China's Big Trade Deficit May Kill Yuan Appreciation

Photograph by ImagineChina/AP Images

China exported nearly $2 trillion worth of stuff in 2011, more than any other country in the world. Which is why the recent dip in its trade balance is so surprising—not so much because it happened, but because of how big it was. Over the weekend, China reported a $31.5 billion trade deficit for February. While it was the third time China’s trade balance had gone negative in the last two years, this deficit dwarfs the country’s previous ventures into the red. China posted a $7.3 billion trade deficit in February 2011 and a $7.2 billion deficit in March 2010.

The first two months of China’s balance-of-trade data tend to be cloudy because the period includes Chinese New Year, the country’s biggest holiday, when people take a week off work and exports tend to fall. That said, February’s deficit was China’s biggest since December 1989, when it soared to $66 billion. Still, most China analysts hesitate to read too much into the February number. “I’m not so sure that this reveals a new reality of any kind,” says Steven Dunaway, an adjunct senior fellow for international economics at the Council on Foreign Relations. “What is clear is that their export growth is slowing down.”

The recession that’s spreading across much of Europe has a lot to do with that, since the continent is the biggest market for Chinese goods. China’s export slowdown also reflects an erosion of historic cost advantages, as Chinese wages have continued to rise over the last few years. It might also be early evidence of an economy that’s starting to cool after a decade of near-double-digit gross domestic product growth.

If that’s the case, one of the biggest casualties could be China’s begrudged effort to raise the value of its currency. As Bloomberg News reported Monday morning, after the trade deficit report was announced, China’s central bank lowered its daily fixing of the yuan by the most since August 2010. “While it remains perfectly feasible that later this year we will see substantial trade surpluses again, the short term effect [of the deficit] is that it will likely strengthen the voices within China who do not want to see further appreciation of the yuan,” says Kenneth G. Lieberthal, director of the China Center at the Brookings Institution.

After rising 4.7 percent in 2011, the value of China’s yuan has fallen 0.5 percent so far this year, according to Bloomberg News. Given the lower economic growth target Chinese Premier Wen Jiabao announced earlier this month, CFR’s Dunaway believes China will probably continue to slow, if not stop, the appreciation of its currency. That, in turn, would likely renew tension with the U.S. over trade issues. “The Treasury Department may tolerate some moderate slowing, but if China reverts back to fixing its exchange rate, that could spark major tensions,” says Dunaway.

Depending on what happens with China’s foreign currency reserves this year, the guessing game over whether or not the yuan continues to appreciate could become moot. For the last decade, China has steadily increased its stockpile of foreign currency, from less than $500 billion in 2001 to its current mother lode of $3.2 trillion. Over the first six months of 2011, China added $350 billion to its foreign currency reserves. Since then, the growth has stopped. “That is the big mystery we’re facing on China right now,” says Derek Scissors, a China analyst at the Heritage Foundation. “To go from adding $350 billion in six months to stopping cold—we do not understand that change.”

“If their balance of payments surplus is gone, then there is no reason for them to keep adjusting their currency to kill off the imbalances,” says Scissors.

U.S. lawmakers have been relatively quiet on the issue of China currency manipulation over the last several months. Last fall, a bill that aimed to crack down on China’s history of manipulating its currency was moving through the U.S. Senate. The issue has since died out. That could change quickly over the next few months. “Spring is typically when people complain about China,” says Scissors. “Lawmakers come back from recess after going back to their districts, where people tend to tell them they can’t compete with Chinese goods.”

Given that it’s a U.S. election year, the silence on China’s currency issues certainly won’t last.

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