China's Currency: Economic Issues and Options for U.S. Trade Policy
China’s Currency: Economic Issues
and Options for U.S. Trade Policy
Updated May 22, 2008
Wayne M. Morrison
Specialist in International Trade and Finance
Foreign Affairs, Defense, and Trade Division
Specialist in Macroeconomics
Government and Finance Division
Economic Issues and Options for U.S. Trade Policy
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.
In troduction ......................................................1
U.S. Concerns Over China’s Currency Policy and Recent Action............2
Most Recent Events............................................4
Treasury Department Reports on Exchange Rates.....................5
China’s Concerns Over Changing Its Currency Policy.....................6
The Economics of Fixed Exchange Rates...............................7
A Critique of Various Estimates of the Yuan’s Undervaluation.........14
Estimates Based on Fundamental Equilibrium Exchange Rates.....15
Estimates Based on Purchasing Power Parity...................20
Treasury Department Assessment of Economic Models...........22
Trends and Factors in the U.S.-China Trade Deficit......................23
Economic Consequences of China’s Currency Policy.....................26
Implications for China’s Economy...............................27
Implications for the U.S. Economy...............................28
Effect on Exporters and Import-Competitors....................28
Effect on U.S. Borrowers...................................29
Effect on U.S. Consumers..................................29
U.S.-China Trade and Manufacturing Jobs.....................30
Net Effect on the U.S. Economy.............................31
The U.S.-China Trade Deficit in the Context of the Overall
U.S. Trade Deficit....................................32
The Value of the Yuan in the Context of the Falling Dollar........34
Policy Options for Dealing with China’s Currency Policy.................34
Tighten Requirements on Treasury Department’s Report on
Intensify Diplomatic Efforts................................35
Raise Tariffs or Other Trade Sanctions........................37
Utilize the Dispute Resolution Mechanism in the WTO...........37
Apply U.S. Countervailing Trade Laws to Non-Market Economies..38
Apply Estimates of Currency Undervaluation to U.S. Antidumping
Utilize Special Safeguard Measures..........................39
Other Bilateral Commercial Considerations........................39
China’s Holdings of U.S. Federal Debt Instruments..............40
Changes to the Current Currency Policy and Potential Outcomes........41
Legislation in the 110th Congress.....................................44
Appendix. Legislation in the 109th Congress...........................51
List of Figures
Figure 1. China’s Foreign Exchange Reserves: 1998-March 2008..........11
Figure 2. China-U.S. Exchange Rates: 2004-April 2008..................11
Figure 3. Nominal and Real Yuan-Dollar Exchange Rate, 1994-2007........13
List of Tables
Table 1. China’s Foreign Exchange Reserves and Overall Current Account
Table 2. Foreign Exchange Reserves and Current Account Balance in
Selected Asian Countries, 2007..................................19
Table 3. China’s Merchandise Trade Balance: 2003-2007................23
Table 4. U.S. Merchandise Exports to Major Trading Partners in 2001
Table 5. Exports and Imports by Foreign-Invested Enterprises in China:
Table 6. Major Foreign Suppliers of U.S. Computer Equipment Imports:
Table 8. Comparisons of Savings, Investment, and Consumption as a
Percentage of GDP Between the United States and China, 2006........33
Table 9. Comparison of Major Currency Legislation in the 110th Congress....47
China’s Currency: Economic Issues and
Options for U.S. Trade Policy
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 and2
controls over capital transactions. 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
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
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.
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
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 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.
U.S. Concerns Over China’s Currency Policy
and Recent Action
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
3 A brief summary of this report can be found in CRS Report RS21625, China’s Currency:
A Summary of the Economic Issues, by Wayne Morrison and Marc Labonte.
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 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
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 Wayne M. Morrison.
6 Supporters of this legislation cited estimates of the yuan’s undervaluation ranging from
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.
Most Recent Events
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 12-month 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
!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.
!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
7 BLS Press Release, available at [http://www.bls.gov/news.release/ximpim.nr0.htm].
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.
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.
Treasury Department Reports on Exchange Rates
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 semi-annual 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
!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 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
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.
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"
China’s Concerns Over Changing
Its Currency Policy
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
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.
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 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
The Economics of Fixed Exchange Rates
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,
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.
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 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 = [(Private Capital Outflow-Inflow) +
Income+ Net Unilateral Transfers]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.,
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.
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
Table 1. China’s Foreign Exchange Reserves
and Overall Current Account Surplus: 1995-2007
Cumulative Foreign Exchange ReservesCurrent Account Balance
Billions of $% of GDP% of Imports% of GDPBillions 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: Year end values. The 2007 data for GDP, imports, and current account balance are estimates
from Global Insight.
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
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.
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 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 from22
1998-2004). The continued rapid accumulation of foreign reserves suggests that
if the yuan were allowed to freely float, it would appreciate more rapidly.
20 Year-end values. Reserves totaled $1.7 trillion as of March 2008.
21 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.
22 See CRS Report RL33178, Japan’s Currency Intervention: Policy Issues, by Dick K.
Figure 1. China’s Foreign Exchange Reserves: 1998-March 2008
Source: People’s Bank of China and Chinese State Administration of Foreign Exchange.
Figure 2. China-U.S. Exchange Rates: 2004-April 2008
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 has risen. Appreciation
in the nominal exchange rate has brought the yuan almost back to its 1998 level in
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.
Figure 3. Nominal and Real Yuan-Dollar Exchange Rate, 1994-2007
94 996 998 000 002 004 006
Real Exchange RateNominal Exchange Rate
Source: CRS calculations based on IMF data.
Note: Real exchange adjusted for inflation using the consumer price index. Charted is inverted for
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 the24
inflation rate in China to rise, all else equal. Over time, as prices rise, exports will
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
become more costly abroad and 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.
A Critique of Various Estimates of the Yuan’s Undervaluation
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
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 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.
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 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.
Estimates Based on Fundamental Equilibrium Exchange Rates.
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 FDI26
would be zero and the yuan would appreciate by 40%, based on the U.S. ratio.
25 Ernest H. Preeg, “Exchange Rate Manipulation to Gain an Unfair Competitive Advantage:
The Case against Japan and China,” in C. Fred Bergsten and John Williamson, eds., Dollar
Overvaluation and the World Economy (Washington, DC: Institute for International
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
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 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
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
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 sustainable28
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-
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.
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.
28 Morris Goldstein, testimony before the Subcommittee on Domestic and International
Monetary Policy, Committee on Financial Services, U.S. House of Representatives, October
29 Jim O’Neill and Dominic Wilson, How China Can Help the World, Goldman Sachs
Global Economics Paper 97, September 17, 2003.
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 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
30 Virginie Coudert and Cecile Couharde, “Real Equilibrium Exchange Rate in China,”
Centre d’Etudes Prospectives et d’Informations Internationales, working paper 2005-01,
31 A thorough attempt to estimate exchange rates using this method can be found in John
Williamson, ed., Estimating 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.
accumulation of foreign official reserves for reasons other than to influence the
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
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
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 Economy,” International Monetary Fund, Occasional Paper 232,
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
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
Table 2. Foreign Exchange Reserves and Current Account
Balance in Selected Asian Countries, 2007
Foreign Exchange ReservesCurrent Account Surplus
Billions of $% of GDPBillions of $% of GDP
J a pan 953 21.8 210 4.8
China 1,528 47.1 381 11.8
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.
Foreign Exchange ReservesCurrent Account Surplus
Billions of $% of GDPBillions of $% of GDP
T a iwan 270 70.5 32 8.4
Malays ia 101 54.0 30 16.0
Singapore 163 101.2 46 28.6
Source: Economist Intelligence Unit estimates.
Estimates Based on Purchasing Power Parity. 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% in37
February 2007. 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 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
37 “The Big Mac Index,” Economist, February 1, 2007.
38 Li Ong, “Burgernomics: The Economics of the Big Mac Standard,” Journal of
International Money and Finance, vol. 16, no. 6 (December 1997), p. 865.
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
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 non-tradeable 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
39 William Cline and John Williamson, “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
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
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
Treasury Department Assessment of Economic Models. 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 trade48
flows are swamped by financial flows.
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.
46 Yin-Wong Cheung, Menzie Chinn, and Eiji Fujii, “The Overvaluation of Renminbi
Undervaluation,” National Bureau of Economic Research, working paper 12850, January
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.
Trends and Factors in
the U.S.-China Trade Deficit
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 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
2003 2004 2005 2006 2007
China’s merchandise trade balance25.632.0101.9177.6261.9
China’s merchandise trade balance with124.0162.0201.6232.2256.3
the United States (U.S. data)
China merchandise trade balance with the-98.4-130.0-99.7-54.65.6
rest of the world (U.S. & Chinese data)
Sources: 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.
49 U.S. and Chinese data on their bilateral trade differ substantially, due mainly to how each
side counts Chinese 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
$162.9 billion trade surplus with the United States in 2007. The United States counts
imports from Hong Kong that originated from China as imports from China, but it often fails
to attribute exports to China that pass through Hong Kong as exports to China. As a result,
the United States and China cannot agree on the actual size of the U.S.-China trade
imbalance. See Robert Feenstra et al., “The U.S.-China Bilateral Trade Balance: Its Size
and Determinants,” NBER Working Paper 6598 (June 1998).
Second, the sharp rise in the U.S. trade deficit with China diverts attention from
the fact that, while U.S. imports from China have been rising rapidly, U.S. exports
to China have been increasing sharply as well. Table 4 lists U.S. exports to its top
10 major export markets in 2007. These data indicate that U.S. exports to China
from 2001-2007 rose significantly faster than those to any other major U.S. trading
partner. In 2007, total U.S. exports rose 18.1% over the previous year (they increased
by 32.0% in 2006). In 2007, China overtook Japan to become the third largest U.S.
Table 4. U.S. Merchandise Exports to Major Trading Partners in
2001 and 2007
($ in billions and % change)
2001 2007Percent Changefrom 2006-2007 Percent Changefrom 2001-2007
Canada 163.7 248.4 7.9 51.7
Mexico 101.5 136.5 1.8 34.5
China 19.2 65.2 18.1 239.6
J a pan 57.6 62.7 5.1 8.9
Germany 30.1 49.7 20.2 65.1
Netherlands 19.5 33.0 6.1 69.2
France 19.9 27.4 13.2 37.7
World 731.0 1,162.7 12.1 59.7
Source: USITC DataWeb.
Note: Ranked by top 10 U.S. export markets in 2007.
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.
Table 5. Exports and Imports by Foreign-Invested
Enterprises in China: 1986-2007
FDI inExports by FIEImports by FIEs
YearDeficit withChina% of Total% of Total
($ billions)$ billions $ billionsChineseExports $ billionsChineseImports
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
50 One analyst has estimated that the domestic value-added content of Chinese exports to the
United States by foreign-invested 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
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.
Table 6. Major Foreign Suppliers of U.S. Computer Equipment
($ in billions and % change)
T otal 68.5 62.3 73.9 83.8 86.3 26.0
China 8.3 12.0 29.5 40.0 44.5 436.1
Malays ia 4.9 7.1 8.7 11.1 10.9 122.4
Mexico 6.9 7.9 7.4 6.6 6.6 -4.3
J a pan 13.4 8.1 6.3 6.3 5.0 -62.7
Singapore 8.7 7.1 6.6 5.6 4.3 -50.6
Source: U.S. International Trade Commission Trade Data Web.
Note: Ranked according to top six suppliers in 2007.
Economic Consequences of China’s
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
Implications for China’s Economy
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
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 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
51 In August 2007, the Chinese government reported that consumer prices in July 2007 were
52 For the most part, the Chinese government has tried to use administrative action to slow
credit and investment growth with mixed success.
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
Implications for the U.S. Economy
Effect on Exporters and Import-Competitors. 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 Many of the affected firms are in the55
manufacturing sector, as will be discussed below. 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,
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 Craig K. Elwell.
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.
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.
Effect on U.S. Borrowers. 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 (after57
Japan). If the U.S. trade deficit with China were eliminated, Chinese capital would
no 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.
Effect on U.S. Consumers. 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
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).
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 12-month 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
U.S.-China Trade and Manufacturing Jobs. 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
Finally, there is a long-run trend that is moving U.S. employment away from60
manufacturing and toward the service sector. U.S. employment in manufacturing
as a share of total nonagricultural employment has fallen from 31.8% in 1960 to61
22.4% in 1980, to 10.7% in 2005, to 10.5% in 2006, to 10.2% in 2007. 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 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
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
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, by Craig Elwell. 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.
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
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
Net Effect on the U.S. Economy. 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,
The U.S.-China Trade Deficit in the Context of the Overall U.S.
Trade Deficit. 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 been64
in gradual decline. 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 the65
result. 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
China’s situation is very different. As Table 8 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
64 See Congressional Budget Office, Causes and Consequences of the Trade Deficit, March
65 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.
changes to their saving/investment patterns to reduce the overall U.S. trade deficit
and China’s overall trade surplus in the long run.
Table 8. Comparisons of Savings, Investment, and
Consumption as a Percentage of GDP Between
the United States and China, 2006
Gross savings as a % of GDP51.313.5
Private consumption as a % of GDP36.870.0
Gross fixed investment as a % of GDP 42.820.0
Gross national savings as a % of gross national117.867.5
Current account balance as a % of GDP9.0-6.2
Source: 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,69
it would still have to borrow from other countries.
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 Current Deficit:
Its Cause and What It Means for the Economy, by Marc Labonte and Gail Makinen.
The Value of the Yuan in the Context of the Falling Dollar. 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 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
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 at71
times to retard the appreciation of their currency against the dollar. (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
Policy Options for Dealing with China’s
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),
70 For more information, see CRS Report RL34311, Dollar Crisis: Prospect and
Implications, by Craig K. Elwell.
71 For more information, see CRS Report RS21951, The U.S. Trade Deficit: Role of Foreign
Governments, by Marc Labonte and Gail E. Makinen.
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
Tighten Requirements on Treasury Department’s Report on
Currency. 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.th
2942, S. 796, and S. 1607 (110 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 might73
make China more willing to boost reform efforts to avoid being designated.
Ultimately, the discretion to label the yuan as misaligned with the dollar would still
rest with the Treasury, however.
Intensify Diplomatic Efforts. 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
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 “Two-Stage Currency Reform for China,” Wall Street Journal,
September 12, 2003.
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
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 China to reform its currency
policy, including by linking China’s possible future membership in the G-7 to such
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.
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.
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
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 Jonathan E. Sanford.
Raise Tariffs or Other Trade Sanctions. 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 new80
financing by the U.S. Overseas Private Investment Corporation (OPIC).
Utilize the Dispute Resolution Mechanism in the WTO. 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
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.
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
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,
by Jeanne J. Grimmett.
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
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
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.
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.
Apply U.S. Countervailing Trade Laws to Non-Market Economies.
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
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 Wayne Morrison.
85 USTR press release, November 12, 2004.
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.
Apply Estimates of Currency Undervaluation to U.S. Antidumping
Measures. 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.
Utilize Special Safeguard Measures. 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 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.
Other Bilateral Commercial Considerations
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
86 See CRS Report RS20570, Trade Remedies and the U.S.-China Bilateral WTO Accession
Agreement, by William H. Cooper.
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.
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
China’s Holdings of U.S. Federal Debt Instruments. 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 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
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
89 The United States has pending WTO dispute resolution cases against China on IPR
protection and market access, trade subsidies, and discriminatory import tariffs.
90 See article at [http://www.telegraph.co.uk].
91 See text of letter at [http://grassley.senate.gov/public/].
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.
Changes to the Current Currency Policy
and Potential Outcomes
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 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.
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.
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 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.
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,94
Thailand, and Indonesia. 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
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.
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
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.
Legislation in the 110th Congress
Currency legislation in the 110th Congress on China’s currency policy include the
!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 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
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.
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
Table 9. Comparison of Major Currency Legislation in the 110th Congress
Major ProvisionsS. 1607 (Baucus)S. 1677 (Dodd)H.R. 782 (Tim Ryan)/S. 796 (Bunning)H.R. 2942 (Tim Ryan)
ficial TitleCurrency Exchange RateCurrency Reform and FinancialFair Currency Act of 2007Currency Reform for Fair Trade
Oversight Reform Act of 2007Markets Access Act of 2007Act of 2007
e Treasury Department’sRequires Treasury to identifyRequires Treasury to designateRequires Treasury toRequires Treasury to identify
uirement to identify countriescountries with “fundamentallycountries that manipulate theiradditionally identify currenciescountries with “fundamentally
anipulate their currenciesmisaligned currencies” and tocurrencies regardless of intent,that are in “fundamentalmisaligned currencies,” defined
ts bi-annual report ondesignate currencies forestablish an action plan (withmisalignment” (defined as aas a situation in which a
iki/CRS-RL32165national monetary policy“priority action” (based onspecific timetables andmaterial sustained disparitycountry’s prevailing real
g/wd currency exchange rates.protracted large-scalebenchmarks), and to initiatebetween the observed levels ofeffective exchange rate is
s.orintervention, excessive reservebilateral negotiations.an effective exchange rate for aundervalued relative to the
leakaccumulation, restrictions oncurrency and the correspondingcountry’s equilibrium real
capital flows, and any otherlevels of an effective exchangeeffective exchange rate, and the
://wikipolicy or action that wouldrate for that currency that wouldSecretary determines that the
httpwarrant designation). RequiresTreasury to seek bilateralbe consistent with fundamentalmacroeconomic conditionsamount of the undervaluationexceeds 5% over an 18 month
negotiations. based on a generally acceptedperiod. Requires Treasury to
economic rationale); and to seekdesignate a currency for
negotiations. “priority action” based on
intervention, excessive reserve
accumulation, restrictions on
capital flows, and any other
policy or action that would
Major ProvisionsS. 1607 (Baucus)S. 1677 (Dodd)H.R. 782 (Tim Ryan)/S. 796 (Bunning)H.R. 2942 (Tim Ryan)
untervailing lawsNo provision.No provision.Applies countervailing laws toApplies countervailing laws to
non-market economies andnon-market economies and
establishes alternativeestablishes alternative
methodologies for identifyingmethodologies for identifying
and measuring subsidies. and measuring subsidies.
Includes exchange rateIncludes exchange rate
misalignment as amisalignment as a
countervailing subsidy.countervailing subsidy if a
misaligned currency is found to
iki/CRS-RL32165be undervalued by 5% over an18month period.
s.orti-dumping lawsWould require the CommerceNo provision.No provision.Would require the Commerce
leakDepartment to factor in theDepartment to factor in the
fundamental misalignment of afundamental misalignment of a
://wikicurrency (identified for prioritycurrency (identified for priority
httpaction) for determining dumpingaction) for determining dumping
margins on products from suchmargins on products from such
strictions on federalWould prohibit federalNo provision.Prohibit the Department ofNo provision.
rement for designatedprocurement of products fromDefense from purchasing
ntriescountries designated for prioritycertain products imported from
action unless that country is aChina (waivable) if it is
member of the WTO’sdetermined that China’s
Government Procurementcurrency misalignment has
Agreement.disrupted U.S. defense
ind ustr i es.
Major ProvisionsS. 1607 (Baucus)S. 1677 (Dodd)H.R. 782 (Tim Ryan)/S. 796 (Bunning)H.R. 2942 (Tim Ryan)
O and IMF provisionsWould require the United StatesWould require Treasury toNo provision.Would require the United States
to request the IMF Managingrequest IMF consultations and toto request the IMF Managing
Director to hold consultationsbring a WTO case within 300Director to hold consultations
with countries whose currenciesdays if currency manipulationwith countries whose currencies
have been identified for prioritypersists (both actions would behave been identified for priority
Would require the USTR toWould require the USTR to
bring a WTO case if there was abring a WTO case within 360
iki/CRS-RL32165persistent failure to adoptappropriate policies after 360days if the currencymisalignment persisted.
leaknancing restrictionsWould ban OPIC financing,No provision.Requires the United States toWould ban OPIC financing,
instruct U.S. representatives atoppose proposed changes in theinstruct U.S. representatives at
://wikimultilateral banks to oppose thegovernance arrangement (in themultilateral banks to oppose the
httpapproval of new financing, andform of increased voting sharesapproval of new financing, and
require the United States toor representation) of certainrequire the United States to
oppose proposed changes (in theinternational financial institutionoppose proposed changes (in the
form of increased voting shares(such as the IMF) if they areform of increased voting shares
or representation) of certain found to benefit countries foundor representation) of certain
international financialto have a currency that isinternational financial
institutions (such as the IMF)manipulated or in fundamentalinstitutions (such as the IMF)
for a country whose currencymisalignment and has anfor a country whose currency
has been designated for priorityadverse impact on the U.S.has been designated for priority
actio n. econo my. actio n.
Major ProvisionsS. 1607 (Baucus)S. 1677 (Dodd)H.R. 782 (Tim Ryan)/S. 796 (Bunning)H.R. 2942 (Tim Ryan)
her Major ProvisionsMajor actions would beWould allow Congress, throughMakes China’s exchange rateEstablishes an Advisory
waivable, but subject to aenactment of a joint resolution,misalignment a factor inCommittee on International
possible congressionalto disapprove the determinationdetermining market disruptionExchange Rate Policy
resolution of disapproval.of Treasury relating to itsunder the China-specific(consisting of six appointees by
findings over currencysafeguard provisions of U.S.Congress and one by the
Treasury would have to consultmanipulation.law. President) to advise Treasury,
with the Board of Governors ofthe Congress, and the President.
the Federal Reserve System toWould require Treasury to issueWould include exchange rate
consider undertaking remedialannual reports on market accessmisalignment as a factor in
iki/CRS-RL32165intervention in internationalcurrency markets in response tobarriers for U.S. financial firms,including (in the first year)determining if a country shouldbe treated as a non-market
g/wthe fundamental misalignmentprogress made on financialeconomy country under U.S.
s.orof a currency designated forservices in the U.S.-Chinaanti-dumping law.
leakpriority action. Strategic Economic Dialogue.
://wikiWould include designations of
httpcurrencies 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.
Appendix. Legislation in the 109th Congress
Several bills were introduced in the 109th Congress to deal with foreign
exchange rate policies. This section offers a summary of bills that saw legislative
!S.Amdt. 309 (Schumer) to S. 600 would impose a 27.5% tariff on
Chinese goods if China failed to substantially appreciate its currency
to market levels. On April 6, 2005, the Senate failed (by a vote of
33 to 67) to reject the amendment, In response to the vote, the
Senate leadership moved to allow a vote on S. 295 (which has same
language as S.Amdt. 309) no later than July 27, 2005, as long as the
sponsors of the amendment agreed not to sponsor similarth
amendments for the duration of the 109 Congress. However, on
June 30, 2005, Senator Schumer and other sponsors of S. 295 agreed
to delay consideration of the bill after they received a briefing from
Administration officials and were told that China was expected to
make significant progress on reforming its currency over the next
few months. Disappointment over China’s July 2005 currency
reforms led Senator Schumer to push for consideration of S. 295
(under the previous compromise). On November 16, 2005, the
Senate agreed to consider the bill no later than March 31, 2006. On
March 28, 2006, Senators Schumer and Graham stated that they
would move to delay taking up S. 295 in the Senate, based on their
assessment during a trip to China that the Chinese government was
serious about reforming its currency policy. However, on September
14, 2006, Senator Schumer stated that he was disappointed with
China’s movement to date on currency flexibility, and requested the
Senate to take up S. 295. On September 28, 2006, Senators
Schumer and Graham announced that they had been persuaded by
President Bush not to pursue a vote on S. 295 in order to give
Secretary of Treasury Henry Paulson more time to negotiate with
China on its currency policy.
!H.R. 3283 (English) would (among other things) apply U.S.
countervailing laws (dealing with foreign government subsidies) to
non-market economies (such as China); and require the Treasury
Department to define “currency manipulation,” describe actions that
would be considered to constitute manipulation, and report on
China’s new currency regime. The bill passed (255 to 168) on July
27, 2005. A similar bill was introduced in the Senate, S. 1421