China’s Currency: Economic Issues and Options for U.S. Trade Policy

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Prepared for Members and Committees of Congress

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The continued rise in China’s trade surplus with the United States and the world, and complaints

from U.S. manufacturing firms and workers over the competitive challenges posed by Chinese

imports have led several Members to call for a more aggressive U.S. stance against certain

Chinese trade policies they deem to be unfair. Among these is the value of the China’s currency

(the renminbi or yuan) relative to the dollar. From 1994 to July 2005, China pegged its currency

to the U.S. dollar. On July 21, 2005, China announced it would let its currency immediately

appreciate by 2.1% and link its currency to a basket of currencies (rather than just to the dollar).

Although the yuan has appreciated 16% since 2005, many Members complain that China

continues to “manipulate” its currency in order to gain an unfair trade advantage, resulting in U.S.

job loss. Numerous bills have been introduced to induce China to adopt a more flexible currency

policy.

If the yuan is undervalued against the dollar (as many analysts believe), there are likely to be both

benefits and costs to the U.S. economy. It would mean that imported Chinese goods are cheaper

than they would be if the yuan were market determined. This lowers prices for U.S. consumers

and dampens inflationary pressures. It also lowers prices for U.S. firms that use imported inputs

(such as parts) in their production, making such firms more competitive. When the U.S. runs a

trade deficit with the Chinese, this requires a capital inflow from China to the United States, such

as Chinese purchases of U.S. Treasury securities. This, in turn, lowers U.S. interest rates and

increases U.S. investment spending. On the negative side, lower priced goods from China may

hurt U.S. industries that compete with those products, reducing their production and employment.

In addition, an undervalued yuan makes U.S. exports to China more expensive, thus reducing the

level of U.S. exports to China and job opportunities for U.S. workers in those sectors. However,

in the long run, trade can affect only the composition of employment, not its overall level. Thus,

inducing China to appreciate its currency would likely benefit some U.S. economic sectors, but

would harm others. U.S. data indicate that in 2008, imports from China have slowed significantly

and that import prices have risen sharply. Some economists are now concerned that the overall

fall in the dollar, which a stronger yuan would exacerbate, could become economically

destabilizing.

Critics of China’s currency policy contend that the large and growing U.S. trade deficit with

China ($256 billion in 2007) is evidence that the yuan is undervalued and harmful to the U.S.

economy. However, the relationship is more complex. First, an increasing level of Chinese

exports are from foreign-invested companies in China. Second, the deficit masks the fact that

China has become one of the fastest growing (and is now the third largest) market for U.S.

exports. Finally, the trade deficit with China accounted for 29% of the sum of total U.S. bilateral

trade deficits in 2007, indicating that the overall U.S. trade deficit is not caused by the exchange

rate policy of one country, but rather the shortfall between U.S. saving and investment. That being

said, there are a number of reasons why a more flexible currency policy could benefit both

countries. For a brief summary of this report, see CRS Report RS21625, China’s Currency: A

Summary of the Economic Issues, by (name redacted) and (name redacted).

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Introduction ..................................................................................................................................... 1

U.S. Concerns Over China’s Currency Policy and Recent Action .................................................. 2

Most Recent Events................................................................................................................... 3

Treasury Department Reports on Exchange Rates.................................................................... 4

China’s Concerns Over Changing Its Currency Policy ................................................................... 5

The Economics of Fixed Exchange Rates ....................................................................................... 6

A Critique of Various Estimates of the Yuan’s Undervaluation .............................................. 12

Estimates Based on Fundamental Equilibrium Exchange Rates....................................... 13

Estimates Based on Purchasing Power Parity................................................................... 17

Treasury Department Assessment of Economic Models................................................... 19

Trends and Factors in the U.S.-China Trade Deficit ..................................................................... 19

Economic Consequences of China’s Currency Policy .................................................................. 23

Implications for China’s Economy.......................................................................................... 23

Implications for the U.S. Economy......................................................................................... 24

Effect on Exporters and Import-Competitors.................................................................... 24

Effect on U.S. Borrowers.................................................................................................. 25

Effect on U.S. Consumers................................................................................................. 26

U.S.-China Trade and Manufacturing Jobs....................................................................... 26

Net Effect on the U.S. Economy....................................................................................... 27

The U.S.-China Trade Deficit in the Context of the Overall U.S. Trade Deficit .............. 28

The Value of the Yuan in the Context of the Falling Dollar.............................................. 29

Policy Options for Dealing with China’s Currency Policy............................................................ 30

Tighten Requirements on Treasury Department’s Report on Currency............................ 31

Intensify Diplomatic Efforts ............................................................................................. 31

Raise Tariffs or Other Trade Sanctions ............................................................................. 32

Utilize the Dispute Resolution Mechanism in the WTO................................................... 33

Apply U.S. Countervailing Trade Laws to Non-Market Economies ................................ 34

Apply Estimates of Currency Undervaluation to U.S. Antidumping Measures................ 34

Utilize Special Safeguard Measures ................................................................................. 34

Other Bilateral Commercial Considerations ........................................................................... 35

China’s Holdings of U.S. Federal Debt Instruments......................................................... 35

Changes to the Current Currency Policy and Potential Outcomes.......................................... 36

Conclusion..................................................................................................................................... 38

Legislation in the 110th Congress .................................................................................................. 39

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Figure 1. China’s Foreign Exchange Reserves: 1998-March 2008 ................................................. 9

Figure 2. China-U.S. Exchange Rates: 2004-April 2008 .............................................................. 10

Figure 3. Nominal and Real Yuan-Dollar Exchange Rate, 1994-2007...........................................11

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Table 1. China’s Foreign Exchange Reserves and Overall Current Account Surplus: 19952007.............................................................................................................................................. 8

Table 2. Foreign Exchange Reserves and Current Account Balance in Selected Asian

Countries, 2007 .......................................................................................................................... 17

Table 3. China’s Merchandise Trade Balance: 2003-2007 ............................................................ 20

Table 4. U.S. Merchandise Exports to Major Trading Partners in 2001 and 2007 ........................ 20

Table 5. Exports and Imports by Foreign-Invested Enterprises in China: 1986-2007 .................. 22

Table 6. Major Foreign Suppliers of U.S. Computer Equipment Imports: 2000-2007 ................. 23

Table 7. Comparisons of Savings, Investment, and Consumption as a Percentage of GDP

Between the United States and China, 2006 .............................................................................. 29

Table 8. Comparison of Major Currency Legislation in the 110th Congress ................................. 41

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Appendix. Legislation in the 109th Congress................................................................................. 44

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Author Contact Information .......................................................................................................... 44

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From 1994 until July 21, 2005, China maintained a policy of pegging its currency to the U.S.

dollar at an exchange rate of roughly 8.28 yuan to the dollar.1 The Chinese central bank

maintained this peg by buying (or selling) as many dollar-denominated assets in exchange for

newly printed yuan as needed to eliminate excess demand (supply) for the yuan. As a result, the

exchange rate between the yuan and the dollar basically stayed the same, despite changing

economic factors which could have otherwise caused the yuan to either appreciate or depreciate

relative to the dollar. Under a floating exchange rate system, the relative demand for the two

countries’ goods and assets would determine the exchange rate of the yuan to the dollar. Many

economists contend that for the first several years of the peg, the fixed value was likely close to

the market value. But in the last few years of the peg, economic conditions changed such that the

yuan would likely have appreciated if it had been floating.

The Chinese government modified its currency policy on July 21, 2005. It announced that the

yuan’s exchange rate would become “adjustable, based on market supply and demand with

reference to exchange rate movements of currencies in a basket,” (it was later announced that the

composition of the basket includes the dollar, the yen, the euro, and a few other currencies), and

that the exchange rate of the U.S. dollar against the yuan would be immediately adjusted from

8.28 to 8.11, an appreciation of about 2.1%. Unlike a true floating exchange rate, the yuan would

(according to the Chinese government) be allowed to fluctuate by 0.3% (later increased to 0.5%)

on a daily basis against the basket, it remained not fully convertible in international markets, and

China continued tight restrictions and controls over capital transactions.2 The current situation

might be best described as a “managed float”—market forces are determining the general

direction of the yuan’s movement, but the government is retarding its rate of appreciation through

market intervention.

Since July 2005, China has allowed the yuan to appreciate steadily, but slowly. It has continued to

accumulate foreign reserves at a rapid pace, which suggests that if the yuan were allowed to

freely float, it would appreciate more rapidly. China’s foreign exchange reserves grew from $403

billion at the end of 2003 to $1.7 trillion at the end of March 2008, and China’s large trade

surplus totaled $262 billion in 2007. Since the 2005 reforms, there has been a significant shift in

the economic environment in China and the United States. The yuan has risen 16% against the

dollar—far more than the Japanese yen during the same period, for example. The overall value of

the dollar has fallen significantly, to the point where some economists and policymakers fear that

a further fall could be destabilizing to the U.S. economy. (By definition, any rise in the yuan is

equivalent to a fall in the dollar.) Partly as a result of the falling dollar, total U.S. exports are the

fastest growing sector of the economy, and the growth rate of imports from China appears to have

slowed recently.

Nevertheless, the increase in the value of the yuan to date has done little to ease concerns raised

in the United States. But China, with concerns about its own economy, has been reluctant to make

1

The official name of China’s currency is the renminbi (RMB), which is denominated in yuan units. Both RMB and

yuan are used to describe China’s currency.

2

The currency is convertible on a current account basis (such as for trade transactions), but not on a capital account

basis (for various types of financial flows, such as portfolio investment). In addition, holdings of foreign exchange by

Chinese firms and individuals are regulated by the government.

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significant changes to their currency. This paper reviews the various economic issues raised by

China’s present currency policy.3 Major topics surveyed include

•

The economic concerns raised by the United States over China’s currency policy

and China’s concerns over changing that policy.

•

How China’s fixed exchange rate regime works and the various economic studies

that have attempted to determine China’s real, or market, exchange rate.

•

Trends and factors in the U.S.-China trade imbalance. (What is causing it? Is

China’s currency policy to blame?)

•

Economic consequences of China’s currency policy for both China and the

United States.

•

China’s massive accumulation of foreign exchange reserves and purchases of

U.S. federal debt instruments.

•

Policy options on how the United States might induce China to reform its present

currency policy, including current legislation introduced in Congress.

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Many U.S. policymakers, business people, and labor representatives have charged that China’s

currency is significantly undervalued vis-à-vis the U.S. dollar by as much as 40%, making

Chinese exports to the United States cheaper, and U.S. exports to China more expensive, than

they would be if exchange rates were determined by market forces. They further argue that the

undervalued currency has contributed to the burgeoning U.S. trade deficit with China, which has

risen from $30 billion in 1994 to $256 billion in 2007, and has hurt U.S. production and

employment in several U.S. manufacturing sectors (such as textiles and apparel and furniture)

that are forced to compete domestically and internationally against “artificially” low-cost goods

from China. Furthermore, many analysts contend that China’s currency policy induces other East

Asian countries to intervene in currency markets in order to keep their currencies weak against

the dollar to remain competitive with Chinese goods.4 Several groups are pressing the Bush

Administration to pressure China either to revalue its currency or to allow it to float freely in

international markets.5 These issues are addressed in more detail later in the report.

President Bush and Administration officials have criticized China’s currency policy on a number

of occasions, stating that exchange rates should be determined by market forces. Initially, the

Bush Administration rejected calls from several Members of Congress to apply direct pressure on

3

A brief summary of this report can be found in CRS Report RS21625, China’s Currency: A Summary of the

Economic Issues, by (name redacted) and (name redacted).

4

See Prepared Remarks of Dr. C. Fred Bergsten, President, Institute for International Economics, before the House

Small Business Committee, June 25, 2003.

5

Besides the currency issue, several U.S. interest groups have complained about other Chinese economic policies

deemed unfair, including Chinese government subsidies, selling goods below cost (dumping), poor environmental

practices, abusive labor practices, and piracy of U.S. intellectual property rights. These issues are discussed in CRS

Report RL33536, China-U.S. Trade Issues, by (name redacted).

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China to force it to abandon its currency peg. Instead, the Administration sought to encourage

China to reform its financial system—under the auspices of a joint technical cooperation program

agreed to on October 14, 2003, for example—and take other measures that would pave the way

toward adopting a more flexible currency policy.

The Administration’s position on China’s currency peg appears to have toughened beginning

around April 2005 when then-U.S. Treasury Secretary John Snow asserted at a G-7 meeting (on

April 16, 2005) that “China is ready now to adopt a more flexible exchange rate.” This was likely

driven in part by growing complaints from Members over China’s currency policy and the

introduction of numerous currency bills. For example, during the 109th congressional session, the

Senate on April 6, 2005, failed (by a vote of 33 to 67) to reject an amendment (S.Amdt. 309)

attached by Senator Schumer to S. 600 (a foreign relations authorization bill), which would have

imposed a 27.5% tariff on Chinese goods if China failed to substantially appreciate its currency to

market levels.6 In response to the outcome of the vote, the Senate Republican leadership

negotiated an agreement with the supporters of the bill to allow a vote on S. 295 (which was

sponsored by Senator Schumer and which has same language as S.Amdt. 309) at a later date as

long as the sponsors of the amendment agreed not to offer similar amendments to other bills for

the duration of the 109th Congress. Supporters of S. 295 threatened to bring the bill up a vote on

the bill on two separate occasions in 2006, but were convinced not to by Administration and

Chinese officials. Numerous other currency bills were introduced as well.

˜œȱŽŒŽ—ȱŸŽ—œȱ

Over the past year, some of the most significant events concerning China’s currency policy have

included the following:

•

On May 13, 2008, the U.S. Bureau of Labor Statistics reported that, from April

2007 to April 2008, import prices from China increased 4.1%—the largest 12month increase recorded since the index was first published in December 2003.7

•

On May 9, 2008, the U.S. Census Bureau reported that U.S. imports from China

over the first three months of 2008 had risen by only 1.8% over the same period

in 2007.

•

On May 8, 2008, the Bank of China reported that the exchange rate with the

dollar was 7.00 yuan, an appreciation of 15.9% since the July 2005 were

introduced.

•

On April 14, 2008, the Bank of China reported that China’s foreign exchange

reserves reached $1.68 trillion at the end of March 2008.

•

On September 29, 2007, the Chinese government officially launched the China

Investment Corporation (CIC), stating that the new entity was created to better

manage its foreign exchange reserves. With an initial capitalization of $200

billion, CIC is one of the world’s largest state-owned funds. On December 15,

2007, the CIC announced it would invest $5 billion in Morgan Stanley.

6

Supporters of this legislation cited estimates of the yuan’s undervaluation ranging from 15% to 40%; they derived the

27.5% tariff figure in their bill from the average of the low-high estimates.

7

BLS Press Release, available at http://www.bls.gov/news.release/ximpim.nr0.htm.

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•

On August 13, 2007, China’s Xinhua News Agency reported that China had no

plans to sell off its dollar assets. The statement appeared to be in response to an

article that appeared in the Daily Telegraph (August 10, 2007) in which high

level Chinese government officials reportedly claimed that China would sell off

its dollar assets if the United States imposed sanctions against China over its

currency policy. In addition, the government announced the elimination of

regulations requiring domestic firms to convert part of their current-account

foreign exchange holdings into yuan.8

•

In June 2007, the International Monetary Fund clarified its definition of currency

manipulation as “engaging in policies that are targeted at—and actually affect—

the level of the exchange rate...in order to increase net exports.” To discourage

currency manipulation, the IMF announced it “must be prepared to deliver clear

and sometimes difficult policy messages to members....”9

•

On May 17, 2007, 42 House Members filed a Section 301 petition with the U.S.

Trade Representative’s office over China’s currency practices and requested that

a trade dispute case be brought to the World Trade Organization (WTO). On June

13, 2007, the USTR’s office announced that it had declined the petition.

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The 1988 Omnibus Trade and Competitiveness Act requires the Treasury Department to annually

report on the exchange rate policies of foreign countries that have large global current account

surpluses and large trade surpluses with the United States and to determine if they “manipulate”

their currencies against the dollar in order to prevent “effective balance of payment adjustments”

or to gain an “unfair competitive advantage in international trade.” If currency manipulation is

found, Treasury is required to negotiate an end to such practices. Over the past several years,

Treasury has issued a Report on International Economic and Exchange Rate Policies on a semiannual basis, focused mainly on major U.S. trading partners. China was cited under this report for

manipulating its currency five times from May 1992 to July 1994, largely because of its use of a

dual exchange rate system (which it unified in early 1994) and restrictions that were imposed on

access to foreign exchange by domestic firms. Neither China nor any other country has been

designated as a currency manipulator since 1994.10 However, over the past few years, the

Treasury Department reports have increased their focus on China and have stepped up criticism

of China’s currency policy and the pace of its reforms. Since China reformed its currency in July

2005, Treasury has made the following observations:

•

The November 28, 2005 report praised China’s July 2005 currency reforms, but

stated that it had failed to fully implement its commitment to make its new

exchange rate mechanism more flexible and to increase the role of market forces

to determine the yuan’s value. The report further stated that China’s new

8

According to the Xinhua News Agency, China has gradually eased restrictions on companies retaining foreign

exchanges. In 2002, firms were allowed to retain 20% of their foreign exchange revenues. This proportion was raised to

50% in 2004 and to 80% in 2005.

9

International Monetary Fund, “IMF Surveillance—The 2007 Decision on Bilateral Surveillance,” June 2007.

10

General Accountability Office, Treasury Assessments Have Not Found Currency Manipulation, but Concerns about

Exchange Rates Continue, Report GAO-05-351, April 2005 http://www.gao.gov/new.items/d05351.pdf. South Korea

and Taiwan have also been designated for currency manipulation in the Treasury reports.

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managed float exchange rate regime, which Chinese officials described as “based

on market supply and demand with reference to a basket of currencies,” did not

appear to play a significant role in determining the daily closing level of the

yuan, and that trading behavior since the reforms strongly suggested that “the

new mechanism remains, in practice, a tightly managed currency peg against the

dollar.”11 However, Treasury stated that it decided not to cite China as a currency

manipulator under U.S. trade law because of assurances it had received from

Chinese officials that China was committed to “enhanced, market-determined

currency flexibility” and that it would put greater emphasis on promoting

domestic sources of growth, including financial reform.12

•

The Treasury Department’s June 2007 report stated that although China’s central

bank continued to heavily intervene in currency markets and that China’s

currency was significantly undervalued, it did not meet the technical

requirements under U.S. law regarding currency manipulation. However, the

report stated that “Treasury forcefully raises the Chinese exchange rate regime

with Chinese officials at every available opportunity and will continue to do

so.”13

•

The Treasury Department’s December 2007 report stated that China should

significantly accelerate the appreciation of the RMB’s effective exchange rate in

order to minimize the risks that are being created for China itself as well as the

world economy.

Many Members have been critical of Treasury’s decision (since 1994) not to cite China as a

currency manipulator, despite its large scale currency interventions to control the exchange rate

with the dollar, its large global current account surpluses, and large and growing trade surpluses

with the United States. Many Members have called for enactment of legislation to revise the

criteria Treasury uses to make its currency manipulation determination or to require it to estimate

the level of the yuan’s misalignment against the dollar (see the “Legislation in the 110th

Congress” section below).

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Chinese officials argue that its currency policy is not meant to promote exports or discourage

imports. They claim that China adopted its currency peg to the dollar, a policy that is practiced by

a variety of developing countries, in order to foster economic stability and investor confidence.

Chinese officials have expressed concern that abandoning the current currency policy could spark

an economic crisis in China and would especially be damaging to its export industries at a time

when painful economic reforms (such as closing down inefficient state-owned enterprises and

11

U.S. Treasury Department, Report to Congress on International Economic and Exchange Rate Policies, November

2005.

12

The 1988 Omnibus Trade and Competitiveness Act requires the Treasury Department to determine whether countries

manipulate the rate of exchange between their currency and the United States dollar for purposes of preventing

effective balance of payments adjustment or gaining an unfair competitive advantage in international trade.

13

Treasury Department, Report to Congress on International Economic and Exchange Rate Policies, June 2007, p. 2.

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laying off millions of workers) are being implemented.14 In addition, Chinese officials also appear

to be worried about the rising level of unrest in the rural areas, where incomes have failed to keep

up with those in urban areas and public anger has spread over government land seizures and

corruption. Chinese officials contend that appreciating the currency could reduce domestic food

prices (because of increased imports) and agricultural exports (by raising prices in overseas

markets), thus lowering the income of farmers and further raising tensions. They further contend

that the Chinese banking system is too underdeveloped and burdened with heavy debt to be able

to deal effectively with possible speculative pressures that could occur with a fully convertible

currency, which typically accompanies a floating exchange rate.15

The combination of a convertible currency and poorly regulated financial system is seen to be one

of the causes of the 1997-1998 Asian financial crisis.16 Prior to the crisis, Chinese officials were

reportedly considering moving towards reforming their currency policy, but the severe negative

economic impact among several East Asian countries that had a floating currency appears to have

convinced officials that China’s currency peg was one of the main reasons why China’s economy

was relatively immune from crisis, and that gradually implementing reforms to make the currency

more flexible was the best way to maintain stable economic growth.

U.S. officials counter that they are not asking China to immediately adopt a floating currency

system, but to move more quickly to reform the financial sector and to make the currency more

flexible (including allowing faster appreciation of the yuan, widening the band, and decreasing

the level of intervention in international currency markets).

‘ŽȱŒ˜—˜–’Œœȱ˜ȱ’¡Žȱ¡Œ‘Š—ŽȱŠŽœȱ

Fixed exchange rates have a long history of use, including the Bretton Woods system linking the

major currencies of the world from the 1940s to the 1960s and the international gold standard

before then. To understand how China’s currency policy works, it is easiest to start with an

explanation of how a fixed exchange rate works, which China operated until July 2005. Under the

fixed exchange rate, the Chinese central bank bought or sold as much currency as was needed to

keep the yuan-dollar exchange rate constant at level (formerly about 8.28 yuan per dollar).17 The

primary alternative to this arrangement would be a floating exchange rate, as the United States

maintains with economies like the Euro area, in which supply and demand in the marketplace

14

China has reportedly eliminated over 60 million jobs in the state sector since 1997; layoffs over the past few years

have averaged two million annually. See, Morgan Stanley, Global Economic Forum, The Coming Rebalancing of the

Chinese Economy, March 27, 2006.

15

Many analysts counter that China’s currency policy may actually be undermining the financial stability of the

banking system because, in order to purchase foreign currency to maintain a target exchange rate, the government must

boost the money supply. While some of this money may be “sterilized” by government-issued bonds, some of it may

enter the economy. Analysts contend that this has made the banks more prone to extend loans to risky ventures and thus

may increase the level of bank-held non-performing loans.

16

Chinese officials contend that during the Asian crisis, when several other nations sharply devalued their currencies,

China “held the line” by not devaluing its currency (which might have prompted a new round of destructive

devaluations across Asia). This policy was highly praised by U.S. officials, including President Clinton.

17

Prior 1994, China maintained a dual exchange rate system: an official exchange rate of about 5.8 yuan to the dollar

and a market swap rate (used mainly for trade transactions) of about 8.7 yuan to the dollar (at the end of 1993). The

reforms in 1994 unified the two rates. Since Hong Kong also fixes its exchange rate to the dollar, China in effect also

maintains a fixed exchange rate with Hong Kong.

˜—›Žœœ’˜—Š•ȱŽœŽŠ›Œ‘ȱŽ›Ÿ’ŒŽȱ

Ŝȱ

‘’—ŠȂœȱž››Ž—Œ¢DZȱŒ˜—˜–’Œȱ œœžŽœȱŠ—ȱ™’˜—œȱ˜›ȱǯǯȱ›ŠŽȱ˜•’Œ¢ȱ

ȱ

causes the euro-dollar exchange rate to continually fluctuate. Under a floating exchange rate

system, the relative demand for the two countries’ goods and assets determines the exchange rate

of the euro to the dollar. If the demand for Euro area goods or assets increased, more euro would

be demanded to purchase those goods and assets, and the euro would rise in value (if the central

bank kept the supply of euro constant) to restore equilibrium.

When a fixed exchange rate is equal in value to the rate that would prevail in the market if it were

floating, the central bank does not need to take any action to maintain the peg. However, over

time economic circumstances change, and with them change the relative demand for a country’s

currency. If the Chinese had maintained a floating exchange rate, appreciation would likely have

occurred in the past few years for a number of reasons. For instance, productivity and quality

improvements in China may have increased the relative demand for Chinese goods and foreign

direct investment in China. For the exchange rate peg to be maintained when economic

circumstances have changed requires the central bank to supply or remove as much currency as is

needed to bring supply back in line with market demand, which it does by increasing or

decreasing foreign exchange reserves. This is shown in the following accounting identity, used to

record a country’s international balance of payments:

Current Account Balance

=

Capital Account Balance

[(Exports-Imports) + Net Investment

Income+ Net Unilateral Transfers]

=

[(Private Capital Outflow-Inflow) + Change

in Foreign Exchange Reserves]

Net investment income and net unilateral transfers between the United States and China are

relatively small, so the current account balance is close to the trade balance (exports less imports).

Thus, anytime net exports (exports less imports) or net private capital inflows (private capital

inflows less outflows) increase, foreign exchange reserves must increase by an equivalent amount

to maintain the exchange rate peg.

For the past several years, there has been excess demand for yuan (equivalently, excess supply of

dollars) at the prevailing exchange rate peg. The central bank maintained the peg through 2005 by

increasing its foreign reserves by buying dollars from the public in exchange for newly printed

yuan. Rather than hold U.S. dollars, which earn no interest, the Chinese central bank mostly holds

U.S. financial securities—primarily U.S. Treasury securities, but also U.S. Agency securities

(e.g., the obligations of Fannie Mae and Freddie Mac).18 A peg can be maintained as long as the

central bank is willing to accumulate more foreign exchange reserves.19

18

In March 2007, the Chinese finance minister announced that it would shift a small portion of the foreign reserves into

higher yielding assets. Presumably, these reserves would remain invested in foreign assets; otherwise, the portfolio shift

would alter the currency’s value. See Jim Yardley and David Barboza, “China to Open Fund to Invest Currency

Reserves,” New York Times, March 9, 2007.

19

If the demand for yuan relative to dollars were to decline, the central bank would face the opposite situation. It would

need to buy yuan from the public in exchange for U.S. dollars to maintain the peg. This strategy could only be

continued until the central bank’s dollar reserves were exhausted, at which point the peg would have to be abandoned.

˜—›Žœœ’˜—Š•ȱŽœŽŠ›Œ‘ȱŽ›Ÿ’ŒŽȱ

ŝȱ

‘’—ŠȂœȱž››Ž—Œ¢DZȱŒ˜—˜–’Œȱ œœžŽœȱŠ—ȱ™’˜—œȱ˜›ȱǯǯȱ›ŠŽȱ˜•’Œ¢ȱ

ȱ

Table 1. China’s Foreign Exchange Reserves and Overall Current Account Surplus:

1995-2007

Year

Cumulative Foreign Exchange Reserves

Billions of $

% of GDP

% of Imports

Current Account Balance

% of GDP

Billions of $

1995

75.4

10.8

57.1

0.2

1.3

1996

107.0

13.1

77.1

0.8

5.6

1997

142.8

15.9

100.4

3.6

32.5

1998

149.2

15.8

106.4

3.1

31.2

1999

157.7

15.9

95.1

1.4

21.1

2000

168.3

15.6

74.8

1.7

20.5

2001

215.6

18.1

88.5

1.3

17.5

2002

291.1

22.1

98.6

2.4

35.4

2003

403.3

28.1

97.7

2.8

31.4

2004

609.9

31.5

108.6

3.5

58.7

2005

818.9

35.5

124.1

7.1

116.1

2006

1,068.5

38.6

134.7

9.0

249.9

2007

1,528.2

47.1

159.9

9.1

294.8

Source: Economist Intelligence Unit, International Monetary Fund, and People’s Bank of China.

Note:

Insight.

Year end values. The 2007 data for GDP, imports, and current account balance are estimates from Global

Since July 2005, China has continued to accumulate foreign reserves at a rapid pace (see Figure

1), and in 2006, China overtook Japan to become the world’s largest holder of foreign exchange

reserves. As seen in Table 1, foreign reserves grew from $75 billion in 1995 to $168 billion in

2000 to $1.53 trillion in 2007.20 From 2006 to 2007, China’s foreign exchange holdings rose by

$463 billion, or 43%. But, unlike a fixed exchange rate regime, it has no longer purchased enough

foreign reserves to entirely prevent the yuan from appreciating against the dollar. After an initial

revaluation of 2% in July 2005, the yuan has appreciated steadily. By the end of April 2008, it had

appreciated by about 16% to 7 yuan per dollar (see Figure 2). The current situation might be best

described as a “managed float”—market forces are determining the general direction of the

yuan’s movement, but the government is retarding its rate of appreciation through market

intervention (and thus, to some extent, is still pegging the yuan to the dollar).21 Some of China’s

20

Year-end values. Reserves totaled $1.7 trillion as of March 2008.

Officially, China fixed its exchange rate to a currency basket in July 2005, which is similar to fixing the yuan to one

currency except the yuan is now theoretically fixed against the (weighted) average value of the currencies in its

“basket”: primarily the dollar, euro, yen, and Korean won. The exact weights of the currencies in the basket has not

been announced. Obstfeld has noted that it unclear how the yuan could be fixed to a basket when the yuan has been

much more stable against the dollar than the euro or yen. Theoretically, this means that the yuan would no longer be

fixed to the dollar, since every time the other exchange rates in the basket appreciate or depreciate against the dollar, so

will the yuan, but to a lesser extent. Thus, fixing the yuan to a basket of currencies does not rule out the possibility that

the yuan could appreciate against the dollar (anytime the other currencies in the basket appreciate against the dollar).

There is no standard definition of whether an exchange rate is fixed or floating. For example, the IMF defines an

exchange rate as fixed if it fluctuates within a 2% range over a three month period. Maurice Obstfeld, “The Renminbi’s

Dollar Peg at the Crossroads,” Monetary and Economic Studies, December 2007.

21

˜—›Žœœ’˜—Š•ȱŽœŽŠ›Œ‘ȱŽ›Ÿ’ŒŽȱ

Şȱ

‘’—ŠȂœȱž››Ž—Œ¢DZȱŒ˜—˜–’Œȱ œœžŽœȱŠ—ȱ™’˜—œȱ˜›ȱǯǯȱ›ŠŽȱ˜•’Œ¢ȱ

ȱ

neighbors also maintain managed floats (such as Malaysia) or have intervened in currency

markets from time to time to keep its currency low against the dollar (such as Japan from 19982004).22 The continued rapid accumulation of foreign reserves suggests that if the yuan were

allowed to freely float, it would appreciate more rapidly.

Figure 1. China’s Foreign Exchange Reserves: 1998-March 2008

Source:

22

People’s Bank of China and Chinese State Administration of Foreign Exchange.

See CRS Report RL33178, Japan’s Currency Intervention: Policy Issues, by (name redacted).

˜—›Žœœ’˜—Š•ȱŽœŽŠ›Œ‘ȱŽ›Ÿ’ŒŽȱ

şȱ

‘’—ŠȂœȱž››Ž—Œ¢DZȱŒ˜—˜–’Œȱ œœžŽœȱŠ—ȱ™’˜—œȱ˜›ȱǯǯȱ›ŠŽȱ˜•’Œ¢ȱ

ȱ

. China-U.S. Exchange Rates: 2004-April 2008

Figure 2

Source: Global Insight and Bank of China.

Note: Chart inverted for illustrative purposes.

Preventing the yuan from appreciating against the dollar is not the only reason the Chinese

government could be accumulating foreign exchange reserves. Foreign exchange reserves are

necessary to finance international trade (in the presence of capital controls) and to fend off

speculation against one’s currency. A country would be expected to increase its foreign reserves

for these purposes as its economy and trade grew. However, Table 1 illustrates that the increase in

foreign exchange reserves in China has significantly outpaced the growth of GDP or imports in

the last few years. When China accumulates foreign reserves that are non-U.S. assets, it does not

influence the yuan’s value against the dollar. Little public information is available on the nature of

China’s foreign reserves, so it is not known what share of China’s reserves are held in U.S. assets.

It is also not known what share of the annual increase in reserves is due to new accumulations, as

opposed to valuation changes, exchange rate effects, or the reinvestment of earnings.

Economic activity, including the level of imports and exports, is not determined by the nominal

exchange rate, but by the real (inflation-adjusted) exchange rate. Because the United States and

China had roughly similar increases in the overall price levels from 1994 to 2003 (39% in China

vs. 31% in the United States), the difference between the real and nominal rate was small.

However, China had much higher inflation than the United States from 1994 to 1997, so the real

and nominal exchange rates diverged considerably during that time. The real exchange rate

appreciated from China’s perspective, making their exports more expensive and U.S. imports

cheaper. From then until 2003, the real and nominal exchange rates converged because China’s

inflation rate was lower than U.S. inflation. This can be seen in Figure 3. In 2003, the Chinese

exchange rate reached its lowest level since 1994 in real terms, from the Chinese perspective,

making their exports progressively less expensive since 1997. Since then, the value of the yuan

˜—›Žœœ’˜—Š•ȱŽœŽŠ›Œ‘ȱŽ›Ÿ’ŒŽȱ

ŗŖȱ

‘’—ŠȂœȱž››Ž—Œ¢DZȱŒ˜—˜–’Œȱ œœžŽœȱŠ—ȱ™’˜—œȱ˜›ȱǯǯȱ›ŠŽȱ˜•’Œ¢ȱ

ȱ

has risen. Appreciation in the nominal exchange rate has brought the yuan almost back to its 1998

level in real terms.23

. Nominal and Real Yuan-Dollar Exchange Rate, 1994-2007

Figure 3

CRS calculations based on IMF data.

Note: Real exchange adjusted for inflation using the consumer price index. Charted is inverted for illustrative

purposes.

Source:

In the long run, real (inflation-adjusted) exchange rates return to their market value whether they

are (nominally) fixed or floating. Imagine that the demand for Chinese goods and services were to

increase. If the yuan were floating, it would appreciate, as more yuan were acquired to purchase

Chinese goods. It would continue to appreciate until the excess demand for Chinese goods was

exhausted (since they are now more expensive in terms of foreign currency), at which point the

trade balance would return to its equilibrium level. With a fixed exchange rate, the real exchange

rate returns to its market value through price adjustment instead, which takes time. If the

exchange rate were fixed below the level that would prevail in the market, Chinese exports would

be relatively inexpensive and U.S. imports would be relatively expensive. As long as this

situation prevailed, the trade surplus with the United States would persist. The trade surplus (plus

net remittances) is equal to the capital flowing from China to the United States. Part of this capital

consists of the purchase of U.S. assets by private Chinese citizens. The other portion consists of

the accumulation of dollar reserves by the Chinese central bank. By increasing its dollar reserves,

the central bank is also increasing the supply of yuan. This causes the inflation rate in China to

rise, all else equal.24 Over time, as prices rise, exports will become more costly abroad and

23

Some commentators have suggested that the extent of yuan undervaluation can be estimated from inflation

differentials. In other words, although the nominal exchange rate has been constant, adjusting for inflation can

determine how much the real rate has depreciated, and proves that the yuan is undervalued. The problem with this

approach is that the estimate will be highly sensitive to the selection of the base year. For example, if the base year was

1996, the yuan would have been undervalued by 14% in 2002, but if the base year was 1994, the yuan would have been

overvalued by 5% in 2002. The current account balance was close to zero (one definition of equilibrium) in both years.

24

The Chinese can try to offset the upward pressure on prices by selling Chinese government securities to take the

additional yuan out of circulation (called “sterilized intervention”). But this will push interest rates back up, attracting

more foreign capital to China, causing the central bank’s dollar reserves and the supply of yuan to expand again. It is

difficult to tell whether the Chinese have sterilized their foreign reserve accumulation in recent years. All else equal, if

China sterilized its intervention, the growth rate of the money supply and the inflation rate would not rise. The growth

(continued...)

˜—›Žœœ’˜—Š•ȱŽœŽŠ›Œ‘ȱŽ›Ÿ’ŒŽȱ

ŗŗȱ

ȱ

‘’—ŠȂœȱž››Ž—Œ¢DZȱŒ˜—˜–’Œȱ œœžŽœȱŠ—ȱ™’˜—œȱ˜›ȱǯǯȱ›ŠŽȱ˜•’Œ¢ȱ

imports less costly. At that point, the trade surplus will return to its equilibrium value. Although

the nominal exchange rate never changed, because of the rise in prices, the real exchange rate

would now equal the market rate that would prevail if the exchange rate had been floating. Thus,

undervaluing a fixed exchange rate does not confer any permanent competitive advantage for a

country’s exporters and import-competing industries. However, because price adjustment takes

time, floating exchange rates return to the equilibrium value much more quickly than fixed

exchange rates.

Thus, when a country uses its monetary policy to influence the value of it currency, it can no

longer use its monetary and fiscal policy to counteract changes in the business cycle (the U.S.

loses no policy flexibility from China’s peg). For example, a peg would prevent a country from

lowering its interest rates to offset an economic downturn. If it did, capital would flow out of the

country to assets with higher interest rates in the rest of the world, and the country would find its

currency peg under pressure (since investors would sell the country’s currency and buy foreign

currency to transfer their capital abroad) until it raised its interest rates.

This loss of monetary autonomy is relatively unimportant for small countries that fix their

exchange rate to large neighbors that share the same business cycle, since the large neighbor

would also likely be affected by the downturn and lower its interest rates. But the loss in

autonomy is costly when a country is tied to a partner to whom it is not closely linked and does

not experience similar business cycles, as is arguably the case between the United States and

China.

However, China loses less monetary autonomy than most countries with a fixed exchange rate

through its use of capital controls (legal barriers restricting access to foreign currency). The

currency is convertible on a current account basis (such as for trade transactions), but not on a

capital account basis (for various types of financial flows, such as portfolio investment). In

addition, nearly all Chinese enterprises are required to turn over their foreign currency holdings to

China’s state bank in exchange for yuan, and purchases of foreign exchange by individuals and

firms in China are closely regulated. Because capital cannot easily leave China when interest

rates are lowered, China retains some flexibility over its monetary and fiscal policy despite the

fixed exchange rate.

ȱ›’’šžŽȱ˜ȱŠ›’˜žœȱœ’–ŠŽœȱ˜ȱ‘ŽȱžŠ—Ȃœȱ—Ž›ŸŠ•žŠ’˜—ȱ

Although it is certain that the yuan would appreciate if the central bank were not increasing its

foreign reserves, since the value of the yuan has changed little since 1994, there is no direct way

to determine how much it would appreciate—even if there was a consensus about what China’s

current account balance should be, there are no observations until June 2005 to estimate how

sensitive its imports and exports would be to changes in the exchange rate. Estimates of the extent

of the yuan’s undervaluation have been cited in many articles and interviews. This report attempts

to evaluate only those estimates in which the author explains how the estimate was derived. It

(...continued)

rate of one measure of the Chinese money supply, M2, accelerated in both 2001 and 2002. The growth rate of another

measure, M1, decelerated in 2001 but accelerated in 2002. Inflation was very low through 2003, but rose to 3.9% in

2004. However, inflation and money growth could have been affected by factors other than reserve accumulation in

recent years. It has been argued that sterilization is an “unfair” practice to use with a peg, since it is meant to prevent

the price adjustment that brings trade between the two countries back into equilibrium.

˜—›Žœœ’˜—Š•ȱŽœŽŠ›Œ‘ȱŽ›Ÿ’ŒŽȱ

ŗŘȱ

ȱ

‘’—ŠȂœȱž››Ž—Œ¢DZȱŒ˜—˜–’Œȱ œœžŽœȱŠ—ȱ™’˜—œȱ˜›ȱǯǯȱ›ŠŽȱ˜•’Œ¢ȱ

should be noted that many of the estimates were made some time ago, when the value of the yuan

and China’s trade surplus were lower, so the yuan may be more or less undervalued at this point.

The estimates are grouped below into two broad methodological categories: the “fundamental

equilibrium exchange rate” method and the “purchasing power parity” method.

œ’–ŠŽœȱŠœŽȱ˜—ȱž—Š–Ž—Š•ȱšž’•’‹›’ž–ȱ¡Œ‘Š—ŽȱŠŽœȱ

One method for estimating misalignments in exchange rates is referred to as the fundamental

equilibrium exchange rate (FEER) method. It is based on the belief that current account balances

at the present are temporarily out of line with their “fundamental” value, either because of

unsustainable forces in the economy or government intervention. Once an estimate has been made

of what the fundamental current account balance should be, one can calculate how much the

exchange rate must change in value to achieve that current account adjustment. As will be

discussed below, this is not an uncontroversial method. Many economists would reject the notion

that current account balances worldwide are misaligned, or that economists can predictably

determine how much they must be adjusted to come back into alignment. Thus, the following

estimates are only valid if one accepts the assumptions underlying them.

Ernest Preeg, senior fellow at the Manufacturers’ Alliance, estimated that the yuan was

undervalued by 40% in 2003.25 While this claim is not based on any formal analysis, he uses

several rule-of-thumb estimates to reach this conclusion. His first observation is that the increase

in Chinese foreign exchange reserves equaled 100% of the Chinese trade surplus less net foreign

direct investment (FDI) flows in the first six months of 2002. He concludes that the entire trade

surplus less net foreign direct investment would be zero in the absence of the increase in foreign

exchange reserves. His second observation is a rule-of-thumb estimate that a 1% decline in the

dollar leads to a $10 billion decline in the trade deficit in the United States He then observes that

the dollar would need to decline by 40% according to that rule of thumb to eliminate the trade

deficit since the U.S. trade deficit equaled about $400 billion in 2002. Since the Chinese trade

surplus plus net FDI flows equaled 100% of the increase in foreign exchange reserves, he

concludes that if the central bank no longer increased its foreign exchange reserves by letting the

yuan float, the surplus less FDI would be zero and the yuan would appreciate by 40%, based on

the U.S. ratio.26

The Institute for International Economics (IIE) estimates that the yuan was 15%-25%

undervalued in 2003. It argues that the “underlying” current account surplus was 2.5%-3% of

25

Ernest H. Preeg, “Exchange Rate Manipulation to Gain an Unfair Competitive Advantage: The Case against Japan

and China,” in C. Fred Bergsten and (name redacted), eds., Dollar Overvaluation and the World Economy

(Washington, DC: Institute for International Economics, 2003).

26

In addition to the general criticisms of all studies below, there some specific criticisms of the Preeg estimate. First,

Preeg’s conversion of the rule of thumb from dollar terms to percentage of the total trade deficit is without justification.

His conversion implies that if the U.S. trade deficit were $1, a 40% decline in the dollar would lower the deficit by $1.

By that logic, if the trade deficit were $1 trillion, a 40% decline in the dollar would lower the deficit by $1 trillion.

Clearly, a 40% decline in the dollar cannot have such different effects on the trade deficit simply because the dollar

value of the trade deficit has changed. Second, Preeg applies his estimate based on U.S. data to the Chinese trade

surplus without any supporting evidence. Since the United States and China have different economies, trading patterns,

trade balances, and exchange rate regimes, there is no reason to think the estimate would be the same for both

countries. He also uses overall and bilateral trade balances interchangeably. There is no reason to think that a 40%

decline in the dollar would have the same effect on a $400 billion U.S. overall trade deficit (from which he does not

subtract FDI) as a 40% decline in the yuan would have on a $60 billion bilateral Chinese trade surplus less FDI.

˜—›Žœœ’˜—Š•ȱŽœŽŠ›Œ‘ȱŽ›Ÿ’ŒŽȱ

ŗřȱ

‘’—ŠȂœȱž››Ž—Œ¢DZȱŒ˜—˜–’Œȱ œœžŽœȱŠ—ȱ™’˜—œȱ˜›ȱǯǯȱ›ŠŽȱ˜•’Œ¢ȱ

ȱ

GDP in 2003, larger than the actual surplus (1.5%) (it does not explain why).27 It then argues that

the surplus should be reduced by $50 billion (or 4% of GDP) to return to equilibrium, which

would leave China with a deficit of 1%-1.5% of GDP in equilibrium. It believes that the

revaluation required to achieve this reduction in the current account surplus is unusually large

because of the extensive use of imports in the production of Chinese exports. IIE Fellow Morris

Goldstein testified that

These estimates of [yuan] misalignment can be obtained either by solving a trade model for

the appreciation of the RMB that would produce equilibrium in China’s overall balance of

payments, or by gauging the appreciation of the RMB that make a fair contribution to the

reduction in global payment imbalances, especially the reduction of the U.S. current-account

deficit to a more sustainable level.28

Goldman Sachs Economic Research Group has estimated that the yuan was 9.5%-15%

undervalued in 2003.29 They argue that the current account less FDI should be zero in equilibrium

(which means that China would have a current account deficit equal to FDI), which could be

accomplished with a 9.5%-15% revaluation. This is based on their elasticity (i.e., the degree to

which demand changes due to price changes) estimates that exports would fall 0.2% and imports

would rise 0.5% when the exchange rate rose 1%.

Virginie Coudert and Cecile Couharde use the most sophisticated analysis to estimate their

parameters. They argue that China has an underlying current account deficit of between 1.5% and

2.8% of GDP. The smaller number comes from a cross-country regression of the current account

balance based on variables such as per-capita income, demographics, and the budget deficit; the

larger number is an estimate of the largest current account deficit that would stabilize China’s

debt-to-GDP ratio. They estimate that the yuan was 44%-54% undervalued against the dollar in

2003.30

All of these estimates are based on a similar logic, so a few general observations can be made

about all of them. First, none of the estimates are the product of theoretically grounded,

econometrically estimated economic models. Rather, they are “back of the envelope” estimates

based on a few simple “rule of thumb” assumptions. “Rules of thumb” such as the Preeg 10%-$1

billion estimate or the Goldman Sachs import and export elasticities may not be accurate over

time or over large changes in the exchange rate.

The main source of contention in all of the estimates of the yuan’s undervaluation is the definition

of an “equilibrium” current account balance. All of the estimates are based on the appreciation

that would be required for China to attain “equilibrium” in the current account balance. But there

is no consensus based on theory or evidence to determine what equilibrium would be; rather, the

authors base equilibrium on their own personal opinion, with some using arbitrary assumptions

and others more sophisticated ones.31 Yet this assumption is crucial—Dunaway et al. demonstrate

27

According to the data cited elsewhere in this report, the actual surplus in 2002 was 2.9% of GDP and 2.2% in 2003.

Morris Goldstein, testimony before the Subcommittee on Domestic and International Monetary Policy, Committee

on Financial Services, U.S. House of Representatives, October 1, 2003.

29

Jim O’Neill and Dominic Wilson, How China Can Help the World, Goldman Sachs Global Economics Paper 97,

September 17, 2003.

30

Virginie Coudert and Cecile Couharde, “Real Equilibrium Exchange Rate in China,” Centre d’Etudes Prospectives et

d’Informations Internationales, working paper 2005-01, January 2005.

31

A thorough attempt to estimate exchange rates using this method can be found in (name redacted), ed., Estimating

(continued...)

28

˜—›Žœœ’˜—Š•ȱŽœŽŠ›Œ‘ȱŽ›Ÿ’ŒŽȱ

ŗŚȱ

ȱ

‘’—ŠȂœȱž››Ž—Œ¢DZȱŒ˜—˜–’Œȱ œœžŽœȱŠ—ȱ™’˜—œȱ˜›ȱǯǯȱ›ŠŽȱ˜•’Œ¢ȱ

that changing the assumed equilibrium current account balance by 2 percentage points of GDP

changes the estimated undervaluation by as much as 25 percentage points.32 Some economists

argue that the current account balance would always be close to zero in equilibrium, but this

neglects the fact that countries with different saving and investment rates may willingly lend to

and borrow from one another for long periods of time.

In fact, the Preeg, IIE, and Goldman Sachs estimates use an assumption of equilibrium less

favorable to China than the current account balance. These studies actually call for balance only

in official and portfolio borrowing. They still allow for foreign direct investment (FDI) inflows,

which means their estimate of China’s overall “equilibrium” current account position is actually a

deficit. If they had chosen balance (the traditional “equilibrium” measure with a fixed exchange

rate) instead of a deficit as their equilibrium benchmark, their estimates of the yuan’s

undervaluation would have been smaller. Even if portfolio flows are essentially limited by capital

controls at present, it is not clear why requiring the Chinese to borrow from the rest of the world

is any less unsustainable than the current arrangement where China is lending to the rest of the

world. With capital controls and net FDI inflows, increasing foreign reserves is the only way that

China can keep its net foreign indebtedness from increasing. And all measures rule out any

accumulation of foreign official reserves for reasons other than to influence the exchange rate.

It is particularly difficult to determine the equilibrium current account balance in China because

of the presence of capital controls. If China were to maintain capital controls after currency

reform (if, for example, they revalued the peg rather than let the yuan float), current account

balance may be a reasonable assumption. But if capital controls were eliminated, as is typically

the case with a floating exchange rate, the economic situation would change entirely—

“equilibrium” could now involve persistent borrowing from or lending to the rest of the world by

private Chinese citizens, which would result in a corresponding persistent trade deficit or surplus,

respectively. If private citizens lent as much to the United States in equilibrium as the Chinese

central bank is currently lending (and U.S. lending to China remained unchanged), then the

equilibrium market exchange rate would be equal to the current fixed rate, and the trade deficit

would remain unchanged. If private capital outflows exceeded the current increase in foreign

reserves, the yuan would depreciate. Since China is a country with both a high national saving

rate and a high investment rate, it is not clear whether China would be a net borrower (in which

case it would run a current account deficit) or lender (current account surplus) if their currency

floated and capital controls were abolished. This issue is particularly relevant when the

equilibrium exchange rate is defined as “market determined,” since capital controls currently

prevent portfolio investment flows from being market determined. Bosworth argues that China’s

high internal saving rate is more than sufficient to finance its investment, so it makes sense for

China to offset FDI inflows with official outflows in the form of foreign reserve accumulation

rather than run a current account deficit. Therefore, he argues, foreign reserve accumulation

should not be considered proof of undervaluation.33 Wang argues that, based on estimates derived

from other developing economies, China’s equilibrium current account surplus may be even

larger than the actual surplus, so the yuan is overvalued.34

(...continued)

Equilibrium Exchange Rates (Washington, DC: Institute for International Economics, 1994).

32

Steven Dunaway et al., “How Robust are Estimates of Equilibrium Real Exchange Rates: The Case of China,” IMF

working paper 06/220, October 2006.

33

Barry Bosworth, “Valuing the Renminbi,” paper presented at Tokyo Club Research Meeting, February 9-10, 2004.

34

Tao Wang, “Exchange Rate Dynamics,” in Eswar Prasad, ed., “China’s Growth and Integration into the World

(continued...)

˜—›Žœœ’˜—Š•ȱŽœŽŠ›Œ‘ȱŽ›Ÿ’ŒŽȱ

ŗśȱ

ȱ

‘’—ŠȂœȱž››Ž—Œ¢DZȱŒ˜—˜–’Œȱ œœžŽœȱŠ—ȱ™’˜—œȱ˜›ȱǯǯȱ›ŠŽȱ˜•’Œ¢ȱ

The FEER approach is also based on a belief that the overall U.S. trade deficit is unsustainable,

and revaluing the yuan would reduce it. This goes beyond an argument that China has fixed the

yuan at an artificially low level, and argues that the dollar, which is market determined against

most of its trading partners, is incorrectly valued. For example, the Coudert and Couharde

estimate that the yuan is 54% undervalued is based on a corresponding estimate that the dollar

was 35% overvalued, the yen 37% undervalued, and the euro 27% undervalued in 2003. If trade

and financial markets are rational over the medium run, then the value of the dollar and the size

of the trade deficit are never unsustainable—if they were, investors would be unwilling to hold

U.S. assets and would sell the dollar, and the trade deficit would decline. There is no widely

accepted theoretical approach to determining trade deficit sustainability, and prima facie evidence

does not suggest the U.S. trade deficit is unsustainable over the next few years—it has lasted

several years, it did not prevent the U.S. economy from achieving record growth and low

unemployment in the late 1990s, U.S. investment income paid to foreigners is not large, and there

have not been any unusually large or sudden declines in the dollar since the trade deficit

emerged.35

Further, if the Chinese central bank stopped buying U.S. assets, and hence reduced its bilateral

trade deficit with the United States, it is unlikely that the overall U.S. trade deficit would fall by a

corresponding amount. Other foreigners would still be free to lend to the United States, which

could cause its other bilateral trade deficits to widen. Thus, it is not clear that a “fair share” of a

reduction in the U.S. trade deficit can be apportioned to China. And even if China’s overall trade

surplus were eliminated, it might still run a bilateral trade surplus with the United States. Even

countries with overall trade deficits, including the United States, have some trading partners with

whom they run surpluses and some with whom they run deficits.

Does international experience suggest what the Chinese current account balance would be in

equilibrium? The closest comparison is probably to other East Asian countries, which also grew

rapidly and maintained high saving rates in recent decades. The experience of these countries is

mixed. From 1980 to 1997, South Korea, Malaysia, Philippines, Indonesia, and Thailand typically

ran current account deficits, while Hong Kong, Singapore, Taiwan, and Japan (which had already

industrialized) typically ran current account surpluses. Since the Asian financial crisis in 1997, all

of these countries have run large current account surpluses. This may suggest that the current

economic environment is not conducive to developing world borrowing.

As seen in Table 2, the same combination of large foreign exchange reserves and a large current

account surplus can be seen in several other countries in the region, even though these countries

range in their exchange rate regimes from a float (Japan and South Korea) to a currency board

(Hong Kong). Although large compared to other regions, China’s current account balance does

not seem out of line with its neighbors.36

(...continued)

Economy,” International Monetary Fund, Occasional Paper 232, 2004, Ch. 4.

35

Sensible rules of thumb for long-term sustainability, such as estimating the current account deficit that would keep

U.S. assets a constant share of foreign investment portfolios, need not hold in the short run. For instance, after a change

in fundamentals, current account deficits may persist for several years as the United States transitions to a new steady

state.

36

On the other hand, some analysts note that China’s current account surplus (both totals and as a percent of GDP) has

risen sharply over the past few years.

˜—›Žœœ’˜—Š•ȱŽœŽŠ›Œ‘ȱŽ›Ÿ’ŒŽȱ

ŗŜȱ

‘’—ŠȂœȱž››Ž—Œ¢DZȱŒ˜—˜–’Œȱ œœžŽœȱŠ—ȱ™’˜—œȱ˜›ȱǯǯȱ›ŠŽȱ˜•’Œ¢ȱ

ȱ

. Foreign Exchange Reserves and Current Account Balance in Selected Asian

Countries, 2007

Table 2

Foreign Exchange Reserves

Billions of $

% of GDP

Japan

Current Account Surplus

Billions of $

% of GDP

953

21.8

210

4.8

China

1,528

47.1

381

11.8

Taiwan

270

70.5

32

8.4

South Korea

Hong Kong

Malaysia

Singapore

262

153

101

163

27.0

73.9

54.0

101.2

6

27

30

46

0.6

13.0

16.0

28.6

Source:

Economist Intelligence Unit estimates.

œ’–ŠŽœȱŠœŽȱ˜—ȱž›Œ‘Šœ’—ȱ˜ Ž›ȱŠ›’¢ȱ

There are other estimates of the yuan’s undervaluation based on the theory of purchasing power

parity (PPP)—the theory that the same good should have the same price in two different

countries. If it did not, then arbitrageurs could buy it in the cheaper country and sell it in the more

expensive country until the price disparity disappeared.

One of the simplest estimates based on PPP is the Economist magazine’s Big Mac Index, which

estimated that China’s currency was undervalued by 56% in February 2007.37 The Economist

portrays the Big Mac Index as a “light hearted guide” to exchange rates, and there are important

drawbacks to relying too heavily on it. The Big Mac Index compares the price of a McDonald’s

Big Mac in China and the United States. Since a Big Mac in China was 56% cheaper than in the

United States, the index concludes that the yuan is undervalued by that much. But purchasing

power parity only applies to tradeable goods, and a Big Mac is not tradeable. In fact, Li Ong

estimates that 94% of the value of a Big Mac comes not from the hamburger itself, but the

services associated with the hamburger.38 These include the wages of employees serving the Big

Mac and the rent of the restaurant in which it is eaten, both of which are determined by local

factors. Since the hamburger itself is the only tradeable portion of the Big Mac, only a small

fraction of the Big Mac’s value should be determined by purchasing power parity. As a result, a

Big Mac in New York City is more expensive than a Big Mac purchased in the U.S. rural south.

Taken literally, the Big Mac Index would imply that a dollar in the rural south is undervalued

compared to a dollar in New York City.

While PPP is a simple idea that is powerful in theory, it has been proven to be unreliable in

reality: prices are consistently lower in developing countries than industrialized countries. Some

economists have tried to estimate what the yuan’s value would be by attempting to control for

predictable divergences from PPP. Still, these estimates should be considered with caution—even

when sophisticated modifications have been made, PPP has been shown to help predict exchange

37

“The Big Mac Index,” Economist, February 1, 2007.

Li Ong, “Burgernomics: The Economics of the Big Mac Standard,” Journal of International Money and Finance,

vol. 16, no. 6 (December 1997), p. 865.

38

˜—›Žœœ’˜—Š•ȱŽœŽŠ›Œ‘ȱŽ›Ÿ’ŒŽȱ

ŗŝȱ

ȱ

‘’—ŠȂœȱž››Ž—Œ¢DZȱŒ˜—˜–’Œȱ œœžŽœȱŠ—ȱ™’˜—œȱ˜›ȱǯǯȱ›ŠŽȱ˜•’Œ¢ȱ

rates only over the long run. Estimates based on PPP would identify any country’s currency as

overvalued or undervalued, except the country to which it is being compared. Another drawback

to the PPP approach is that the estimate will not tend to change much over time (if prices are

relatively stable), even if the trade deficit is significantly changing.39

Economist Jeffrey Frankel argues that income level can be regressed on the exchange rate using a

cross-sample of countries to find a predictable relationship between a country’s income level and

its equilibrium exchange rate based on PPP. By this measure, he estimates that China’s exchange

rate was undervalued by 36% in 2000.40 He speculates that, if anything, the undervaluation has

increased since then. Coudert and Couharde make a similar calculation for 2003 and estimate the

yuan to be undervalued by 41%-51%, depending on what countries are included in their sample.41

Frankel acknowledges a number of caveats to this analysis. First, PPP only holds over the long

run, at best, and financial flows can cause even market-determined exchange rates to significantly

diverge from PPP for several years. Second, the regression does not control for other factors and

only explains 57% of the variation in the data. Third, he argues that any adjustment in the

exchange rate should be gradual so as not to be economically disruptive. He also warns that “It is

not even true that an appreciation of the renminbi against the dollar would have an immediately

noticeable effect on the overall U.S. trade deficit or employment....”42

There should be some theoretical rationale for linking income levels to exchange rate values;

otherwise, the results may represent nothing more than spurious correlation. One rationale is

called the “Balassa-Samuelson” effect: as countries get richer, their exchange rates are predicted

to appreciate because productivity growth will be more rapid for tradeable goods than nontradeable goods. Since these differences in productivity growth cannot easily be measured

directly, income levels can be used as a proxy. But if the proxy is not an accurate one, then neither

will be the results. Another proxy is the ratio of the consumer price index to the producer price

index. When Coudert and Couharde used this proxy over time with a smaller sample, they

estimated that the yuan was 18% undervalued in 2003. Benassy-Quere et al. regressed this proxy

and net foreign assets on a panel of the G20 countries and found the yuan to be undervalued by

47% in 2003.43 Wang also uses this proxy (for China only), as well as net foreign assets and

openness to trade, in a regression, and finds evidence that the yuan was only modestly

undervalued in 2003.44 However, the authors cautioned that the price index proxy could be

inaccurate for China since many consumer prices are not market determined. In addition, they

observed that restrictions on the mobility of labor and capital in China may interfere with the

Balassa-Samuelson effect.45

39

William Cline and (name redacted), “Estimates of the Equilibrium Exchange Rate of the Renminbi,” paper

presented at the Conference on China’s Exchange Rate Policy, Peterson Institute, October 12, 2007.

40

Bosworth points out that, by this measure, the Indian rupee is even more undervalued, yet few people make that

argument. Bosworth, op. cit.

41

Coudert and Couharde, op. cit.

42

Jeffrey Frankel, “On the Renminbi: The Choice Between Adjustment Under a Fixed Exchange Rate and Adjustment

Under a Flexible Exchange Rate,” National Bureau of Economic Research, working paper 11274, April 2005, p. 3.

43

A. Benassy-Quere et al., “Burden Sharing and Exchange-Rate Misalignments with the Group of 20,” Centre d’Etudes

Prospectives et d’Informations Internationales, working paper 2004-13, September 2004. They find the dollar to be

overvalued by 14% overall in 2001.

44

Wang, op. cit.

45

For a survey of valuation estimates and an overview of methodological considerations, see Steven Dunaway and

Xiangming Li, “Estimating China’s “Equilibrium” Real Exchange Rate,” International Monetary Fund, working paper

05/202, October 2005.

˜—›Žœœ’˜—Š•ȱŽœŽŠ›Œ‘ȱŽ›Ÿ’ŒŽȱ

ŗŞȱ

ȱ

‘’—ŠȂœȱž››Ž—Œ¢DZȱŒ˜—˜–’Œȱ œœžŽœȱŠ—ȱ™’˜—œȱ˜›ȱǯǯȱ›ŠŽȱ˜•’Œ¢ȱ

Cheung et al. are able to replicate others’ results that the yuan is significantly undervalued, but

point out that these estimates do not meet generally accepted standards of statistical inference.

Specifically, the undervaluation estimates are not statistically significant, which means that the

results are not robust enough to be sure that the yuan is undervalued at all. Moreover, when they

adjust their specification to take into account serial correlation (the fact that this year’s exchange

rate is influenced by last year’s), the estimated undervaluation becomes much smaller.46 Dunaway

et al. demonstrate that when additional explanatory variables are added to the PPP model, such as

openness to trade, the estimated undervaluation becomes much smaller. They also show that the

estimate changes greatly when seemingly insignificant changes are made to the model, such as

changing the time period or omitting one country from the sample.47

›ŽŠœž›¢ȱŽ™Š›–Ž—ȱœœŽœœ–Ž—ȱ˜ȱŒ˜—˜–’Œȱ˜Ž•œȱ

The Treasury Department’s December 2006 report on exchange rates discusses the use of

economic models and methodology to estimate a currency’s “misalignment” or what the fair

market rate exchange rate should be. The report noted that there is no single model that accurately

explains exchange rate movements, that such models rarely, if ever, incorporate financial market

flows, and that their conclusions can vary considerably, based on the variables used. However,

Treasury stated that examining such models can produce useful information in understanding

exchange rate movements if they: focus only on serious misalignments; use real effective, not

bilateral, exchange rates; utilize several different models, recognizing that no one model will

provide precise answers; focus only on protracted misalignments where currency adjustments are

not taking place; supplement judgments about misalignment with analysis of empirical data,

indicators, policies and institutional factors; and verify whether there are any market-based

reasons for a currency’s misalignment. Treasury points out that most models (including the two

classes analyzed above) estimate equilibrium exchange rates in terms of trade flows, while in

reality trade flows are swamped by financial flows.48

›Ž—œȱŠ—ȱŠŒ˜›œȱ’—ȱ‘ŽȱǯǯȬ‘’—Šȱ›ŠŽȱŽ’Œ’ȱ

Critics of China’s currency peg often point to the large and growing U.S.-China trade imbalance

as proof that the yuan is significantly undervalued and constitutes an attempt to gain an unfair

competitive advantage over the United States in trade. However, bilateral trade balances reflect

structural causes as well as exchange rate effects. There are a number of other factors at work that

are also important to consider when analyzing the bilateral trade deficit.

First, although China (according to U.S. statistics) had a $256 billion merchandise trade surplus

with the United States in 2007, its overall trade surplus was $262 billion (Chinese data),

indicating that China had a small ($6 billion) trade surplus in its trade with the world excluding

the United States (see Table 3).49 If the yuan is undervalued against the dollar, it should also be

46

Yin-Wong Cheung, Menzie Chinn, and Eiji Fujii, “The Overvaluation of Renminbi Undervaluation,” National

Bureau of Economic Research, working paper 12850, January 2007.

47

Steven Dunaway et al., “How Robust are Estimates of Equilibrium Real Exchange Rates: The Case of China,” IMF

working paper 06/220, October 2006.

48

U.S. Treasury Department, Report on International Economic and Exchange Rate Policies, December 2006,

Appendix II.

49

U.S. and Chinese data on their bilateral trade differ substantially, due mainly to how each side counts Chinese

(continued...)

˜—›Žœœ’˜—Š•ȱŽœŽŠ›Œ‘ȱŽ›Ÿ’ŒŽȱ

ŗşȱ

‘’—ŠȂœȱž››Ž—Œ¢DZȱŒ˜—˜–’Œȱ œœžŽœȱŠ—ȱ™’˜—œȱ˜›ȱǯǯȱ›ŠŽȱ˜•’Œ¢ȱ

ȱ

undervalued against other currencies, yet China runs trade deficits with several countries. For

example, according to Chinese data, it had a $77.5 billion trade deficit with Taiwan, a $47.9

billion deficit with South Korea, and a $38.1 billion deficit with Japan.

Table 3. China’s Merchandise Trade Balance: 2003-2007

(+surplus/-deficit) ($billions)

China’s merchandise trade balance

(Chinese data)

China’s merchandise trade balance with the

United States (U.S. data)

China merchandise trade balance with the rest of

the world (U.S. & Chinese data)

2003

2004

2005

2006

2007

25.6

32.0

101.9

177.6

261.9

124.0

162.0

201.6

232.2

256.3

-98.4

-130.0

-99.7

-54.6

5.6

Global Trade Atlas, USITC Dataweb, and World Trade Atlas.

Note: Trade balance with the rest of the world equals Chinese data on global trade balance minus U.S. data on

imports from China.

Sources:

Second, the sharp rise in the U.S. trade deficit with China diverts attention from the fact that,

while U.S. imports from China have been rising rapidly, U.S. exports to China have been

increasing sharply as well. Table 4 lists U.S. exports to its top 10 major export markets in 2007.

These data indicate that U.S. exports to China from 2001-2007 rose significantly faster than those

to any other major U.S. trading partner. In 2007, total U.S. exports rose 18.1% over the previous

year (they increased by 32.0% in 2006). In 2007, China overtook Japan to become the third

largest U.S. export market.

Table 4. U.S. Merchandise Exports to Major Trading Partners in 2001 and 2007

($ in billions and % change)

Canada

Mexico

China

Japan

United Kingdom

Germany

2001

2007

Percent Change

from 2006-2007

Percent Change

from 2001-2007

163.7

101.5

19.2

57.6

40.8

30.1

248.4

136.5

65.2

62.7

50.3

49.7

7.9

1.8

51.7

34.5

18.1

239.6

5.1

10.8

20.2

8.9

23.3

65.1

(...continued)

exports and imports that are transshipped through Hong Kong. China counts most of its exports that go to Hong Kong

but are later re-exported to the United States as Chinese exports to Hong Kong. As a result, Chinese statistics state that

it had a $162.9 billion trade surplus with the United States in 2007. The United States counts imports from Hong Kong

that originated from China as imports from China, but it often fails to attribute exports to China that pass through Hong

Kong as exports to China. As a result, the United States and China cannot agree on the actual size of the U.S.-China

trade imbalance. See Robert Feenstra et al., “The U.S.-China Bilateral Trade Balance: Its Size and Determinants,”

NBER Working Paper 6598 (June 1998).

˜—›Žœœ’˜—Š•ȱŽœŽŠ›Œ‘ȱŽ›Ÿ’ŒŽȱ

ŘŖȱ

‘’—ŠȂœȱž››Ž—Œ¢DZȱŒ˜—˜–’Œȱ œœžŽœȱŠ—ȱ™’˜—œȱ˜›ȱǯǯȱ›ŠŽȱ˜•’Œ¢ȱ

ȱ

Percent Change

from 2006-2007

Percent Change

from 2001-2007

2001

2007

South Korea

22.2

34.7

6.9

56.3

Netherlands

19.5

33.0

6.1

69.2

France

19.9

27.4

13.2

37.7

Taiwan

18.2

26.4

14.5

45.1

World

731.0

1,162.7

12.1

59.7

Source:

Note: Ranked by top 10 U.S. export markets in 2007.

USITC DataWeb.

Finally, there is strong evidence to suggest that a significant share of the growing level of imports

(and hence U.S. trade deficit) from China is coming from export-oriented multinational

companies, especially from East Asia, that have moved their production facilities to China to take

advantage of China’s abundant low-cost labor (among other factors). Chinese data indicate that

the share of China’s exports produced by foreign-invested enterprises (FIEs) in China has risen

dramatically over the past several years. As indicated in Table 5, in 1986, only 1.9% of China’s

exports were from FIEs, but by 1996, this share had risen to 40.7%, and by 2007 it had risen to

57.1% A similar pattern can be seen with imports: FIEs accounted for only 5.6% of China’s

imports in 1986, rose to 47.9% by 2000, and to 58.5% in 2007. FIEs import raw materials and

components (much of which come from East Asia) for assembly in China, after which point,

much of the final product is exported. As a result, China tends to run trade deficits with East

Asian countries and trade surpluses with countries with high consumer demand, such as the

United States. These factors have led many analysts to conclude that much of the increase in U.S.

imports (and hence, the rising U.S. trade deficit with China) is a result of China becoming a

production platform for many foreign companies (who are the largest beneficiaries from this

arrangement), rather than unfair Chinese trade policies.50 The rising importance of FIEs may

represent a fundamental change in trade between China and the United States that could affect the

bilateral trade deficit independently of the exchange rate regime.

50

One analyst has estimated that the domestic value-added content of Chinese exports to the United States by foreigninvested firms in China to be about 20%, while 80% comes from the value of imported parts that come into China for

assembly. As a result, an appreciation of China’s currency would likely have only a minor effect on China’s exports to

the United States (since the cost of imported inputs would fall as a result). See Testimony of Professor Lawrence J. Lau

before the Congressional-Executive Commission on China, Is China Playing by the Rules? Free Trade, Fair Trade,

and WTO Compliance, hearing, September 24, 2003.

˜—›Žœœ’˜—Š•ȱŽœŽŠ›Œ‘ȱŽ›Ÿ’ŒŽȱ

Řŗȱ

‘’—ŠȂœȱž››Ž—Œ¢DZȱŒ˜—˜–’Œȱ œœžŽœȱŠ—ȱ™’˜—œȱ˜›ȱǯǯȱ›ŠŽȱ˜•’Œ¢ȱ

ȱ

. Exports and Imports by Foreign-Invested Enterprises in China: 1986-2007

Table 5

FDI in

Year

China

$ billions

Exports by FIE

% of Total

$ billions

Chinese

Exports

Imports by FIEs

% of Total

$ billions

Chinese

Imports

U.S. Trade Deficit with

China ($ billions)

1986

1.9

$0.6

1.9%

$2.4

5.6%

-1.7

1990

3.5

7.8

12.6

12.3

23.1

-10.4

1995

37.5

46.9

31.5

62.9

47.7

-33.8

2000

40.7

119.4

47.9

117.2

52.1

-83.8

2001

46.9

133.2

50.0

125.8

51.6

-83.1

2002

52.7

169.9

52.2

160.3

54.3

-103.1

2003

53.5

240.3

54.8

231.9

56.0

-124.0

2004

60.6

338.2

57.0

305.6

58.0

-162.0

2005

60.3

444.2

58.3

387.5

57.7

-201.6

2006

63.0

563.8

58.2

472.6

59.7

-232.2

2007

75.0

695.5

57.1

559.4

58.5

-256.3

Source:

China’

s Customs Statistics and U.S. International Trade Commission Dataweb.

The sharp rise in the share of China’s trade by FIEs appears to be strongly linked to the rapid

growth in foreign direct investment (FDI) in China, which grew from $1.9 billion in 1986 to

$74.8 billion in 2007, much of which went to export-oriented manufacturing, a large share of

which was exported to the United States. Table 5 indicates that the U.S. trade deficit with China

began to increase rapidly beginning in the early 1990s; a significant rise in FDI and exports by

FIEs in China occurred at roughly the same time. By comparing exports and imports in Table 5,

one can see that FIEs have little effect on China’s overall trade balance, since the FIEs import

roughly 80% as much as they export.

Table 6 provides an illustration of how foreign multinational companies have shifted a significant

level of production from other (mainly) East Asian countries to China in one industry. In 2000,

Japan was the largest foreign supplier of U.S. computer equipment (with a 19.6% share of total

shipments), while China ranked 4th (with a 12.1% share). In just seven years, Japan’s ranking fell

to 4th, the value of its shipments dropped by over half, and its share of shipments declined to 7.0%

(2007). China was by far the largest foreign supplier of computer equipment in 2007 with a

51.5% share of total U.S. imports. While U.S. imports of computer equipment from China rose by

436% over the past seven years, the total value of U.S. imports from the world of these

commodities rose by only 26%. A large share of the increase in Chinese computer production has

reportedly come from foreign computer companies that have moved manufacturing facilities

China.

˜—›Žœœ’˜—Š•ȱŽœŽŠ›Œ‘ȱŽ›Ÿ’ŒŽȱ

ŘŘȱ

‘’—ŠȂœȱž››Ž—Œ¢DZȱŒ˜—˜–’Œȱ œœžŽœȱŠ—ȱ™’˜—œȱ˜›ȱǯǯȱ›ŠŽȱ˜•’Œ¢ȱ

ȱ

. Major Foreign Suppliers of U.S. Computer Equipment Imports: 2000-2007

Table 6

($ in billions and % change)

Total

China

Malaysia

Mexico

Japan

Singapore

2000

2002

2004

2006

2007

68.5

8.3

4.9

6.9

13.4

8.7

62.3

12.0

7.1

7.9

8.1

7.1

73.9

29.5

8.7

7.4

6.3

6.6

83.8

40.0

11.1

6.6

6.3

5.6

86.3

44.5

10.9

6.6

5.0

4.3

2000-2007

% change

26.0

436.1

122.4

-4.3

-62.7

-50.6

U.S. International Trade Commission Trade Data Web.

Note: Ranked according to top six suppliers in 2007.

Source:

Œ˜—˜–’Œȱ˜—œŽšžŽ—ŒŽœȱ˜ȱ‘’—ŠȂœȱž››Ž—Œ¢ȱ˜•’Œ¢ȱ

If the yuan is undervalued against the dollar, as many critics charge, then there are benefits and

costs of this policy for the economies of both China and the United States.

–™•’ŒŠ’˜—œȱ˜›ȱ‘’—ŠȂœȱŒ˜—˜–¢ȱ

If the yuan is undervalued, then Chinese exports to the United States are likely cheaper than they

would be if the currency were freely traded, providing a boost to China’s export industries (which

employ millions of workers and are a major source of China’s productivity gains). An

undervalued currency also increases the attractiveness of China as a destination for foreign

investment in export-oriented production facilities, much of which comes from U.S. firms.

Foreign investment is an important source of technology transfers, which contribute to economic

development. However, an undervalued currency makes imports more expensive, hurting Chinese

consumers and Chinese firms that import parts, machinery, and raw materials. Such a policy, in

effect, benefits Chinese exporting firms (many of which are owned by foreign multinational

corporations) at the expense of non-exporting Chinese firms, especially those that rely on

imported goods. This may impede the most efficient allocation of resources in the Chinese

economy in the long run.

In the short run, a revaluation of the yuan could reduce aggregate spending in China by raising

imports and reducing exports. Whether this would be desirable depends on the current state of the

Chinese economy. Some observers argue that the Chinese economy is currently overheating, and

revaluation would help place it on a more sustainable path and prevent inflation from rising.

Others argue that there is a large pool of underemployed labor in rural China that the undervalued

yuan is helping to absorb. In this view, revaluation could be economically and socially disruptive.

Many economists note that China’s currency policy essentially denies the government the ability

to use monetary policy (such as interest rates) to promote stable economic growth (e.g., fighting

˜—›Žœœ’˜—Š•ȱŽœŽŠ›Œ‘ȱŽ›Ÿ’ŒŽȱ

Řřȱ

‘’—ŠȂœȱž››Ž—Œ¢DZȱŒ˜—˜–’Œȱ œœžŽœȱŠ—ȱ™’˜—œȱ˜›ȱǯǯȱ›ŠŽȱ˜•’Œ¢ȱ

ȱ

inflation).51 Secondly, they contend that the currency policy has skewed the economy into

becoming overly dependent on fixed investment and net exports for economic growth, which, in

the long run can not be sustained. Thirdly, they maintain that China’s currency policy may

actually be undermining the financial viability of the banking system by expanding the level of

easy credit, which has made the banks more prone to extend loans to risky and/or speculative

ventures, and thus may increase the level of bank-held non-performing loans. In addition, the

policy has contributed to an inflow of “hot money” into short-term speculative ventures (such as

real estate and the stock market) by investors hoping to cash in on future appreciation of the

currency. Banks are restricted from using interest rate policies to better regulate investment

decisions because raising interest rates beyond a certain level could increase flows of foreign

capital into the country. Keeping interest rates low in a booming economy may prevent the most

efficient allocation of capital and could lead to overproduction in some sectors.52

The accumulation of large foreign exchange reserves by China may make it easier for Chinese

officials to move more quickly toward adopting a fully convertible currency (if the government

feels the reserves could defend the currency against speculative pressures). However, the

accumulation of large foreign exchange reserves also entails opportunity costs for China: such

funds could be used to fund China’s massive development needs (such as infrastructure

improvements and pollution control), improvements to China’s education system and social

safety net, and recapitalization of financially shaky banks. These alternatives may have higher

rates of return to the economy than U.S. Treasuries or Chinese bonds held by banks to sterilize

the effects of exchange rate intervention.53

–™•’ŒŠ’˜—œȱ˜›ȱ‘ŽȱǯǯȱŒ˜—˜–¢ȱ

ŽŒȱ˜—ȱ¡™˜›Ž›œȱŠ—ȱ –™˜›Ȭ˜–™Ž’˜›œȱ

When a foreign reserve accumulation causes the yuan to be less expensive than it would be if it

were determined by market forces, it causes Chinese exports to the United States to be relatively

inexpensive and U.S. exports to China to be relatively expensive. As a result, U.S. exports and the

production of U.S. goods and services that compete with Chinese imports fall, in the short run.54

51

In August 2007, the Chinese government reported that consumer prices in July 2007 were 5.6% higher than the same

period in 2006, the largest increase in more than a decade.

52

For the most part, the Chinese government has tried to use administrative action to slow credit and investment

growth with mixed success.

53

This generally refers to those reserves that are sterilized (such as through the issuance of government bonds and the

expansion of bank reserve requirements). According to the IMF, in 2005, about half of China’s new foreign exchange

reserves were sterilized, while the rest were added to the money supply.

54

Putting exchange rate issues aside, most economists maintain that trade is a win-win situation for the economy as a

whole, but produces losers within the economy. This view derives from the principle of comparative advantage, which

states that trade shifts production to the goods a country is relatively talented at producing from goods it is relatively

less talented at producing. As trade expands, production of goods with a comparative disadvantage will decline in the

United States, to the detriment of workers and investors in those sectors (offset by higher employment and profits in

sectors with a comparative advantage). Economists generally argue that free trade should be pursued because the gains

from trade are large enough that the losers from trade can be compensated by the winners, and the winners will still be

better off. Critics argue that the losses from free trade are not acceptable as long as the political system fails to

compensate the losers fairly. See CRS Report RL32059, Trade, Trade Barriers, and Trade Deficits: Implications for

U.S. Economic Welfare, by (name redacted).

˜—›Žœœ’˜—Š•ȱŽœŽŠ›Œ‘ȱŽ›Ÿ’ŒŽȱ

ŘŚȱ

ȱ

‘’—ŠȂœȱž››Ž—Œ¢DZȱŒ˜—˜–’Œȱ œœžŽœȱŠ—ȱ™’˜—œȱ˜›ȱǯǯȱ›ŠŽȱ˜•’Œ¢ȱ

Many of the affected firms are in the manufacturing sector, as will be discussed below.55 This

causes the U.S. trade deficit to rise and reduces aggregate demand in the short run, all else equal.

China has become the United States’s second largest supplier of imports (2006 data). A large

share of China’s exports to the United States are labor-intensive consumer goods, such as toys

and games, textiles and apparel, shoes, and consumer electronics. Many of these products do not

compete directly with U.S. domestic producers—the manufacture of many such products shifted

overseas several years ago. However, there are a number of U.S. industries (many of which are

small and medium-sized firms), including makers of machine tools, hardware, plastics, furniture,

and tool and die that are expressing concern over the growing competitive challenge posed by

China.56 An undervalued Chinese currency may contribute to a reduction in the output of such

industries.

On the other hand, U.S. producers also import capital equipment and inputs to final products from

China. For example, U.S. computer firms use a significant level of imported computer parts in

their production, and China was the largest foreign supplier of computer equipment to the United

States in 2007. An undervalued yuan lowers the price of these U.S. products, increasing their

output and competitiveness in world markets. And many imports from China are produced by

U.S.-invested enterprises (as discussed above), which benefit from an undervalued exchange rate.

ŽŒȱ˜—ȱǯǯȱ˜››˜ Ž›œȱ

An undervalued yuan also has an effect on U.S. borrowers. When the United States runs a current

account deficit with China, an equivalent amount of capital flows from China to the United

States, as can be seen in the U.S. balance of payments accounts. This occurs because the Chinese

central bank or private Chinese citizens are investing in U.S. assets, which allows more U.S.

capital investment in plant and equipment to take place than would otherwise occur. Capital

investment increases because the greater demand for U.S. assets puts downward pressure on U.S.

interest rates, and firms are now willing to make investments that were previously unprofitable.

This increases aggregate spending in the short run, all else equal, and also increases the size of

the economy in the long run by increasing the capital stock.

Private firms are not the only beneficiaries of the lower interest rates caused by the capital inflow

(trade deficit) from China. Interest-sensitive household spending, on goods such as consumer

durables and housing, is also higher than it would be if capital from China did not flow into the

United States. In addition, a large proportion of the U.S. assets bought by the Chinese,

particularly by the central bank, are U.S. Treasury securities, which fund U.S. federal budget

deficits. According to the U.S. Treasury Department, China held $397 billion in U.S. Treasury

securities (as of September 2007), making it the second largest foreign holder of such securities

(after Japan).57 If the U.S. trade deficit with China were eliminated, Chinese capital would no

55

See Mohsen Bahmani-Oskooee and Yongqing Wang, “United States-China Trade at the Commodity Level and the

Yuan-Dollar Exchange Rate,” Contemporary Economic Policy, vol. 25, no. 3, July 2007, p. 341; Won Koo and Renan

Zhuang, “The Role of Exchange Rate in Sino-U.S. Bilateral Trade,” Contemporary Economic Policy, vol. 25, no. 3,

July 2007, p. 362.

56

Testimony of Franklin J. Vargo, National Association of Manufacturers, before the House Committee on Financial

Services, Subcommittee on Domestic and International Monetary, Trade, and Technology Policy hearing, China’s

Exchange Rate Regime and Its Effects on the U.S. Economy, October 1, 2003.

57

Chinese Treasury security holdings constitute about 18.6% of total foreign holdings of such securities (as of July

2007).

˜—›Žœœ’˜—Š•ȱŽœŽŠ›Œ‘ȱŽ›Ÿ’ŒŽȱ

Řśȱ

ȱ

‘’—ŠȂœȱž››Ž—Œ¢DZȱŒ˜—˜–’Œȱ œœžŽœȱŠ—ȱ™’˜—œȱ˜›ȱǯǯȱ›ŠŽȱ˜•’Œ¢ȱ

longer flow into this country on net, and the U.S. government would have to find other buyers of

its U.S. Treasuries at higher interest rates. This would increase the government’s interest

payments, increasing the budget deficit, all else equal.

ŽŒȱ˜—ȱǯǯȱ˜—œž–Ž›œȱ

A society’s economic well-being is usually measured not by how much it can produce, but how

much it can consume. An undervalued yuan that lowers the price of imports from China allows

the United States to increase its consumption of both imported and domestically produced goods

through an improvement in the terms-of-trade. The terms-of-trade measures the terms on which

U.S. labor and capital can be exchanged for foreign labor and capital. Since changes in aggregate

spending are only temporary, from a long-term perspective the lasting effect of an undervalued

yuan is to increase the purchasing power of U.S. consumers.58 The rise of the yuan against the

dollar (and other factors, such as rising prices for raw materials) may be beginning to impact the

price of Chinese products sold in the United States. The U.S. Bureau of Labor Statistics reported

that, from April 2007 to April 2008, import prices from China increased 4.1%—the largest 12month increase recorded since the index was first published in December 2003.59 In addition,

from January to March 2008, U.S. imports from China rose by only 1.8% over the previous

period in 2008 (they rose by 11.7% from 2006-2007).

ǯǯȬ‘’—Šȱ›ŠŽȱŠ—ȱŠ—žŠŒž›’—ȱ ˜‹œȱ

Critics of China’s currency policy argue that the low value of the yuan has had a significant effect

on the U.S. manufacturing sector, where 2.7 million factory jobs have been lost since July 2000.

While job losses in the U.S. manufacturing sector have been significant in recent years, there is

no clear link between job losses and imports from China. First, only some manufacturers export

to China or compete with Chinese imports. Second, manufacturing output has reached an all-time

high; manufacturing employment has fallen over this time because of productivity growth, not a

decline in output. Third, the growing trade deficit has not been limited to China; the overall trade

deficit is still increasing.

Finally, there is a long-run trend that is moving U.S. employment away from manufacturing and

toward the service sector.60 U.S. employment in manufacturing as a share of total nonagricultural

employment has fallen from 31.8% in 1960 to 22.4% in 1980, to 10.7% in 2005, to 10.5% in

2006, to 10.2% in 2007.61 This trend is much larger than the Chinese currency issue, and is

caused by changing technology (which requires fewer workers to produce the same number of

goods) and comparative advantage. With increasing globalization, comparative advantage

predicts the United States will produce knowledge- and technology-intensive goods that it is best

58

Some commentators have compared the undervalued exchange rate to a Chinese tariff on U.S. imports. One major

difference between a tariff and the peg is that a tariff does not result in any benefit to U.S. consumers, as the peg does.

A more appropriate comparison might be an export subsidy, which benefits consumers who purchase the subsidized

product at a lower cost, but may harm some domestic firms that must compete against the subsidized product.

59

BLS Press Release, available at http://www.bls.gov/news.release/ximpim.nr0.htm.

60

See CRS Report RL32350, Deindustrialization of the U.S. Economy: The Roles of Trade, Productivity, and

Recession, by (name redacted). A thorough analysis of the trend can also be found in Robert Rowthorn and Ramana

Rasmaswamy, Deindustrialization: Its Causes and Implications, Economic Issues 10 (Washington, DC: International

Monetary Fund, 1997).

61

Council of Economic Advisers, 2008 Economic Report of the President.

˜—›Žœœ’˜—Š•ȱŽœŽŠ›Œ‘ȱŽ›Ÿ’ŒŽȱ

ŘŜȱ

ȱ

‘’—ŠȂœȱž››Ž—Œ¢DZȱŒ˜—˜–’Œȱ œœžŽœȱŠ—ȱ™’˜—œȱ˜›ȱǯǯȱ›ŠŽȱ˜•’Œ¢ȱ

at producing for trade with countries, such as China, who are better at producing labor-intensive

goods. Since the production of some manufactured goods is labor-intensive and some services

cannot be traded, trade leads to more manufacturing abroad, and less in the United States.62 Over

time, it is likely that the trend shifting manufacturing abroad will continue regardless of China’s

currency policy.

Alan Greenspan, former Chairman of the Federal Reserve, testified in 2005 that “I am aware of

no credible evidence that ... a marked increase in the exchange value of the Chinese renminbi

relative to the dollar would significantly increase manufacturing activity and jobs in the United

States.”63

ŽȱŽŒȱ˜—ȱ‘ŽȱǯǯȱŒ˜—˜–¢ȱ

In the medium run, an undervalued yuan neither increases nor decreases aggregate demand in the

United States. Rather, it leads to a compositional shift in U.S. production, away from U.S.

exporters and import-competing firms toward the firms that benefit from the lower interest rates

caused by Chinese capital inflows. In particular, capital-intensive firms and firms that produce

consumer durables would be expected to benefit from lower interest rates. Thus, it is expected to

have no medium- or long-run effect on aggregate U.S. employment or unemployment. As

evidence, one can consider that while the trade deficit with China (and overall) has widened, the

overall unemployment rate has fallen from 6.3% in 2003 to around 5% in 2008. However, the

gains and losses in employment and production caused by the trade deficit will not be dispersed

evenly across regions and sectors of the economy: on balance, some areas will gain while others

will lose.

Although the compositional shift in output has no negative effect on aggregate U.S. output and

employment in the long-run, there may be adverse short-run consequences. If output in the trade

sector falls more quickly than the output of U.S. recipients of Chinese capital rises, aggregate

spending and employment could temporarily fall. If this occurs, then there is likely to be a decline

in the inflation rate as well (which could be beneficial or harmful, depending if inflation is high or

low at the time). A fall in aggregate spending is more likely to be a concern if the economy is

already sluggish than if it is at full employment. Otherwise, it is likely that government

macroeconomic policy adjustment and market forces can quickly compensate for any decline of

output in the trade sector by expanding other elements of aggregate demand.

By shifting the composition of U.S. output to a higher capital base, the size of the economy would

be larger in the long run as a result of the capital inflow/trade deficit. U.S. citizens would not

enjoy the returns to Chinese-owned capital in the United States. U.S. workers employing that

Chinese-owned capital would enjoy higher productivity, however, and correspondingly higher

wages.

62

Lower wages alone do not give China a price advantage relative to the United States. U.S. workers are much more

productive than Chinese workers, and this primarily accounts for their higher wages. Lower unit labor costs (wages

divided by productivity) determine which country has a price advantage. In labor-intensive industries, China is likely to

have lower unit labor costs; in knowledge-intensive industries, the United States is likely to have lower unit labor costs.

63

Testimony of Chairman Alan Greenspan before the Senate Finance Committee, June 23, 2005.

˜—›Žœœ’˜—Š•ȱŽœŽŠ›Œ‘ȱŽ›Ÿ’ŒŽȱ

Řŝȱ

ȱ

‘’—ŠȂœȱž››Ž—Œ¢DZȱŒ˜—˜–’Œȱ œœžŽœȱŠ—ȱ™’˜—œȱ˜›ȱǯǯȱ›ŠŽȱ˜•’Œ¢ȱ

‘ŽȱǯǯȬ‘’—Šȱ›ŠŽȱŽ’Œ’ȱ’—ȱ‘Žȱ˜—Ž¡ȱ˜ȱ‘ŽȱŸŽ›Š••ȱǯǯȱ›ŠŽȱŽ’Œ’ȱ

While China is a large trading partner, it accounted for only about 17% of U.S. imports in 2007

and 29.0% of the sum of the bilateral trade deficits (or 32% of the total U.S. trade deficit,

including countries where the United States has a trade surplus). Over a span of several years, a

country with a floating exchange rate can run an ongoing overall trade deficit for only one reason:

a domestic imbalance between saving and investment. This has been the case for the United

States over the past two decades, where saving as a share of gross domestic product (GDP) has

been in gradual decline.64 On the one hand, the United States has high rates of productivity

growth and strong economic fundamentals that are conducive to high rates of capital investment.

On the other hand, it has a chronically low household saving rate, and recently a negative

government saving rate as a result of the budget deficit. As long as Americans save little,

foreigners will use their saving to finance profitable investment opportunities in the United

States; the trade deficit is the result.65 The returns to foreign-owned capital will flow to foreigners

instead of Americans, but the returns to U.S. labor utilizing foreign-owned capital will flow to

U.S. labor.

China’s situation is very different. As Table 7 shows (based on 2006 data), China’s gross national

saving as a percent of GDP (51.3%) is nearly five times greater than the U.S. level (13.5%).66

Conversely, the rate of private consumption as a percent of GDP is significantly higher in the

United States (70%) than it is in China (36.8%). China maintains a higher rate of gross fixed

investment as a percent of GDP than does the United States (42.8% versus 20.0%). Finally,

China’s gross national saving as a percent of its gross national investment is equal to 118% versus

68% in the United States. Thus, the United States must borrow from abroad to fund its investment

needs while China has excess saving that it can invest overseas. The net result of these differences

can be seen in the data on current account balances as a percent of GDP: 9.0% for China

compared with -6.2% for the United States. These data imply that both China and the United

States would need to make fundamental changes to their saving/investment patterns to reduce the

overall U.S. trade deficit and China’s overall trade surplus in the long run.

64

See Congressional Budget Office, Causes and Consequences of the Trade Deficit, March 2000.

Nations that fail to save enough to meet their investment needs must obtain savings from other countries with high

savings rates. By obtaining resources from foreign investors for its investment needs, the United States is able to enjoy

a higher rate of consumption than it would if investment were funded by domestic savings alone (although many

analysts warn that America’s low savings rate could be risky to the U.S. economy in the long run). The inflow of

foreign capital to the United States is equivalent to the United States borrowing from the rest of the world. The only

way the United States can borrow from the rest of the world is by importing more than it exports (running a trade

deficit).

66

The rate of U.S. saving is among the lowest by industrialized nations. China on the other hand has one of the world’s

highest saving rates. China’s extraordinarily high saving rate is largely the result of China’s undeveloped health care

system, pension system, and social safety net. For example, many Chinese individuals believe they will need to draw

on personal savings to pay for health care if they or a family member had a serious illness. In addition, an

underdeveloped financial system prevents most people from being able to borrow money for large purchases (such as a

car or home), forcing people to rely on savings.

65

˜—›Žœœ’˜—Š•ȱŽœŽŠ›Œ‘ȱŽ›Ÿ’ŒŽȱ

ŘŞȱ

‘’—ŠȂœȱž››Ž—Œ¢DZȱŒ˜—˜–’Œȱ œœžŽœȱŠ—ȱ™’˜—œȱ˜›ȱǯǯȱ›ŠŽȱ˜•’Œ¢ȱ

ȱ

Table 7. Comparisons of Savings, Investment, and Consumption as a Percentage of

GDP Between the United States and China, 2006

Gross savings as a % of GDP

Private consumption as a % of GDP

Gross fixed investment as a % of GDP

Gross national savings as a % of gross national investment

Current account balance as a % of GDP

Source:

China

United States

51.3

36.8

42.8

117.8

9.0

13.5

70.0

20.0

67.5

-6.2

BEA and EIU.

Some analysts contend that China is moving in this direction, based on a number of statements by

high level officials that China plans to boost consumer spending. The Treasury Department’s

November 2005 report on International Economic and Exchange Rate Policies stated that a key

factor in Treasury’s decision not to designate China as a country that manipulates its currency was

“China’s commitment to put greater emphasis on sustainable domestic sources of growth,

including by modernizing the financial sector....” However, others contend that it will take several

years for China to switch its reliance on exports and domestic investment to consumption for

much of its GDP growth, and government policy can, at best, only indirectly alter long run

consumption patterns.67

Economists generally are more concerned with the overall trade deficit than bilateral trade

balances. Because of comparative advantage, it is natural that a country will have some trading

partners from which it imports more, and some trading partners to which it exports more. For

example, the United States has a trade deficit with Austria and a trade surplus with the

Netherlands even though both countries use the euro, which floats against the dollar. Of concern

to the United States from an economic perspective is that its low saving rate makes it so reliant on

foreigners to finance its investment opportunities, and not the fact that much of the capital comes

from China.68 If the United States did not borrow heavily from China, it would still have to

borrow from other countries.69

‘ŽȱŠ•žŽȱ˜ȱ‘ŽȱžŠ—ȱ’—ȱ‘Žȱ˜—Ž¡ȱ˜ȱ‘ŽȱŠ••’—ȱ˜••Š›ȱ

From January 2002 to January 2008, the dollar fell in value by 24% in nominal terms and 22% in

inflation-adjusted terms against the Federal Reserve’s broad index of currencies. Its depreciation

against the euro, pound, Canadian dollar, and other currencies with floating exchange rates has

been larger. A gradually declining dollar would not be expected to disrupt economic activity since

it would stimulate U.S. exports and reduce the demand for foreign imports. But some economists

fear that there is a possibility that the dollar could suddenly plummet in value, and that this would

cause severe dislocations for the U.S. economy. The scenario through which they envision this

67

According to the Chinese government, fixed investment and exports from January-June 2007 was up 27% and 32%,

respectively over the same period in 2006, indicating that China’s economic growth continues to be driven largely by

fixed investment and exports.

68

From a foreign policy perspective, some U.S. policymakers have expressed concern over the high level of U.S.

government debt owed to the Chinese government.

69

For more information, see CRS Report RL30534, America’s Growing Trade Deficit: Its Cause and What It Means

for the Economy, by (name redacted) and (name redacted).

˜—›Žœœ’˜—Š•ȱŽœŽŠ›Œ‘ȱŽ›Ÿ’ŒŽȱ

Řşȱ

ȱ

‘’—ŠȂœȱž››Ž—Œ¢DZȱŒ˜—˜–’Œȱ œœžŽœȱŠ—ȱ™’˜—œȱ˜›ȱǯǯȱ›ŠŽȱ˜•’Œ¢ȱ

occurring is based on the size of the trade deficit. The trade deficit is unsustainably large, in the

sense that if it were to persist at current levels, the net debt owed to foreigners would grow

without bounds. Therefore, it must eventually shrink, presumably through further dollar

depreciation. Some economists worry that this adjustment could happen suddenly and rapidly if

investors suddenly came to realize that significant dollar depreciation was inevitable, and fled

dollar assets in an attempt to avoid these losses. If this occurred, there could be significant

dislocations in U.S. financial markets that could interfere with efficient financial intermediation.

This scenario is seen by most economists to be highly unlikely. Since the scenario would be so

costly to the economy, it may be worth guarding against in spite of its improbability, however.70

The primary reason that the dollar has not depreciated more rapidly since 2002 has been because

central banks in China and many other developing countries (mainly Asian and oil producing

countries) have accumulated foreign reserves at times to retard the appreciation of their currency

against the dollar.71 (By definition, any rise in the value of the yuan is matched by a fall in the

dollar.) Other Asian countries may feel compelled to continue this policy as long as China does,

since they view their exports as competing directly with China. The commitment by China and

other developing countries to support the value of the dollar may be one reason that private

investors have felt secure investing in U.S. assets despite its large trade deficit. Were China and

these other countries to cease intervening in currency markets, it is possible that the dollar would

fall significantly in a short time. A sudden decline in the dollar could trigger the currency crisis

scenario described above.

˜•’Œ¢ȱ™’˜—œȱ˜›ȱŽŠ•’—ȱ ’‘ȱ‘’—ŠȂœȱž››Ž—Œ¢ȱ

˜•’Œ¢ȱ

The United States could utilize a number of options to try to put more pressure on China to make

further reforms to its exchange rate policy if U.S. policymakers desired. Options for currency

reform include making the yuan fully convertible, allowing the currency to appreciate by a certain

amount (immediately or gradually), lessening China’s intervention in currency markets, widening

the band in which the currency is allowed to fluctuate, and furthering reforms to the financial

sector to enable greater currency flexibility.72

Determining the best approach to achieving these outcomes has sparked a lively policy debate.

Options to induce China to reform its exchange rate regime (including proposed legislation) are

listed below (see also section on legislation in the 110th Congress):

70

For more information, see CRS Report RL34311, Dollar Crisis: Prospect and Implications, by (name redacted).

For more information, see CRS Report RS21951, Financing the U.S. Trade Deficit: Role of Foreign Governments,

by (name redacted) and (name redacted).

72

Morris Goldstein and Nicholas Lardy (Institute for International Economics) have proposed a two-stage solution.

During the first stage, the yuan would be appreciated by 15%-25%, the currency band expanded to between 5% and

7%, and the yuan would be pegged to a basket of major foreign currencies (the dollar, the yen, and the euro). In the

second stage, China would, once it reformed its financial sector, adopt a managed floating exchange system. See “TwoStage Currency Reform for China,” Wall Street Journal, September 12, 2003.

71

˜—›Žœœ’˜—Š•ȱŽœŽŠ›Œ‘ȱŽ›Ÿ’ŒŽȱ

řŖȱ

‘’—ŠȂœȱž››Ž—Œ¢DZȱŒ˜—˜–’Œȱ œœžŽœȱŠ—ȱ™’˜—œȱ˜›ȱǯǯȱ›ŠŽȱ˜•’Œ¢ȱ

ȱ

’‘Ž—ȱŽšž’›Ž–Ž—œȱ˜—ȱ›ŽŠœž›¢ȱŽ™Š›–Ž—ȂœȱŽ™˜›ȱ˜—ȱž››Ž—Œ¢ȱ

Several Members of Congress have expressed frustration over the Treasury Department’s failure

to designate China as a currency manipulator (since 1994) in its semi-annual exchange rate

policies report. They contend that such a designation would itself increase pressure on China to

reform its currency. (From a practical perspective, such a designation would require Treasury to

negotiate with China to end such practices, something Treasury is already doing.) According to

the Treasury Department’s November 2005 currency report: “Reaching judgments about

countries’ currency practices and their relationships to the terms of the Act (i.e., currency

manipulation) for the purpose of designation is inherently complex, and there is no formulaic

procedure that accomplishes this objective.” H.R. 782, H.R. 2942, S. 796, and S. 1607 (110th

Congress) would require Treasury to identify “fundamentally misaligned currencies” rather than

manipulated currencies. S. 1677 would require to Treasury to cite a country for currency

manipulation regardless of the “intent” of its currency policy. These bills would increase the

likelihood that China would be designated, which, some observers claim, would increase pressure

on Treasury to make greater efforts to induce China to reform its currency and might make China

more willing to boost reform efforts to avoid being designated.73 Ultimately, the discretion to

label the yuan as misaligned with the dollar would still rest with the Treasury, however.

—Ž—œ’¢ȱ’™•˜–Š’Œȱ˜›œȱ

The U.S. government could attempt to persuade China through direct negotiations to change or

reform its exchange rate policy. President Bush and Administration officials have contended that

China’s currency policy is bad for China’s economy, as well as that of its trading partners and

world growth as a whole. The United States has attempted to assist China in reforming its

financial sector to provide a foundation for further currency reforms. In addition, the United

States has sought to utilize high level talks, such as the Strategic Economic Dialogue and the

U.S.-China Trade Promotion Coordinating Committee to encourage (and assist) China to adopt

policies to promote greater domestic consumption and lessen its dependence on exports and fixed

investment.

In recognition of its growing importance as a major world economy, China (since 2004) has been

invited to attend G-7 (group of seven largest economies) finance meetings.74 China’s currency

policy has been a major topic in these discussions, and the United States has sought to use the

forum to bring pressure on China to quicken steps to make the currency more flexible. A February

10, 2007 joint statement of G-7 finance ministers and central bank governors stated that “In

emerging economies with large and growing current account surpluses, especially China, it is

desirable that their effective exchange rates move so that necessary adjustments will occur.”75 The

United States could attempt to build a greater consensus within the G-7 to put more pressure on

73

Treasury appears to believe that under current U.S. law, there has to be intent to prevent an effective balance of

payments or to seek an unfair competitive advantage, before a country can be designated as a currency manipulator.

Sponsors of legislation to replace the term currency manipulation with fundamental currency misalignment appear to

be attempting to force Treasury to make a designation when countries with large trade surpluses make large scale

interventions in currency markets to keep the value of their currencies low, regardless of whether or not they do so for

balance of payments or competitive reasons.

74

G-7 members include the United States, Japan, Canada, the United Kingdom, France, Germany, and Italy. China has

also participated in G-8 meetings, which includes G-7 members plus Russia.

75

Treasury Department Press Release, February 10, 2007.

˜—›Žœœ’˜—Š•ȱŽœŽŠ›Œ‘ȱŽ›Ÿ’ŒŽȱ

řŗȱ

ȱ

‘’—ŠȂœȱž››Ž—Œ¢DZȱŒ˜—˜–’Œȱ œœžŽœȱŠ—ȱ™’˜—œȱ˜›ȱǯǯȱ›ŠŽȱ˜•’Œ¢ȱ

China to reform its currency policy, including by linking China’s possible future membership in

the G-7 to such reforms.76

Alternatively, the United States could attempt to persuade China to participate in talks with other

East Asian economies (that are viewed as intervening in currency markets) in order to reach a

consensus on exchange rate policy.77 Proponents of this approach argue that, because of China’s

size, other East Asian countries are afraid that their exports would be uncompetitive if they made

any unilateral change in their currency’s value that was not matched by a similar change by

China. Finally, the United States could press the International Monetary Fund to become more

active in working with China to help it understand the long-term economic risks of over-relying

on exports and domestic investment for much of its growth, and promote the development of

policy tools that lead to more balanced economic growth (such as more domestic consumption).78

A key factor in any negotiations would be to convince China that liberalization of its exchange

rate system would serve China’s long term economic interests and not lead to economic

instability.

Š’œŽȱŠ›’œȱ˜›ȱ‘Ž›ȱ›ŠŽȱŠ—Œ’˜—œȱ

The U.S. government could attempt to pressure China by threatening to impose unilateral trade

sanctions if it did not change its currency regime. Some Members support legislation, such as

H.R. 1002, that would impose additional tariffs of 27.5% on imports from China unless it

appreciates its currency to fair market levels. Proponents of such legislation contend that

congressional threats to sharply increase tariffs on Chinese goods were instrumental in moving

China to reform and appreciate its currency policy in July 2005 and hence should be further

utilized to press China for greater action to reform and appreciate its currency. Opponents of such

legislation contend that imposing sanctions against China would violate WTO rules, and that

threats of sanctions may backfire because Chinese officials would be less likely to reform its

currency if they felt that such moves were seen as resulting from U.S. political pressure.79 Some

proposals seek to impose sanctions on currency policy that would avoid violating WTO rules. For

example, S. 1607 would deny certain designated countries with misaligned policies access to U.S.

government procurement, direct U.S. officials to vote against any new multilateral bank loans for

such countries, and cut off any new financing by the U.S. Overseas Private Investment

Corporation (OPIC).80

76

Press reports indicate that Japan has been reluctant to put pressure on China over its currency system in the G-7, in

part because of criticism Japan has received over its own currency policies.

77

Some analysts argue that China’s currency policy has induced other East Asian economies, particularly Japan,

Taiwan, and South Korea to intervene in currency markets to keep their currencies weak (in order to compete with

Chinese exports). Thus, the United States could seek to reach a broad consensus with all the major economies in East

Asia to halt or limit currency interventions.

78

For more information on this option, see CRS Report RL33322, China, the United States and the IMF: Negotiating

Exchange Rate Adjustment, by (name redacted).

79

In addition, any imposed U.S. trade restrictions of Chinese goods would likely reduce overall U.S. economic welfare,

because the reduction in the welfare of U.S. consumers (as import prices rise) would likely exceed the increase in

welfare of U.S. producers.

80

Note, OPIC is already barred from operating in China due to existing U.S. sanctions.

˜—›Žœœ’˜—Š•ȱŽœŽŠ›Œ‘ȱŽ›Ÿ’ŒŽȱ

řŘȱ

ȱ

‘’—ŠȂœȱž››Ž—Œ¢DZȱŒ˜—˜–’Œȱ œœžŽœȱŠ—ȱ™’˜—œȱ˜›ȱǯǯȱ›ŠŽȱ˜•’Œ¢ȱ

’•’£Žȱ‘Žȱ’œ™žŽȱŽœ˜•ž’˜—ȱŽŒ‘Š—’œ–ȱ’—ȱ‘Žȱȱ

Some critics have charged that China’s currency policy violates WTO rules.81 The United States

could file a case before the WTO’s Dispute Settlement Body (DSB) against China’s currency

peg.82 If the DSB ruled in favor of the United States, it would direct China to modify its currency

policy so that it complies with WTO rules. If China refused to comply, the DSB would likely

authorize the United States to impose trade sanctions against China. The advantage of using the

WTO to resolve the issue is that it involves a multilateral, rather than unilateral, approach,

although there is no guarantee that the WTO would rule in favor of the United States.83

For example, it could threaten to initiate a Section 301 case, a provision in U.S. trade law that

gives the U.S. Trade Representative authority to respond to foreign trade barriers, including

violations of U.S. rights under a trade agreement, and unreasonable or discriminatory practices

that burden or restrict U.S. commerce.84 U.S. obligations in the WTO would likely require the

United States to pursue a Section 301 case with the WTO. If the United States failed to use the

WTO dispute resolution procedures and instead imposed unilateral trade sanctions under Section

301, China might file a WTO case against the United States.

In 2004, the Bush Administration rejected two Section 301 petitions on China’s exchange rate

policy: one by the China Currency Coalition (a group of U.S. industrial, service, agricultural, and

labor organizations) and one filed by 30 Members of Congress. Both petitions sought to have the

United States bring a case before the WTO against China in the hope that the WTO would rule

that China’s currency peg violated WTO rules. On May 17, 2007, 42 House Members filed a

Section 301 petition with the USTR’s office over China’s currency practices and requested that a

trade dispute case be brought to the WTO. However, the USTR declined the petition in June. The

Bush Administration has expressed doubts that the United States could win such a case in the

WTO and contends that such an approach would be “more damaging than helpful at this time.”85

H.R. 321, H.R. 782, H.R. 2942, S. 796, S. 1607, and S. 1677 contain provisions that would

require U.S. officials (under certain circumstances) to bring a case against China over its currency

policy, and H.R. 321 also calls on the United States to work within the WTO to modify and

clarify rules regarding currency manipulation for trade advantage to reflect modern day monetary

policy not envisioned at the time current rules were adopted in 1947.

81

For example, some analysts contend that China’s currency policy violates: (1) Article XV of the General Agreement

on Tariffs and Trade (GATT) agreement dealing with exchange arrangements, (2) the WTO Agreements on Subsidies

and Countervailing Measures, and/or (3) GATT Article XXIII dealing with nullification or impairment of the benefits

of a trade agreement.

82

Dispute resolution in the WTO is carried out under the Dispute Resolution Understanding (DSU). See CRS Report

RS20088, Dispute Settlement in the World Trade Organization (WTO): An Overview, by (name redacted).

83

Many trade analysts argue that countries are more likely to comply with rulings by multilateral organizations to

which they are parties (and whose rules they have agreed to comply with) than accede to the wishes of another country

under the threat of unilateral sanctions.

84

Section 301 to 309 of the 1974 Trade Act, as amended. For additional information, see CRS Report 98-454, Section

301 of The Trade Act of 1974, As Amended: Its Operation and Issues Involving its Use by the United States, by (name

redacted).

85

USTR press release, November 12, 2004.

˜—›Žœœ’˜—Š•ȱŽœŽŠ›Œ‘ȱŽ›Ÿ’ŒŽȱ

řřȱ

ȱ

‘’—ŠȂœȱž››Ž—Œ¢DZȱŒ˜—˜–’Œȱ œœžŽœȱŠ—ȱ™’˜—œȱ˜›ȱǯǯȱ›ŠŽȱ˜•’Œ¢ȱ

™™•¢ȱǯǯȱ˜ž—Ž›ŸŠ’•’—ȱ›ŠŽȱŠ œȱ˜ȱ˜—ȬŠ›”ŽȱŒ˜—˜–’Žœȱ

U.S. countervailing laws allow U.S. parties to seek relief (in the form of higher duties) from

imported products that have been subsidized by foreign governments. For many years, the

Commerce Department contended that countervailing laws could not be applied to non-market

economies, such as China, because it would be nearly impossible to identify a government

subsidy in an economy that was not market based. However, in November 2006, the Commerce

Department decided to pursue a countervailing case against certain imported Chinese coated free

sheet paper products. On March 30, 2007, the Commerce Department issued a preliminary ruling

to impose countervailing duties (ranging from 11 to 20%) against the products in question.

Commerce contends that, while China is still a non-market economy for the purposes of U.S.

trade laws, economic reforms in China have made several sectors of the economy relatively

market based, and therefore it is possible to identify the level of government subsidies given to

the Chinese paper firms in question.

Some Members contend that China’s currency policy constitutes a form of export subsidy that

should be actionable under U.S. countervailing laws. H.R. 782, H.R. 2942, S. 364, and S. 796

would apply U.S. countervailing laws to non-market economies and would also specify that

currency misalignment or manipulation be actionable under those laws. Several Members contend

that such legislation would be consistent with WTO rules (which allows countries to utilize

countervailing duty procedures). However, critics contend that it would be difficult to determine

the subsidy level conveyed by China’s currency, and possible U.S. countervailing measures

applied against China over its currency could be challenged in the WTO.

™™•¢ȱœ’–ŠŽœȱ˜ȱž››Ž—Œ¢ȱ—Ž›ŸŠ•žŠ’˜—ȱ˜ȱǯǯȱ—’ž–™’—ȱŽŠœž›Žœȱ

U.S. antidumping laws allow U.S. parties to seek relief (in the form of increased duties) from

imports that are sold at less than fair value and injure U.S. industries. Many critics of China’s

currency policy contend that undervaluing the yuan is a major factor affecting the price of

Chinese exports to the United States and that this has harmed many U.S. industries. For example,

H.R. 2942 and S. 1607 would require the government to factor in the impact of certain

fundamentally misaligned currencies on export prices when determining the level of antidumping

duties that should be applied. Critics of this approach contend that it would be very difficult to

come up with a precise figure on how much a country’s currency is undervalued, and it is not

clear whether such a method would be compatible with WTO rules on trade remedies.

’•’£Žȱ™ŽŒ’Š•ȱŠŽžŠ›ȱŽŠœž›Žœȱ

Another option might be to utilize U.S. trade remedy laws relating to special provisions that were

part of China’s accession to the WTO. For example, the United States could invoke safeguard

provisions (under Sections 421-423 of the 1974 Trade Act, as amended) to impose restrictions on

imported Chinese products that have increased in such quantities that they have caused, or

threaten to cause, market disruption to U.S. domestic producers.86 This option could be used to

provide temporary relief for U.S. domestic firms that have been negatively affected by a surge in

86

See CRS Report RS20570, Trade Remedies and The U.S.-China Bilateral WTO Accession Agreement, by (name redac

ted).

˜—›Žœœ’˜—Š•ȱŽœŽŠ›Œ‘ȱŽ›Ÿ’ŒŽȱ

řŚȱ

ȱ

‘’—ŠȂœȱž››Ž—Œ¢DZȱŒ˜—˜–’Œȱ œœžŽœȱŠ—ȱ™’˜—œȱ˜›ȱǯǯȱ›ŠŽȱ˜•’Œ¢ȱ

Chinese exports to the United States (regardless of its cause).87 The sharp increase in textile and

apparel imports from China over the past few years led the Bush Administration on a number of

occasions to invoke the special China textile and apparel safeguard to restrict imports. Eventually,

the Administration sought and obtained (in November 2005) an agreement with China to limit the

level of certain textile and apparel exports to the United States through the end of 2008. However,

the Bush Administration on six different occasions has chosen not to extend relief to various

industries under the China-specific safeguard. H.R. 782 and S. 796 would require that exchange

rate misalignment by China be considered a factor in making determinations of market disruption

under the China-specific safeguard.

‘Ž›ȱ’•ŠŽ›Š•ȱ˜––Ž›Œ’Š•ȱ˜—œ’Ž›Š’˜—œȱ

A number of policy analysts have argued against pushing China too hard on its currency policy,

either because it would not serve U.S. economic interests, or because U.S. pressure would likely

be ineffective as long as the Chinese government believed changing the peg would damage

China’s economy.88 Such analysts argue that U.S. policymakers should address China’s currency

policy as part of a more comprehensive U.S. trade strategy to persuade China to accelerate

economic and trade reforms and to address a wide range of U.S. complaints over China’s trade

practices. This appears to be the Administration’s policy in the SED talks. U.S. officials have

urged China to boost domestic consumption while making its currency policy more flexible as

part of a long-term solution to global trade imbalances.

Some policymakers contend that the more immediate focus of U.S. trade policy should be on

pressing China to comply with its WTO commitments. Major WTO-related issues of concern to

the United States include market access, inadequate protection of U.S. intellectual property rights

(IPR), industrial policies that promote domestic content over imports, and indirect subsidization

of Chinese state-owned enterprises by China’s banking system. Because China’s WTO

commitments are clear and binding, and there is a legal process within the WTO to seek

compliance with trade agreements, the United States is in a stronger position to get China to

liberalize its economy and open its markets than it would be if it tried to push China to reform its

currency regime (where multilateral rules and options on the issue are less clear). Finally,

supporters of this policy argue that China’s leaders are more likely to respond to pressures to

adhere to international rules of conduct than to perceived direct U.S. pressure.89

‘’—ŠȂœȱ ˜•’—œȱ˜ȱǯǯȱŽŽ›Š•ȱŽ‹ȱ —œ›ž–Ž—œȱ

Many U.S. policymakers have expressed concern over China’s large holdings of U.S. federal

debt, claiming that China could use it as a political tool against the United States. A recent article

in the Telegraph,”China Threatens ‘Nuclear Option’ of Dollar Sales,” cited interviews with

87

The U.S. International Trade Commission is in charge of making market disruption determinations under the

safeguard provisions for most products (with the exception of textiles and apparel, which are handled by the Committee

for the Implementation of the Textile Agreements, an inter-agency committee chaired by the U.S. Commerce

Department). Import relief is subject to presidential approval.

88

It is also possible that if China made changes to its exchange rate policy (such as allowing the yuan to appreciate

more rapidly) in order to ease political pressure from the United States, it would expect something in return, such as

U.S. pressure on China to ease on other trade issues.

89

The United States has pending WTO dispute resolution cases against China on IPR protection and market access,

trade subsidies, and discriminatory import tariffs.

˜—›Žœœ’˜—Š•ȱŽœŽŠ›Œ‘ȱŽ›Ÿ’ŒŽȱ

řśȱ

‘’—ŠȂœȱž››Ž—Œ¢DZȱŒ˜—˜–’Œȱ œœžŽœȱŠ—ȱ™’˜—œȱ˜›ȱǯǯȱ›ŠŽȱ˜•’Œ¢ȱ

ȱ

officials from two leading Chinese government think tanks who reportedly stated that China had

the power to make the dollar collapse (if it chose to do so) by liquidating large portions of its U.S.

Treasuries holdings if the United States imposed trade sanctions to force a yuan revaluation, and

that the threat to do so could be used as a “bargaining chip.”90 The article prompted concern

among many U.S. policymakers, including Senator Charles Grassley, who, in an August 9, 2007

letter to the Chinese ambassador to the United States, asked the Chinese government to confirm

that “the comments do not reflect the official position of the Chinese government.”91 In response,

the Chinese ambassador to the United States wrote to Senator Grassley on August 13 that “China

does not have a plan to drastically adjust the structure of its foreign reserves.” In addition, in an

article in the Xinhua News Agency on August 13, an unnamed official at the People’s Bank of

China was quoted as saying that “dollar-denominated assets, including U.S. government

securities, are an important component in China’s foreign exchange reserve investment portfolio,”

and that China was “a responsible investor.”

Although a move by China to liquidate a large portion of its dollar-denominated assets would

likely have a significant impact on the value of the dollar in international currency markets, it is

unlikely China would make such a move. Doing so would likely cause a sharp appreciation of the

yuan against the dollar, which would result in a capital loss for China on the sale of Treasuries,

lower the value of its remaining U.S. assets, and increase the cost of its exports to the United

States. Secondly, such a move could reduce economic growth in the United States (especially if

other foreign investors sold their U.S. asset holdings, and the U.S. was forced to raise interest

rates in response), which would diminish U.S. demand for imports, including those from China.

On September 29, 2007, the Chinese government officially launched the China Investment

Corporation (CIC) in an effort to better manage its foreign exchange reserves. It reportedly will

initially manage over $200 billion, making it one of the world’s largest state-owned funds. Some

contend China might try to diversify away from dollar denominated assets, such as Treasury

securities. (Since 2007, China’s holding of Treasury securities have increased very little.) It is not

clear to what degree such diversification, should it occur, might affect U.S. interest rates.

‘Š—Žœȱ˜ȱ‘Žȱž››Ž—ȱž››Ž—Œ¢ȱ˜•’Œ¢ȱŠ—ȱ˜Ž—’Š•ȱžŒ˜–Žœȱ

If the Chinese were to allow their currency to be determined by private actors in the market based

on the supply and demand for Chinese goods and assets relative to U.S. goods and assets. If the

yuan appreciated as a result, this would boost U.S. exports and the output of U.S. producers who

compete with the Chinese. The U.S. bilateral trade deficit would likely decline (but not

necessarily disappear). At the same time, the Chinese central bank would no longer purchase U.S.

assets to maintain the peg. U.S. borrowers, including the federal government, would now need to

find new lenders to finance their borrowing, and interest rates in the United States would rise.

This would reduce spending on interest-sensitive purchases, such as capital investment, housing

(residential investment), and consumer durables. The reduction in investment spending would

reduce the long-run size of the U.S. capital stock, and thereby the U.S. economy. In the present

context of the falling dollar, some analysts fear that a sudden decline in Chinese demand for U.S.

assets (if China was no longer purchasing assets to influence the exchange rate) could lead to a

drop in the value of the dollar that could potentially destabilize the U.S. economy. Another

90

91

See article at http://www.telegraph.co.uk.

See text of letter at http://grassley.senate.gov/public/.

˜—›Žœœ’˜—Š•ȱŽœŽŠ›Œ‘ȱŽ›Ÿ’ŒŽȱ

řŜȱ

ȱ

‘’—ŠȂœȱž››Ž—Œ¢DZȱŒ˜—˜–’Œȱ œœžŽœȱŠ—ȱ™’˜—œȱ˜›ȱǯǯȱ›ŠŽȱ˜•’Œ¢ȱ

concern is that, with inflation rising in the United States, a rise in the value of the yuan could

cause import prices to rise and add to inflationary pressures.

If the relative demand for Chinese goods and assets were to fall at some point in the future, the

floating exchange rate would depreciate, and the effects would be reversed. Floating exchange

rates fluctuate in value frequently and significantly.92

A move to a floating exchange rate is typically accompanied by the elimination of capital controls

that limit a country’s private citizens from freely purchasing and selling foreign currency. Capital

controls exist in China today, and arguably one of the major reasons China opposes a floating

exchange rate is because it fears that the removal of capital controls would lead to a large private

capital outflow from China. This might occur because Chinese citizens fear that their deposits in

the potentially insolvent state banking system are unsafe. If the capital outflow were large

enough, it could cause the floating exchange rate to depreciate rather than appreciate.93 If this

occurred, the output of U.S. exporters and import-competing firms would be reduced below the

prevailing level, and the U.S. bilateral trade deficit would expand. In other words, the United

States would still borrow heavily from China, but it would now be private citizens buying U.S.

assets instead of the Chinese central bank. China could attempt to float its exchange rate while

maintaining its capital controls, at least temporarily. This solution would eliminate the possibility

that the currency would depreciate because of a private capital outflow. While this would be

unusual, it might be possible. It would likely make it more difficult to impose effective capital

controls, however, since the fluctuating currency would offer a much greater profit incentive for

evasion.

Another option is to maintain the status quo. Although the nominal exchange rate may continue to

rise only slowly in this case, over time the real rate would adjust as inflation rates in the two

countries diverged. As the central bank exchanged newly printed yuan for U.S. assets, prices in

China would rise along with the money supply until the real exchange rate was brought back into

line with the market rate. This would cause the U.S. bilateral trade deficit to decline and expand

the output of U.S. exporters and import-competing firms. This real exchange rate adjustment

would only occur over time, however, and pressures on the U.S. trade sector would persist in the

meantime.

None of the solutions guarantee that the bilateral trade deficit will be eliminated. China is a

country with a high saving rate, and the United States is a country with a low saving rate; it is not

surprising that their overall trade balances would be in surplus and deficit, respectively. At the

bilateral level, it is not unusual for two countries to run persistently imbalanced trade, even with a

floating exchange rate. If China can continue its combination of low-cost labor and rapid

92

Some economists argue that short-term movements in floating exchange rates cannot always be explained by

economic fundamentals. If this were the case, then the floating exchange rate could become inexplicably overvalued

(undervalued) at times, reducing (increasing) the output of U.S. exporters and U.S. firms that compete with Chinese

imports. These economists often favor fixed or managed exchange rates to prevent these unexplainable fluctuations,

which they argue are detrimental to U.S. economic well-being. Other economists argue that movements in floating

exchange rates are rational, and therefore lead to economically efficient outcomes. They doubt that governments are

better equipped to identify currency imbalances than market professionals.

93

This argument is made in Morris Goldstein and Nicholas Lardy, “A Modest Proposal for China’s

Renminbi,”Financial Times, August 26, 2003. Alternatively, if Chinese citizens proved unconcerned about keeping

their wealth in Chinese assets, the removal of capital controls could lead to a greater inflow of foreign capital since

foreigners would be less concerned about being unable to access their Chinese investments. This would cause the

exchange rate to appreciate.

˜—›Žœœ’˜—Š•ȱŽœŽŠ›Œ‘ȱŽ›Ÿ’ŒŽȱ

řŝȱ

ȱ

‘’—ŠȂœȱž››Ž—Œ¢DZȱŒ˜—˜–’Œȱ œœžŽœȱŠ—ȱ™’˜—œȱ˜›ȱǯǯȱ›ŠŽȱ˜•’Œ¢ȱ

productivity gains, which have been reducing export prices in yuan terms, its exports to the

United States are likely to continue to grow regardless of the exchange rate regime. As evidence,

consider that the significant appreciation of the yuan since 2005 has not led to any reduction in

the trade deficit.

˜—Œ•žœ’˜—ȱ

The current debate among U.S. policymakers over China’s currency policy has been strongly

linked to concerns over the growing U.S. trade deficit with China, the sharp decline in U.S.

manufacturing employment over the past few years, and the rise of China as a major economic

power. Since 2005, China’s exchange rate has appreciated slowly, but the cumulative change

since then has been significant. Most economists agree that China’s currency would likely

appreciate against the dollar initially if allowed to float (barring any disruption in China’s

financial sector), although market forces could drive it up or down in the long run as conditions

change. But the failure of the bilateral trade deficit to fall in response to the appreciation that has

occurred thus far suggests that it is caused by more than just the value of the yuan.

If the yuan were to appreciate, there is considerable debate over the net effects this policy would

have on the U.S. economy since it may benefit some U.S. economic sectors and harm other

sectors, as well as consumers. The trade deficit with China has not prevented the United States

from reaching full employment. In addition, U.S. trade with China is only one of a number of

factors affecting manufacturing employment, including increased productivity growth,

employment shifts to the service sector, and the overall trade deficit. It is also not clear to what

extent production in certain industrial sectors has shifted to China from the United States, as

opposed to shifting to China from other low-wage countries, such as Mexico, Thailand, and

Indonesia.94 The extensive involvement of foreign multilateral corporations in China’s

manufactured exports further complicates the issue of who really benefits from China’s trade, as

well as the implications of a rising U.S. trade deficit with China (since a large share of U.S.

imports are coming from foreign firms, including U.S. firms, that have shifted production from

one country to China). The effects of an appreciating yuan can also be considered in the broader

context of concerns about the potentially destabilizing effects of the falling dollar. By definition,

increases in the value of the yuan are equivalent to decreases in the value of the dollar, so China’s

accumulation of U.S. assets retards the rate at which the dollar falls. Thus, there is considerable

debate over what policy options would promote U.S. economic interests since changes to the

current system would produce both winners and losers in the United States (as well as in China).

Chinese officials have stated they plan to make the currency more flexible in the near term and to

eventually adopt a floating currency in the long run, but they insist that reforms should be gradual

in order to avoid disruptions to the economy. For example, they claim they need to first

implement further reforms to the banking system and to reduce the level of non-performing loans.

Yet the present currency policy may be undermining these efforts by expanding the money supply

(as a result of the accumulation of foreign reserves). A rising money supply promotes easy credit

94

Even in cases where jobs have shifted from the United States to China, there are still questions as to the net impact to

the United States. If the United States is no longer internationally competitive in certain industries, it may be more

economically efficient to allow market forces to direct resources away from those industries and toward economic

activities where the United States has a greater comparative advantage. The challenge for policymakers is how to help

displaced workers get the training they need to find well-paying jobs that are comparable to or better than the jobs they

lost.

˜—›Žœœ’˜—Š•ȱŽœŽŠ›Œ‘ȱŽ›Ÿ’ŒŽȱ

řŞȱ

‘’—ŠȂœȱž››Ž—Œ¢DZȱŒ˜—˜–’Œȱ œœžŽœȱŠ—ȱ™’˜—œȱ˜›ȱǯǯȱ›ŠŽȱ˜•’Œ¢ȱ

ȱ

policies by the banks—which could result in more non-performing loans. Efforts to limit bank

loans in booming sectors of the economy have mainly been the result of government

administrative directives rather than market forces, which may undermine the ability to establish

a market-based financial system where monetary policy is used to halt inflation and bank loans

are extended to ventures that offer the highest rate of return. In addition, China’s currency policy

constitutes a de facto subsidy, which, while benefitting some export industries, undermines other

sectors, and prevents the most efficient distribution of resources in the economy.

While U.S. officials acknowledge China’s concerns over exchange rate reforms, they contend that

China’s exchange rate reforms are overly cautious. They further contend that China’s currency

policy is preventing adjustments in global trade imbalances, especially in the United States, and

that this could eventually undermine world economic growth. This would hurt China’s economy,

given its dependence on exports. Both U.S. and Chinese officials publicly agree that China needs

to undertake major economic reforms to boost domestic consumption and to obtain more even

growth, and that the United States must do more to boost its level of domestic saving. China

officials have stated their intention to boost economic development in the hinterland and expand

spending on social security, health care, and education. However, this will likely take many years

to implement.

Ž’œ•Š’˜—ȱ’—ȱ‘ŽȱŗŗŖ‘ȱ˜—›Žœœȱ

Currency legislation in the 110th Congress on China’s currency policy include the following:

•

H.R. 321 (English) would require the Treasury Department to determine if China

has manipulated its currency and to estimate the rate of that manipulation (if such

a determination were made), which then would require the imposition of

additional tariffs on Chinese products (equal to the estimated rate of

manipulation). The bill also calls on the United States to file a WTO case against

China over its currency policy and to work within the WTO to modify and clarify

rules regarding currency manipulation.

•

H.R. 782 (Tim Ryan)/S. 796 (Bunning) would apply U.S. countervailing laws

(dealing with government subsidies) to products imported from non-market

economies (such as China) and would establish an alternative methodology for

estimating the amount of government subsidy benefit provided if information is

not available on the amount of subsidies given to various industries in that

country. The bills also make exchange rate misalignment actionable under U.S.

countervailing law, require the Treasury Department to determine whether a

currency is misaligned in its semi-annual reports to Congress on exchange rates,

prohibit the Department of Defense from purchasing certain products imported

from China if it is determined that China’s currency misalignment has disrupted

U.S. defense industries, and would include currency misalignment as a factor in

determining (China-specific) safeguard measures on imports of Chinese products

that cause market disruption.

•

H.R. 1002 (Spratt) would impose 27.5% in additional tariffs on Chinese goods

unless the President certifies that China is no longer manipulating its currency.

•

H.R. 2942 (Tim Ryan) would apply countervailing laws to nonmarket economies,

make an undervalued currency a factor in determining antidumping and

˜—›Žœœ’˜—Š•ȱŽœŽŠ›Œ‘ȱŽ›Ÿ’ŒŽȱ

řşȱ

‘’—ŠȂœȱž››Ž—Œ¢DZȱŒ˜—˜–’Œȱ œœžŽœȱŠ—ȱ™’˜—œȱ˜›ȱǯǯȱ›ŠŽȱ˜•’Œ¢ȱ

ȱ

countervailing duties, require Treasury to identify fundamentally misaligned

currencies and to list those meeting that criteria for priority action. If

consultations fail to resolve the currency issues, the USTR would be required to

take action in the WTO.

•

S. 364 (Rockefeller) would apply U.S. countervailing laws on non-market

economies and would make exchange rate manipulation actionable under such

laws.

•

S. 1607 (Baucus) would require the Treasury Department to identify currencies

that are fundamentally misaligned and to designate such currencies for priority

action under certain circumstances in its semi-annual reports to Congress on

exchange rates.95 If after consultations the country maintaining the designated

currency policy fails to adopt appropriate policies within 180 days, the U.S.

would make currency undervaluation a factor in determining antidumping duties,

ban federal procurement of products or services from the designated country, bar

financing by the U.S. Overseas Private Investment Corporation (OPIC),96 and

would require U.S. officials to oppose multilateral financing for that country. If

the designated country failed to take appropriate measures, the USTR would be

required to file a case in the WTO, and the Treasury Department would be

directed to consider taking remedial intervention in international currency

markets. A modified version of the bill passed the Senate Finance Committee on

July 31, 2007.

•

S. 1677 (Dodd) requires the Treasury Department to identify countries that

manipulate their currencies regardless of their intent and to submit an action plan

for ending the manipulation; and gives Treasury the authority to file a case in the

WTO. The bill was approved by the Senate Banking Committee on August 1,

2007.

•

S. 2813 (Bunning) would also require the Treasury Department to identify

currency manipulators, submit an action plan to end the manipulation, and to

consult with the IMF.

A side-by-side comparison of five major currency bills: S. 1607 (as introduced), S. 1677, H.R.

782, and S. 796 (which are identical), and H.R. 2942) follows (Table 8).

95

A designation would occur based on such factors as protracted large-scale currency intervention, excessive reserve

accumulation, restrictions on capital flows, or any other policy the Treasury Department determines that would warrant

such a designation.

96

OPIC has been banned from operating in China since 1989 under U.S. sanctions.

˜—›Žœœ’˜—Š•ȱŽœŽŠ›Œ‘ȱŽ›Ÿ’ŒŽȱ

ŚŖȱ

ȱ

Table 8. Comparison of Major Currency Legislation in the 110th

Major Provisions

Official Title

H.R. 782 (Tim Ryan)/

S. 796 (Bunning)

S. 1607 (Baucus)

S. 1677 (Dodd)

Currency Exchange Rate

Oversight Reform Act of 2007

Currency Reform and

Financial Markets Access Act

of 2007

Requires Treasury to

designate countries that

manipulate their currencies

regardless of intent, establish

an action plan (with specific

timetables and benchmarks),

and to initiate bilateral

negotiations.

Fair Currency Act of 2007

Currency Reform for Fair Trade

Act of 2007

Requires Treasury to

additionally identify currencies

that are in “fundamental

misalignment” (defined as a

material sustained disparity

between the observed levels

of an effective exchange rate

for a currency and the

corresponding levels of an

effective exchange rate for

that currency that would be

consistent with fundamental

macroeconomic conditions

based on a generally accepted

economic rationale); and to

seek negotiations.

No provision.

Applies countervailing laws to

non-market economies and

establishes alternative

methodologies for identifying

and measuring subsidies.

Includes exchange rate

misalignment as a

countervailing subsidy.

Requires Treasury to identify

countries with “fundamentally

misaligned currencies,” defined

as a situation in which a

country’s prevailing real effective

exchange rate is undervalued

relative to the country’s

equilibrium real effective

exchange rate, and the Secretary

determines that the amount of

the undervaluation exceeds 5%

over an 18 month period.

Requires Treasury to designate a

currency for “priority action”

based on protracted large-scale

intervention, excessive reserve

accumulation, restrictions on

capital flows, and any other

policy or action that would

warrant designation.

Applies countervailing laws to

non-market economies and

establishes alternative

methodologies for identifying

and measuring subsidies.

Includes exchange rate

misalignment as a countervailing

subsidy if a misaligned currency

is found to be undervalued by

5% over an 18month period.

The Treasury Department’s

requirement to identify

countries that manipulate

their currencies in its biannual report on international

monetary policy and currency

exchange rates.

Requires Treasury to identify

countries with “fundamentally

misaligned currencies” and to

designate currencies for

“priority action” (based on

protracted large-scale

intervention, excessive

reserve accumulation,

restrictions on capital flows,

and any other policy or action

that would warrant

designation). Requires

Treasury to seek bilateral

negotiations.

Countervailing laws

No provision.

ȬŚŗȱ

Congress

H.R. 2942 (Tim Ryan)

ȱ

Major Provisions

Anti-dumping laws

Restrictions on federal

procurement for designated

countries

WTO and IMF provisions

ȬŚŘȱ

S. 1607 (Baucus)

S. 1677 (Dodd)

H.R. 782 (Tim Ryan)/

S. 796 (Bunning)

H.R. 2942 (Tim Ryan)

Would require the

Commerce Department to

factor in the fundamental

misalignment of a currency

(identified for priority action)

for determining dumping

margins on products from

such countries.

Would prohibit federal

procurement of products

from countries designated for

priority action unless that

country is a member of the

WTO’s Government

Procurement Agreement.

No provision.

No provision.

Would require the Commerce

Department to factor in the

fundamental misalignment of a

currency (identified for priority

action) for determining dumping

margins on products from such

countries.

No provision.

No provision.

Would require the United

States to request the IMF

Managing Director to hold

consultations with countries

whose currencies have been

identified for priority action.

Would require the USTR to

bring a WTO case if there

was a persistent failure to

adopt appropriate policies

after 360 days.

Would require Treasury to

request IMF consultations and

to bring a WTO case within

300 days if currency

manipulation persists (both

actions would be waivable).

Prohibit the Department of

Defense from purchasing

certain products imported

from China (waivable) if it is

determined that China’s

currency misalignment has

disrupted U.S. defense

industries.

No provision.

Would require the United

States to request the IMF

Managing Director to hold

consultations with countries

whose currencies have been

identified for priority action.

Would require the USTR to

bring a WTO case within 360

days if the currency

misalignment persisted.

ȱ

Major Provisions

Financing restrictions

Other Major Provisions

ȬŚřȱ

S. 1607 (Baucus)

S. 1677 (Dodd)

Would ban OPIC financing,

instruct U.S. representatives

at multilateral banks to

oppose the approval of new

financing, and require the

United States to oppose

proposed changes (in the form

of increased voting shares or

representation) of certain

international financial

institutions (such as the IMF)

for a country whose currency

has been designated for

priority action.

No provision.

Major actions would be

waivable, but subject to a

possible congressional

resolution of disapproval.

Treasury would have to

consult with the Board of

Governors of the Federal

Reserve System to consider

undertaking remedial

intervention in international

currency markets in response

to the fundamental

misalignment of a currency

designated for priority action.

Would include designations of

currencies for priority action

as a factor in determining if a

country should be treated as a

non-market economy country

under U.S. anti-dumping law.

Would allow Congress,

through enactment of a joint

resolution, to disapprove the

determination of Treasury

relating to its findings over

currency manipulation.

Would require Treasury to

issue annual reports on

market access barriers for

U.S. financial firms, including

(in the first year) progress

made on financial services in

the U.S.-China Strategic

Economic Dialogue.

H.R. 782 (Tim Ryan)/

S. 796 (Bunning)

H.R. 2942 (Tim Ryan)

Requires the United States to

oppose proposed changes in

the governance arrangement

(in the form of increased

voting shares or

representation) of certain

international financial

institution (such as the IMF) if

they are found to benefit

countries found to have a

currency that is manipulated

or in fundamental

misalignment and has an

adverse impact on the U.S.

economy.

Makes China’s exchange rate

misalignment a factor in

determining market disruption

under the China-specific

safeguard provisions of U.S.

law.

Would include exchange rate

misalignment as a factor in

determining if a country

should be treated as a nonmarket economy country

under U.S. anti-dumping law.

Would ban OPIC financing,

instruct U.S. representatives at

multilateral banks to oppose the

approval of new financing, and

require the United States to

oppose proposed changes (in

the form of increased voting

shares or representation) of

certain international financial

institutions (such as the IMF) for

a country whose currency has

been designated for priority

action.

Establishes an Advisory

Committee on International

Exchange Rate Policy (consisting

of six appointees by Congress

and one by the President) to

advise Treasury, the Congress,

and the President.

‘’—ŠȂœȱž››Ž—Œ¢DZȱŒ˜—˜–’Œȱ œœžŽœȱŠ—ȱ™’˜—œȱ˜

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