The Trump yuan

Is the President-elect missing the boat on China?

As Donald Trump scrambles to assemble a policy agenda for his unexpected Presidency, reporters are peppering him with questions about his campaign promises. One vow of interest to Central Asia is to impose a tariff, reportedly 45%, on Chinese imports.  A senior policy adviser, Wilbur Ross, explains, “He’s been misquoted about the 45 percent. Everybody says, ‘Oh, he’s going to slap 45 percent tariff on everything out of China.’ That’s not what he said, and it’s not what he intends. What he actually said was if it turns out that the Chinese yuan is 45 percent overvalued, or as much as 45, and if they won’t negotiate with us, then it may become necessary as a negotiating measure to threaten them with as much as a 45 percent tariff.”

Gentle Reader may now wish to scratch her head in wonderment. Normally, “overvaluation” means that the government values its currency at a higher foreign price than the market does. To use a simple (though ridiculous) example, suppose that the yuan is worth $1 on the market but that the government trades one yuan for $2. Then it overvalues the yuan by $1. In effect, it taxes Chinese exports at a rate of 100%: A whirligig that would have sold in the US for $1 at the market exchange rate, costs $2 at the official exchange rate. Since the Chinese are already shooting themselves in the foot with the overvaluation, the US need not slap on an additional tax (which is what a tariff amounts to).

In fact, Trump should bless Beijing for any overvaluation, since this subsidizes American exports to China. A can of Spam that sells for $2 in the US will go in China for just one yuan at the official exchange rate.  At the market rate, it would have cost two yuan. Since Spam is cheap in China (thanks to the subsidy), the Chinese will buy lots of it. Indeed, the US Treasury Department concluded last month that the Chinese government was wading into currency markets in order to prevent “rapid depreciation” of its currency.

Presumably Trump’s aide meant to say that Mr. President-Elect might punish the Chinese for undervaluation of the yuan, since this would subsidize Chinese exports to the US and tax Chinese imports from the US. His misuse of elementary economic ideas does not bode well for the new administration. –Leon Taylor tayloralmaty@gmail.com

Notes

What is the benchmark for determining whether a currency is under- or over-valued? One approach is to calculate the exchange rate that would ensure that a given bundle of products sells at the same dollar price in both countries, since free markets should tend towards this outcome. This is “purchasing power parity.” If the actual exchange rate implies a stronger currency than purchasing power parity would require, then the currency is overvalued. If it implies a weaker currency than required by PPP, the currency is undervalued.

Suppose that we use the Big Mac as our product for comparison. (This is not a great choice, but it is the one made famous by The Economist newspaper.).  And suppose, in yet another simple-but-ridiculous example, that the current exchange rate is one yuan for $1, the price of a Big Mac in the US is $3, and that the price of a Big Mac in China is one yuan. Then the implied current dollar price of the Mac in China is $1, since one could exchange the yuan for a buck.  To increase the Mac price in China to $3, the yuan would have to strengthen from equaling $1 to equaling $3. So it is now undervalued.     

  

References

Jose A. DelReal. Trump team is hedging on some pledges.  Washington Post.  November 12, 2016.

Ana Swanson. Trump calls China a currency cheat. But is he right? Washington Post. November 12, 2016.

Good reading

Paul Krugman, Maurice Obstfeld and Marc Melitz. International economics: Theory and policy. Ninth edition.  Addison-Wesley. 2012.