China has run a bilateral trade surplus with the United States since the late 1980s. These surpluses increased steadily in the 1990s, and China became the largest single source of the US global deficit in 2003. In 2008, the US bilateral trade deficit with China reached $268 billion—about 30% of its global trade deficit. US imports from China are now almost five times as large as US exports to China.

Some observers claim that this lopsided trade imbalance has been a result of China’s undervalued currency, the yuan or RMB (renminbi). Other things being equal, an undervalued yuan makes China’s goods cheaper to export to the US and US goods more expensive to import into China. It is true that China has kept the yuan from rising freely by selling yuan for dollars. This process of intervention by buying dollars has swollen its foreign exchange reserves to over US$2 trillion towards the end of 2009, by far the largest in the world.

Having big foreign exchange reserves may be a sign of economic strength, but it is not without costs. First, mopping up dollar export earnings means an open-ended expansion of yuan in the domestic economy. The resulting easy money could lead and have led to asset bubbles and price inflation. The housing market and the stock market are just 2 examples of such asset bubbles.

Second, investing the foreign exchange reserves in US government bonds may not be the best way to preserve their value in a declining dollar.

It may be a good thing if a rising yuan could substantially reduce China’s trade surplus. In late 2005, experts estimated that the average exchange rate of the yuan was undervalued by 20 to 40 percent (and that its bilateral rate against the dollar was undervalued by even more). The yuan has gone up by some 15% against the dollar since then, but the trade surplus with the US has gone up even more by 33%.

It is doubtful that simply raising the yuan’s exchange rate alone would eliminate the US’s current account deficit with China. The US current account deficit with China is but a mirror image of the excess of US gross domestic investment over US gross domestic saving. In other words, the US is consuming too much and not saving enough to finance its investment. As a result, it must make up the deficit by importing it from China. On the other hand, China’s current account surplus with the US is but a mirror image of China’s excess of gross domestic saving over China’ gross domestic investment. In other words, China is consuming too little and saving more than enough to finance its investment. As a result, it must reduce its surplus by exporting it to the US.

Inasmuch as domestic consumption and investment patterns are entrenched in the economic fabrics of each country, simply changing the foreign exchange rates between the yuan and the dollar without any corresponding structural changes is not going to materially address the external imbalance. In any case, the amount of revaluation needed (say 50%) may be too large to be practical in a fell swoop. But gradual revaluation may encourage substantial inflow of hot money into China expecting a foreign exchange windfall.

Reducing US consumption would require the US government and households to spend less than they earn for the foreseeable future. Similarly, increasing China’s consumption would require that the share of wages out of China’s GDP be increased and investment in industrial over-capacity be stopped. A lot of domestic institutional transformations need to take place for these changes to take hold.