Why the U.S. can’t win the trade war with China — and shouldn’t try

Allegations about China’s manufacturing overcapacity have sparked heated discussions among policymakers. During her visit to China in April, U.S. Treasury Secretary Janet L. Yellen argued that “when the global market is flooded by artificially cheap Chinese products, the viability of American and other foreign firms is put into question,” adding that it was the same story a decade ago.

Yellen is partly correct: The Sino-American trade war has strengthened, not weakened, China’s export competitiveness. In 2023, China accounted for about 14% of total global exports, up 1.3 percentage points from 2017 (before the conflict began). More striking still, China’s trade surplus was around $823 billion in 2023, nearly double what it was in 2017.

Over a decade ago, China’s trade surplus was largely the result of an undervalued yuan (CNY). Today’s circumstances are somewhat similar. My research shows that in 2023, the CNY was 16% undervalued against the dollar, contributing to China’s high exports and trade surplus.

I reached this conclusion because the inflation rate in the United States over the past two years has been 10 percentage points higher than in China. According to purchasing-power-parity calculations, the CNY should have appreciated by 10% against the dollar; instead, it depreciated by 11%. From this perspective, the CNY was 21% undervalued against the dollar.

Of course, short-term exchange rates are influenced more by the interest-rate differential than by the inflation rate. I therefore used econometric methods, incorporating factors such as the interest-rate spread and economic growth, to estimate what the CNY exchange rate should be.

My comparative studies found that the extent of CNY undervaluation has been much greater than that of major ASEAN currencies over the past two years. Compared to the last round of U.S. Federal Reserve rate hikes during 2015 to 2018, the extent of the CNY’s undervaluation in recent years has also significantly increased.

Strangely, there is no evidence that the Chinese government is targeting the exchange rate. Even the U.S. agrees that China has not acted as a currency manipulator in recent years. In this respect, the situation today is very different from a decade ago, as China has made significant progress in reforming its exchange-rate system in the intervening period. As a result, the volatility of the CNY exchange rate has become more pronounced.

This raises the question of why the CNY is still undervalued. Looking at the balance of payments in 2020 and 2021, the cumulative net inflow of capital from direct and securities investments exceeded $400 billion, whereas in 2022 and 2023, the cumulative net outflow from the capital and financial account exceeded $500 billion. China’s enormous current-account surplus has not led to CNY appreciation — as one might expect — because of these high capital outflows. This makes exchange-rate changes ineffective in adjusting the trade balance.

Such capital outflows cannot be attributed solely to the changes in the interest-rate spread between China and the U.S. In fact, the capital outflow is mainly a result of noneconomic factors, including some of China’s own policies such as its clampdown on certain industries. Recognizing this, the Chinese government began to incorporate noneconomic policies into its self-assessment framework late last year.

More importantly, the recent escalation of Sino-American tensions has led the U.S. to adopt a series of policies that discourage investment in China. This includes limiting venture-capital flows into China and exaggerating the risks of traveling there. The U.S. Congress is also considering legislation that would further restrict American investment in China. Together, these factors have exacerbated capital outflows, thereby amplifying the degree of CNY undervaluation and further undermining the effect that exchange-rate adjustments would typically have on the trade balance.

As long as Sino-American relations continue to be rocky, the CNY exchange rate will most likely remain significantly undervalued and Yellen’s complaints will become ever more difficult to resolve. Of course, the political factors distorting the exchange rate will also slow the development of China’s services sector, and thus hinder its structural-adjustment efforts.

Given all this, the solution seems clear. In the interest of both sides, China must develop a consistent mechanism for assessing the impact of its noneconomic measures and the U.S. must ease its restrictive policies.