Currency Manipulation and Tariffs

My hobby is model railroading. Today, virtually all model railroad equipment is manufactured in China and is imported by American companies. Most model railroad products are produced in limited runs of merchandise ordered months in advance of production. In recent days, many importers have announced retroactive price increases on pre-ordered products that are affected by the impending tariffs.

Let’s consider a model locomotive that is manufactured in China at a cost of $100. The American importer ships the locomotive to the U.S., where it is sold to the consumer for $140. If the locomotive arrives at an American port of entry after the effective date of the tariff’s imposition, a 10% tariff will be levied. The U.S. government will charge the importer 10% of what the importer paid for the locomotive. The price on which the tariff is imposed is expressed in U.S. dollars. After the tariff is paid, the importer’s cost will increase to $110 ($100 + 10% tariff).

In my example, the importer pays a $10 tariff to the U.S. government that can either be absorbed by the importer or passed onto the customer. Eventually, as the market for model locomotives adjusts to the tariff, the $10 will be shared by the Chinese manufacturer, the importer and the consumer.

The Chinese government can circumvent this by devaluing the Chinese currency. Instead of denominating the sales price in U.S. dollars, Chinese manufacturers are encouraged to denominate sales contracts in Chinese Yuan.

For example, if the exchange rate was 7 Chinese Yuan to the dollar (roughly 14.3 cents), then the cost of the model locomotive was 700 Yuan ($100 x 7.0). However, if the Chinese government allows the value of the Yuan

to drop by 10% to 7.7 Yuan to the dollar (roughly 13 cents), the cost of production, in U.S. dollars, is now about $91 (700 Yuan x $0.13).

Since the tariff is based on the price paid by the importer, denominated in U.S. dollars, the tariff is about $9 (10% of $91 rounded to the nearest dollar). The after-tariff cost in dollars to the importer ($91 + $9 tariff) is now the same as the pre-tariff cost of $100. (For simplicity, the amounts in my example are hypothetical and are imprecise due to rounding differences.)

This move effectively trumps the tariff. (I couldn’t resist the pun!) In response, the U.S. Treasury cried foul and designated the Chinese government a currency manipulator. This means that the U.S. government can impose financial sanctions on China, which, in the current situation, are largely symbolic.

Ironically, on July 26, President Trump stated that he had not completely ruled out weakening the U.S. currency after such action was suggested by Peter Navarro, assistant to the president, and director of trade and manufacturing policy. Mr. Trump wants the Fed to lower U.S. interest rates. Lowering interest rates would manipulate our currency by weakening the dollar. Perversely, this is substantively similar to the Chinese actions that were condemned by the Treasury Department.

Unfortunately, we live in a global economy and other countries, many of whom are our friends and allies, are adversely affected by the U.S./China trade war. Consider the case of New Zealand, which responded to the Chinese move by devaluing its own currency.

New Zealand’s biggest industry is the timber industry. Approximately 3% of its economic output represents timber exports to China. The Chinese devaluation of the Yuan not only affected exchange rates with the United States; it also impacted exchange rates globally. Thus, in my example, New Zealand timber becomes 10% more expensive in China. Chinese demand for New Zealand timber will drop as a result.

To elude this problem, on Aug. 7, New Zealand’s central bank reduced interest rates by a halfpercentage point. This effectively countered the Chinese currency manipulation because it caused the New Zealand dollar to drop. Unfortunately for New Zealand, which imports most of what it consumes, prices of imported goods will increase as a result of these actions.

In fairness to President Trump, he is addressing long-term economic issues we have had with China. Prior administrations have failed to see the elephant in the parlor and didn’t do much. Regrettably, tariffs are a simpleton’s solution. Tariffs create considerable collateral damage. The last time the global economy saw the widespread use of tariffs was during the 1930s. Many economists believe that tariffs prolonged and exacerbated the global Great Depression, setting the stage for World War II.

Perhaps the best way to deal with China is to isolate it by having other large economic powers, whose interests with respect to China coincide with ours, apply global pressure. To date, Mr. Trump does not appear to have considered that strategy.