FIN 500 – Global Corporate Finance

Case Study 1: USA-China Trade Relations

Peter Samuel Shahinian

FIN500 Case Study 1: USA-China Trade Relations 05/24/2009

1) What are some of the sources of trade friction between China and the USA? Why do some scholars
view this friction as a positive sign?

Under a new leadership regime, China, for about 13years had applied for WTO (World
Trade Organization) membership, but their efforts had been futile primarily due to U.S.
opposition. The U.S. argued against China, that they still had a few economic and political issues
that had to be taken care of prior to China’s entry into the WTO. Some of these issues were
related to human rights, tensions between Taiwan and China, objections from labor unions in
the U.S., China’s nuclear arsenal, and the use of protectionist policies by China against the U.S.
Many advocates were worried of China becoming a member of the WTO due to
concerns about an increasing trade imbalance between the USA and China. Between 1990 and
2002, total trade had rose from $20million to $116billion, however, according to U.S. trade
data, the trade deficit with China kept on increasing year-after-year. The U.S. blamed this
growing deficit trend towards China’s high tariffs and numerous restrictions on U.S. exports. In
addition, many economists believe that the Chinese currency was undervalued (by as much as
40%), which basically gives Chinese goods a price advantage against identical U.S. products.
However, despite these sources of trade friction between China and the USA, some
scholars view this friction as a positive sign. With trade frictions emerging and trade policies
being implemented and dealt with, China finally becomes a member of the WTO on December
11, 2001. With this, China agrees to lower its average tariff rates from 16.7% in 2000 to 10% in
2005, and also promising to reduce the number of items under import license and quota, from
300 items to zero. Also, by entering the WTO, China agreed to liberalize foreign investment
banking, insurance, financial services, wholesale/retail trade, and telecommunications, in order
to boost foreign direct investment. By choosing to follow this path, China will increase its
opportunities for growth, which will help them become one of the major players in the global
economy.

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FIN500 Case Study 1: USA-China Trade Relations 05/24/2009

2) What is managed trade and how does it apply to China and the USA?

According to Alan V. Deardorff (2001), managed trade is the use of trade policies to
manipulate trade for political purposes. These trade policies may be domestic forms of
government intervention such as quotas, tariffs, embargos, and/or subsidies. Managed trade
theory applies to China and the USA, in a way that both these countries have engaged in
managed trade in order to promote their own country’s growth and balance of payments
stability. In the past we notice that when the People’s Republic of China was formed and the
economy was completely state controlled, the embargo toward China caused a significant and
sharp decline in USA-China trade relations. A few years later, under a new leadership, China
initiated economic reforms, and new policies that affected trade between USA-China in a
positive manner. Where U.S. trade accounted for only 1.6% of China’s total trade, the
modernization of certain areas of China’s economy allowed trade between these countries to
increase significantly (mentioned in question 1 above). Also, 1990-2002 the U.S. experiences an
increasing trade deficit with China, which was primarily due to China’s high tariffs, and the fact
that the Chinese Yuen was undervalued by approximately 40%. Once China, became a member
of the WTO, these tariffs were reduced to 10% (decrease of 6.7%), and other import restrictions
(quotas, and licenses) on U.S. goods were eliminated. Subsequently, the U.S. also removed it’s
import quota on certain Chinese products, allowing certain Chinese industries to boom.

3) Discuss what steps the USA can take to reduce its trade deficit with China. Mention the deflation of
economies, devaluation of the currency, and the establishment of public control.

Deflating the economy

If the U.S. adopts a tight monetary or fiscal policy, its inflation and income levels are
most likely to decrease. With lower inflation (lower general prices of goods/services) and
income, exports are expected to increase and imports are expected to decrease; as a result the
U.S. would experience a trade balance surplus. Therefore, in order for the U.S. to reduce its
trade deficit, it should control government budget deficits, decrease the money supply, and
implement price and wage controls. However, despite the fact that these policies might
improve the trade deficit, they are also prone of slowing down the growth of the economy.

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FIN500 Case Study 1: USA-China Trade Relations 05/24/2009

Devaluing the currency

The U.S. may reduce its trade deficit with China by devaluating the dollar ($), against
China’s currency (yuan) and other major currencies. Dollar devaluation may improve the trade
deficit because a weak currency makes imported goods more expensive and exported goods
less expensive. However, it’s also important to note that devaluating the U.S. currency might
not improve the trade balance with China. The reason for this could be that despite the cheaper
prices of goods/services that the U.S. offers, China might decide not to respond to the lower
prices due to other reasons. Also, if U.S. companies do not possess the capacity to produce
more goods for export, then this would offset the effect of devaluating the currency and place
the U.S. in a bigger deficit than before.

Establishing public control

Two ways in which the U.S. can establish public control is through foreign exchange control,
and trade controls. If the U.S. is facing a major trade deficit, it may manipulate its exports and
imports by imposing protectionist measures such as tariffs, quotas, and subsidies. High tariffs,
and quota restrictions imposed on Chinese goods, by the U.S., would reduce U.S. imports. Also,
if the U.S. subsidized some of its own exports, this would make these goods/services more
competitive in the world markets and thus increase the volume of U.S. exports. On the other
hand, U.S. firms could also impose special taxes on foreign direct investment (FDI), which would
tend to decrease U.S. capital inflows. However, the public control tools that governments could
impose, are prone to increase U.S. inflation levels, diminish purchasing power parity, and lower
the standard of living.

4) Suppose the value of the US dollar sharply depreciates. Under these conditions, how would the J-
curve discussed in this chapter apply to the trade relationship between China and the USA?

Change in the 0 Time

trade balance

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FIN500 Case Study 1: USA-China Trade Relations 05/24/2009

The J-curve is used by economists to graphically describe the relationship between a

country’s trade balance and its currency devaluation. The J-curve theory states that a country’s
currency depreciation causes its trade balance to worsen initially for a short time, before a
significant improvement occurs in the long-run. Therefore, when the value of the U.S. dollar
sharply depreciates against the Chinese yuen; U.S. exports are expected to increase, and
imports are expected to decrease, which ultimately improves the U.S. trade balance. In the
short-run however, the U.S. trade deficit may deteriorate after the dollar ($) depreciates,
because the higher cost of imports will more than offset the reduced volume of imports.

5) Discuss in broad terms the major changes since WWII in the trade relations between China and the
USA in terms of actual BOP and FDI.

 1950-1953 – Korean War and the subsequent embargo toward China caused a sharp
decline in USA-China trade relations. This would decrease the level of foreign direct
investment between both countries and as a result also negatively affect their balance
of payments.

 1972 – American share of China’s total trade accounted for only 1.6%. Deterioration in
the trade balance and the balance of payments due to trade balance deficits.

 1978 – under a new leadership, Deng Xiaoping, China began the process of economic
reform. These reforms - modernization of industry, agriculture, science and tech, and
national defense- represented a significant shift in policy and helped to initiate a steady
growth in the trade between USA and China. This would allow some improvement in
both countries BOP, however FDI was still low due to strict government regulations in
part of the Chinese market system.

 1990-2000 – total trade rose from $20million to over $116billion. By 2000 USA had
become China’s second largest trade partner and China was the USA’s fourth-largest
importer, supplying a wide variety of goods. We would expect an improvement in the
balance of payments and the level of foreign direct investment in both countries.
o According to U.S. trade data, the trade deficit with China was as follows:

Year Amount (billions)

1999 $69
2000 $83
2001 $85
2002 $103

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FIN500 Case Study 1: USA-China Trade Relations 05/24/2009

 2001 – investors pour money into China, with $400billion invested in 2001, with $28.5billion of
it coming from the U.S. alone. With such a large amount of investment coming from the U.S.
alone, the balance of payments in the U.S. is expected to improve in the long-run, while FDI in
China is expected to increase.

6) The website of the US Central Intelligence Agency (www.cia.gov) and the website of the US Census
Bureau, (www.census.gov) both contain economic data and stats on trade. Use specific numbers from
these two sites to support some of your claims in the answer to question 5.

 1972 – American share of China’s total trade accounted for only 1.6%. According to the U.S. Census
Bureau (2009), the U.S. balance of payments was experiencing a surplus from 1960-1970. The
embargo towards China caused the balance of payments to go into a deficit in the years of 1971-
1972. The following table is a snapshot from the U.S. Census Bureau website supporting the
information:

U.S. Census Bureau, Foreign Trade Division.

 1978 – under a new leadership, Deng Xiaoping, China began the process of economic
reform. These reforms - modernization of industry, agriculture, science and tech, and
national defense- represented a significant shift in policy and helped to initiate a steady
growth in the trade between USA and China. According to the CIA (2009), China’s economic
restructuring have resulted in efficiency gains that have allowed “to a more than tenfold

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FIN500 Case Study 1: USA-China Trade Relations 05/24/2009

increase in GDP since 1978”. Annual inflows of FDI have increased over $80 billion in 2007
due to China opening its borders to foreign trade and investment.
Bibliography:

 Central Intelligence Agency, "The World Factbook". CIA. Accessed on May 25th, 2009
<https://www.cia.gov/library/publications/the-world-factbook/fields/2116.html>.

 Deardorff, Alan V.. "Deardorff's Glossary of International Economics". Accessed on May

24th, 2009 from <http://www-personal.umich.edu/~alandear/glossary/m.html>.

 United States Census Bureau, "Foreign Trade Statistics". U.S. Census Bureau. Accessed
on May 25th, 2009
<http://www.census.gov/foreigntrade/statistics/historical/gands.pdf>.