Currency Manipulation and the US Trade Balance - Research Paper Example

Background of the study

The United States is an open economy with many trading partners. Being a free market, it is expected that the market forces determine the optimal allocation of resources in the global market and determine the price of the factors of production. However, governments may sometimes intervene in the market and interfere with the natural market forces. One of these interventions has been on the currency. Countries have been intervening on the supply of their currencies in order to keep up the demand and trade surplus. The resultant deficit is spread to other trading partners throughout the world. The United States has been the biggest victim of these currency manipulations. When a country makes persistent unilateral efforts to debase its currency and sterilize price changes, it is trying to change its real exchange rate and is often called currency manipulation or “beggar-thy-neighbor’ policies (Laffer, 2016).

The effect is suspected to lead to persistent trade deficits over the years, leading to many job losses. This study sets out to determine whether currency manipulation is directly related to the trade deficits, based on foreign exchange reserves as well as the manipulating country’s trade balance. The country of focus is China, given the existence of a significant amount of literature on it as a currency manipulator. The United States trades with China on the foreign market and as such, any currency manipulation practices will have a direct impact. As the United States faces an imminent threat of recession, much attention has been given to its ballooning bilateral trade deficit with China (NCBFAA, 2016).

Statement of the problem

Trade deficits have handicapped the United States economy over the decades. This has eroded the country’s quest to increase the level of employment and led to many job losses as a result.

Purpose of the study

The purpose of this study to determine whether currency manipulation leads to trade deficits.

Objective of the study

To determine the effect of manipulating country’s foreign exchange reserve on the target country’s trade balance.

To determine the effect of manipulating country’s trade balance on the target country’s trade balance.

Significance of the study

This study will be of interest to policy makers in understanding the role of currency manipulation on the level of trade and address the issue before adopting any major trade decisions.

Hypotheses

Hypothesis 1: The United States has a prolonged trade deficit with China.

Hypothesis 2: China’s foreign exchange reserves affect the U.S. trade.

Research question

Does the US have prolonged trade deficit with China?

Does China’s foreign exchange reserve affect US trade balance?

Scope of the study

The scope of the study is delimited to currency manipulation and the level of trade in the United States. The study focuses only on currency manipulation and trade between the United States and China. This will be a fair representation of the phenomena of currency manipulation between trading partners.

Limitation of the study

Currency manipulation may not be the only factor affecting trade, and the study only considers China yet there are other trading partners whose situation may be different.

Conceptual framework

Dependent variable Independent variables

Currency manipulation is represented by the independent variables which are China foreign currency reserve and China trade surplus with the US

Theoretical framework

The IMF surveillance procedures related to Article IV characterizes currency manipulation as “protracted large-scale involvement in one direction in the exchange market,” with “one direction” obviously meaning that the central bank buys the foreign currencies since this is the way to maintain an undervalued currency so as to gain an unfair competitive advantage (Preeg, 2008). The law of supply and demand applies both in the exchange of goods and services as well as the currencies. The law of supply and demand says that the price of products or services results from the interaction of two factors, supply, and demand (Chiras, 1992). Therefore, the market forces are supposed to determine the currency price.

When a country experiences a trade surplus, its currency will go up since other countries need to buy more of its currency so that they can get things from that country. Consequently, the demand for the currency will go up, pushing its price up making it strong. By definition, a trade surplus implies that the value of exports exceeds the value of imports (Mankiw, 2007). On the other hand, when a country is buying more from the world than it is supplying thus having a trade deficit, the world market becomes flooded with its currency, pushing its price down which makes it weak. A trade deficit implies that the value of exports is less than the value of imports (Mankiw, 2007).When a country experiences a trade surplus, its currency becomes relatively stronger, and it costs other countries more to buy from them and costs them less to buy from other countries. In the subsequent years, their trade surplus goes down as they continue to buy more and sell less. For those countries with a trade deficit, their currency is relatively weaker, and it costs them more to buy from others and as such they can’t buy much. It costs other countries less to buy from them. This results in more being bought from them than they are buying from others, making their trade deficit to reduce.

In the world market, there are fluctuations in currency rates as the market is constantly in a changing state to attain an equilibrium state. When the market forces are left to determine the price of currencies, the world trade automatically balances out. Currency manipulation goes against the natural market forces. Currency manipulation occurs when countries sell their currencies in the foreign exchange markets, usually against the dollar, to keep their exchange rates weak and the dollar strong (Bergsten, 2015). By so doing, the countries are effectively subsidizing their exports while raising their imports prices. The result is to increase their trade surplus which consequently strengthens their international competitive position, while improving their domestic conditions by increasing production and employment opportunities at the expense of the target country.

A country trading on a surplus has other countries buying more of its currency resulting to the country holding a surplus of its currency. The increase in the supply of its currency is supposed to push its demand down, making it weaker. A country may try to control this situation by using the surplus cash to buy the currencies of other countries. This will enable the country to maintain the high demand for its goods and at the same time keep up the currencies of other countries, making their goods cost more and goods still from the currency manipulating country to continue costing less. The trade surplus in this country will continue to go up without adjusting, defying the natural market forces. The result will be adverse for other countries as their factories close leading to job losses, with the wealth of nations shifting to the currency manipulating country.

Origin of currency manipulation

Initially, the gold standard determined the exchange rates currencies and no country could arbitrarily determine the value of its currency through manipulation. The gold standard was an initiative by member nations to fix the costs of their household coinage as far as a predefined measure of gold. National cash and different types of cash; bank stores and notes, were unreservedly changed over into gold at the fixed cost (Bordo, 2008). However, in 1971, this standard collapsed which led to many countries adopting the floating exchange rate system. This meant that central banks could use independent policy in controlling their money. The value of the currency was no longer dependent on the interest rate. Countries could, therefore, determine their inflation rate without having to accept inflation from their trading counterparts since floating exchange rates automatically stabilize the changes in external inflation. The floating exchange rate has enabled countries to devalue their currencies against trading partners’ currencies through the practice of currency devaluation.

How to determine currency manipulation

The IMF and the WTO have provisions disallowing the utilization of currency control to pick up exchange focal points. Taking into account IMF standards, a three-section test can be utilized to unmistakably distinguish a currency controller inside the prevailing or future trade covenants: if a country has more exports than imports over a set of six-month period, if the country adds to its foreign exchange reserves over that same six-month period, and if the country’s foreign exchange reserves are more than sufficient over three months’ normal imports (Currency Manipulation 101, 2016).

Impact of currency manipulation on the US

Many countries are increasingly intervening in the foreign exchange market to improve their domestic economic conditions at the expense of other countries. More than 20 nations have expanded their total remote trade holds and other official foreign resources by a yearly average of almost $ 1 trillion as of late (Bergsten, 2012). These countries thus deliberately undervalue their currency and increase their trade surplus while creating a corresponding trade deficit which is spread throughout the world to other trading partner countries. The largest share of the trading loss centers on the United States, whose trade deficit has increased by $ 200 billion to $ 500 billion per year. The United States has lost 1 million to 5 million jobs as a result of this foreign currency manipulation (Bergsten, 2012).

The U.S. has lost 2.4 million jobs between 2001 and 2008 as a result of China’s trade and currency rules (Poole, 2016). China is believed to engage in currency manipulation trading policy which is negatively impacting on the U.S economy by frustrating job creation efforts and eroding on the already existing jobs. Currency control twists exchange streams by misleadingly bringing down the expense of U.S. imports and raising the expense of U.S exports, and is the main source of resolutely high U.S. exchange shortfalls in the course of recent years. More than 20 nations, headed by China, have, together, been spending around 1 trillion every year purchasing outside advantages for misleadingly stifle the estimation of their monetary forms (Scott, 2016). Most trade and investment agreements entered into by the U.S are said to result in more trade deficits and job losses as a result of member countries engaging in currency manipulation.

U.S. intervention on currency manipulation

The U.S. Omnibus Trade and Competitiveness Act of 1988 provides for the Treasury department to assess any possibility of countries manipulating their currencies with the aim of gaining a trading advantage.Some observers have been concerned that China and Japan may have maintained undervalued currencies with adverse U.S. impacts, which has brought increased attention to treasury’s assessments (Yager, 2005). There are four basic forms of currency manipulation: two positive forms (protective and permissive) and two negative forms (predatory and passive) (Kirshner, 1997). The distinction has nothing to do with the effect that currency manipulation has on the target country but rather on whether the intention is meant to support or punish the target country.

The U.S. Treasury utilizes three criteria to choose if a nation is being uncalled for, including the span of its exchange and current record surpluses and additionally whether it purchases remote resources equivalent to 2 percent of yield throughout the year to deteriorate its coin (Zachariahs & Mogi, 2016). This will have an implication to its trading partners’ currency policies as they cannot ignore this message since the currency policy is bilateral. Once a country is considered as a currency manipulator, the Treasury must initiate negotiations with the country in question as fast as possible in the IMF or with the country to ensure that it adjusts the exchange rate between its currency and the U.S. dollar with the aim of adjusting the balance of payment in order to eliminate the unfair advantage. As expected, this may result in disagreement of policy makers on matters concerning currency.

However, the U.S. has not been proactive in applying such provisions even though it may be obvious that some countries are currency manipulators. This is attributed to the fact that such negotiations may not be effective after all. The adequacy of these commanded transactions are far-fetched; the following authorizes and levies could raise the cost of crude materials and consumer products with no privately created choices and end up being all the more detrimental to both the U.S. economy and worldwide financial security than the coin control itself (Milicic, 2016). Particularly, China has been known for decades to engage in currency manipulation. Despite a lot of rhetoric concerning this issue, no American president has dared to confront the issue. There are four reasons the United States exercises restraint in dealing with China’s currency manipulation: lack of effective measures, the relative unimportance of currency exchange rates in a globalized economy, the benefits to the United States of an undervalued Yuan, and the strategic disadvantages that a weak Yuan presents to China (Milicic, 2016).

There is bound to be disagreements whenever currency manipulation is considered. A week ago, Japanese Finance Minister Taro Aso talked openly about the ongoing contradiction between U.S. what's more, Japanese policymakers about whether the ascent in the Yen seen following the start of the year has been sufficiently extreme to warrant a mediation. Japan may support a weaker coin fundamentally in light of the fact that it makes the nation's exports more appealing (Adinolfi, 2016). The IMF could be expected to protect its members from predatory currency manipulation by other member countries, but this has not been the case. China agreed to avoid manipulating exchange rates, limiting its internationally recognized sovereign rights to manage its currency, in order to gain membership into the IMF. The IMF practically can do next to nothing to implement this understanding and check China's interventionist cash approach. Truth be told, no nation has ever been assigned a currency controlled by the IMF (Milicic, 2016).

Research design and methodology

This study exclusively uses secondary data as the sole information source. The research design applied is surveyed study which was carried out through the collection of data from relevant secondary sources. It has applied the census study in the collection of currency manipulation data from China and trade data from the United States ranging from the years 2000-2015. Correlation co-coefficient will be used to determine the relationship between dependent and independent variables for data analysis.

Testing Hypotheses 1 and 2

Data presentation, analysis and findings

Total US trade deficit China trade surplus with US China forex reserve

(Billion US dollars) (Million US dollars) (Billion US dollars)

2006-761.72 234,101.3 1,066.3

2007-705.38 258,506.0 1,528.2

2008-708.73 268,039.8 1,946

2009-383.77 226,877.2 2,399.2

2010-494.66 273,041.6 2,847.3

2011-548.63 295,249.7 3,181.1

2012-536.77 315,102.5 3,311.6

2013-478.39 318,683.8 3,821.3

2014-508.32 344,863.2 3,843

2015-531.5 367,172.9 3,330.4

U.S. Total trade deficit (Billion US dollars)

Source (Statista, 2016).

China trade surplus with US (Million US dollars)

Source (United States Census Bureau 2015).

China Foreign Exchange Reserve (Billion US dollars)

Source (Statista, 2016).

Pearsons product moment correlation coefficient (r)

The Pearsons product- moment correlation coefficient is a measure of the strength of a linear association between two variables and is denoted by r (Laerd Statistics, 2013).

YEAR

2006 0.234,1013 1,066.3 249.6222 1,136,995.69 0.0548

2007 0.258,5060 1,528.2 395.0489 2,335,395.24 0.0668

2008 0.268,0398 1,946 521.6055 3,786,916.00 0.0718

2009 0.226,8772 2,399.2 544.3238 5,756,160.64 0.0515

2010 0.273,0416 2,847.3 777.4313 8,107,117.29 0.0746

2011 0.295, 2497 3,181.1 939.2188 10,119,397.21 0.0872

2012 0.315, 1025 3,311.6 1,043.4934 10,966,694.56 0.0993

2013 0.318,6838 3,821.3 1,217.7864 14,602,333.69 0.1016

2014 0.344,8632 3,843 1,325.3093 14,768,649.00 0.1189

2015 0.367,1729 3,330.4 1,222.8326 11,091,564.16 0.1348 n=10 ∑2.901638 ∑27,274.4 ∑8,236.6722 ∑72,551,826.27 ∑0.8613

R= = 0.8066

Foreign exchange reserves

The correlation coefficient between China’s foreign exchange reserves and the United States trade deficit with China over the ten years shows a very strong relationship with a value of 0.8066.This is a strong positive correlation, which means that high X variable scores go with high Y variable scores while low X variable scores go with relatively low Y variable scores. This implies that high currency manipulation in terms of foreign exchange reserve by China directly affects the level of trade in the United States. This shows that the more the foreign exchange reserves are held by China, the higher the trade deficit for the US.

China’s trade surplus with the US/US’s trade deficit with China

China’s trade surplus with the US is the same as US trade deficit with China. Over the ten years, there has been an increasing trend. This indicates that there has been a continuous currency manipulation by China resulting to the ever-rising trade deficit in the US with a corresponding trade surplus in China. The secondary data and subsequent data analysis confirm both hypotheses that the United States has a prolonged trade deficit with China and that China’s foreign exchange reserves affect the U.S trade. This leads to the acceptance of both hypotheses.

Conclusion

The criteria used to determine whether a country is manipulating its currency as stipulated by the IMF principles include a persistent trade surplus, and more than sufficient foreign exchange reserves that are increasing over a period of six months. The secondary data indicates that China’s foreign exchange reserves, as well as its trade surplus with the US, have been increasing over the ten years period. This means that the country is a currency manipulator. The Pearson’s product-moment correlation coefficient used to determine the relationship between China’s foreign exchange reserves and US’s trade deficit with the country indicates a very strong relationship. This confirms that indeed, currency manipulation by China leads to trade deficits in the United States.