China vs. the US: A Trade Battle In The Works?

Today, Bloomberg tells us that Chinese shoemakers are suing the European Union over customs duties recently imposed on their shipments. The American Congress is also threatening to slap the Chinese with a tariff on imports, in order to encourage them to allow their yuan (local money) to float so our gigantic trade imbalance can straighten itself out. (The Chinese are keeping their money, the yuan, cheap by "pegging" it to the dollar. For an explanation of this and how the Chinese and other nations are fixing the exchange rate of their currency in a manner that is against the rules, see my previous post.)


[Thanks to hapkido.it for the image.]

However, the Europeans and Americans may find that the Chinese are a more combative and armed trading partner than they previously thought.

The WTO (World Trade Organization) voted China into its membership on December 11, 2001. This did three things: (1) It opened their production to wider acceptance in the major foreign markets; (2) it required them to agree to adhere to WTO guidelines; and (3) it gave them access to -- and responsibility towards -- the WTO's supranational jurisdiction in trade matters.

The first one is hardly something they needed, because they are already one of the major world exporters given their industriousness and their comparative low cost of living that translates into low export prices, at least as long as it lasts. They seem to be learning fast about No. 3, if we are to judge by their European lawsuit. As to No. 2, this is the only one that makes them a little vulnerable to criticism and legal pursuit, e.g. for intellectual property violations (they export a huge quantity of pirated software and entertainment and have had trouble policing it), and for pegging their currency to the dollar (they have demonstrated an unwillingness to play by the international foreign exchange rules.)

This second problem opens them up to a claim by their trading partners, mostly the US and Europe, of currency manipulation. The US could allege that this manipulation has contributed unfairly to the present unusually large US Current Account Balance. (This is a balance sheet composed of trade balance + foreign investment balance, and it now shows a huge "surplus" in China and "deficit" in the US. See this article for a more detailed explanation.)

Here's how this EU example has played out: A few years ago, the Europeans began to note an influx of cheaper Chinese shoes and concluded that this must hurt their own shoe industry and that they must protect it by imposing customs duties. (Aside: This is a useless and counterproductive action, because it causes the price of shoes to rise, thereby penalizing the average consumer. Although the legislators may believe the customs duty preserves the European shoe manufacturing industry and therefore jobs, most realize that all it does is preserve higher shoe prices, keep the shoe factories from converting their activity into something more useful, and delay the inevitable. Sometimes, however, legislators do it anyway because they think it will force their trading partner to stop abusive practices.)

Under normal foreign exchange conditions, an influx such as this of cheaper products would eventually and quite normally cause the trade balance to become lopsided in China's favor; but it would also cause the importer's currency to drop in value given its increased availability on the currency market. Likewise, the exporter's currency would normally begin to rise in value because of its unavailability on that market. (i.e. The Chinese would be buying less from outside their country than they are selling there.) This is a well known market dynamic. As these changes in exchange value occur, they will tend to dampen the speed of influx of exports/imports that were causing the problem in the first place, because the rise in the exporter's currency would increase the price of the exporter's goods, and lower the price of the importer's competing export goods. Eventually, a balance is struck.

However, China is pegging its currency. In essence, it is absorbing most of the dollars and euros it receives as payment for its exports and using them internally, instead of allowing them to return to the foreign exchange market as they should, thereby forcing the lower-than-expected supply of dollars and euros on the international currency market to prop the dollar and euro price higher than it would otherwise be. They thereby prevent the tendency towards equilibrium between exports and imports from materializing. Although it maintains China's export advantage, it worsens the lopsidedness of the US/China or Europe/China trade balance and encourages economically unsophisticated legislators to respond to political pressure from their manufacturing-sector constituents by counterattacking with tariffs or customs duties.

This has now happened in Europe. This could happen here in the US very soon (see my previous post), but the Chinese have an important arm on their side: In the US, the law requires the Treasury Department to give an evaluation of status to the Congress twice a year. However, the language in this law makes it easy to avoid accusing a trading partner of manipulating their currency, and for some reason that is what Treasury Secretary Henry Paulson seems to want to do. (Could it be because a drastic change in the yuan/dollar ratio at this moment might increase the US CPI and damage our economy's current tentative status?)

This is an interesting development because we are seeing for the first time that the pegging activities of the Chinese central bank are finally causing repercussions, as would be expected; but they are not coming from outside, but through an unexpected back door: Their own shoe manufacturing industry's WTO complaints.

Something's gotta give.