Since the US House of Representatives on Wednesday passed a bill to press China to let its currency rise faster, it is clear that the world is tilting inexorably towards more trade conflict. But excessive focus on currencies and tariffs is likely to make a bad situation worse.
There are many ways for China to rebalance, and they all involve the same process of transferring income from producers to households. Raising the value of the yuan, for example, increases the real value of household income in China by reducing the cost of imports.
It balances this by lowering the profitability of exporters. The net result is that if done carefully, raising the value of the yuan causes the household income share of gross domestic product to rise, and with it consumption rises, too. Since China must export the difference between what it produces and what it consumes, raising the value of the currency also reduces its trade surplus.
But what happens if China revalues the yuan too quickly? In that case, the profitability of the export sector might decline so quickly that exporters would be forced into bankruptcy or into moving abroad to lower-wage countries. Either way, they would have to fire workers, whose consumption would then decline.
This is the problem China faces. It must raise the value of the yuan as part of its rebalancing towards greater domestic consumption, but if it does so too quickly, the rebalancing will occur not as an increase in consumption relative to rising production, but rather as a drop in production relative to declining consumption.
