Smith Faculty Opinion Article	June 8, 2007
By Dr. Peter Morici, Professor of International Business E-MAIL WEB SITE

U.S. Records $58.5 Billion Trade Deficit in April
Oil, China and Autos Push Up Deficit

Today, the Commerce Department reported the April deficit on trade in goods and services was $58.5 billion. This was down from the $62.4 billion deficit in March and well below the consensus forecast, which was $64.0 billion.

The improvement in the trade deficit was largely attributable to an unexpected drop in the quantity of petroleum imports, and a drop in nonpetroleum imports from countries other than China. The overall deficit remains an unhealthy 5.1 percent of GDP and will likely rise in May as petroleum imports rebound and imports from China continue to surge.

The petroleum deficit was $22.3 billion in April, virtually unchanged from $22.4 billion in March, while the trade deficit on nonpetroleum products fell from $45.5 billion in March to $42.3 billion in April. The drop in the quantity of petroleum imports recorded by the Commerce Department was inconsistent with the Department of Energy, indicating petroleum imports in the balance of trade data will surge in May.

The trade deficit with China increased to $19.4 billion in April from $17.3 billion in March. Trade with China contributes almost as much to the trade deficit as does petroleum, making the yuan-dollar exchange rate as important as the price of oil for the size of the trade deficit and the outlook for U.S. GDP and jobs growth.

The deficit on automotive products fell to $10.1 billion in April from
$11.2 billion in March, reflecting the slower pace of car sales and the continuing build out of Japanese automobile plants in the United States.

Since December 2001, the U.S. monthly trade deficit has increased $31.9 billion. This has saddled the economy with a huge foreign debt and slowed growth. Dysfunctional energy policies and the overvalued dollar against the Chinese yuan are responsible for 98 percent of this growth.

To finance trade deficits, Americans have borrowed $6 trillion, over and above foreign direct investment in the United States, and the debt service comes to about $300 billion a year.

By reducing the demand for high-skill and technology-intensive products, U.S. made goods and services, the deficit reduces GDP by about $250 billion, and by cutting investments in R&D and labor skills, the trade deficit cuts potential annual economic growth from about 4 percent a year to 3 percent.

The manufacturing sector is particularly hard hit. Over the last 86 months, over 3.2 jobs have been lost. The rapid growth in the nonpetroleum deficit is responsible for the loss of about 2 million manufacturing jobs, mostly in technology-intensive durable goods industries where inexpensive Chinese labor offers few competitive advantages. The balance of the job losses were caused by rapid improvements in labor productivity.

Breaking down the Deficit

Petroleum, China and automotive products account for about 94 percent of the trade deficit, and no solution is possible without addressing issues particular to these segments.

Petroleum products account for $22.3 billion of the monthly trade gap.
Since December 2001, net petroleum imports have increased $16.8 billion, as the average price of a barrel of imported oil has risen from $15.46 to $57.3, and monthly imports have increased 353 to 402 million barrels.

Technologies such as simply retuning conventional gasoline engines and transmissions, hybrid systems, lighter weight steel and other materials, and alternative energy sources could substantially reduce U.S. dependence on foreign oil. Accelerating the build out of these solutions requires national leadership, but both Republican and Democratic Party leaders have failed to champion a policy framework that would accomplish what is now clearly possiblegreatly reduced dependence on Middle East oil and the threats to national security it engenders.

China accounted for $19.4 billion of the April trade deficit, up from $5.5 billion in December 2001. The bilateral deficit remains keeps rising, because China undervalues the yuan, and this makes Chinese exports artificially inexpensive and U.S. products too expensive in China.

Although China revalued the yuan from 8.28 to 8.11 in July 2005 and announced it would adjust the currency to a basket of currencies, the yuan continues to track the dollar closely and currently is trading at about 7.66, down about 5.6 percent in 22 months. Modernization and productivity advances raise the implicit value of the yuan about 5 percent every twelve months, and the yuan remains undervalued against the dollar by at least 40 percent.

Chinas huge trade surplus creates an excess demand for yuan on global currency markets; however, to limit appreciation of the yuan against the dollar and drive it down against the euro, the Chinese central bank purchases about $250 billion in U.S. and other foreign currency and securities each year. This comes to about 9 percent of Chinas GDP and about 24 percent of its exports. These purchases provide foreign consumers with two trillion yuan to purchase Chinese exports, and create a 24 percent off budget subsidy on foreign sales of Chinese goods, and an even larger implicit tariff on Chinese imports.

In addition, China provides numerous tax incentives and rebates, and low interest loans, to encourage exports and replace imports with domestic products. These practices clearly violate Chinas obligations in the WTO and it agreed to remove those when it joined the trade body. The Bush Administration has filed a WTO petition to force China to either rescind these practices or ultimately to face WTO approved tariffs to offset their effects.

Consistent with WTO rules, the United States has recently decided to apply its countervailing duty laws to subsidized Chinese imports, as it does to imports from Japan, Korea and most industrialized and developing countries. This will permit private U.S. firms harmed by Chinas subsidized exports to bring suit for relief, and these actions would bring quicker and more certain action than the WTO complaint process.

However, the Bush Administration did not include Chinas undervalued currency and foreign exchange market intervention in its WTO complaint, despite the fact that these practices have been identified as a subsidy encouraging exports by Federal Reserve Chairman Ben Bernanke. Currency subsidies are the largest single subsidy China applies to exports, and export subsidies are considered to be among the most egregious violations of WTO rules.

Many U.S. multinationals corporations, like GE, Caterpillar and GM, have earned huge profits investing in Chinas protected markets. Those MNCs have profited greatly from the conditions in China created by its blatant violations of WTO rules and currency subsidies; hence, it is not surprising they have lobbied the Congress and Administration not to take action against Chinese mercantilism and have persistently characterized as protectionist U.S. advocates for affirmative steps to offset Chinas export subsidies. The Bush Administration has bent to these pressures, refusing to even acknowledge the subsidy on exports Chinas currency market intervention creates, and has placed these corporate interests ahead of free trade principles.

The history of WTO disputes addressing broad subsidies, like tax holidays and bank credits, indicate the U.S. complaint against tax and credit subsidies will likely take years to resolve. China will have many options to reconfigure these practices before it ultimately, if ever, relinquishes them. The real danger is that the Bush Administration is using the WTO complaint process to butt congressional pressure to apply the countervailing duty laws to China and to avoid taking meaningful steps against Chinese currency manipulation.

Automotive products accounts for about $10.1 billion of the monthly trade deficit and has increased 19 percent since December 2001.

Japanese and Korean manufacturers have captured larger market shares by offering more attractive and reliable vehicles than U.S. competitors, and are expanding their U.S. production. However, Asian manufacturers tend to use more imported components than domestic companies, and GM and Ford are pushing their parts suppliers to move to China.

The U.S. remains a competitive place to make cars and many components; however, GM, Ford and Chrysler carry a $2,500 cost disadvantage against Toyota plants located in the United States, thanks to clumsy management, excessive executive compensation, and the unrealistically high wages, costly health benefits and arcane work rules imposed by contracts with the United Auto Workers. These disadvantages far exceed those imposed by legacy costs, such as providing health benefits for retired blue collar workers, and it would persist even with the implementation of national health insurance.

In addition, the yen may be even more undervalued against the dollar than the yuan, thanks to sluggish growth and near zero interest rates in Japan. However fundamental realignment of the yen dollar exchange rate is unlikely, because Treasury Secretary Paulson has voiced an agnostic position about the value of the yen and yuan.

The auto industry sorely needs a fairly valued yen, better management, and new labor contracts that align costs with Toyota and other Asia transplants operating in the United States. Essential elements would include pay for performance, health benefits in line with those offered by most U.S. employers, and adopting defined contributions pensions systems. Without these essential reforms, even the reincarnation of Henry Ford and Alfred Sloan could not save the domestic automakers from their inevitable ride through Chapter 11.

Deficits, Debt and Growth

Trade deficits must be financed by foreigners investing in the U.S. economy or Americans borrowing money abroad. Direct investments in the United States provide only about a tenth of the needed funds, and Americans borrow about 50 billion each month. The total debt is about $6 trillion, and at five percent interest, the debt service comes to about $2000 per U.S.
worker each year.

High and rising trade deficits tax economic growth. Each dollar spent on imports, not matched by a dollar of exports, shifts workers into activities where productivity is lower and reduces domestic demand and employment.

Productivity is at least 50 percent higher in industries that export and compete with imports, and reducing the trade deficit and moving workers into these industries would increase GDP. Also, by suppressing wages and benefits, the trade deficit has pushed down the percentage of adults participating in the labor force.

Were the trade deficit cut in half, GDP would increase by nearly $250 billion, or about $1500 for every working American. Workers wages would not be lagging inflation, and ordinary working Americans would more easily find jobs paying higher wages and offering decent benefits.

Manufacturers are particularly hard hit by this subsidized competition.
Through recession and recovery, the manufacturing sector has lost 3.2 million jobs since 2000. Following the pattern of past economic recoveries, the manufacturing sector should have regained about 2 million of those jobs, especially given the very strong productivity growth accomplished in durable goods and throughout manufacturing.

Longer-term, persistent U.S. trade deficits are a substantial drag on growth. U.S. import-competing and export industries spend three-times the national average on industrial R&D, and encourage more investments in skills and education than other sectors of the economy. By shifting employment away from trade-competing industries, the trade deficit reduces U.S. investments in new methods and products, and skilled labor.

Cutting the trade deficit in half would boost U.S. GDP growth by one percentage point a year, and the trade deficits of the last two decades have reduced U.S. growth by one percentage point a year.

Lost growth is cumulative. Thanks to the record trade deficits accumulated over the last 10 years, the U.S. economy is about $1.5 trillion smaller.
This comes to about $10000 per worker.

The damage grows larger each month, as the Bush administration dallies and ignores the corrosive consequences of the trade deficit.

Peter Morici is a professor at the University of Maryland School of Business and former Chief Economist at the U.S. International Trade Commission.