Making the Case for Protectionism

As the rhetoric heats up over a possible trade war between the US and China, I thought it only fair to layout the arguments put forward by some US lawmakers as justification for the imposition of tariffs on certain goods shipped from China. If you’ve read some of my recent commentaries, you already know my feelings on this subject, and my view remains that overall, trade restrictions do far more harm to an economy than they do good.

I do understand however that from a political standpoint, setting up trade barriers in the name of saving jobs at home is an easy “win” – and I also acknowledge that there are likely short-term benefits for the industry protected by the tariffs, but usually this is a temporary reprieve. More damaging in the long term, is the effect the inevitable retaliations from other countries will have on overall trade activity.

China and the US have a tumultuous history. As part of the Allies during World War II, China helped the West defeat the Axis powers, but much like the case with fellow ally Russia, the post-war period saw the two nations taking opposite political positions. This led to a total breakdown in relations, and it was not until 1979 that relations were normalized. A series of trade agreements soon followed, and in 1980, the two countries ushered in a new era of trade cooperation by bestowing each other with the status of Most-Favored-Nation.

Free Trade Yes – But Within Reason

As is the case with most trade agreements, good intentions and openness may be the public face, but distrust and accusations of unfair trading practices often bubble away below the surface. Most accusations of unfair trading practices have been leveled by the US against China – often with good reason; but despite these rough patches, trade between the two countries reached nearly $300 billion a year by the early 2000s. Unfortunately for the US, the bulk of this trade has been one way – from China and to the US, and the burgeoning trade deficit has become a growing source of concern for US authorities.

Wages and Subsidies

The most widely held example of unfair trading practices identified by the US deals with wages and subsidies. US officials freely acknowledge that cheaper labor is the main advantage enjoyed by Chinese manufacturers – some estimates are US labor costs are 20 to 25 times more – but this alone does not account for the lower costs with which goods can be produced in China. Chinese manufacturers also benefit from what the US charges are a system of subsidies – both direct and indirect – that help keep costs down.

These subsidies can take many forms, including the free use of land to build factories, and cheap energy to power those factories – even China’s weaker environmental laws are seen as another form of subsidy giving factories in China cost-saving advantages over other jurisdictions. However, the most controversial subsidy is China’s reluctance to allow its currency – the yuan – to float freely against other currencies. This is seen as a key predatory practice preventing other countries from operating on a level playing field with Chinese firms.

Pegging the Yuan to the Dollar

Officially, the People’s Bank of China ended the direct pegging of the yuan to the dollar in late 2005, but the yuan is still far from “free-floating” as desired by the US government. The yuan peg has long been a trading issue for the US, and for the decade before the practice ended, the Bank of China assigned an exchange rate of 8.25 yuan to the dollar, thus ensuring that the exchange rate between the two currencies remained constant.

China could peg the yuan because it is not fully convertible in international forex markets as the government retains control over capital transactions. This means that the yuan’s exchange rate vis a vis other currencies is not based on market forces, and US lawmakers have long accused China of deliberately preventing its currency from appreciating. If the yuan were allowed to appreciate, the US believes that Chinese exports would be more expensive for American consumers, leading to a decrease in demand which would help close the rapidly growing US trade deficit.

In actual fact, the yuan has never been allowed to float freely. Even after the change in 2005, the yuan’s value was simply permitted to fluctuate within a very narrow band based on a basket of currencies. These currencies included the dollar, euro, won, and the yen, but the actual weighting of the currencies in the basket was kept secret. Analysts have attempted to work out the weighting formula, and initially, it appeared that the yuan was based equally on the dollar and the euro; by early 2009 however, the weighting appears to now be 100 percent against the US dollar. In other words, the yuan is once again pegged to the dollar.

The Future

Now I am not saying that the US is not justified in some of its accusations as there is no question that China has engaged in acts that run counter to the trade agreements. However, I am saying that the US must proceed with caution as the last thing its slowly-recovering economy can withstand right now is an all-out trade war with one of its largest trading partners – a trading partner that also happens to hold $800 billion in US debt and supplies the US with much of the credit needed each year to cover its deficit.

On the other hand, it is also true that China relies heavily on the US to buy its products, a fact that has long been recognized by China’s government. To reduce this dependency, China has endeavored to not only cultivate relationships with other countries, but also to encourage greater domestic consumption.

In attempting to limit Chinese products into its markets, the US jeopardizes the freedom with which American producers can sell into China’s market. In this regard, the US has the most to lose as China remains the last great untapped pool of potential consumers on the planet. The US desperately needs greater access to this growing market – a point made abundantly clear in the following paragraph reproduced from a 2005 briefing for Congress entitled simply “China – US Trade Issues”.

China’s unmet infrastructural needs are staggering. Foreign capital, expertise, and equipment will have to brought in if China is to build all the ports, roads, bridges, airports, power plants, telecommunications networks and rail lines it needs.

This article is for general information purposes only. It is not investment advice or a solution to buy or sell securities. Opinions are the authors; not necessarily that of OANDA Corporation or any of its affiliates, subsidiaries, officers or directors. Leveraged trading is high risk and not suitable for all. You could lose all of your deposited funds.