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March 1, 2007

NO CURE FOR THE TRADE DEFICIT

The U.S. dollar continues to decrease in value. Why then do imports continue to surge?

 
Jeff Rosensweig

The dollar has continued to fall significantly in value against the currencies of the United States’ major trading partners, which should make U.S. products cheaper relative to foreign production. Why then do U.S. imports keep surging, outpacing the rise in exports, and thus resulting in record trade deficits? The answer has a lot to do with China’s emergence as an economic power.

 

The United States in 2006 suffered a new record deficit of nearly $900 billion on manufactured goods and commodities. The same sad record is true for the overall deficit on goods and services, which reached nearly $820 billion last year, although the United States consistently maintains a small surplus on services.

International business theory says that a lower U.S. dollar value relative to other major currencies should help cure a deficit. The U.S. dollar has fallen significantly in value against the currencies of major trading partners including the euro, the Canadian and Australian dollars, and the British pound. This depreciated exchange rate for the dollar makes U.S. products relatively cheaper vs. foreign production. However, this is not yet having a noticeable impact on the deficit.

NO SHRINK IN SIGHT

Why has the dollar lost a significant amount of value, making U.S. production relatively cheaper as compared to the start of 2002? First, the U.S. stock market bubble burst, so foreigners sold their U.S. stocks and dumped U.S. dollars to bring their wealth back home. Second, crises at Enron, Worldcom and Tyco, among others, led to disrespect for the safety and soundness of the U.S. financial system. Third, the accumulating, record U.S. trade deficits made foreign exchange market participants fear that the United States cannot compete and was building up an unsustainable foreign debt.

These exchange rate movements make U.S. exports cheaper to potential purchasers. This impact, along with increased demand resulting from a few years of good economic growth worldwide, largely accounts for the good news: the progression of record U.S. export sales.

The standard theory asserts that major foreign currencies rising in value should make their foreign products relatively expensive in the U.S. market. After a time lag to build up alternative U.S. domestic suppliers, U.S. imports should be curtailed. Along with the rise in exports, this downward import impact should eventually shrink the trade deficit.

There are three reasons why the deficit isn’t shrinking.

First, the good news: Imports can rise as a result of a nation’s increased overall demand by firms and households because of economic growth. Since 2002, the United States has enjoyed good growth in the economy, jobs and wealth. Real estate, bonds and stocks, including mutual funds, have all yielded good returns. This demand impact is clear in the metals industry.

Second, the overall import bill can rise as a result of increased worldwide prices for key commodities that a nation needs, such as energy and iron ore. Prices of such crucial commodities have risen dramatically over the past few years. Metals industry executives sure know this!

Third, imports can rise if large nations increase their productivity while having low wages. Wages in such nations are even lower relative to those in the United States if their currencies are cheap in terms of the U.S. dollar. It is well known by metals industry executives that China and some other large economies in Asia, such as Japan, still have cheap currencies despite rapidly rising productivity and quality. Why are their exchange rates still cheap, when the currency values in other key U.S. trading partners, such as Canada and Europe, have increased so much?

The answer is revealed in the graph above “Piling Up.” A number of Asian nations that have emerged as big global trade players are accumulating massive reserves of foreign currencies. This means that their central banks are intervening in the foreign exchange market, buying currencies foreign to their own, especially the U.S. dollar. They do this to support the exchange value of the dollar, printing their own money to supply it to the market and mop up excess dollars in order to keep their own exchange rates low.

Most noteworthy are the gargantuan foreign exchange reserves held by both China and Japan. Japan’s continued purchase of U.S. dollars helped support the value of the dollar vs. the yen. This stands in stark contrast to the hands-off, let-the-free-markets-prevail European and Canadian behavior.

What all metals executives need to understand is the implication of the truly remarkable trend graphed—the jump in China’s foreign reserves to a total even exceeding the reserves that Japan has been accumulating for decades. China’s foreign currency reserves passed the world record threshold of a trillion dollars in October 2006.

What is the motivation behind China’s massive intervention, whereby its central bank purchases U.S. dollars and sells Chinese yuan in the currency market in order to keep its currency from becoming less cheap (ignoring the small currency value gains China started allowing last summer)?

This intervention renders China’s exports of an increasing range of products highly attractive. This effect is amplified as foreign direct investment pours in, adding to technology, training and quality. This boosts China’s productivity and global competitiveness.

The graph to the right, “China to Become World's Leading Exporter of Goods,” shows the success of this strategy and its global impact when combined with the world-leading labor force size and the beneficial impacts of the hard work and high-saving behavior of the Chinese.

China will soon be the largest exporter of goods in the world. This may not surprise some readers faced daily with the impact of China. However this is an amazing rise from near-zero exports before China began opening to the world in 1979.

Note that Germany, known for precision cars and equipment, is still the largest exporter of goods. The United States is second, but China is on such a rapid growth path that it is forecast to pass the United States this year or next. China is expected to pass Germany in 2008 and total more goods exports than any other nation.

Maintaining some U.S. pride, of course the United States will exceed China in per-capita exports of goods. Also, the United States will continue to lead in exports of services (travel, financial, education, etc.).

Still, the conclusion is inescapable: In both its appetite for commodities and its flooding of world markets with manufactured exports, the rise of China has changed the face of business—particularly metals and allied industries—forever.

For U.S. manufacturers to compete, effective pressure must finally be applied to motivate China to curtail its intervention and allow the market to work. Even a significant rise in the price of the yuan will give U.S. manufacturers a more level playing field. China has a trade surplus of roughly $250 billion with the United States, so if China will not play fair, it has a lot to lose if the new U.S. Congress taxes or restricts imports from China.

Jeff Rosensweig is a finance and international business professor at the Goizueta Business School of Emory University in Atlanta, and the author of “Age Smart,” a book published in 2006 that integrates advice for a healthy, prosperous and productive life.