Chinese Currency Issue is a Red Herring

How determined is Congress to make China inflate its currency? Earlier this month the Senate, by a margin of 67 to 33, voted to consider a proposal to impose a 27.5 percent tariff on all imports from China unless it does.

While the tariff proposal is not law -- yet -- its consideration bodes ill for U.S. trade policy.

Misconceptions have spawned misgivings about trade in the Congress, where too many policy makers view it as an adversarial, zero sum game. The country either wins or loses, and the trade balance determines the score. According to this view, our growing trade deficit (search) means that we are losing, and our record bilateral deficit with China is proof that our toughest opponent is cheating. But this obsession is a fool's errand.

While economists generally agree that the Yuan (search) -- pegged at 8.28 to the dollar -- is undervalued, its relationship to the bilateral trade deficit is likely overblown. Relative currency values do influence trade flows, but so do other important factors, including relative prices, the availability of domestic or other foreign substitutes, and the economic and opportunity costs of finding new suppliers. Recent U.S. experience indicates that these other factors can mitigate the effects of currency changes.

The dollar has been declining against major currencies for three years, yet the trade deficit continues to rise. From the beginning of 2002 through the end of 2004, the Federal Reserve's nominal index of major currencies shows a dollar depreciation of 28 percent. But the U.S. trade deficit in goods -- excluding trade with China -- increased by 51 percent during this period. Why then does Congress have so much faith that raising the value of the Yuan will reduce the bilateral deficit?

The evidence shows that while the dollar has been declining against floating currencies (search), U.S. consumers have been choosing to pay more to continue consuming imports. Unless U.S. consumption of Chinese products declines by at least the same percentage that the currency appreciates, import value will rise. And unless Chinese consumption of U.S. products increases by at least the same percentage that the currency appreciates, U.S. export value will decline. Thus, it is quite plausible that Yuan revaluation would bloat the bilateral deficit.

Furthermore, proponents of currency adjustment (search) fail to account for the fact that China runs a trade deficit with most of the rest of the world. Like the United States, China relies heavily on imports to feed its industries. Yuan appreciation would reduce the relative prices of imported raw materials, enabling Chinese producers to lower their selling prices. So, while Yuan appreciation is touted as a "cure" to the bilateral U.S. trade deficit, the fact is that such appreciation would enable Chinese producers to lower their own costs of production, and hence their prices for export, possibly erasing the intended effect of the currency adjustment.

That policy makers would even consider imposing a 27.5 percent tariff as a proxy for currency adjustment is inane enough. But to do so in the name of a policy for which the consequences have not been properly considered is irresponsible. There is not a whole lot of upside to a tariff that would tax U.S. consumers, violate U.S. international trade commitments, incite retaliation, and encourage other countries to disregard their own international obligations.

What it boils down to is that too many policymakers have an aversion to imports and fail to consider the collateral damage their proposals could cause, as long as the intended target gets hit. But import fears ignore certain facts about how the U.S. economy operates. U.S. producers require imported materials and components for their own production. There is a strong positive correlation between goods, imports, and manufacturing output. In other words, imports and output rise and fall together. Policies that promote imports are also good for exports, and policies that discourage imports are bad for exports.

A change in China's currency would be unlikely to have a meaningful impact on trade. On the other hand, unilateral U.S. actions outside of the rules would have a regrettable impact.

Daniel Ikenson is a trade policy analyst at the Cato Institute.