December 17, 2007

The conventional wisdom among most American policy makers and commentators gazing on the huge U.S. trade deficit with China is that the yuan must be revalued. But evidence from the past two years suggests that a revaluation would have little impact on the deficit, and would only to hurt Chinese workers and small manufacturers.

The latest Strategic Economic Dialogue between China and the United States, held in Beijing last Wednesday and Thursday, ended without much gain on one of Washington’s main objectives – persuading China to follow a more aggressive revaluation of its currency.

Conceding to earlier pressures, China changed its decade-long policy of pegging the yuan to the dollar in July 2005. The yuan rose by more than 5 percent in the first year, and 12 percent by the time of the recent meeting in Beijing.

Yet the U.S. trade deficit with China continued to swell by more than 15 percent, from $201 billion in 2005 to $232 billion in 2006; it is expected to reach $260 billion by the end of 2007. The policy failed to achieve its objective.

The failure is the result of a mistaken understanding of China’s structural economic relations with the United States, and the way in which American firms contribute to the deficit.

In recent years, the U.S. economy has undergone fundamental changes that reduce the effectiveness of exchange rates in changing patterns of trade, particularly with countries like China.

The revaluation of the yuan would have had the desired effect were the goods imported from China also produced in the United States. Facing the rising prices of imports caused by the revaluation, some American consumers would have switched to domestic substitutes.

But that is not the situation with most Chinese imports, for which there are few American substitutes. The Chinese apparel, computer parts, electronics, furniture, toys and many other things in the lengthening list of imports no longer compete with similar American products.

If not from China, the United States would have to buy them from elsewhere. The deficit would remain; it would only be with other countries.

The trade deficit with China is structural in nature; it is largely caused by the aggressive globalization of U.S. firms and their international repositioning since the 1980s, a move supported by all recent U.S. administrations.

Taking advantage of China’s vast supply of cheap labor and lack of market regulations, many American firms moved to China, setting up branches and subsidiaries. Purchases by American firms from their affiliates in China increased from 10 percent of total imports in 1992 to 24.6 percent in 2006. It continues to rise at a fast rate.

The deficit is aggravated by the widespread use of subcontracting agreements between American firms and thousands of small and large independent manufacturers in China, making semi-finished and finished goods for the U.S. market.

Although the aggregate trade statistics do not show the value of subcontracted imports, the category is significant and growing. Mattel, Nike, New Balance and many other large U.S. companies have strict long-term subcontracting agreements with non-affiliates that produce solely for them.

Since the subcontractors are paid in U.S. dollars, the revaluation of the yuan leaves the American multinationals and their demand for Chinese products unaffected. Imports from China remain unchanged.

However, the revaluation hurts the profitability of the subcontractors that face a reduction in their income after conversion to the local currency. To make matters worse, many American firms have been demanding lower prices from their subcontractors, threatening to move to India, Vietnam or elsewhere.

The result has been devastating for thousands of small, labor-intensive Chinese producers without the technological capacity to improve productivity or the ability to weather the changes. Trying to cope with the situation, many have been pressuring their employees, demanding overtime work (frequently without compensation), reducing labor standards and using lower quality materials.

Many will be forced out of the market. This may be a welcomed consequence of the policy for China, streamlining the market and weeding out inefficient producers. Nevertheless, the short-term effect is more hardship for Chinese workers.

“In a factory like mine, profit can only be made by exploiting the workers,” a small subcontractor supplying an American company told me in my recent tour of the industrial city of Shenzhen. Meanwhile, the U.S. trade deficit with China continues to rise.