The Trade ‘War’

Trade – The thing that everyone is opinionated about right now. If you are unwilling to put up with logic and facts, you are going to want to stop reading right now. However, if you do want to understand how the world economy (or even the US economy for that matter) works and what makes sense for the greater good, read on.

Essentially trade allows the world to be more efficient. This hasn’t been as true as it is now than ever before due to globalization and economies of scale. It allows someone who has a natural ability and advantage at producing something do what they do best and then trade that for the things they need from others who are naturally positioned better to do other things. At the most personal and basic level, trade prevents a doctor from having to write his own computer code in order to pay his bills online and more importantly, forcing the software engineer to perform surgery on themselves. The real problem that people are mad about is not Trade, its Globalization. It is globalization that has made trade efficient enough to make some jobs obsolete.

There are a lots of people in the United States (including the president) that are angry because they can no longer do what they know how to do best because someone else offshore can do it better and cheaper and send it over to the United States. What they don’t realize is that this allows the entire country (including themselves until the day before they lost their jobs) afford more because things are cheaper. They can certainly have the jobs they want which would then make the things they produce more expensive because the US simply isn’t positioned as competitively in the world to produce those goods and services. The current trade war is not necessarily a war on trade, it is a war on globalization and a wave of nationalism which is why it is scary. Wanna know another country that hardly trades and is completely nationalist? North Korea. Let that simmer for a while.

People that do not like trade often talk about the US trade deficit. I will be honest, before I understood global economics, I felt worried about the deficit and US government debt too. However, after understanding the special position that the US holds in the global macroeconomic environment, I feel that there is not much to worry about. I hope that after you read this, you will feel the same way. If everyone in the world owed money to each other (which is in fact the case), what currency do you think they would pay that debt in? It cannot be their own currency because then they could just print a bunch of money and pay off their debt. This means that there has to be one currency across the world that people trust to be stable enough to pay each other’s debts in. A currency that they cannot just print and pay off their debts. That currency is the US dollar. The fact that this is the case, grants the United States a very special status when it comes to its own debt. It is the one country that could potentially just print its currency and pay off its debts. However doing this would result in a massive oversupply of US dollars in China which would devalue the US dollar and cause massive inflation because China would dump all of that money back into the United States (unless of course the US decided to make it difficult for China to bring this US currency back to our shores somehow which would then result in souring our relationship with China drastically).  However it important to know that it is already pretty difficult for Chinese nationals to take their money offshore.

It is impossible to understand trade and trade deficit without understanding currencies and how currency exchange works.  We will talk about 4 different scenarios to truly understand how US trade works with countries that regulate their currency (Example – China) and countries that have floating exchange rates (Example Canada, India and most others).

Scenario 1 – US imports from China

Scenario 2 – China imports from the US

Scenario 3 – US imports from Canada

Scenario 4 – Canada imports from the US

Scenario 1 – US imports from China

Lets say Levi’s needs to purchase cloth for its Jeans from a Chinese company X. It needs to pay X in CNY (Chinese Yuan) since that is the currency it knows what to do with. Lets assume that the cloth costs CNY 7 million. This means that Levi’s first has to acquire 7 million CNY from somewhere. For China, the place to purchase Yuan is the People’s Bank of China. Since China regulates its currency, the People’s bank decides the exchange rate. Lets assume the current exchange rate is 1 USD = 7 CNY. Levi’s goes to the People’s bank and pays them $1 million, they print the the CNY 7 million that Levi’s wants to purchase based on the fixed exchange rate they decided and give Levi’s the 7 million CNY they want to purchase. Levi’s then pays their supplier and gets their cloth. The People’s bank now has USD 1 million in their foreign exchange reserves. You can see how by doing this constantly, the People’s bank of China can build massive reserves of the currency of all countries that want to import from China.

Scenario 2 – China imports from the US

Lets assume that a Chinese re-seller Y needs to purchase USD 1 million worth of iPhones to sell in the Chinese market. Y has CNY 7 million in its bank account ready for the purchase but Apple being an American company needs USD in order to pay its shareholders a dividend. The Chinese government regulates the currency flow in and out of China so re-seller Y needs to go to the People’s Bank of China to purchase the USD 1 million it needs to purchase the iPhones. The bank gives the re-seller Y USD 1 million for CNY 7 million reducing the USD foreign reserves of the People’s bank by USD 1 million. Below is how the Chinese Yuan was valued against the USD over the last month. While there is some fluctuation, the line overall is smooth indicating consistency in terms of valuation (this is due to the rate regulation by the People’s Bank of China).

Scenario 3 – US imports from Canada

Canada is the second largest exporter to the US after China so its only fair that we look at Canada for our other scenarios. However, there is one very big difference in terms of trade with Canada. The Canadian dollar (CAD) has a floating exchange rate with the USD. This means that basic economic forces of supply and demand determine the rate at which these currencies trade against each other. Lets look at this with an example. A small store in the US wants to purchase CAD 3000 worth of maple syrup from a supplier in Canada. The Canadian supplier obviously wants to be paid in CAD. This means that the US store needs to procure CAD 3000 somehow. At this point, the store figuratively goes out looking for someone who will take their USD for CAD 3000 at an exchange rate that is acceptable to both parties. If one quotes a rate too high or too low, the other party walks away. This also implies that the party purchasing USD for CAD has some utility for the USD they are purchasing.

Scenario 4 – Canada imports from the US

Lets say Jack, a Canadian citizen is looking to purchase USD for his CAD 3000 that he saved to take a trip to see the Grand Canyon in Arizona. He will need USD for expenses related to that trip so in essence, the US is exporting tourism. Jack could just exchange his CAD 3000 with the store in Scenario 3. However, if the rate at which the store is willing to make the exchange is not acceptable, Jack will go looking somewhere else. Essentially Jack needs to find someone who needs CAD and is willing to trade USD to buy them. Also understand that going to Grand Canyon is a luxury and Jack doesn’t have to go. If his $3000 CAD doesn’t buy him enough USD to make the trip, he might just cancel altogether. This is very important to understand about floating currencies because for all floating currencies, what drives their value in the short term is the desirability of what they are exporting. In this case, the US is exporting tourism which is not necessarily a necessity however, the US also exports a lot of technology which the world would come to standstill without. Imagine a world without Google or Bing or even the internet for that matter and you will know what I mean. Essentially, in the short run, the exchange rate of a currency is determined by the importance and value of the basket of items it trades with another country. Compare the images that show the exchange rates of USD to CNY and CAD. Notice how small the day-to-day changes are for the CNY exchange rate versus the CAD exchange rate for the entire year. That is the difference between a regulated and a floating exchange rate. As prices and desirability of items that the US trades with Canada fluctuate, so do the exchange rates. People on either side make importing and exporting decisions based on the current exchange rates and trade only takes place when the necessity justifies the cost. When trade happens at a specific rate a currency was bought or sold, that becomes the new exchange rate.

So based on the information above, if the US has a product that Canadians cannot survive without, the US can charge a large amount of CAD for a single USD. This is precisely why relatively small countries like Bahrain, Jordan and Kuwait have some of the most valuable currencies in the world – because they export one thing that is very desirable around the world – Oil. On the flip side, major oil consumers with most of their consumption supported by imports have devalued currency, Ex. India.

I put short term while talking about exchange rates above in bold because if all else (including the basket of goods a country exports and the global demand of this basket of goods) stays more or less consistent, a different phenomenon relating to the target inflation stemming from a central bank’s monetary policy drives exchange rates in the long term which I will likely cover in a different article at another time.

So based on all of the information above, we can see that China does not trade like other countries. I agree that due to them holding their currency value somewhat lower than what their basket of exports would otherwise make it to be, the system only works because they make it extremely difficult for their own (or any other currency for that matter) to flow outward. If China were to start letting currency flow offshore freely, they could not hold the rates artificially low because then people would just start exchanging currency like US and Canada do with commercial banks acting as facilitators for the transactions. So in essence, China has two options – Artificially deflate their currency to increase their foreign currency reserves while disallowing all that wealth it is building to be spent globally (which makes all that wealth useless in a way), or allow floating currency which would then let Chinese currency to be valued much higher than it is now to make Chinese exports less attractive globally. So far, China is choosing to do the former. Either way, the world doesn’t have much to worry about. If China decided to flip the switch one day, all its exports would stop in a jiffy due to the instant currency adjustment and their economy would collapse (read an old CNN money article about Thailand switching to floating currency to learn more). Thailand was small and it had an impact that took years to adjust to. For an economy of China’s size, it would be hard to imagine what switching would do to to them.

Hence, forcing China into inflating or floating their currency is a foolish thing to do in my opinion. This choice enables them to efficiently utilize the one thing they are leading the world in – population. That is what they are exporting – labor. The United States should focus on building up the things that it is better positioned for, for greater economic prosperity long term. Things like the leading educational institutions in the world, the entrepreneurial spirit and the innovation engine so we can build more Googles and Apples of the world. That is what America has an edge at.

Business school applications in the most elite US schools dropped last year while European Schools maintained the annual increase. This nationalistic rhetoric is killing our ability to create the future Googles and Apples of the world by driving away the ones that will create or manage them. This trade war is doing nothing but costing more US jobs as demonstrated by recent news of GM shuttering plants due to additional costs related to tariffs.

Lets try and educate ourselves to better understand what America needs to continue to be great because lets face it, America has always been great.

Sanjog-