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The recent revival of import tariffs by the U.S. has created a puzzle. Why, in the midst of this “trade war,” has China not used the weakness in its exchange rate to offset the effects of President Trump’s tariffs? Since April 2018, the renminbi’s decline has increased China’s receipts in their own currency for each dollar by more than 10%; yet, as a recent paper from the New York Fed noted, “import prices for goods from China (have) not fall(en) to offset tariffs”.
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Under the law of comparative advantage, this is a genuine anomaly. China could have largely maintained its volume of exports to the U.S. even with the imposition of tariffs. Instead, Chinese exporters have sold fewer goods while keeping their dollar prices unchanged. With the comparative advantage of its lower labor costs, the Chinse were already successfully producing and selling goods at the “old” prices. Why would Chinese exporters choose to increase domestic profit margins at the expense of at least part of their market share?
Even though many textbooks continue to give David Ricardo credit for discovering the law of comparative advantage, Ricardo never claimed such an honor. Neither did he, in fact, support the contention that countries could successfully ignore prices in favor of costs. “In one and the same country, profits are, generally speaking, always on the same level; or differ only as the employment of capital may be more or less secure and agreeable….. If the profits of capital employed in Yorkshire, should exceed those of capital employed in London, capital would speedily move from London to Yorkshire, and an equality of profits would be effected…It is not so between different countries… (T)he fancied or real insecurity of capital, when not under the immediate control of its owner… check(s) the emigration of capital.(I)f capital freely flowed towards those countries where it could be most profitably employed, there could be no difference in the rate of profit to capital throughout the world.”
Read the full article here by Stefan Jovanovich, Advisor Perspectives
