How China Cuts US Economic Growth By 1 Percent Per Year

Peter Morici from The Street argues that a rumored deal between the US and China to allow the Yuan to appreciate by 3% will do little to help the huge trade imbalance. In fact he argues that the Yuan is undervalued by about 40% which will cause a 1 percent decrease per year in US economic growth. See the following post from The Street for more on this.

The Washington Post reports Friday that Treasury Secretary Timothy Geithner and Chinese Vice Premier Wang Qishan were close to a deal that would permit the Chinese yuan to appreciate by 3% this year.

This is wholly inadequate and would do little to resolve the U.S.-China trade imbalance, which was $227 billion in 2009 and 60% of the total U.S. trade deficit. The balance was largely oil.

Our modern free trade system, facilitated by World Trade Organization agreements, is intended to permit countries to both export and import to obtain the gains in productivity and income attendant to specialization through comparative advantage. When trade imbalances occur that exceed private investment flows motivated by differences in developmental opportunities, exchange rates are the adjustment mechanism, similar to prices in markets for commodities.

Simply, when currencies are freely traded demand exceeds supply for the currency of trade surplus countries, especially recipients of private investment like China.

In China's case, more U.S. businesses want to buy yuan with dollars to obtain Chinese products and invest there than Chinese businesses want to sell yuan for dollars to obtain U.S. products and invest here. That should push up the value of the yuan, making Chinese products more expensive, U.S. products less expensive and bringing trade accounts into closer balance.

China, by pegging its currency to the dollar, frustrates this process and abuses the WTO system. A huge importer of private foreign private investment, China would not have a trade surplus, and certainly not a huge trade surplus with the United States, but for the fact that Beijing intervenes in currency markets.

China's yuan is likely undervalued by 40%, and Beijing accomplishes this by printing yuan and selling those for dollars to augment private transactions. In 2009, those purchases were $450 billion, or about 10% of China's gross domestic product and 28% of its exports of goods and services.

The U.S. trade deficit with China and on oil causes a shortage of demand for U.S. made goods and services and stifles investment in U.S. export industries, which are the most productive and research and development-intensive industries.

In 2010, the trade deficit with China is reducing U.S. GDP by more than $400 billion or nearly 3%. Unemployment would be falling rapidly and the U.S. economy recovering more rapidly but for the trade deficit with China and Beijing's currency policies.

Longer term, China's currency policies reduce U.S. growth by one percentage point a year. The U.S. economy would likely be $1 trillion larger today, but for the trade deficits with China over the last 10 years.

A 3% revaluation of China's currency will do little to change those numbers. In fact, because of Chinese modernization, the intrinsic value of China's currency rises each year. Hence, a 3% revaluation over the next year would not even amount to the change in yuan undervaluation.

As the U.S. trade balance with China grew worse, Beijing could say, "See exchange rates don't matter."

Beijing is playing the Obama administration for fools.

This post has been republished from The Street, an investment news and analysis site.