Question

China is a large open economy with a large trade surplus. The latter has faced since 2018 a trade war launched by US President Donald Trump in order to rebalance trade with China. This trade war has had some success. China recorded a drop in its trade surplus towards the end of 2019.

What effect does the decline in China's trade surplus have on the world interest rate? What is the effect on the Canadian current account (we will assume that the Canadian current account is in deficit), consumption, investment and savings?

I await a rigorous and concise economic reasoning.

Answer 1

1. Trade surplus means export is greater than import in values. South Korea, Japan, Taiwan, USA, Australia, Malaysia, Brazil and Switzerland are major trading partner of China. China is related to many other countries through trade. Therefore, change in trade surplus of China has an impact of the trading countries. China’s trade surplus has been growing since China has became a member of World Trade Organization in 2001. In order to reduce Chinese trade surplus with US, USA government imposed high import tariff on Chinese goods. As a result, both Chinese import from and export to US both declined in 2018. A drop-in export demand reduced trade surplus. Drop in Chinese trade surplus has direct impact on national savings. Drop in employment and aggregate demand both fell in China. Chinese demand for import from rest of the world had a fall creating economic pressures on those countries in terms of GDP growth, weaker export demand, risk of economic slowdown.

A trade surplus causes net inflow of capital in the economy in the form of inflow of domestic currency from foreign market. Drop in surplus results in net outflow of currency. That is why Chinese currency value dropped in the international market. Devaluation of domestic currency leads to decrease in interest rate in domestic market. Interest rate in the international market is greater than the Chinese market.

2. Canada faces current account deficit (import is greater than export in values). Canada is also a large trading partner of China after US. It is expected that demand drop from China for Canadian goods definitely has impact on Canadian economy. Trade balance of Canada with China is likely to fall. IT means trade deficit with China is even worse than previous. Then Canadian consumption, investment and saving all are likely to drop. Drop in aggregate demand reduces investment demand. Therefore, economic output is likely to fall. Canada thus has shifted their export from China to US economy to improve trade deficit.