Why Trump Cannot Win the Trade War

What’s going on in the news right now? The world is watching an expensive dispute play out between two of its most powerful countries. In 2017, the US imported $506 billion worth of goods from China, while China imported only $130 billion from us-- there is a $375 billion trade deficit. President Trump wants to close the deficit and bring more jobs back to American manufacturers by imposing tariffs on Chinese goods, raising the price of Chinese goods sold in America. However, a glance at the statistics tells us this strategy will not work. Everyone’s paying attention to the business side of it-- the energy sector, the automobile sector. That’s fine, but what also needs to be addressed here isn’t China’s retaliatory tariffs, but the simple currency phenomenon already brewing in the Chinese government. Here’s how the numbers play out, and how you might be affected by this clash of political titans.

Inflation means good news to Chinese businesses

How do Chinese manufacturers make money in the US market? First, they buy raw materials from Chinese suppliers using the Chinese currency, yuan or CNY (¥). Then they sell the finished product to American consumers, who pay them in American currency, dollars or USD ($). The Chinese government has foreign exchange control laws in place that changes all dollars into yuan according to the exchange rate. That works if the value of the currencies compared to each other were stable, but it is not.

Link to larger image: https://drive.google.com/file/d/1kbdH6ht9t-2ip0RAiRr3D7TKHjJvFdE1/view

This chart shows how much yuan can be exchanged for dollars, over time. You can see that it’s going up, so the value of the Chinese yuan in relation to the US dollar has been decreasing since the start of the trade war in April-- meaning, Chinese currency is being inflated. That’s good for the Chinese companies that export to the United States. Why?

Say you are a Chinese manufacturer who sells pens and other writing utensils to Americans for $1 each. Say that $1 equals ¥6. Say that you buy raw materials (metal, plastic) from domestic Chinese suppliers for ¥5 each pen, so you make a profit of ¥1 or $0.17 for each pen you sell. But then say the exchange rate goes up 10% (or the value of CNY falls 9.1%, whichever you prefer), making $1 equivalent to ¥6.60. You still sell your pen for $1, but the Chinese government exchanges that $1 with ¥6.60 instead of the usual ¥6.

Your supplier is still supplying raw material at ¥5, so you make a good profit of ¥1.60 or $0.24, meaning you made 7 cents more profit. 7 cents per pen may not sound like much, but considering your previous profit was $0.17, that extra 7 cents of profit means the profitability of your business increased 41%! And for doing what, exactly? Simply by having the government exchange dollars into yuan while the exchange rate increases.

Look again at the chart. 3 months ago we exchanged $1 for ¥6.29. Now, we can get ¥6.81 for $1. The exchange rate has increased by 8.3% (meaning the real value of Chinese money has fallen or deprecated 7.8%). This does not seem to be stopping anytime soon (this is July 27th, 2018 data, which will get old very quickly.) In fact, let’s try to predict the pattern of the graph by looking at its historical behavior.

The tariff will not be enough to raise prices of Chinese goods

Larger image: https://drive.google.com/file/d/1PUjTcTQ8lZx4J3SN06Z3evkrm88JHbU8/view

Here’s the data again, zoomed out to cover 5 years. Exchange rate variations, like stock prices, tend to come in waves. You can see the previous wave of increased exchange rates during 2014-2017. From around ¥6.04 per $1 in 2014 to ¥6.94 in 2017, the exchange rate grew around 15% (CNY deprecated 13%) over these 3 years.

This second wave, starting with the trade war in April, has an even steeper slope than the first wave-- experts predict that in 3 years, the exchange rate may climb to ¥8.50 to ¥9.00 for every dollar. This means an exchange rate increase of 26-33% (value of CNY deprecates 20-25%). In our hypothetical situation above, a simple exchange rate increase of 10% could increase the profitability of a Chinese company by 41%-- imagine, then, how much the actual level of Chinese currency inflation could benefit these Chinese businesses.

Here’s the punchline of this sad joke-- those foreign exchange control laws that China has? We don’t have them. Meaning, Chinese businesses are always going to be exchanging their dollars for yuan and their yuan for dollars-- it’s the law. American exporters, like the farmers who raise pork or soybeans to sell to Chinese consumers, don’t get paid in yuan. They get paid in dollars, converted right from the Chinese government with the increased exchange rate. We are not benefiting from the variations in exchange rate.

Now, Trump has threatened to impose a 10% tariff on another $200 billion worth of Chinese goods. The goal here is to raise the price of those goods by 10% so less Americans would buy them, theoretically narrowing the trade gap and bringing demand back to American businesses. Well, it’s not going to work. Heck, even if the president manages to hit all $506 billion worth of Chinese goods with a 10% tariff, nothing’s going to happen. Why?

Recall our previous example of the Chinese pen company. You sell your pens for $1 each in America, with the exchange rate of ¥6 for $1. Trump imposes a 10% tax on you, raising the price of your pen to $1.10 and lowering your sales, letting your American competitors cut into your market. Not for long!
The benevolent Chinese government exchanges your USD into CNY at the exchange rate that has now increased by 10% (¥6.6 for $1). To fight the tariff, you can now comfortably lower the price of your pen to $0.90 per pen without tax-- (with Trump’s 10% tariff your consumers will pay $0.99). At ¥6.6 for $1, you make ¥5.94 for the 90 cents you take home, and remember that raw material costs ¥5 per pen. You are still making ¥0.94 or $0.14 worth of profit per pen. That’s a little less ludicrous than the previous $0.17 you made before Trump imposed the tax, but not by much.

Also, remember that the price of your pen is now at $0.99 instead of $1? The lower price is actually going to increase sales, meaning more profit-- and for doing absolutely nothing. Obviously, a 10% tariff is not going to be enough with the way foreign exchange rates are climbing now. Chinese businesses can simply lower prices without risk.

What this means for us

With this rate of Chinese currency inflation, Chinese businesses exporting goods to the United States could earn a profit of 50-60% more. To increase sales even further, businesses would even cut prices lower. This means ordinary Americans like you and me can buy even more cheap Chinese stuff. On the macro level, the $375 billion trade deficit would stay the same. It would probably even increase.
Also remember that this trade war is reciprocal, so the price of American goods in China are rising. Chinese people will buy less of our stuff, so American businesses cannot sell as much of what they produce. They’ll be forced to lower prices, cutting into their profit. As a consumer, this is good news-- for you, everything will probably be cheaper. For people working for the companies, not so much.
No matter how much President Trump tries, economically this is not going to play out. Chinese inflation is much too rampant for that-- the authoritarian Chinese government could inflate their currency as much as it wants to without citizens raising their voices in protest. The government certainly has plenty of incentive to do so, at any rate. Look at that scary graph again, and see the steep slope of the line, continually shooting upward for the last 3 months... No, Trump cannot win the trade war.