Political Economist

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February 11, 2006

U.S. Trade Deficit Sets Record, With China and Oil the Causes

By VIKAS BAJAJ

The United States trade deficit widened to a record $726 billion in 2005, the government reported yesterday, adding more fuel to the increasingly partisan debate between advocates of further globalization and those who contend that free trade is causing the loss of too many American manufacturing jobs.

Hitting its fourth consecutive annual record, the gap between exports and imports reached almost twice the level of 2001. It was driven by strong consumer demand for foreign goods and soaring energy prices that added tens of billions of dollars to the nation's bill for imported oil. The nation last had a trade surplus, of $12.4 billion, in 1975.

The continued growth in the trade deficit, particularly with China, is likely to renew a fight in Congress as early as this spring over President Bush's trade policies. Lawmakers have seized on the growing imbalance with China to call on the White House to take a harder line with Beijing over its currency practices.

But as long as the American economy is growing faster than most of its trading partners and energy prices stay at elevated levels, economists expect little improvement, and perhaps even a slight widening, in the trade imbalance this year.

"You would need a dramatic slowdown in domestic U.S. demand to bring down the U.S. trade deficit, and we think that is unlikely," said Dean Maki, chief United States economist at Barclays Capital in New York.

That means the nation will go deeper into debt with the rest of the world as Americans continue to rely on the strong flow of foreign money, particularly from central banks in Asia, to finance the trade gap. China, Japan and other foreign governments are some of the biggest holders of government securities, lending money to cover the substantial federal budget deficit and helping to keep interest rates and home mortgage costs here relatively low.

As a result, American consumers are able to spend more and save less.

Many economists say this situation is unsustainable over the long run, arguing that the United States could eventually face a harsh correction that would depress spending, increase the cost of borrowing and sharply lower the value of the dollar.

"There are certainly going to be inflows, the question is at what price?" said James O'Sullivan, an economist at UBS, an investment house. "As time goes on, it will become a little more difficult to attract foreign funds. That's another way of saying the dollar will fall."

But other economists argue that the huge trade gap mostly reflects stronger American growth and that money is flowing into the country at relatively low rates because of the attractiveness of the United States as a place to invest. They see little reason to fear a dollar crisis.

"As long as foreigners are willing to put their capital in the United States, we can sustain a trade deficit of 6 percent or more" of overall economic activity, said Phillip L. Swagel, a resident scholar at the American Enterprise Institute in Washington who served as a staff economist for President Bush's Council of Economic Advisers.

"It would be better that we saved more on our own," Mr. Swagel added, "but given that we aren't, I would rather have investment go on by foreign capital."

For its part, the Bush administration urged caution on the deficit.

Commerce Secretary Carlos M. Gutierrez, touring an I.B.M. operation in North Carolina, told The Associated Press, "We can't overreact and make tactical choices that will hurt our economy."

As a share of the gross domestic product, the trade gap increased to 5.8 percent, from 5.3 percent in 2004 and 4.5 percent in 2003.

While most economists dismiss the importance of bilateral trade imbalances, it is the deficit with China that has set off the most political fireworks. That nation had the largest gap with the United States of any country, at $201.6 billion for the year, up 24.5 percent from 2004. In December, the deficit with China narrowed nearly 12 percent, to $16.3 billion.

Following increased pressure from the White House, the Chinese government allowed the yuan to rise by about 2 percent in July and allowed its currency to float in a narrow band. Since then the yuan, also known as the renminbi, has risen by an additional 0.7 percent. One dollar buys about 8.0505 yuan.

A stronger Chinese currency would make imports to the United States more expensive and American exports to that country cheaper. Most analysts agree the yuan would rise significantly if it were set free, but many experts also worry that many financial institutions in China are not strong enough to survive the shocks that might accompany a fully convertible currency.

In the Senate, Charles E. Schumer, Democrat of New York, and Lindsey Graham, Republican of South Carolina, have proposed imposing a 27.5 percent tariff on Chinese imports if the country does not allow its currency to appreciate further against the dollar. Late last year, the senators agreed to hold off on the measure after the Senate voted against stopping a floor vote on it.

Mr. Schumer said "there is a very strong likelihood that we will move our bill in March should the Chinese not show further movements."

"If you believe in free trade, you play by the rules," he said when asked if a protectionist tariff would hurt the American economy. "The long-term damage of the Chinese pegging their currency far exceeds any immediate benefits and almost every economist would agree with that. They might not agree with our methodology."

Experts note that a large portion of the deficit with China reflects its growing role as a hub for the assembly of goods as Asian manufacturers have shifted production there to save money. The overall deficit with Asia has changed little in recent years.

Bush administration officials have said they, too, would like to see the yuan appreciate further, but have contended that sanctions like a tariff would be counterproductive and would hurt consumers. This month, the Treasury Department urged the International Monetary Fund to improve its policing of currency manipulations by governments, without directly referring to China.

Treasury Secretary John W. Snow is expected to bring up the issue of exchange rates at a meeting of the Group of 8 finance ministers in Moscow this weekend.

But even some longstanding advocates of free trade are growing increasingly frustrated with China's intransigence on the currency front, warning that it may be inviting protectionist legislation by repeatedly deflecting Washington's requests.

"The administration," said C. Fred Bergsten of the Institute for International Economics in Washington, "has to let the Chinese know that it may not be able to stop it even though it doesn't want it."

While China draws most of the attention, perhaps the most important factor behind the swelling deficit last year was the rising cost of importing oil and other energy supplies. Trade in petroleum products accounted for 29 percent of the total deficit, up from 25 percent in 2004. Imports of petroleum goods climbed 39 percent, to $251.6 billion, after rising by 39 percent in 2004.

Over all, the deficit jumped nearly 18 percent in 2005 compared with the previous year. Excluding oil and other petroleum products, the trade gap grew by 10 percent.

After China, the United States' second-biggest deficit was with Japan, at $82.7 billion, up 9.4 percent, followed by Canada, a big supplier of oil and natural gas, at $76.5 billion, up 15.1 percent.

The deficit with members of the Organization of the Petroleum Exporting Countries increased by 29 percent, to $92.7 billion. For December, the trade deficit grew by 1.5 percent over the previous month, to $65.7 billion, as imports of computers, cars and airplanes rose and exports of planes, which had risen sharply in November, dropped. It was the third-largest monthly trade gap on record.

And with oil prices rising again, said Ashraf Laidi, chief currency analyst for the MG Financial Group in New York, "we can expect to see worse numbers to come."