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Understanding the US-China Trade Deficit

The trade deficit between the US and China has steadily widened over the last two decades, leading critics of free trade to worry that US manufacturing is eroding. But the deficit will likely narrow organically as China lifts its living standard, which is still only 10 to 20 percent of that in the US.

When China joined the World Trade Organization in 2001, few could have foreseen how rapidly the struggling socialist nation would transform itself into an export-focused manufacturing powerhouse. China’s ascent has challenged assumptions about the benefits of free trade, with critics sounding the alarm over widening trade deficits and the perceived erosion of the United States’ competitive advantage.

Free trade does have an inherent downside: when rich nations engage in unrestricted commerce with developing economies, trade imbalances are inevitable. Compounding this problem, Chinese regulators have done a poor job of policing intellectual property theft. But the larger picture remains unchanged—free trade will help hasten China’s economic development, creating tremendous opportunities on both sides of the Pacific.

Demand Drives Deficits

The headline story of the US-China trade deficit is indeed alarming—since the opening of the Chinese economy to tariff-free trade in 2001, the trade imbalance between the two nations has steadily widened, reaching $350 billion annually today. The trade in merchandise is even more lopsided, with the US importing $375 billion annually more in manufactured goods from China than it exports. This would seem to support the claim that free trade has eroded America’s manufacturing base.

But a closer look at how the deficit is made up presents a less dire situation. Although expanding in nominal terms, the size of the trade imbalance relative to the broader US economy has held steady over the past decade at about 1.75 percent of GDP. Additionally, the value of US goods and services exported to China has grown steadily, surpassing $200 billion this year.

This implies that the widening trade deficit is largely due to growing demand from American consumers rather than a lack of Chinese interest in US products. With the US economy approaching the peak of its business cycle, the deficit is likely to grow further, at least in the short term. Falling unemployment and rising wages in the US likely will continue to create new demand for merchandise made in China.

In the long run, however, Chinese demand for US exports has extraordinary room for growth. The UN estimates China’s population at 1.4 billion people, although the average Chinese household only has 10 to 20 percent of the purchasing power of their US counterparts. As the Chinese economy matures and its living standards become comparable to that of the US, Chinese consumers will have more discretionary income to spend on US exports, which tend to be higher-end products and services like mobile software and blockbuster films.

Same Script, Different Players

The rise of East Asia today echoes the rebuilding efforts in Europe developed during and after World War II. In 1944, representatives from the Allied nations agreed to adopt a shared monetary system that would fix exchange rates between nations. By pegging foreign currencies to the dollar, the Bretton Woods system allowed European economies to run persistent trade imbalances as the continent rebuilt itself from the war’s devastation.

Today, no formal treaty pegs the Chinese renminbi to the US dollar. Instead, the People’s Bank of China employs a system of tight currency controls to stabilize exchange rates. This allows China’s export-focused industrial base to grow without risking an appreciation of the renminbi that could render Chinese goods uncompetitive on the global market.

The end of the Bretton Woods regime may have implications for the evolution of the US-China relationship. By the late 1960s, Europe’s economies had rebuilt their industrial base, and their citizens’ purchasing power was growing. Fixed exchange rates no longer benefited the continent’s growing consumer class, and nations gradually adopted a floating exchange rate system. Demand for imports rose, trade imbalances subsided, and living standards rose on both sides of the Atlantic.

A similar scenario could play out with China. As the Chinese economy grows, the importance of export-focused manufacturing will likely give way to an expanding service sector and consumer demand. The nation’s citizens will desire greater access to foreign goods as their wealth grows, and a fixed exchange rate will no longer serve the Chinese economy. The nation’s rise is sure to be disruptive, but there are likely to be significant benefits from a prosperous Chinese economy integrated into the global system of trade.

View our economic commentary disclaimer.

Jim Glassman, Head Economist, Commercial Banking

Jim Glassman

Jim Glassman, Head Economist, Commercial Banking

Jim Glassman is the Managing Director and Head Economist for Commercial Banking. From regulations and technology to globalization and consumer habits, Jim's insights are used by companies and industries to help them better understand the changing economy and its impact on their businesses.

Jim Glassman China

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