Since 2001, the United States has adopted a tougher policy of trade protectionism towards China.

Yet, China's trade surplus with US hit US$101 billion in 2005, tripling the 2004 figure.

(a) Explain the factors that could lead to a narrowing of China's trade surplus with US. (10)

Introduction

A balance of trade (BOT) surplus occurs when the value of exports of goods exceeds the value of imports of goods. As such, the receipt from exports of goods to the US is greater than payments for imports of goods from US.

Notwithstanding the current trend, China's trade surplus could narrow in the future. This can happen if there is a fall in value of exports to US and/or rise in value of imports from the US.

FALL IN VALUE OF CHINA'S EXPORTS

Poor Performance of US & World Economy

Firstly, the growth of China's export depends on the growth in the export markets i.e. the US and world economy. If global growth continues to be robust, export growth from China would likely to continue.

However, if the US and world economy slows down, China's export growth will consequently decelerate. In view of surging energy prices, rising political instability in the Middle East and the impending Avian Flu pandemic, US economic growth could slow down in the near future which results in the fall in demand for exports from China. Naturally, this would narrow the trade surplus of China.

Revaluation of Yuan

Secondly, government intervention in the form of revaluation could cause the trade surplus of China to fall. America's worsening trade deficit is often attributed to the undervaluation of the RMB and there is increased pressure for the RMB to be revalued.

An undervalued Chinese RMB could lead to widening of China's trade surplus with US. An undervalued RMB makes China's exports into US cheaper and China's imports from US more expensive. It results in fewer US goods being sold in China and more Chinese goods being sold in the US. This results in a BOT surplus for China.

A revaluation of RMB would narrow China's trade surplus by making China's exports to US more expensive (thus reducing the expenditure on China's exports assuming that the demand is elastic) and making China's imports from US cheaper (thus increasing the spending on imports if the demand is elastic).

In July 2005, the RMB was revalued by 2.1 percent against the dollar. At the same time, Beijing began pegging the RMB's value to a basket of currencies that includes the dollar, euro and yen, among others. In view of probable further revaluations and the greater reliance on market forces to determine the external value of RMB, a reduction of China's trade surplus with US is most likely. The situation would be exacerbated if the US dollar depreciates at the same time.

Change in Global Outsourcing Trend (Decreased FDI = Decreased X)

Thirdly, a change in the global outsourcing trend would in turn affect China's export. In 2003, about half of all goods exported from China are from foreign-owned multinational companies or joint ventures.

That share has been growing about 1 or 2 percentage points annually in recent years but may be currently stabilizing or even falling. An indication of this is that foreign capital coming into China in 2005 has reduced slightly - the first time in many years that it will have fallen. That may mean the share of foreign-produced goods would not grow as fast as it has in the past.

This development could be attributed to increased competition for capital investments from other rising economies, like India and Vietnam. On the other hand, resource constraint is also causing rising costs of production in certain regions in China (reducing its comparative advantage in producing certain goods) which could have caused the outsourcing trend to be reversed in China. Consequently, there would be reduced exports to US and the rest of the world. This would narrow the trade surplus of China.

Government Measures

The Chinese government actions taken to tackle the other economic problems facing the Chinese economy (i.e. an excessively fast pace of growth in investment, excess liquidity, and severe hikes in prices for raw materials) may also impact the trade balance. For instance, one of the top priorities for the Chinese government in recent years is to slow economic growth and curb unprofitable investment.

In 2005, the People's Bank of China raised key interest rates and increased the amount banks are required to hold in reserve (i.e. the cash reserve ratio). By doing so, the interest-sensitive components of the AD are likely to fall and via the multiplier effect, the national income is likely to be reduced. Though the reduction in national income could reduce import expenditure from the US (and hence increase the trade surplus), the effect might not be great as the import volume from US is still relatively small. On the other hand, with the increased interest rates, the export production by domestic firms can be hampered due to increased cost of financing domestic export industries. As a result, China’s trade surplus could be reduced.

INCREASED US EXPORTS TO CHINA

On the other hand, the Chinese trade surplus situation could also be affected by an increase in volume of imports from US.

Rising purchasing power of Chinese (­rise in NY = rise in M)

With the rapid development of the Chinese economy at an annual growth averaging 9-10%, the purchasing power of consumers will inevitably increase which lead to an increase in imports.

To gauge the rising purchasing power of Chinese consumers, the automobile sector is the best example - about 95% of the automobiles sold there are made by foreign companies or joint ventures. If this trend of increased consumption continues, there could be a rise in the demand for US goods, especially consumer products in the near future. This would lead to a narrowing of the China’s trade surplus with US.

Reduction of trade barriers in China & Improved US productivity

Other factors that could lead to a rise in US exports to China could be reduction of trade barriers by China after joining the WTO and improved productivity in the US which is translated to better quality and price competitive products to be exported. However, these might require time to materialize as it takes economic restructuring. This is further hampered by the current protectionist postures taken by the US.

Conclusion

In conclusion, there are various factors that could cause the trade imbalance between China and US to narrow.

The decrease in the value of export from China is likely to occur given the influences of reversed outsourcing trend, bleak outlook of the US and world economy and probable revaluations of the RMB. In addition, the narrowing of trade surplus could take place due to future growth of Chinese demand for US consumer goods.

(b) Comment on the likely effects of a 'tougher policy of trade protectionism' adopted by US on the economies of US and China. (15)

Introduction

Despite the apparent benefits of free trade as encapsulated in the theory of Comparative Advantage, US still took measures to protect their own industries from foreign competition in 2001. Ironically, 2001 was the year China joined WTO when it sought to integrate into the world trade system.

The US government perceived that trade protection could help to deal with a rising competitor and enhance its citizens' welfare. Moreover, there is the possibility of some limited gains such as increased domestic production and employment and reduction in the balance of payment deficit for the US. However, many of these gains could be temporary and self-defeating in nature. In the long run, countries tend to lose from protectionism, as predicted by the Theory of Comparative Advantage.

Effect: Domestic Production & Employment

US
An apparent advantage of increased trade barriers by US is that domestic industries within US would be shielded from competition by the Chinese producers which could produce cheaper goods. With reduced imports from China, domestic producers will now fulfill the demands of the massive American market. Consequently, the output for the domestic industries will increase and new jobs in US, which in turn could improve the standrad living in US. This could lead to positive spillover effects into other supporting sectors, like transportations and marketing.

However, there are extensive statistics to indicate that protectionism could hurt the very country which impose it. For example, it is estimated that between 45,000-75,000 jobs were lost as a result of the steel tariffs imposed by the Bush administration between March 2002 and December 2003. The tariffs caused higher steel prices which in turn made US companies which depended on steel less competitive in the world market.

China
Due to the increased protectionism by US, Chinese exporters will have reduced access to the massive US market on a competitive basis, thus reducing its ability to export and to attract foreign investments. This could lead to fall in production and employment, resulting in slowdown in economic growth.

In the longer-term, this might ultimately lead to the establishment of alternative markets for its exports and further development of its own domestic markets. Incidentally, the Chinese government has been actively promoting in recent years to reduce its reliance on export sector to drive economic growth.

Effect: Balance-of-payments

US
One of the key impetuses of increased protectionism by US is to reduce the trade and BOP deficit. The US government resort to protectionism to reduce the value of Chinese imports. This may reap short-term benefit for the US if the Chinese imports are curtailed. However, China accounts for less than 10% of all US imports, and Chinese imports are far less than 2% of US GDP. Thus, the effects of increased protectionism maybe over exaggerated.

Moreover, this policy to correct balance of payments deficit is an interim measure as protectionism does not remove the fundamental cause of the US's trade deficit which is due to a lack of competitiveness in areas such as pricing, quality, reliability, delivery, design, ineffective marketing etc. Thus, US should instead revise and restructure its economy so as to improve international competitiveness. Thus, in longer-term, the increased protectionism does not resolve the trade deficit problem for US.

China
For China's case, its trade surplus with US could be narrowed due to increased US protectionism. Foreign companies in a variety of industries might relocate its businesses away from China, reversing the outsourcing trend. In the longer-term, increased trade protectionism faced by China might compel China to seek alternative export markets and forge new trade partnerships with other emerging economies, like Russia.

Also, as with other newly industrialised Asian economies, China may seek to restructure its economy into an increasingly more knowledge-based one by diverting its resources from labour-intensive into capital-intensive, high-tech manufacturing and services industries. In the process of restructuring, they will have to bear some dislocation costs, for example rising structural unemployment.

Effects: Inflation Rates & Cost of Production

The protectionist stance by US could have an impact on its price stability. The American consumers including business consumers in the manufacturing sector - are among the beneficiaries of cheap Chinese imports. The cheap Chinese imports have helped many US industries maintain their competitiveness and expand global market share in a way that would not be possible if they were restricted only to US-based production. Chinese production is now well-integrated into the global value-chains of US manufacturers.

Thus, protectionism against China could contribute to a reversal of the low inflation that US consumers have been enjoying for years, which has kept interest rates low even as the US economy recovers from recession. Also, it results in the loss of consumer welfare caused by higher prices and possibly reduced consumer choice.

Conclusion

Although there are some short-term positive effects that make protectionism seems attractive to the US, the costs for protectionism can be high in the longer-term and if viewed from a wider context. Countries practising protectionism usually experience welfare loss in the form of reduced consumer surplus, choices and higher prices and reduced export earnings as protectionism reduced the income and capacity to import by other countries. Protectionism also causes misallocation of resources.

As an alternative to protectionism, US should instead try to stimulate its export competitiveness by making efforts to improve the productivity and lower unit cost of production of domestic industries by having better training and education etc.