China’s Assault on Free Trade

It is easy to understand why most Americans do not view trade with China favorably. For over 30 years, it has been a lopsided affair. Since 1986, the U.S. trade deficit with China has grown an astounding 25,079%, leading many Americans to question the U.S. policy of supporting “free-trade” agreements. For investors, the outcome of this debate is critical. Will the U.S. become protectionist and reverse three decades of political support for free-trade agreements? Will the Chinese economy collapse as a result of decades of government manipulation of its currency to encourage exports?

In the 1950’s, most Americans favored free trade as a way to thaw cold war relations, but as trade deficits grew in the 1990’s, Americans began to view international trade as a threat to their jobs. According to a 2016 Bloomberg poll, 65% of Americans favor greater restrictions on imported goods. The changing view coincides with the growth in Chinese imports. A closer look reveals how China has played an integral role in the growing U.S. trade deficit and why it is a unique problem.

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The chart above illustrates how trade with China has resulted in the growth of the overall U.S. trade deficit in goods. In 1985 China comprised less than 1% of the U.S. trade deficit. In 2018, China accounted for 55% of the entire U.S. trade deficit for goods. The next four largest trading partners (Germany, Japan, Mexico and Canada) made up 31% of the U.S. trade deficit. In all, these five nations made up 86% of the entire U.S. trade deficit for goods.

There are several important things that this data does not point out. First, only imported and exported goods are reflected, not services. While the U.S. has a growing deficit for goods, we are exporting more services than we import. In 2018, the U.S. had a trade surplus of $270 billion for services. Second, the chart does not identify nations with whom we have a trade surplus for goods. Third, with some nations, such as Canada, our trade deficit has been declining and for others the overall deficit has not increased significantly over time. It is also worth mentioning that trade with Mexico and Canada needs to be weighed under the acceptance that the U.S shares a border with both these nations and that there are other economic benefits associated with the historically friendly relations. Flaws aside, what is apparent is that over the past 30 years, U.S. trade with China has not been balanced.

The modern history of U.S. trade with China began during the Cold War. For more than 20 years after World War II, the two countries viewed each other as adversaries and had virtually no trade. The relationship between the two nations began to change when President Nixon visited China in 1972. As diplomatic relations improved, U.S. companies began to explore how they could get into the Chinese market, leading to an initial growth (albeit small) in trade with China. A setback occurred in 1989, when Congress and George H.W. Bush imposed a series of tough trade sanctions due to the Chinese government’s actions during the Tienanmen Square protests. In 1993, President Clinton decoupled China’s human rights abuses from trade and renewed their most-favored-nation status, opening the U.S. market to a sea of Chinese products. According to Amnesty International, China remains an authoritarian state with a poor human rights record. (A sad fact is that as the U.S. embraced free-trade, it also became less involved in addressing human rights abuses.)

In theory, free trade results in two countries having neither a long-term trade surplus nor a long-term deficit. To counterbalance trade surpluses, the currencies of both nations would float freely, increasing or decreasing in value as the demand for each nation’s products and services shifts. For example, as Americans would demand more products from China than the Chinese from the U.S., there would be an increased demand for Chinese yuan vs. the dollar. This would cause the value of the yuan to increase relative to the dollar and thus make Chinese products more expensive for Americans. However, this has not occurred.

As is often reported, China has long prevented its currency (the yuan) from floating in the free market and pursued a policy of keeping the value of the yuan low in relation to the dollar. They do this to encourage exports and have robust economic growth at home. To prevent the yuan from increasing in value, the Chinese offset the increased demand from Americans for the yuan by increasing China’s demand for the dollar. Since the Chinese are importing fewer products from the U.S. than they are exporting and can’t drive up the value of the dollar that way, the Chinese government purchases U.S. Treasury notes to offset America’s demand for the yuan. Today, China holds $1.13 trillion of U.S debt. These actions have caused robust economic growth in China and kept U.S. interest rates low.

However, implementing such a policy seldom ends well. The growth that China encouraged through currency manipulation has led to overbuilding and inflated real estate prices in China. At the same time, it caused U.S. economic growth (as measured by the GDP) to languish. The result is many economists fear that the Chinese economy is a balloon about to burst. Ironically, the only way to prevent this from happening is to allow the yuan to increase in value relative to the dollar in an effort to slow down an overheated Chinese economy. This would cause a decline in imports of Chinese goods, which in turn could reduce the trade deficit with China and lead to greater economic growth in the U.S. For China, the choice is a “catch-22” that will result in the U.S. economy gaining steam after decades of disinflation.

Craig D. Hafer is an investment professional who writes on the market, the economy and current events with a focus how these stories may impact investors.

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