Following concern that China’s unfair trade practices were adversely affecting America’s economy and labor markets, former President Donald Trump announced that he would levy a 25% steel and aluminum tariff against China. Trump’s charges against China ranged from intellectual property rights violations to exchange rate manipulation to illegal production subsidies put into place by the Chinese Communist Party. What followed was a trade war that caused America’s public and private savings to decrease.
While China’s violations of the Agreement on Trade-Related Aspects of Intellectual Property Rights are well substantiated, it is worth asking whether the Trump administration’s accusations of Chinese exchange rate manipulation were veracious. In this vein, this article looks into Dr. Tao Liu and Wing Thye Woo’s “Understanding the U.S.-China Trade War”— in addition to existing research — to investigate the roots of America’s large current account deficit with China and chart out a fiscal path to a more balanced current account.
Value Differentials Between the Renminbi and the US Dollar — A Tale of Two Saving Regimes
An investigation into the savings practices of China and the United States reveals a far more truthful story on the origins of the renminbi-dollar exchange rate than the false narrative of Chinese exchange rate manipulation. On the American side, low savings rates help explain the high value of the USD, vis-à-vis the renminbi. On the other side of the Pacific, the low cost of the renminbi in dollars can be largely attributed to limited domestic financing from state-owned banks in China.
Figure 1 Source: World Bank
Chronically low-savings rates in the United States have been a significant force in creating America’s current account deficit with China. As per Figure 1, Chinese private and public savings have exceeded America’s for years. In 2016, when Donald Trump was elected, China’s gross domestic savings rate was more than double that of the United States. The effects of the savings differentials are significant in the foreign exchange market. Relatively low US savings rates make fewer savings available to lend abroad. With fewer bank deposits available to financial institutions, they have fewer assets available to invest overseas. As a result, fewer dollars are supplied in the foreign exchange market, as fewer foreign transactions are occurring that require an exchange of dollars. This process manufactures a leftward shift of the supply curve of USD, as seen in Figure 2. Due to the forces of supply and demand in the global currency market, the dollar is made to increase in value. Therefore, the first effect of low US savings rates is an appreciated US dollar.
Figure 2 Source: Abraham Solovy
The appreciation of the USD is only one effect along the domino chain created by low gross domestic savings rates. Because of the low exchange rate between the USD and the renminbi, it is less expensive for Americans to buy the renminbi. Barring the materialization of purchasing power parity between the two countries, the relatively higher value of the USD permits American consumers to purchase Chinese goods more cheaply. In addition, the relatively lower-value renminbi makes it more expensive for Chinese consumers to acquire American goods. Thus, economically rational American consumers and firms import Chinese goods, while international market actors in China export their products. Accordingly, America’s trade balance with China was in a deficit long before Trump launched his trade war. Therefore, the Chinese-American exchange rate and trade balance can be largely attributed to differences in savings rates between the two countries rather than exchange rate manipulation by China.
Figure 3 Source: World Bank & FRED
The data tells a similar story. In running a regression analysis of data from the Federal Reserve Bank of St Louis and the World Bank, a one point increase in America’s trade balance as a percentage of GDP from 2015 to 2018 was associated with a .7731 decrease in the Chinese Yuan to USD spot exchange rate (Figure 3). Furthermore, the regression’s R2 value of .914 and T-stat score of approximately -4.612 suggest that the data are significant. Income effects were controlled in the regression by dividing America’s overall trade balance by its nominal GDP, and seasonal effects were controlled by averaging the data over years rather than by day or month. Furthermore, the regression focuses on the conditions surrounding the trade war by including only data from the first three years after the IMF first ruled that China was no longer manipulating its currency and the two years preceding the 2018 trade war. Given the relevance of the regression’s time frame, the statistically strong negative relationship between America’s trade balance and the Yuan exchange rate to the USD confirms that the value of the dollar was interlinked with the US trade balance at the time close to the trade war.
From the Chinese side, insufficient domestic financial intermediation — where savings are turned into investment — has also created an export-friendly USD-renminbi exchange rate. Following a series of reckless loans from state-owned banks to financially unsafe private businesses, the government capped the credit state-owned banks could dole out to China’s many private businesses at risk of defaulting on their debts. As a result, household savings often failed to turn into private domestic investments. Because the banks did not want deposits to sit idly and forgo the opportunity cost of gaining higher returns from investment, excess savings were lent abroad. This outflow of savings resulted in a chain reaction that adheres to the process that the dysfunctional financial market theory accredits with deepening the already low USD-renminbi exchange rate.
Chinese state-owned banks had to purchase foreign assets delineated in foreign currencies to invest abroad. To do so, China’s public financial institutions had to purchase foreign currencies. Because the United States is one of the world’s financial capitals, China’s state-owned banks demanded dollars to fulfill their financial transactions. The USD naturally appreciated due to an increase in demand by Chinese banks. In buying American dollars, Chinese banks increasingly supplied renminbi, resulting in a rightward shift of the renminbi supply curve (Figure 4). In creating a glut in the supply of the renminbi, China’s currency depreciated and helped create an account surplus with the United States.
Figure 4 Source: Abraham Solovy
At first glance, the latter process appears to stem from currency manipulation by China’s government. However, this is not the case. The Chinese central government did not place limits on state-owned banks to depreciate the renminbi. Instead, the controls on state-owned banks promoted safer lending practices. Before state-owned banks were stunted in their abilities to lend domestically, they made risky loans to China’s many risky businesses that put many of the banks on the brink of destruction. In limiting the state-owned banks’ capacities to make domestic investments, China’s financial regulators forced the banks to diversify risk. While a depreciated renminbi was a side-effect of the risk mitigation measure, China was well within its rights to regulate its banks to ensure their viability. Therefore, the depreciation of the renminbi is a product of legal risk-related regulation from China’s government. In sum, the two countries’ structural savings practices created the exchange rate differentials that the Trump Administration falsely attributed to exchange rate manipulation by the Central Bank of China.
Steps to Lower the Trade Deficit — Make America Save Again!
Instead of falsely accusing China of currency manipulation, America’s export sector would be better served by increased private and public domestic savings rates. Because the United States does not have the right to dictate how China’s government regulates its economy, the federal government must look to control what it can and increase national savings rates. To accomplish this, America can decrease its trade balance deficit with China by increasing its private and public savings rates.
To boost public savings — and therefore exports — the United States should repeal the Republican-led Tax Cuts and Jobs Act of 2017 (TCJA) signed by Donald Trump. The law was largely inspired by the theory, set forth by former USC professor Arthur Laffer, that lowering taxes ultimately increases taxable income and boosts net tax revenue. Among other things, the TCJA reduced personal and corporate income taxes. Because public savings equals tax revenue minus government spending, the TCJA has increased public debt. It is for this reason that the Congressional Budget Office (CBO) projected in 2018 that the tax cut would add $1.9 trillion of government debt in the following ten years. Despite claims by supporters of the TCJA that the tax cuts would end up increasing tax revenue and public savings, the CBO’s prediction that the TCJA would increase the federal deficit has so far proven accurate. Indeed, despite growth in real GDP in 2018 and 2019—the two years that followed the TJCA’s passage—the federal deficit grew by 48% from 2017 to 2019.
Given that an increase in GDP decreases federal deficits through automatic stabilization, correlation likely equates to at least partial causation. Because decreased public savings lowered national savings, the TCJA reduced the amount of savings the United States could intermediate into foreign investment. In the absence of the TCJA, more dollar-denominated savings could have been exchanged in the foreign exchange market, and the dollar would have likely depreciated. In depreciating the dollar’s value, America’s negative trade balance with China could have been reduced. American goods would have become cheaper to the international consumer, while foreign goods would have become more expensive to American consumers.
On the flip side, the Biden Administration could increase private savings by reducing capital gains taxes. Many economists, such as Allen Sinai and Martin Feldstein, have claimed that lowering capital gains increases private savings rates and encourages investment. This is because capital gains taxes combine with inflation to decrease the rate of return on lending and saving. Accordingly, the increased lending cost makes it more difficult for firms to source loans for investment. As a result, many firms fall into debt because they are forced to take out loans instead of selling equity to lenders who would have invested in the company without taxes on capital gains. In taking out more debt, capital-scarce American firms lower domestic private savings. Even worse, a lot of the debt is internationally financed, which only leads to a further appreciated dollar. Therefore, lowering taxes on capital gains will increase private savings by lowering the opportunity cost of lending and allowing firms to take on less debt (Meyer 1995). Increasing private savings will make more American funds available for international lending. Boosting international lending will ultimately allow the United States to increase the USD-renminbi exchange rate and increase exports in the process. Therefore, the relatively more favorable tax treatment on capital gains in the TCJA need not be taken out of the tax act of 2017 to boost America’s export sector.
In all, the US-China exchange rate was much more a product of differing savings practices between the two countries than exchange rate manipulation from China’s financial authorities. Instead of focusing on increasing inflationary pressures at home to counteract acts that China is simply not committing, the United States should increase its chronically low private and public savings rates to boost its export capacity. Finally, it is also in the hands of American consumers to lower the negative trade balance with China. Although Americans’ saving practices helped to create the country’s current accounts deficit with China, they can also help to reverse it.
Disclaimer: Savings and Exchange Rates Are Not Everything
In 2014, Trump may have had cause to argue that the renminbi was undervalued vis-à-vis the dollar. However, in 2015 the IMF examined renminbi exchange rates with rigorous criteria and ruled that China’s currency was no longer undervalued. In addition, the IMF found again in July 2019 that the renminbi was slightly overvalued in 2018. Therefore, Trump’s accusation was found to be fallacious when he launched the US-China trade war. There are, however, more questions to be answered. In running the same regression as above from 2000 to 2020, the relationship between exchange rates and the US trade balance as a share of its GDP yields a positive relationship with an insignificant R-squared value of 0.0642. Thus, the relationship between exchange rates and America’s trade balance was historically determined by many other factors, such as consumer demand. This all goes to show that trade balances are determined by many different market dynamics and models, such as the uncovered interest rate approach in the short run, which are not discussed in this article. It is fascinating that the relationship conforms strongly to the more traditional economic relationship between exchange rates and trade from 2015 to 2018. Future research should look at factors other than saving rates to evaluate whether China was manipulating its currency when Trump launched the US-China trade war.
I owe a great deal of gratitude to everyone who has helped me along the process of writing this article. I want to thank Professor Caroline Betts for her research suggestions and teaching me the lessons that have allowed me to write this paper. I would also like to thank Mayansh Upadhyaya and Will Erens for their thoughtful comments and the friendships we share. Finally, thank you to Nicole Park and Jonathan Solovy for their feedback and constant encouragement along the way.