It takes two to tango: why a big Chinese currency appreciation alone won't cut America's trade deficit.

• Author: Lo, Chi

China's trade surplus grew 74 percent to US$177.5 billion and its foreign reserves added more than US$200 billion to reach US$1.07 trillion in 2006. These reports will add fuel for many China critics to cry foul of China's yuan policy, which in fact reflects a serious global economic imbalance problem. Some members of the public and politicians are confused in this yuan policy debate. Others have shown ignorance about, or chosen to ignore, the significant global impact of a forced yuan revaluation.

In my view, this ignorance reflects largely the denial of a fundamental excess demand problem in the United States that has contributed to the economic imbalance. There is no doubt that China needs to play its part to reduce excessive saving in helping to resolve the global imbalance. But that is only a half solution. Understanding the U.S. problem is crucial for setting the yuan policy debate on a proper course and arriving at a solution.

DISTORTED VIEWS

The confusion about the economics behind China's currency policy has led to a wrong view that China's huge foreign reserve accumulation corresponds to its large trade surplus with America, achieved by an undervalued yuan policy. The reserve accumulation is a combined result of China's current account balance and other net capital flows, such as loans and portfolio investment. China had an estimated current account surplus of US$183 billion in 2006 and a net capital inflow of US$31 billion. Altogether, these US$214 billion inflows would have pushed up the yuan exchange rate sharply had Beijing not bought massive amounts of U.S. dollars and put them in the foreign reserves.

We should not see the China-U.S. trade surplus in isolation. Despite China running a US$230 billion-plus trade surplus with the United States, it also runs a large trade deficit of over US$50 billion with other trading partners, notably Asia, due to its large demand for raw materials and capital goods. This deficit subtracts from China's surplus with the United States and makes its overall trade surplus smaller.

Arguably, the root cause of the China-U.S. trade surplus is not an undervalued yuan, which is more of an aggravating factor. It is the change in the international trade structure, combined with a chronic U.S. import demand problem (discussed next). A surge in investment in heavy industries in the 1990s gave China a huge production capacity to manufacture goods to replace imports, making it the world's low-cost factory...