FT.com | The Economists’ Forum | Imbalances and undervalued exchange rates: Rehabilitating Keynes

In our year 2 IB Economics class, we are beginning the part of our International Trade unit on exchange rates and the balance of trade . While the market for a particular currency reflects many of the same characteristics as a product market (i.e. upward sloping supply curve, downward sloping demand curve), the consequences of a change the price of a currency (the exchange rate) is far more powerful than a change in the price of a particular good or service in a product market.

How does the value of a country’s currency affect that country’s balance of trade with other countries? To understand this important concept, we first need to know something about the process by which currencies are exchanged when two countries trade. Let’s look at an example:

When an American consumer wants to buy an iPod that was made in China she will have to pay for it in US dollars, since that’s what she earns her wages in from selling her labor in the resource market. Apple now has the consumer’s $300, which gets split up to cover all the costs the company faced in the manufacture, distribution, marketing and sale of the iPod. Part of that $300 (say $100) will go to the manager of the factory in China where it was made.

The factory manager in Shanghai faces his own costs he must cover. He must pay rent on his factory space, interest on the loans he took out to acquire capital, and wages to the workers assembling iPods on his factory floor. The problem is, these costs are all in Chinese yuan, but he’s holding the US dollars that Apple paid him for his iPod. In order to cover his costs, the Chinese factory owner must take the $100 to a Chinese bank and swap it for RMB. The local bank that changes his money now hands the $100 over to China’s central bank (the PBOC) which prints and exchanges RMB to the bank at whatever the prevailing exchange rate is at the time.

Ultimately, China’s central bank will decide what to do with its holding of US dollars. Most of the dollars are loaned back to the United States through China’s purchase of US Treasury securities (the IOUs the US government sells to finance its deficits). China’s voracious demand for US dollar denominated assets keeps the demand for (and the the value of) dollars high on foreign exchange markets, meaning the RMB remains relatively cheap for Americans and therefore Chinese manufactured goods attractive.

China’s policy of exchange rate manipulation has upset many American politicians over the years, who often blame China for America’s shrinking manufacturing sector. A weak RMB means the cost of producing things like iPods in China is far lower than it would be in the US. By keeping demand for dollars high on the foreign exchange markets through its incessant demand for US treasury securities and other financial and real assets, while simultaneously hoarding vast reserves of US dollars in its central bank, thus keeping supply of dollars on foreign exchange markets low (see graph), China has prevented the RMB from appreciating, fueling the growth of the country’s export-manufacturing sector.

China’s currency manipulations may soon ilicit a response from the United States as president-elect Barack Obama takes office next year. Facing a recession and rising unemployment, combined with the recent appreciation of the US dollar, the pressure is on Obama to take immediate action to restore America’s manufacturing sector. According to the Financial Times blog “the Economists’ Forum”:

If the US economy takes a downturn and the dollar continues to strengthen, a resurgence of protectionist pressures is likely. This time around, these pressures could well take the form of unilateral action against competitive currencies. It is noteworthy that President-elect Obama has actively and repeatedly supported action against “currency manipulation.”

The “competitive currency” perceived to pose the greatest threat to America’s inustrial sector is certainly the Chinese RMB. Currency manipulation is a form of protectionism, which in a time of global economic slowdowns poses a larger threat than ever to both developed and developing nations’ economies alike. For this reason, the World Trade Organization may need to employ carrot and stick methods to create incentives for China to liberalize its currency controls and allow the RMB to strengthan against the dollar and other major currencies:

How would this new rule against undervalued exchange rates be incorporated in the WTO? Through negotiation. The (WTO) should place rules on undervalued exchange rates…. The US and EU have been the principal demandeurs for action by China in the past. But it is important to remember that until very recently, a number of developing countries—Brazil, Mexico, Korea, Turkey and South Africa—were affected by the competitive pressure from the undervalued (RMB). Indeed, some months ago, the Indian Prime Minister urged China to follow a more market-based exchange rate policy. For obvious reasons, more emerging market countries have not voiced their concerns, but it is possible that a coalition of affected countries could unite on this issue.

Clearly, Chinese concerns have to be addressed for any new rules to be crafted and commonly agreed… First, China’s major trading partners could pledge granting China the status of a “market economy” in the WTO contingent on it eliminating currency undervaluation and moving to a market-based system. This status would have significant value for China by shielding it against unilateral trade actions such as anti-dumping and countervailing duties by trading partners. Second, as part of radical governance reform of the IMF, which is desirable in itself, China should be offered a substantially larger voting share in the IMF commensurate with its economic status.

Discussion Questions:

1. How does China continuing to undervalue its currency threaten the industrial economies of its largest trading partners?
2. What is China’s purpose for maintaining the low value of the RMB relative to the currencies of other nations?
3. What would be a unilateral protectionist measure an Obama administration may advocate if the WTO refuses to take action against China’s currency manipulations? How would you advise president-elect Obama on the issue of whether to take protectionist action against China in the context of the current economic crisis in America?

The $1.4 Trillion Question - James Fallows - the Atlantic

What’s the deal with American consumers? How, exactly, does a nation’s average savings rate fall to 2%, then 1%, and then become negative, like in the US over the last couple of years? What does negative savings actually mean? It means that Americans consumer more than they actually produce.

On the micro level, the only way to consume beyond ones income is to borrow from someone else to pay for the additional consumption. In other words, savings must be negative for one to consume beyond his or her income. The US is a nation of borrowers, but from whom do we borrow? China, for one…

China is a nation of “savers”, where national savings averages 50% of income. What exactly does this mean? Well, just the opposite what negative savings means; rather than consuming more than it produces, the Chinese consume only about half of what it produces. Here’s how James Fallows, a Shanghai-based journalist, explains the China/US dilemma:

Any economist will say that Americans have been living better than they should—which is by definition the case when a nation’s total consumption is greater than its total production, as America’s now is. Economists will also point out that, despite the glitter of China’s big cities and the rise of its billionaire class, China’s people have been living far worse than they could. That’s what it means when a nation consumes only half of what it produces, as China does.

What happens to the rest of China’s output? Naturally, it’s shipped overseas for Americans and others in the West to consume. The irony is that the consumption of China’s products has been kept affordable and cheap thanks to the actions the Chinese government has taken to suppress the value of the RMB, thus keeping its products cheap and attractive to American consumers.

When the dollar is strong, the following (good) things happen: the price of food, fuel, imports, manufactured goods, and just about everything else (vacations in Europe!) goes down. The value of the stock market, real estate, and just about all other American assets goes up. Interest rates go down—for mortgage loans, credit-card debt, and commercial borrowing. Tax rates can be lower, since foreign lenders hold down the cost of financing the national debt. The only problem is that American-made goods become more expensive for foreigners, so the country’s exports are hurt.

When the dollar is weak, the following (bad) things happen: the price of food, fuel, imports, and so on (no more vacations in Europe) goes up. The value of the stock market, real estate, and just about all other American assets goes down. Interest rates are higher. Tax rates can be higher, to cover the increased cost of financing the national debt. The only benefit is that American-made goods become cheaper for foreigners, which helps create new jobs and can raise the value of export-oriented American firms (winemakers in California, producers of medical devices in New England).

Clearly, a strong dollar is good for America in many ways. The dollar’s strength in the last decade can be credited partially to the Chinese, who have been buying dollar denominated assets in record numbers over the last seven years.

By 1996, China amassed its first $100 billion in foreign assets, mainly held in U.S. dollars. (China considers these holdings a state secret, so all numbers come from analyses by outside experts.) By 2001, that sum doubled to about $200 billion… Since then, it has increased more than sixfold, by well over a trillion dollars, and China’s foreign reserves are now the largest in the world.

China’s purchase of American assets keeps demand for dollars on foreign exchange markets strong, thus the value of the dollar high relative to other currencies, allowing American firms and consumers the benefits of a strong dollars described above.

As we learn in AP Economics, a nation’s balance of payments consists of the current account, which measures the difference between a country’s expenditures on imports and its income from exports (China last year had a $232 billion current account surplus with the US, meaning the US bought more Chinese goods than China bought of American goods), and the capital account, which measures the difference between the inflows of foreign money for the purchase of real and financial assets at home and the outflows of currency for the purchase of foreign assets abroad. In the capital account, China maintains a deficit (meaning China holds more American financial and real assets than America does of China’s), to off-set its current account surplus.

The two accounts together, by definition, balance out… usually. Any deficit in the China’s capital account that does not cover the surplus in its current account can be held as foreign exchange reserves by the People’s Bank of China. The PBOC, however, prefers not to hold excess dollars in reserve, as the dollar’s value is continually eroded by inflation and depreciation; therefore it invests the hundreds of billions of excess dollars it receives from Americans’ purchase of Chinese goods back into the American economy, buying up American assets, with the aim of earning interest on these assets that exceed the depreciation and inflation rates.

The “assets” the Chinese are using their large influx of dollars to buy are primarily US government bonds. The government issues these bonds to finance its budget deficits (when government spending is greater than tax revenue; this figure was projected at around $400 billion this year alone!), and the Chinese are happy to buy these bonds for a couple of reasons: They are secure investments, meaning that unless the US government collapses, the interest on US bonds is guaranteed income for China. That’s one reason; but the primary reason is that the purchase of these bonds puts US dollars that were originally spent by American consumers on Chinese imports right back into the hands of American consumers (via government spending or tax rebates), so they can continue buying more Chinese imports.

The Chinese demand for dollar denominated financial assets, including government bonds, corporate stocks and bonds, and real assets like real estate, factories, buildings and so on, has resulted in a long period of a strong dollar. If the Chinese ever decided to stem the flow of dollars into American assets, the dollar’s value would plummet to record lows, leading to high inflation and eventually a balancing of America’s enormous current account deficit with China and the rest of the world.

However, a falling dollar is the last thing China wants to see happen, for two reasons: One, it would make Chinese imports more expensive thus less attractive to American households, thus harming Chinese manufacturers and slowing growth in China. Two, US dollars are an asset to China. Its $1.4 billion of US debt would evaporate if the dollar took a major plunge. To China, this would represent a loss of national wealth; in effect all that “savings” that makes China so unique would disappear as the dollar dived relative to the RMB. For these reasons, it seems likely that China will continue to be a willing buyer of America’s debt, thus the financier of Americans’ insanely high consumptive lifestyle.

When it comes to America’s low personal savings rates, I have a theory here as to why we can’t break the consumptive habit that’s caused us to run up $9.3 trillion of national debt. It relates to something I teach my Asian History students when we study ancient China.

Confucius said something about government that might just explain why Americans have evolved into the negative savers that we are: “If a government desires what is good, the people will be good. The character of a ruler is like wind and that of the people like grass. In whatever direction the wind blows, the grass always bends.”

More misleading economic statements from uninformed people who have never taken an economics course!

What about, you say?

I’m glad you asked!

It seems like I continuously read and hear in the American press that the United States is creating a giant wealth transfer by buying oil from other countries. Those “wealth transfer” words imply to the typical citizen that somehow our U.S. money supply is leaving our country, never to return again, and somehow our country is then poorer after the transaction and the country we imported from is now richer!

That is only a half-truth! Yes, the other country becomes richer, but we grow richer also by an equal amount! Both countries always gain economically from trade!

Let’s first get a few things straight before I elaborate: I am not happy either as gas prices rise ($3.50 a gallon in the U.S. as of this writing, although down from over $4.00 recently). I am also not happy that a fairly large share of oil purchases are from countries like Saudi Arabia and Venezuela whose loyalty to our country is certainly questionable. Luckily, the U.S. produces 40% of its own oil consumed and the other 60% consumed is imported from many different countries with 85% of our imports coming from 15 countries with Canada and Mexico being the largest two.

However, when we buy from any of these countries, both countries benefit equally and there is NO transfer of wealth. When the U.S. buys oil from any other country those U.S. dollars paid on the purchase are immediately returned to the United States and are spent almost immediately in our country since the other country cannot use our dollars in their country. What is really happening is that both countries’ citizens GAIN (not lose!) equally as we are, in essence, trading one product for another for both countries to enjoy!

Let’s use an example. Let’s say the U.S. buys 1000 barrels of oil from Saudi Arabia. At today’s price per barrel of $100 that would mean the U.S. would pay Saudi Arabia $100,000 and Saudi Arabia would then, in turn, be forced to turn around and use the paper ($100,00 USD!) on say, a bunch of iPods from Apple. Yes, the Saudi’s are listening to “I Kissed a Girl” by Katy Perry with their IPods under those smart head robes they wear! Ladies and gentlemen: that is why they call it trade: the essence of the transaction is that we have traded some of our iPods for some oil to fuel our cars and heat our homes. Both of us have gained! Katy Perry is hot on the charts and the Saudi’s “got their hands in the air”, and we can now drive to 7-Eleven for a Big Gulp and stay warm in the winter.

Also, think of it this way: when an American buys a gallon of gas the money is, in substance, going to an American business such as Apple! All spending of US dollars is spent back into our economy, and all spending of Saudi dollars (actually they call their currency the “dollar” also but it doesn’t look like ours!) benefit the Saudi economy.

Yes, trade is mutually beneficial. I would rather a warm home this winter and forego another Katy Perry song!

Is international trade really as good for a nation’s standard of living as economists say? And, what the heck is comparative advantage anyway? And what about the foreign currency market and those confusing supply & demand curves? Yes, the quest to understand the economic benefits of international trade is enough to make any citizen or first-year economic student vomit, tremble, get a headache, or at least curse.

Having been an AP Economics’ teacher for 8 years now, I must candidly admit that it took me a few years of study and research to try to reduce international trade to pure simplicity and understanding. Let me give it a shot below. I love simplicity.

The average “Joe Citizen” in almost any country in the world is suspicious of trade, and rightfully so, since he reads or observes factories being closed, jobs lost, and the feeling that somehow his country is going down the toilet as his own home fills up with foreign-made products. Unfortunately, what Joe Citizen does not understand is that the money his own nation is spending for those foreign products (imports) is spent right back into the pockets of his own country, increasing employment and income.

Let’s take a single, real-world, international trade example being careful to accurately explain the whole economic story:

Let’s say that the United States (we’ll say Wal-Mart) decides to buy several shirts costing $400 from a Chinese shirt manufacturer, in lieu of buying those same shirts from a shirt manufacturer in Elon, North Carolina (USA). As a US AP Economics’ teacher I am one of about only 47 Americans in Fairfax County Virginia, which not coincidentally ties to the number of AP Students I taught this year, that quickly understand that the decision to purchase the shirts from China, in lieu of the US manufacturer in North Carolina, is actually BETTER for America and will make my home country better off in the long run! What? Mr. Latter, are you Benedict Arnold, the American traitor, reincarnated?

Let me explain how the US benefits (and China too!) in simple terms ignoring foreign currency transactions, which will just confuse the discussion and cause the student to lose sight of what is really happening:

The first key point is that when Wal-Mart buys the shirts from China for $400 it can only pay China with US dollars. Why? Because Wal-Mart has only US dollars! It has no Chinese currency (Yuan). It literally drains its bank account of US dollars that are transferred/paid to China!

The second key point is that when China receives that same $400 US dollars for the shirts, China cannot, unfortunately, spend any of the $400 in its own economy since only the Yuan is accepted as a medium of exchange in China! China is now forced to either throw the currency away (not advised!), or immediately spend the money back to the USA (advised!).

In summary, China has actually traded a product (shirts!) for paper (US dollars!), and those US dollars cannot be spent in China. For China to receive any value at all for the shirts it sent to America, China must now spend the $400 back into the US economy for, say, a global positioning system (GPS) from FleetMatics out of Waverly, Massachusetts (USA). Cutting through to simplicity, in essence, it’s almost as if Wal-Mart (USA) just paid FleetMatics (USA) $400 directly for the shirts!

Yes, the “punch line” is that all home-currency spending by the domestic nation on foreign products (imports), in turn, are spent right back to the domestic nation increasing the domestic nation’s employment, income, and standard of living. (Note; this is shown in a nation’s balance of payments schedule which always nets to zero, but, yuk, who cares about that right now with summer coming!)

And, yes, let’s not forget that Elon, North Carolina shirt maker that did not get the original $400 from Wal-Mart in our above example! Our nation loves competition (ready for the Olympics?) and I am excited to see if that North Carolina shirt manufacturer can “raise their game” (increase productivity), and hopefully get the next shirt contract from Wal-Mart or some other firm! If not, well, that North Carolina firm may just have to close down.

If you are still reading this post at this point, you may be thinking the following if you have a little economics’ background: “But the US has a growing trade deficit with China, so China may not immediately buy that GPS system from FleetMatics for $400”. And, you are correct, but that is also not a problem for either the United States or China. What China is really doing right now is deciding to temporarily save or invest a minority percentage of their US dollars received back into America in lieu of buying US products. Said another way, China is not buying as many GPS’ as the US is buying shirts and, of course, we call that phenomenon the US trade deficit which immediately seems to speak “problem”. But it is really no problem at all! China is still spending their “saved” US dollars back into the US economy, but in different ways. China is saving and investing some of those US dollars directly into the United States economy by building plants in America, buying US stock to fund American companies’ expansions, and temporarily saving some of their dollars, for future US purchases, by buying US bonds to help the US government pay for the war in Iraq, the war against terrorism, and several other US government initiatives necessitating borrowing. Eventually, China will sell these US bonds and buy that GPS system or build more plants to employ more Americans!

Now one last thing. Promise! Let’s get back to why trade is really so economically advantageous to any nation that pursues it. And by advantageous, I mean how it increases our incomes and standards of living. In one word, the answer is “productivity”. If we go back to the original example of the US buying shirts from China and China taking the US dollars to buy the GPS, we remember that the shirt manufacturer from North Carolina was “left out in the cold” because Wal-Mart did not buy the shirts from them. We can logically conclude that perhaps some Chinese manufacturer of GPS systems was “left out in the cold” because some Chinese business elected to buy from FleetMatics in the USA, and not the Chinese GPS manufacturer. Wow, I love global competition! What a great way to incent businesses in both the USA and China to compete against each other and increase their productivity and conserve our nations’ scarce resources, increase our choice, and lower our costs!

Discussion Questions:

1. Which basic economic principles underly the emergence of international trade as a global economic force.
2. Who are the winners and losers of trade between the US and China as explained above?
3. Why do you think free trade is such a controversial topic among certain groups of Americans an other Western nations’ people?

FT.com / World / Americas - US economy threatens Dominican Republic

Trade based on comparative advantage… the theory originally articulated by Adam Smith, later fine-tuned by David Ricardo, the theory that suggests that if each nation specializes its economic activity on the products for which it faces the lowest opportunity cost, then trades with its neighbors, total world output and efficiency can be maximized: today this theory represents the philosophical underpinning of all free trade agreements signed between and among the nations of the world.

Through trade, countries can exchange their extra output with other nations for the goods specialized in by others, enabling all nations to enjoy a level of consumption beyond what they’d be able to achieve if they tried to produce all goods domestically.

For many developing countries, with their abundance of either land or labor, comparative advantages tend to lie in either agricultural goods or low-skilled manufactured goods. Since global prices for food are highly unstable and dependency on healthy harvests, good weather, and stable rainfall are all highly risky endeavors for a poor country, developing nations prefer to foster the growth of manufacturing sectors in their path towards economic development.

Strategies for economic growth available to developing nations include export-oriented and inward-oriented growth. A country like the Dominican Republic, the largest economy in the Caribbean, has pursued a predominantly export-oriented growth strategy, promoting through “free zones” the growth of a textile industry aimed at producing goods for consumers in developed countries, primarily the US.

To the Domincans, producing textiles for export to America has successfully given the people of this poor nation a grip on a rung of the ladder towards economic development. The import of capital has taken previously unproductive workers out of agriculture and put them into an industry where productivity, thus income, has risen, leading to improvements in living standards. Export-led growth, however, runs some serious risks of its own, as is being realized by the people of the Dominican Republic today.

It had been clear for some time that Luis Caraballo’s textile factory, in one of the Dominican Republic’s largest “free zones”, was struggling.

Finally, last December, he closed the factory gates for the last time: cut-throat competition from China and Vietnam, a weakening US dollar and unsustainable costs had become too much.

Once a hot destination for American companies looking for a cheap place to “off-shore” production of labor intensive textiles, the Dominican Republic today faces new competition, and is finding its comparative advantage slip slowly away from textiles…

The Dominican Republic depends heavily on the US, which is the destination of more than 85 per cent of exports. But textile exports – these days accounting for less than a third of total exports – fell by 32 per cent over 2007.

Although other countries in the Caribbean are also suffering from Asian competition – with Chinese textile exports to the US tripling between 2000 and 2005, while Vietnam’s multiplied almost 117 times – the Dominican Republic has been worst hit.

Here’s the thing: a nation’s comparative advantage may shift over time (from land to labor to capital intensive goods) as the structure of the global economy evolves. Once an economy like the Dominican Republic’s has undergone a period of structural adjustment, away from agriculture and towards industry, the flow of low wage workers from farm to factory begins to slow to a trickle, leading to rising wages and increased competition from countries with more abundant supplies of cheap labor.

The challenge for policy makers is to manage the structural changes as they come, minimizing the deleterious impact such global shifts of productive resources has on the citizens of a country like the D.R. Clearly, it is in the country’s interest to prepare its citizens for a “new economy”, one in which skilled labor will play a larger role. The problem is, this requires a solid education system, which the D.R., it turns out, does not yet have:

There is widespread acceptance of the need to develop a better-educated workforce, but so far education spending has been inadequate.

“The government simply doesn’t have enough resources,” said Mr Montás. About 40 per cent of its budget goes on debt obligations and another 15 per cent is dished out through subsidies. Just 1.5 per cent goes towards education.

It also turns out that this is a balance of payments story:

Mr Montás calculated that for every percentage point the US economy contracted, the Dominican Republic’s GDP would shrink by 0.4 per cent.

Not only will exporters be hit, but also the huge tourism sector and remittance flows…

One possible result of the decline in exports and flows of remittances from the US will be a depreciation of the D.R. peso, as demand for pesos by Americans falls. A weaker peso might make the country’s exports attractive once again, assuming the exchange rate is allowed to adjust on foreign exchange markets. A weaker peso should help slow the decline in the D.R.’s exports to the US, at least until new competition emerges, perhaps elsewhere in Asia, maybe even from Africa or other Latin American countries.

In all likelihood, given the increased competition from Asian textile manufacturers, continued economic growth in the Dominican Republic will depend on the country’s ability to educate and train its workforce to adapt to a more capital, technology and information-based economy, which, if successful, will eventually lead to rising incomes and higher standards of living for the people of the this rising Caribbean nation.

Comparative advantages evolve with the emergence of new competition among developing and developed countries. The negative impacts this evolution has on a particular economy can be managed if wise policy actions are taken to assure a country’s workforce is educated and trained to participate in tomorrow’s economy, rather than yesterday’s or today’s.