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The effect of a renminbi appreciation on US-China trade imbalances

The US-China currency dispute remains heated. This column argues that if a real appreciation in the Chinese currency is not achieved through exchange rate adjustment, it will happen through inflation in China and deflation in the US. It says a better Chinese policy mix would involve nominal appreciation of the renminbi combined with absorption-increasing policies such as developing human infrastructure.

The legislation passed by the US House of Representatives last week threatening tariffs against Chinese goods is the latest salvo in the Sino-US currency dispute (Evenett 2010, Sanger and Chan 2010). Before the crisis, the US ran large trade deficits with East Asia, oil-producing countries, and the rest of the world. Since October 2008, the US’ deficit has fallen with respect to most regions. This is not the case for China.

Table 1 shows exports, imports, and the trade balance between the US and the rest of the world before and after the collapse of Lehman Brothers in September 2008. Exports and imports both exhibited sharp drops beginning in October 2008. The sample is thus divided into the year before the crisis (October 2007 - September 2008), the first year after the Lehman shock (October 2008-September 2009), and forecasts for the second year after the Lehman shock (October 2009 – September 2010). Between the US and non-East Asian countries, the deficit fell by 76% during the post-crisis period and equalled $227 billion between October 2008 and September 2009. Between the US and China, it fell by less than 12% and equalled $237 billion between the fourth quarter of 2008 and the third quarter of 2009. Columns (7) through (9) indicate that this pattern is continuing, with China making up 44% of the US’ deficit during the first year after the Lehman shock and 42% during the second year after Lehman.

Table 1. Exports, imports, and trade balance between the US and other countries and regions before and after the Lehman Brothers shock ($ billions)

Notes: The year before the Lehman Brothers shock is from October 2007 to September 2008. The first year after the Lehman Brothers shock is from October 2008 to September 2009. The second year after the Lehman Brothers shock is from October 2009 to September 2010. The forecast for the second year is derived by multiplying data for the first ten months (i.e., October 2009 - July 2010) by 1.2. Rest of East Asia includes Japan, the Republic of Korea, and Taipei,China. Sources: US Census Bureau

In Thorbecke and Komoto (2010), we highlight the unusual nature of the China’s exports to the US. We report results from a gravity model indicating that China’s exports to the world and the US’ imports from the world in 2007 were both much higher than the model predicts. We find that in China’s case the main outlier was exports to the US and in the US case the main outlier was imports from China. China’s exports to the US in 2007 were $200 billion more than our model predicted. These results are presented in Figure 1.

Figure 1a. China's predicted and actual exports, 2007

Figure 1b. US predicted and actual imports, 2007

Note: Predicted exports or imports represent the sum of predicted exports or predicted imports from 31 countries based on a gravity model. The gravity model includes income in the exporting and importing countries, the real exchange rate, distance, a common language dummy, importer and exporter fixed effects, dummy variables for Mexico and Canada, and a time trend as explanatory variables. Source: Authors’ calculations.

Is the imbalance sustainable?

The massive imbalances between China and the US have been financed by the accumulation of US Treasury securities (external reserves) by the People’s Bank of China. Many argue that continued foreign reserve accumulation by the Bank of China is unsustainable because it produces an increasingly inefficient allocation of resources. Both private and social rates of return are much higher for investments in the Chinese economy than for investments in US securities. For instance, investing in education would pay high dividends by helping Chinese firms to assimilate new technologies and move up the value chain.

Investing in rural education is particularly important (see Rozelle 2010). Most rural children in China cannot afford pre-school, and even though elementary school is free attendance has declined because of poor accessibility and long, dangerous commutes. In addition, poor health and nutrition restrict students’ ability to learn. At the high school level, tuition is expensive (20 times the per capita annual income of the rural poor) and little financial aid is available. As a result, only one in four rural students finish high school. At the college level, tuition is prohibitively expensive (60 times the annual per capita income of the rural poor). Only three out of one hundred are able to go to tier 1 or tier 2 universities.

If China were to invest in the domestic economy rather than accumulating additional foreign reserves, its currency would appreciate. How would this affect trans-Pacific imbalances? Cheung et al. (2010) use quarterly data over the 1993 to 2006 period to show that a 10% appreciation of the renminbi would reduce China’s exports to the US by between 8% and 20%. Thorbecke (2006), using quarterly data over the 1988 to 2005 period, finds that a 10% appreciation of the renminbi would reduce China’s exports to the US by between 4% and 14%. An appreciation of the renminbi against the dollar should thus help to reduce imbalances between the two countries.

If China does not let the renminbi appreciate, and if the imbalances prove unsustainable, how else would adjustment occur? Cheung et al. (2010) and Thorbecke (2006) both report that a fall in income in the US would not affect China’s exports. One explanation for this is the “Walmart effect” discussed by Plummer and Petri (2009). They argue that since Chinese exports are at low price points within product categories, demand for Chinese imports may increase even as overall demand shrinks. The idea that there is a tenuous relationship between Chinese exports and US income is supported by recent experience. The yuan has remained tightly pegged to the dollar, and a once-in-a-generation crisis barely reduced China’s exports to the US and its trade surplus. A real appreciation of the yuan is thus probably necessary to reduce imbalances between China and the US.

If a real appreciation cannot be achieved by nominal exchange rate adjustment, then it will be achieved by inflation in China and deflation in the US. Because this outcome would be very painful for both countries, a better policy mix would involve nominal exchange rate appreciation in China combined with absorption-increasing policies such as building human infrastructure (particularly in rural areas) and using deregulation to promote competition and productivity growth in the non-tradable sector. This policy mix would help China to move away from unsustainable exports to the West and instead promote production for domestic consumers.


Cheung, Y, M Chinn, and E Fujii (2010), “China’s Current Account and Exchange Rate”, in R Feenstra and S-J Wei (eds.), China's Growing Role in World Trade, University of Chicago Press.

Evenett, Simon J (ed.), The US-Sino Currency Dispute: New Insights from Economics, Politics, and Law, A VoxEU.org Publication, 15 April.

Petri, P and M Plummer (2009), “The Triad in Crisis: What We Learned and How it Will Change Global Cooperation”, Journal of Asian Economics, 20:700-713.

Rozelle, Scott (2010), “China’s 12th 5 Year Plan Challenge: Building a Foundation for Long Term, Innovation-Based Growth and Equity”, Paper presented at NDRC-ADB International Seminar on China’s 12th Five Year Plan, Beijing, 19 January.

Sanger, David and Sewell Chan (2010), “Eye on China, House Votes for Greater Tariff Powers,” New York Times, 29 September.

Thorbecke, W (2006), “How Would an Appreciation of the Renminbi Affect the US Trade Deficit with China?” B.E. Journal of Macroeconomics 8:1-15.

Thorbecke, W and G Komoto (2010), “Investigating the Effect of Exchange Rate Changes on Transpacific Rebalancing”, forthcoming in Barry Bosworth and Masahiro Kawai (eds.), Trans-Pacific Rebalancing, Brookings Institution Press.

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