Macroeconomics Case Study

Walloping US-China trade deficit: Is appreciation of Yuan the only solution to it?

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Abstract:
The United States and China, two of the most powerful nations of the world had been sharing the most imbalanced trade relationships with each other. The United States had been suffering from a huge trade deficit in recent years and their leaders had been alleging China's pegged exchange rate policy as the major contributor to the US trade deficit. According to the US leaders, China's pegged exchange rate policy had been making the Chinese exports cheaper and popular in the US markets affecting the competitiveness of the US producers. China, on the other hand, had been following this exchange rate policy since its reform in 1978. The pegged exchange rate was introduced mainly to promote export growth among the Chinese producers. Moreover, the Chinese leaders following the expansionary credit policy to promote investment and production had also been supporting this pegged exchange rate policy. However, under continuous international pressure, on 21 July 2005, China shifted from its pegged exchange rate policy to a 'managed float', where Chinese yuan was adjusted against a basket of currencies. Despite this, the US had been blaming China for its rising trade deficit. They had been pressurising China to resort to a policy of flexible exchange rate. In this context, the US had implemented several import restrictions against the Chinese producers. However, several economists felt that such pressure by the US would ultimately hurt not only the US consumers, but also the US producers as China might retaliate by blocking its huge market for US goods. Moreover, even if China followed a policy of sudden yuan appreciation, it would affect China's economic stability instead of its huge trade surplus, as was the case of Japan in the 1990s. All these considered, it remained to be seen how China would react to the US allegations.

Pedagogical Objectives:

• To analyse the US allegations against China's currency policy and the actions taken by them
• To study China's expansionary credit policy as a reason behind the pegged exchange rate policy.
• To analyse the retaliatory actions taken by China against the US allegations and its effects on the US market.
• To discuss the effects of a sudden appreciation of the yuan on the Chinese economy.

Keywords :  US-China trade deficit, Pegged currency, Managed float, Expansionary credit policy, Trade surplus, Undervalued Chinese currency, Consumption habits of the US, US-China trade relations, Fair Currency Act Bill, Sudden appreciation of yuan, Liquidity trap, Recession, US consumers, Chinese exports, Countervailable subsidies