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China's trade strategy explained
Howard Richman, 2/12/2012

[I recently had a chat with one of my students in which I explained how China's trade strategy works. I thought some of you who are confused about China's strategy might find it interesting also.]

Student 6:01 pm
Can you describe how building up foreign reserves help the economy?

Howard Richman 6:03 pm
It lets those producing in the mercantilist country make huge profits by selling at a low currency rate. That gets businesses to build factories in the mercantilist country. The mercantilist country gets manufacturing investment, and its trading partners don't. Fixed investment causes long-term growth, and there's more to it than just that. The mercantilist country's workers learn by doing. So become better and better workers.

Howard Richman 6:05 pm
And so the mercantilist country takes over its trading partners' comparative advantages. But China's main goal is power. It wants to increase its power and bring down ours, and that's what it's doing, and we're letting them. Power was always one of the main goals of the mercantilists.

Student 6:06 pm
Well it seems like a risky investment that they're putting so much into our dollar when it's on the verge of crashing. If our dollar becomes completely worthless does it benefit them?

Howard Richman 6:07 pm
You are correct. Their government will lose much of the money that it loaned to the United States.

Howard Richman 6:07 pm
But, they're putting as much as they can into assets that won't lose their value when the dollar crashes.

Student 6:07 pm
What kind of assets are those?

Howard Richman 6:08 pm
Stocks, land, etc.. Also they are trying to get the International Monetary Fund (IMF) to turn its Special Drawing Rights (SDRs) into a global currency. If China gets its way, the IMF will convert China’s dollar reserves into SDRs.

Student 6:11 pm
That sounds sensible.

Howard Richman 6:11 pm
Still, they are bound to lose a lot. But look what they get in return:

  • investment in their economy,
  • a 10% rate of economic growth,
  • growing economic power,
  • they are threatened by democracy, so they prove that their totalitarian system of government is more effective than ours at growing an economy,
  • eventually, they get to dominate their region.

Student 6:13 pm
haha, not a bad trade!

Howard Richman 6:13 pm
It's a bad trade for us, though.

Student 6:14 pm
Yes definitely.

Howard Richman 6:14 pm
We get consumer goods that we couldn’t afford otherwise, but we trade away our future to get them.

Student 6:15 pm
I was wondering how to argue against people who claim that we shouldn't put tariffs on countries, even if they put tariffs on us. (Let's assume for simplicity that the country isn't mercantilist.)

Howard Richman 6:15 pm
Well, if trade is balanced, then tariffs don't help. The problem is, most economists don't realize that they are assuming balanced trade when they conclude that tariffs don't help.

Student 6:18 pm
How is it the case that tariffs don't help when trade's balanced?

Howard Richman 6:19 pm
If trade is balanced, then if a country restricts imports it is also reducing its own exports. So it hurts itself just as much as it hurts its trading partners.

Student 6:22 pm
How does it reduce exports? Timothy Taylor [The Great Courses economics lecturer] tried to explain this by saying that exports are used to pay for imports always, and that they had to equal.... so by bringing down imports you inevitably had to bring down exports. But this payment argument didn't make much sense to me considering the mess we're in right now.

Howard Richman 6:22 pm
Timothy Taylor is assuming balance. That means export = imports. He doesn't understand mercantilism, just like most other economists in the universities.

Student 6:23 pm
OK, let's assume balance.

Howard Richman 6:23 pm
OK. Then if you reduce imports, since imports = exports, you necessarily reduce exports.

Howard Richman 6:25 pm
Assume that there are no loans between countries. Then if country B puts a tariff on the products of Country A, it reduces its imports. Now its businesses are getting lots of A's dollars. They sell them in currency markets. A's currency goes down. Then other products that A sells become more inexpensive in Country B. So trade comes back into balance.

Howard Richman 6:27 pm
But if country B is China, it buys the dollars that are earned by its exporters, and lends them to the U.S., so that it can perpetuate the trade surplus.

Student 6:28 pm
So the reason why things aren't coming into balance is because they're not selling the dollars in the currency markets?

Howard Richman 6:29 pm
Correct. That's how they do it. There's a name for it. It's called "sterilization."

Student 6:30 pm
Okay, I understand it a lot better now.

Howard Richman 6:30 pm
They "sterilize" the dollars that their exporters earn.

Student 6:30 pm
So they're virtually giving us the high imports without giving themselves the raised prices?

Howard Richman 6:31 pm
You got it!

Student 6:32 pm
Wow, I'm understanding this a lot better now.

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