Undervalued Yuan at Root of Problem

The United States trade deficit with China continues to be a sensitive issue in Washington as it came in at a staggering $19.6 billion in July, down marginally from June but nonetheless something that was not well received in Washington. The trend of a high trading deficit will most likely push the U.S. trade deficit with China to a record this year versus the $202 billion deficit in 2005.

 The U.S. trade deficit with China accounts for 28.82% of the total trade deficit at a record $68 billion as the country expects to record a trade deficit for the fifth straight year. The dependence on foreign oil by the U.S. helped to drive up the deficit.

 It’s clear that the trend for China’s trade surplus is rising and at a much greater rate than the country’s main trading partners would like to see. The United States, the country’s main trading partner, is not happy about the situation.

 The continued strength of the July surplus will clearly place pressure on the Chinese government to allow the yuan to strengthen in the foreign exchange market, something that the United States and other deficit trading countries have long been pushing for.

 China will need to seriously evaluate the value of its yuan and interest rates. The massive surplus implies amble cash flowing into the country and raises the threat of inflation.

 The central bank will need to curb inflationary pressures or risk the real possibility of a bubble if the current surplus trend is left unabated.

 It is clear that the undervalued yuan is the root of the problem. China has been told about this constantly, but so far has made only simple gestures and has yet to allow the yuan to float unhampered in the foreign exchange market where surely its value would rise.

 The reality is the yuan needs to rise in value. China’s strong GDP growth is simply too high and could lead to a market bubble. The Chinese government is expecting GDP growth to hold at double digits going forward.

 The Group of Seven industrial nations are asking China to allow the yuan more flexibility. The United States is frustrated and has said that if China does not do something, it will go ahead with a Senate vote this month to impose a 27.5% duty on all Chinese goods. Of course, such a high tariff will help the trade deficit with China, but at the same time it would increase consumer prices in the country for Chinese made goods and this would drive inflation higher.

 Stay tuned.