Source: Bloomberg News

iPod Nation's Revaluation Is No Deficit Panacea In a politically charged atmosphere, the odds are increasing that China will be compelled to revalue its currency by 5 percent in the coming months and perhaps 20 percent over the coming two or three years.

Arguments over China’s exchange-rate policy, though, largely focus on the wrong thing. Instead of fixating on the total trade figures, the regional supply chain -- where sophisticated components of assembled goods are actually made -- needs to be better understood. With a closer look at the overall picture in East Asia, it’s clear that even major currency adjustments won’t necessarily reduce global trade tensions and an appreciation of China’s currency may not benefit the West.

On one side of the debate, China critics say a major yuan appreciation would reduce an unsustainable U.S.-China trade imbalance. China defenders say a large adjustment by itself wouldn’t help as the production of goods would shift to other developing countries, not the U.S. It will also increase American import prices or even make the U.S. trade gap worse.

By focusing on the aggregate quantity of trade, these arguments miss the unique role played by the so-called processing trade: components produced among several East Asian countries, but assembled and exported from China to the West.

Trade Split

The share of China’s exports from processing trade surged from about 25 percent in the mid-1980s to 55 percent in the mid- 1990s. Two-thirds of China’s imports for processing come from East Asia and only 5 percent each from the U.S. and Europe. But there’s an even split in the export of final goods from China -- as much as 45 percent go to East Asia and the same percentage to the U.S. and Europe.

This means that China’s trade surplus is essentially its surplus in processing trade -- significant deficits with the rest of East Asia are offset by larger surpluses with the rest of the world, notably the U.S. The rest of China’s ordinary trade is typically in deficit.

And China so far provides only about 20 percent of the total value of its process-related exports with the other 80 percent being foreign. In sum, the U.S.’s large bilateral deficits aren’t really with China, but with East Asia. With this in mind, a major appreciation of the yuan alone won’t do much to resolve U.S. trade imbalances. An East Asia-wide appreciation and multilateral, rather than bilateral, solutions are needed.

High-End Shift

Moving one level deeper, assume that East Asian exchange rates, including China’s, appreciate in tandem. The end result would probably be a change in the composition and regional sources of the processing trade, which is recorded as Chinese exports, but are actually regional exports. It would also affect China’s non-processing related exports. But whether it would resolve the problem of global imbalances is more complicated.

As the trade shifts in response to new exchange rates, it will intensify the pressure on China to reshape the composition of its exports and focus more on the high end of the technology spectrum. This poses the greatest competitive threat to firms based in the U.S. or Europe.

Some studies suggest China is unusual in its ability to export at both the low and high ends of technology, even though the country’s per-capita income is less than a 10th of those in richer developed countries. Processing trade accounts for 90 percent of China’s high-tech exports and only 30 percent to 50 percent of the rest. The bulk of the high-tech components are produced outside China. An oft-cited example is the $150 iPod that is exported from China to the U.S. -- but the value added originating in China is less than $5.

Migration of Production

Depending on the product, a significant revaluation of the yuan in isolation will have varying consequences. While China’s resource-based exports won’t be affected much by a yuan appreciation, the production of labor-intensive exports will migrate to other developing countries -- but not to the West -- and the competitive position on high-tech goods enjoyed by regional rivals, such as South Korea and Japan, will be strengthened in the short term.

If the yuan is revalued as part of a regional appreciation, China is likely to react in two ways.

First, there will be a stronger incentive to produce processing-related components domestically. China is already improving internal-transport links so that cheaper interior provinces become more competitive relative to production centers located abroad.

Technology Grab

Second, like the other East Asian success stories -- notably Japan, South Korea, and Taiwan -- China will be compelled to quickly transition to the higher end of the technology scale. China is already using incentives to this effect as evidenced in the U.S. government’s recent complaints to the World Trade Organization about Chinese initiatives to capture the renewable-energy market.

Even with major currency adjustments, global trade tensions will continue -- but it won’t be the same. East Asian countries that benefit today may be squeezed by lower-cost firms in China’s interior for low-technology goods, and by more-sophisticated producers on the coast for high-tech products. American and European firms will begin to worry less about the flood of cheap, labor-intensive goods and more about staying ahead of China at the high end of the technology spectrum.

An appreciation of China’s currency may not be such a good thing for the West after all.