Viewpoint: The 1.6% figure that matters most

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China's decision to allow market forces to play a greater role in determining the value of its currency prompted an overreaction in financial markets and the media. Concerns about currency wars, competitive devaluations and deflation were voiced. It is time to take a deep breath and start to consider the facts.

First, and most important, China's currency move has no impact on any other country if Chinese exporters do not react to the move. If Chinese exporters chose to keep the US dollar price of their exports unchanged, then there is no competitive advantage to China. Asian exporters to the US will face no greater Chinese competition.

Why would Chinese exporters choose to leave their US dollar prices unchanged after the renminbi weakened? Perhaps because Chinese exporters never raised their overseas prices when the renminbi rose against the euro this year. Europe is as important an export market as is the US. If China does not raise prices on a rising currency, why assume China will cut prices on a falling currency?

The important thing is not the level of the renminbi, but how Chinese exporters react to it. But let us suppose there is a reaction. How important is Chinese trade to, say, US inflation? The answer is that 1.6% of the basket of goods and services that goes to make up US inflation results from Chinese economic activity. Some 98.4% of the basket of goods and services comes from elsewhere.

This takes a bit of explaining. The weightings of consumer price inflation are an attempt to replicate the proportion in which consumers spend their income on various goods and services.

If we were to try and assess the impact of a change in the oil price on CPI, we could look at the weightings of oil products in the CPI basket. Heating oil is around 0.1% of the US inflation basket for instance. However, this approach does not capture the fact that oil prices impact electricity prices, which impact fertiliser prices, which impact food prices. To understand what a change in the price of oil means for the US, we have to think about oil and fertiliser and other prices.

Economists have a solution. GDP measures the income of an economy. If (hypothetically) total oil consumption in the US, including the oil embedded in fertiliser, is around 4% of GDP, that means US consumers spend 4% of their incomes on oil. Thus oil is likely to impact 4% of the contents of the basket of goods and services that make up the US CPI. What we do for oil, we can do for Chinese exports. We need to know how much of the US CPI basket is "made in China", including all the indirect effects.

So, how much does the US import from China? Two point eight per cent of US GDP. Two point eight per cent is clearly a larger number than 1.6%. So why is the impact lower?

The answer is re-exports. I always use the Apple iPad as an example.

The US imports 2.8% of goods from China, but not all of that 2.8% is made in China. An Apple iPad is "Made in China" (it says so on the box) but only around 5% of the price paid for an Apple iPad is actually paid for Chinese economic activity. About 45% goes to Apple in the US, South Korea takes around 8% for components, and so forth.

China has to import all those things, package them together and then export the finished product. We need to adjust China's exports to the US and remove re-exports to the US. The import to China and the export from China cancel each other out.

When we go through and make this adjustment, 1.6% of what the US spends its money on goes on economic activity from China. Hence 1.6% of the US CPI basket will be affected by the things that affect economic activity in China.

If 1.6% seems small, remember that much of what Americans spend their money on can have no conceivable tie to economic activity in China. Housing is the largest part of US CPI (over 40%). Healthcare and education are huge chunks of the index.

Food (China does not export food) is another big part. And finally even when an American buys something genuinely made in China, as consumers they still have to pay for the warehousing, distribution, retailer's overheads, the shop assistants' wages, and so on — and those are domestic costs (primarily domestic labour costs). US labour costs are around 60% of US CPI.

So when it comes to the US interest rates, the economists of the Federal Reserve are going to be focused on domestic labour pressures. China's currency moves are barely noticeable background noise. This is why US rates are likely to increase in September. 


Paul Donovan is senior global economist at UBS Investment Bank. His latest book The Truth About Inflation was published by Routledge in April 2015.

 

This article first appeared in Opinion, digitaledge Weekly, on August 24 - 30, 2015.