On Wednesday, Chinese President Hu Jintao will meet with President Obama to discuss the relationship between China and the United States, focusing particularly on issues of trade. This has been a hotly contested issue for sometimes now as the US has pressured China to appreciate their currency, claiming that China has held the exchange rate artificially low so that Chinese businesses can enjoy a trade advantage over their US counterparts. In an interview with the Wall Street Journal, Jintao has fired back at the US saying that “the monetary policy of the Untied States has a major impact on global liquidity and capital flows and therefore, the liquidity of the US dollar should be kept at a reasonable level.” He also suggested that China will consider making the yuan a global currency, while conceding that it “will be a fairly long process.” This is the setting for what should be an intense bilateral discussion between the leaders of the two biggest economies in the world.
The yuan has tremendous potential as a global currency because of China’s continuing emergence as a global economy. Currently, less than 1% of China’s $2.3 trillion imports are done in yuan. According the the Wall Street Journal article “New Move to Make Yuan a Global Currency,” “some analysts have predicted that it will be only a few years before 20% to 30%” of the imports “will be conducted in yuan rather than dollars.” This suggests that there is already a demand for direct yuan exchange in foreign exchange markets.
Trade between the United States and China constitutes a large portion of the United States’ goods deficit and China’s surplus. Of the United States’ $51 billion monthly goods deficit, $26 billion is attributable to China. The trade between the two countries means that both countries have a stake in each other, present and future. The US has helped China build its economy by buying their goods, and as a result of this capital outflow and wealth, China has accumulated US financial assets.
From an economics perspective, it should be understood that both countries can benefit from a yuan as a global currency, one that is subject to appreciation and convertible for direct trade with other countries. The appreciation of the yuan relative to the dollar can help the US industry and trade in a number of ways. However, it can also help China by reducing its exposure to the US, reducing its transaction costs in trade and making foreign resources less expensive. The decision to make the yuan a global currency should have mutually beneficial consequences.
The US has been clamoring for the Chinese government to appreciate their currency for sometime. Because the yuan has been pegged at a fixed rate, China has enjoyed advantageous trade with several countries, but in particular the United States. We know from our stock and flow model that countries neither want to face a trade deficit (because of the marginal cost of debt) nor accumulate foreign financial assets forever (because of the risk of default). Eventually, the demand for a flow of foreign goods and services must shift, leading to an appreciating yuan. An stronger yuan should help the US trade deficit by making its goods cheaper and China’s goods more expensive.
Devaluing currency often is depicted in a negative light because it is usually caused by inflation. Traditionally, inflation has been the primary cause of a depreciating dollar. Additionally, a strong dollar is important for buying foreign foods and for travel. However, it has been detrimental to domestic industry and labor. First, depreciating the dollar relative to the yuan is not a result of inflation but rather a consequence of the market forces; there is a demand to conduct trade directly in yuan rather than in dollars. Second, a strong dollar has hurt the US by making domestic goods less attractive to foreign countries, influencing the balance of trade. It has also made it more attractive to invest in cheaper foreign labor by outsourcing, since domestic labor has been relatively more expensive. As other currencies appreciate relative to the dollar, companies from those other countries will be more attracted to hiring US labor. Having the dollar depreciate relative to other currencies can have a positive impact on the balance of trade and labor without the worry of inflation.
China has been accumulating US financial assets through the influx of dollars from the imbalance in trade. The combination of accumulating US assets as well as the growth in the US budget deficit has made China increasingly exposed to the US default risk. While US bonds have always had the reputation of being a safe asset to hold, the recent financial crisis has reinforced the important of diversification. China has been concerned that the US will “inflate away its debt” “by printing money.” By making the yuan a global currency and relying less on the dollar as a medium of exchange, China will accumulate less dollars which will not necessitate the purchase of US financial assets. Instead, China will be trading in their own currency and accumulating other foreign currencies and financial assets. This will increase their portfolio’s diversification and help stronger relationships with foreign countries. It will make the countries interdependent on China just as the US has been. Diversification will make China less susceptible to fluctuations in the United States, enabling for a more stable economic environment.
Another advantage of opening the yuan to global trade is reducing transaction costs. By using the dollar as a medium of exchange, China is paying a spread, the difference between the price to buy or sell, of the dollar exchange rate. Essentially, for every transaction that China is conducting in dollars, China is paying a tax. They are paying more and getting less than what they would if they had direct exchange through the yuan. While it may only be a small fraction of the transaction, with the magnitude of trade that China is involved in, its sum adds up. If it makes the yuan a global currency, it can trade directly with other countries rather than using the dollar as an intermediary medium of exchange.
As a developing country, China has become a huge player in the commodities industry. Commodities are very much the life blood of industry and commodity production is integral to industrialization. The mark of an industrialized nation is consuming 300 kilogram per capita of steel. Currently, China is producing 426 kilograms per capita. To produce steel, you need coke, which is a product of coal. Additionally, 68.7% of China’s electricity comes from coal. While China is the leading producer of coal, it imports nearly 3 million tons of coal from the United States. This is only one example of China growing demand for resources, but a stronger yuan would make these resources, these factors of production, cheaper.
The bilateral meetings Wednesday should serve as an opportunity to discuss the possibility of opening up the yuan to the world. As Juntao said, it will be a “long process.” As the world’s two largest economies, China and the United States are the leaders of the global economy. For both sides, it is important for them to come to a resolution that is mutually beneficial. A war of words between two countries so interdependent on each other is not a viable solution. Appreciating the yuan can go a long way to better the relationship by helping trade and industry in the US and making trade less costly and risky for the Chinese.
