the Chinese government to revalue their currency and I like to demonstrate that a stronger Chinese Yuan may not lead to an improvement of the US trade deficit with China.

To help us out here, let us examine some historic charts.  The two charts below show how the US Dollar traded against the Japanese Yen and the Deutsche Mark since 1971 (Ed. Note: The Deutsche Mark has been the legal tender of Germany until it was abandoned in favor of the Euro in 2002.   From Jan-2002 onward, we used the official conversion rate of  DM 1.95583 = 1 Euro to establish a hypothetical Deutsche Mark value for the purpose of charting this currency trend).

Although we did not have access to trade data of 1971, we were able to chart the US imports from Japan and Germany since 1985 and super-imposed those with the currency exchange rates.  To illustrate the fallacy in Mr. Krugman’s proposition, we can point to numerous periods when the US Dollar weakened and conversely the foreign currency appreciated while imports to the US had grown rather than decreased.

Take for instance the period between 1985 and 1995 when the US Dollar depreciated from ¥254 = $1 to about ¥100 = $1, that’s a 60% decrease in the value of the US$.  Meanwhile imports from Japan grew over 54% in the same time period.  A similar case could be made for the data from Germany.

In the same time period between 1985 and 1995, German imports to the US grew 46% while the US$ lost over 50% against the German Mark.  From 2000 until summer 2008, German imports to the US grew by nearly 120% while the greenback lost another 35% in value.  Having examined the actual data side by side, there is simply no correlation between these two sets of data (send me an email if you like a copy of our spreadsheet and data analysis). 

I realize that by not examining the other side of the trade equation (we shall examine that in a future article), we might run short of a more substantial proof that Mr. Krugman’s suggestion is flawed. However, it is commonly understood that the US has not been a leading exporter for several decades now and irrespective of where the US Dollar may have traded.  Moreover, it is often forgotten that that the demand for high quality products (i.e. Japanese consumer electronics, cars or German machinery/cars), even at a higher price, may still lead to higher sales figures through increased profit margins.  In simplified terms, I only need to sell half as many goods at double the price to achieve the same net profit.  Granted that the suggested taxes might take the biggest chunk out of the price increases temporarily but they would also create a new price benchmark and once repealed, the new price levels would be an immediate windfall for the exporters – overall, not a good solution.

When Japan entered the US market, initially gaining market share by supplying the cheapest products available and when the Japan bashing and calls for import duties entered the popular press, Japan countered with better products eventually selling at higher prices. Japanese car makers responded by adding substantial manufacturing capacity directly inside the US.  They effectively circumvented trade or import duties that may have been in place. 

China is a slightly different animal but they have come very far in a short period of time and they will not forego the biggest consumer market that easily.  Import Duties of 25% may put a damper on the massive US trade deficit with China, but it is unlikely that it will be an effective way to stop imports from China or from any other country for that matter. It is also questionable whether China would revalue its currency in response to trade barriers.  It is rather more likely that China will revalue its currency only when it serves its own economic or political purpose.  More probable still, China will increasingly focus on producing higher quality products which will be less sensitive to potential price changes i.e. via a stronger or eventually floating currency.  Finally, let’s not forget that a stronger Chinese Yuan has numerous positive effects on producers in China as well.  The price of commodities and raw materials which China has an increasing appetite for, would also fall for the Chinese manufacturers, offsetting at least some of the losses from Chinese exports via stronger currency.

When the Chinese Yuan might appreciate is anyone’s guess.  However, it is widely accepted that China will have to revalue its currency at some point anyway, making Mr. Krugman’s call for a 25% import tax seem rather desperate.  As history has shown time and again, prices can only be manipulated for so long, eventually the economic imbalances will become so great that price adjustments will have to be made, either through gradual and manipulated adjustments or via the natural forces of supply and demand.   Instead of blaming China for the economic misery of the world, one should consider what can be done to steer consumer demand away from cheap consumption goods to high quality and durable products that add value to society. Sometimes less is more.

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