Tuesday, November 13, 2007

Article in Question: China's Trade Surplus Sets a Record

An excerpt from China’s trade surplus sets a record” published in the Boston Globe on November 13, 2007

The statement: “The surge in import revenue has strained the government's ability to restrain pressure for prices to rise. The central bank drains billions of dollars a month from the economy through bond sales, and has piled up the world's biggest foreign reserves at $1.3 trillion.

China's trade surplus with the United States rose 12 percent to $15.7 billion on total two-way trade of $26.7 billion, according to the customs agency. US lawmakers are working on several proposals to impose punitive tariffs on Chinese imports if Beijing fails to take action on its currency controls.

The United States and other trading partners complain that China's currency, the yuan, is kept undervalued, giving its exporters an unfair price advantage and adding to the country's surpluses.”

This is partially true. The nominal exchange rate is only half of the story. Correctly, the article associates price controls with import demand. Incorrectly, the article jumps to the conclusion that it is the nominal exchange rate driving export demand (as do many politicians and reporters). Actually, it is the real exchange rate that drives export demand. Let’s see why. The real exchange rate takes into account the following: the nominal exchange rate, the domestic price level, and the foreign price level. The article clearly states that price controls keep the price of Chinese goods from rising with import demand –low relative foreign prices are a factor in export growth as well. This keeps the real exchange rate at a depreciated level, and Chinese exports high. The fact that the Chinese government targets the Yuan according to a basket of currencies at a weakened level only depreciates the real exchange rate further.

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