How a Currency Equalization Tax Will Put Real, Useful Pressure on the Chinese Economy

To grasp the extent of the cumulative imbalances on the Chinese’s subsidizing their export economy, here is a look at Foreign Exchange Reserves.    Foreign Exchange Reserves  are a “[t]otal of a country’s gold holdings and convertible foreign currencies held in its banks, plus special drawing rights (SDR) and exchange reserve balances with the International Monetary Fund (IMF).”   Let’s compare China’s Foreign Exchange Reserves, as accumulated from all their trading partners, as a percentage of their GDP to the Foreign Exchange Reserves of the United States as a percentage of our GDP:

U.S. and China Foreign Exchange Reserves

Therefore, China’s accumulation of Foreign Exchange Reserves is 59 times greater than our own.   In fact, since 2000, the United States has run a cumulative trade deficit with China of $1.739 trillion.   The Chinese are bleeding all of their trading partners and no one has done anything about it yet.

By artificially suppressing the real value of the Chinese currency, the Yuan, the Chinese create a whole host of distortions in the trade between China and the United States.   Here is how a Currency Equalization Tax (C.E.T.) on Chinese goods imported into the United States will set in motion economic forces to eliminate these distortions.

First, we assume that the overvaluation of the Yuan is 10%.   The exact amount would be a proper political question.  To proceed with this analysis, we do not need to know its exact overvaluation.   The larger the tax, the greater will be the forces tending to correct the overvaluation.   The lesser the tax, the lesser will be the forces tending to correct the overvaluation.   The tax is self-eliminating when the Yuan becomes freely bought and sold around the globe like the U.S. Dollar.

At the 10% overvaluation, here is how we apply the tax.   If a U.S. importer wants to purchase imported goods with a value of $1,000 worth of Yuan, he will have to pay 10% of the $1,000, or $100.   This will make the imported price $1,100, which would approximate the imported price if the Yuan was freely floating.

Effect on American Importers

Let’s examine some of the decisions that the U.S. importer has with the imposition of a C.E.T. of 10%.

Case 1-The U.S. importer could continue importing the Chinese goods and absorb the 10% increase on his cost of goods sold because this increase in costs will not destroy all his profits.   He will continue to offer them to retail American consumers as before.

Case 2-The U.S. importer could decide to pass along the increased cost to his customers by increasing his selling price.   Suppose that the imports are 50% of his selling price and distribution, overhead, salaries, taxes and profit are the other 50%.   Therefore, before the tax, his selling price is $100+$100=$200.   After the C.E.T., his selling price is $110+$100=$210.   So his customers experience a 5% increase in the retail price.   This increase should reduce his sales somewhat, but it probably will not hurt him too much.

Case 3-The $10 increase in the cost of the Chinese imports is burdensome, but not deadly.   The American importer starts an aggressive search for another source.   And so, the U.S. importer will start aggressively searching to find another supplier, foreign or domestic, to beat the $10 increase in this cost of goods sold.   There just might be a “Made in America” source that just needed a little more revenue ($10) to justify producing the product.

Case 4-The $10 increase in the cost of the Chinese imports destroys the American importers profitability, and he will go out of business if he cannot find another source.   He will be the most desperate and, therefore, the most motivated to find the alternative source, whether the source is another foreign source or “Made in America.”

Effect on Chinese Exporter

Now let’s look at the position of the Chinese exporter with the imposition of a 10% C.E.T.

Case 1-If the U.S. importer decides to absorb the 10% C.E.T., there is a good chance the Chinese exporter will continue to be his supplier with no changes in orders.   But, the American importer will certainly be interested in finding a cheaper source of goods.

Case 2-As the American importer raises his retail price, he will probably lose some orders and, therefore, decrease his purchases from the Chinese exporter.   And this could result in the Chinese exporter reducing his price somewhat to maintain his previous order volume.   In this way, he can take action to protect his exports.   So, the Chinese exporter may or may not lose orders.

Case 3- If the U.S. importer decides to seek other sources, foreign or domestic, for the goods, the Chinese exporter would start to lose some of sales.   The Chinese exporter could react by doing nothing or lower his price to the U.S. importer, which would result in less profit for the Chinese exporter but still allow him to compete.   If the Chinese exporter is inefficient, he could stop all production and go out of business.   This reduces the overall supply of exports and might result in an increase in export prices.

Case 4-If the U. S. importer goes out of business, the Chinese exporter would definitely lose all of this U.S. merchant purchases and would have to compete for another U.S. importer to maintain his U.S. market share.

What is going on here is thousands of U.S. importers and Chinese exporters would start to make all sorts of competitive adjustments to offset any negative effects of the 10% C.E.T. to stay profitable and in business.

Effects on the U.S. Consumer

At no time would the U.S. consumer be worse off than had the Chinese Yuan been freely floating during the same time period.   In fact, while the Yuan has not been freely floating, American consumers have been subsidized by American manufacturers’ lost production and their unemployed workers.    It is very important to keep in mind these effects.

Case 1-There would be no effect on the U.S. consumer who would experience no price increase.

Case 2-There would be an increased retail selling price on the U.S. consumer of less than 10% because, in all probability, the Chinese exporter’s percentage of the U.S. importer’s total cost is less than 100%.   In our example, the American importer would only have to increase his selling price by just 5% to recover the C.E.T.   But, he could also choose not to raise it.

Case 3-The U.S. consumer would lose a source of some percentage of the total supply, but probably wouldn’t notice it.   And, there is a good chance that new suppliers could come from somewhere else, including American-based producers.

Case 4-If the U.S. importer, the most desperate, makes a complete substitution by buying products “Made in America” or other foreign sources, then the U.S. consumer experiences some price increase, no decrease in supply and probably a better quality product “Made in America.”

Overall, the effect on the U.S. consumer is almost always less than 10% because of any importers other costs of doing business at a C.E.T. of 10%.   As we said, he/she is the beneficiary of a subsidy.

Effects on the U.S. Manufacturer

At no time would American manufacturers be better off than they would have been had the Chinese Yuan been freely floating during the same time period.   They are just getting back the same pricing and production opportunities they would have had with a free floating Yuan.

The C.E.T. clearly establishes an interim 10% cost advantage that the American manufacturer would have had under a freely floating Yuan, and, so, they are getting exactly what advantages they should have had all along.

The principal effect of the Currency Equalization Tax is that it unleashes a hurricane of economic forces between thousands of exporters and importers and American manufacturers and foreign manufacturers that would tend to compete away the artificial advantages/disadvantages caused by an undervalued Yuan which would otherwise be un-attackable.

Effect on the U.S. Government

If the federal government considers imposing a statutory all encompassing tariff on Chinese goods, much of the competitive energy of the thousands of individual importers and exporters and American or other foreign producers is diminished as they would not have to compete at all to achieve a protected 10% margin of a tariff.   Such a tariff only can be eliminated by the legislative process terminating it.

The prospect of a tariff would also open a Pandora’s Box of special interest groups to get involved and get more for their interested parties that believe they are entitled to various levels of special protections.   It would take forever to produce the resulting massive bill, and once the protections attach, it would take forever to repeal them.

For this reason and others, the Currency Equalization Tax must also automatically end once the Yuan is freely floated.   This is essential.

The C.E.T. taxes remitted to the U.S. Government must be used to purchase back U.S. Government Debt on a dollar for dollar basis to offset the U.S. Treasuries held by the Chinese Government.

Effect on the Chinese Government

From my column,  Obama’s Takedown of Industrial America, I said the following:

The Chinese government never allows the increasing value of the Yuan to reach the hands of their labor forces and/or the consumers of their economy.   Thus wages don’t go up, their purchasing power doesn’t go up and the Chinese consumer doesn’t get an increase in spendable income.

To prevent all this from happening, the Chinese government strips off the appreciated value of the Yuan and retains control over it.   The most important  technique  they use is currency sterilization… .

This scheme produces another very considerable side effect.   They can use the appreciated value of the Yuan that is stripped off the Yuan from consumers to buy United States Government Treasury Securities.     By doing this, China has become America’s largest foreign creditor.   They are buying our rapidly increasing government debt with the surplus value of Yuan which results from all our purchases of Chinese exports.

From the moment this tax is imposed, the Chinese start to lose the amount of the surplus appreciated value of the Yuan that their government skims off and uses to purchase our U.S. Treasury Securities.   If they try to offset this loss, they will have to further suppress the cost structure of their economy (i.e.-perhaps introducing price controls for labor or some such to offset the 10% C.E.T.).   This would put them at increasing odds with the working people of China.   On the other hand, if they allow the full value of the Yuan to flow into their economy, by floating their currency, the C.E.T. will drop to zero, and the Chinese people will enjoy a surge in buying power in their economy.   And, the domestic income tax collections will increase and the Chinese accumulation of U.S. Treasury Securities will be reduced.

The C.E.T., by unleashing a multitude of competitive forces between Chinese exporters and U.S. importers, will hardly impact American consumers, the Chinese people will be much better off, and American industry will be induced to become competitive sources for “Made in America” goods.   This will create more jobs and investment here.   And frankly, the only entity that will be certainly worse off in every case is the Chinese government, which has been subsidized by American manufacturers’ massive loss in production and their unemployed employees, so they can accumulate U.S. Treasury Securities.

WTO Adjudication

If not by Congressional action, how can the United States impose a C.E.T. on imported goods from China?   The United States could pursue a WTO action against China.   A WTO action would put the pressure on the world community to publicly admit China manipulates its currency, put pressure on China to alter its behavior and float its currency and provides the U.S. with legal cover to deal with this issue.

If the U.S. chose to pursue a WTO action against China for currency manipulation, the argument for such an action would be that China has violated Article XV of the GATT Agreement through currency manipulation (i.e.-“exchange action) and has “frustrated” the provisions and intent of the IMF Articles of Agreement.

The reference to the IMF is important because  Article XV  of the GATT Agreement requires that GATT signatory countries that have a dispute about balances of payments, foreign exchange reserves or exchange arrangements must “consult fully with the International Monetary Fund” and “shall accept the determination of the Fund as to whether action by a contracting party in exchange matters is in accordance with the Articles of Agreement of the International Monetary Fund.”

Under  Article IV  of the IMF Articles of Agreement, the IMF is charged with oversight over the international monetary system to ensure that member nations comply with their exchange arrangement obligations and policies that they have informed the IMF that they intend to apply.   Since “exchange arrangements” equates to “exchange rate policies,” the definition of exchange rates under the IMF Articles should apply to the GATT definition of “exchange arrangements” since GATT Article XV is defining a term that is under the sole purview of the IMF.

With that said, Article XII  of the GATT Agreement grants nations authority to impose temporary import restrictions when they face balance of payment difficulties.   The U.S. clearly faces “balance of payment difficulties” when it has sustained a $1.739 trillion trade deficit with China from 2000-2009.

In addition to Article XII,  Article XVIII  of GATT grants nations authority to impose temporary import restrictions when they are at risk of a serious decline in their foreign exchange reserves.   As of July 2010, the U.S. had foreign exchange reserves of $129 billion with a GDP recorded at over $14.1trilion in 2009.   China, on the other hand, had foreign exchange reserves of $2.648 trillion as of September 2010 with a GDP recorded at over $4.984 trillion in 2009.   As we showed in a FOREX chart, China’s FOREX Reserves are 59 times larger than those of the United States.   This vast disparity in foreign exchange reserves in relation to GDP can only be explained by an intentional policy by the Chinese to manipulate their currency lower than its real value.

An undervalued currency encourages exports by reducing their costs and discourages imports by making them more expensive.   Countries that engage in “exchange arrangements” that undervalue their currency to encourage exports and discourage imports are engaging in “exchange action” that “frustrates” the provisions of GATT that are meant to encourage free trade and eliminate trade barriers.

The fact is, all the talk and all the so-called plans to deal with China’s currency manipulation is nothing but talk without action.   Nothing will change without action, whether it is a WTO action or Congressional vote.

America has a legitimate adjudicative action under the WTO and antecedent policy.   Pursuing it aggressively will at worst get all the facts out in the public.   And by offering a viable disincentive, the C.E.T. will force the Chinese to freely float the Yuan.   The C.E.T. would automatically end when the Chinese float the Yuan.

What are we waiting for?