China, the United States and the IMF: Negotiating Exchange Rate Adjustment

CRS Report for Congress
China, the United States and the IMF:
Negotiating Exchange Rate Adjustment
Updated July 19, 2006
Jonathan E. Sanford
Specialist in International Political Economy
Foreign Affairs, Defense and Trade Division

Congressional Research Service ˜ The Library of Congress

China, the United States and the IMF: Negotiating
Exchange Rate Adjustment
Summary
In recent years, the United States and other countries have expressed
considerable concern that China’s national currency (the yuan or renminbi) is
seriously undervalued. Some analysts say the yuan needs to rise by as much as 40%
in order to reflect its equilibrium value. Critics say that China’s undervalued currency
provides it with an unfair trade advantage that has seriously injured the
manufacturing sector in the United States. Chinese officials counter that they have
not pegged the yuan to the dollar in order to gain trade advantages. Rather, they say
the fixed rate promotes economic stability that is vital for the functioning of its
domestic economy.
On July 21, 2005, China announced a new foreign exchange system which is
intended to allow more flexibility and to permit the international value of the yuan
to be established by market forces. The yuan was increased in value by 2% and a
“managed float” was introduced. However, the value of the yuan has changed little
since then. Despite the publication of many studies, scholars do not agree whether
or by what percent the yuan is undervalued. The wide range of estimates suggests
that there is no reason to believe that any particular figure is correct. It is not clear
that the U.S. trade deficit would be lower or U.S. manufacturers would benefit if
China raised the value of the yuan. In the short run, U.S. producers might be able to
sell higher-priced products to U.S. consumers if the inflow of Chinese goods were
reduced. In the long run, though, as long as the United States is a net importer of
capital, it would have a trade deficit and other countries would ultimately replace
China as suppliers of low-cost goods to the U.S. market.
The Treasury Department has strongly urged China in recent years to adopt
procedures that would allow the yuan to rise in value. Congress is considering
legislation that would penalize China if its currency is not revalued. The United
States has pursued the yuan-dollar exchange rate issue as a bilateral U.S.-China
issue. Other countries are also affected by the presumably undervalued yuan — some
more than the U.S. — but they have allowed the United States to take the lead.
There are at least five ways the United States could deal with the yuan exchange
rate issue. Some of these would involve other countries more explicitly in the
process. First, the United States could continue pressing China publicly to raise the
value of the yuan on the assumption that change will not occur without foreign
pressure. Second, it could stop pressing China publicly, on the expectation that China
might move more rapidly towards reform if it is not pressured. Third, the United
States could restrict imports from China pending action to revalue the yuan. Fourth,
the U.S. could ask the IMF to declare that China is manipulating its currency in
violation of IMF rules. Fifth, the United States could refer the issue to the World
Trade Organization (WTO), asserting that the United States has been injured by
unfair trade practices linked to the undervaluation of China’s currency. The WTO,
in turn, could authorize trade remedies (tariffs on Chinese goods, for example) aimed
at correcting this abuse. This report will be updated as new developments arise.

Contents
Scope and Content.................................................1
Overview ....................................................1
This Report in Four Parts........................................2
Events and Issues..........................................2
Five Questions which Frame the Controversy....................2
Three Dilemmas for China...................................5
Policy Options for the United States...........................6
Issues and Events..................................................7
Yuan-Dollar Exchange Rate Issue.................................7
The Controversy...........................................7
Arguments Pro and Con.....................................8
China Announces a Change..................................9
Too Small?..............................................10
New Initiatives Since July 2005..............................11
Market Expectations......................................12
International Views...........................................12
Efforts by the IMF........................................12
Other Countries’ Views....................................13
U.S. Views..............................................15
Five Key Questions...............................................18
Is the Yuan Undervalued? By How Much?........................18
Is China Manipulating Its Currency?..............................22
The IMF and Exchange Rate Policy..........................22
IMF Surveillance.........................................22
China and Manipulation....................................23
China’s View............................................25
How Fast Should China Revalue?................................26
Is China Hiding its Real Trade Surplus?...........................27
Would Revaluation Help the U.S. Economy?.......................29
A Symbiotic Relationship..................................29
The U.S. Imports Capital...................................29
China Wants Growth......................................30
Three Dilemmas For China .........................................31
Intervention and Reserves......................................31
Where’s the Money Coming From?..............................33
Hot Money or Trade?......................................33
Accounting the BOP......................................34
Analyzing China’s BOP........................................34
Policy Implications.......................................35
Would Revaluation Hurt China’s Banks?..........................36
Options for the United States........................................37
Continue Public Pressure.......................................38
Pursue a Policy of Restraint.....................................39

Take It to the IMF............................................42
Refer It to the WTO...........................................43

China, the United States and the IMF:
Negotiating Exchange Rate Adjustment
Scope and Content
Overview
In recent years, there has been growing concern in the United States and
elsewhere that China may be manipulating the value of its currency to gain unfair
trade advantages. Many believe that China’s national currency, the yuan or renminbi
(RMB), may be seriously undervalued compared to the dollar and other major
currencies.¹ The United States and other countries have urged China to raise the
value of its currency. Chinese officials say they want to make their exchange rate
system more flexible, but they say China also needs long-term stability in its currency
value in order to avoid internal dislocations. Discussion of this question has taken
place at the International Monetary Fund (IMF) and at other multilateral fora such as
the periodic meetings of the G-8 (the seven largest industrial countries plus Russia.)
The United States and other countries have also spoken directly to China on a
bilateral basis about this issue.
The key issue is what — if the yuan is undervalued — China and the world
should do about it. China is undergoing a major shift from a state-dominated to a
market-based economy. It has pursued a policy of export-led growth in order to
generate the employment and income necessary to facilitate change in the overall
structure of its economy. It has priced its currency in order to facilitate that policy.
In July 2005, China adopted reforms aimed at giving market forces a possible
role in the valuation of the yuan. Most observers say the initial changes (a 2% rise in
value) were too small and they note that little change has occurred since. Chinese
officials retain firm control over the mechanisms which produce the yuan-dollar
exchange rate and the criteria they use in this process remain opaque. International
discussions have sought to persuade China to accelerate the process but — while the
concerns of other countries may bear weight in the thinking of Chinese officials —

¹ For a comprehensive discussion of the China exchange rate issue, see CRS Report
RS21625, China’s Currency Peg: A Summary of the Economic Issues, and CRS Report
RL32165, China’s Exchange Rate Peg: Economic Issues and Options for U.S. Trade Policy,
both by Wayne M. Morrison and Marc Labonte. See also CRS Issue Brief IB91121, U.S.-
China Trade Issues and CRS Report RS22338, China’s Currency: A Brief overview of U.S.
Options, by Jonathan E. Sanford. The term “renminbi” means “people’s currency” while
“yuan” is the unit of account (one yuan, two yuan, etc.) In this report, for simplicity,
China’s currency will be called the “yuan” except in instances where the term “renminbi”
is used in a quotation or official statement.

there are no effective “teeth” in the International Monetary Fund that could compel
China to change its policies and procedures more rapidly than it wishes to do so.
Many in the United States believe that the large volume of Chinese exports to
the United States is damaging the U.S. manufacturing sector and feeding the U.S.
trade deficit. They believe that the undervalued yuan is an important reason why
China is able to price its goods so competitively and why production in many areas
is shifting to China. Other analysts believe that — by virtue of its undervalued
currency — China is damaging the world trading system and denying export
opportunities to other countries whose currencies are more fairly priced. Congress
is considering legislation which would place countervailing duties or special tariffs
on Chinese goods entering the U.S. in order to offset the trade benefits China
presumably gains from its present exchange rate policies.
This Report in Four Parts
Events and Issues. This report has four parts. The first part discusses the
issues and events surrounding the yuan-dollar controversy. It describes the actions
which Chinese authorities have taken to revalue the yuan and, arguably, to lay the
groundwork for a larger future role for market forces in its valuation. It also
describes the methods the Chinese authorities have used and still use to hold the
value of the yuan at the level they prefer. This section discusses the efforts the
International Monetary Fund, the U.S. Government and other governments have
made to encourage or press China to revalue its currency. It also reviews the U.S.
Treasury Department’s discussion of China in its semi-annual report on currency
manipulation and legislation currently pending in Congress which would levy special
duties on Chinese goods if the yuan is not increased considerably in value.
Five Questions which Frame the Controversy. The second part of this
report looks at five central questions. First, is the yuan undervalued and, if so, by
how much? This question may be harder to answer than many people assume. Most
economists agree the yuan is undervalued, but the 17 studies reviewed in this report
show widely different conclusions. Some say the yuan is slightly overvalued, others
say it is 15% or 25% or perhaps 49% undervalued, while several say it is impossible
to make an accurate computation. The data are poor, China is changing rapidly, and
scholars use different assumptions in their studies. Moreover, new economic data
published in December 2005 seem to render all previous studies obsolete, as they
give a very different picture of the Chinese economy than was available before. In
recent studies, IMF experts say the yuan is undervalued but they also say it is
impossible to know how large the distortion might be. The IMF also says that it is
impossible to separate the trade effects of that distortion from the other factors (labor
costs, productivity, etc.) which also affect the price of Chinese goods.
Without some objective way of determining what the “real” value of the yuan
might be, it may be difficult for China and other countries to agree what size increase
is “enough.” Likewise, without knowing the proper rate, it might be difficult to
design special U.S. tariffs which the world would consider fair and compensatory
rather than arbitrary or punitive. It might be helpful if China, the United States and
other countries could agree on criteria by which to decide how an appropriate
exchange rate for the dollar and yuan might be determined.

Second, does China manipulate the value of the yuan? The IMF rules state
that countries may not manipulate the value of their currency in order to gain unfair
trade advantage. The second section of this report examines China’s behavior in
light of the five standards the IMF uses to judge whether manipulation is taking
place. The IMF has not publicly declared that China is manipulating its currency.
China’s actions seem to meet four of the IMF’s criteria in this regard. The IMF has
no evident means other than persuasion to make countries comply with its rules. In
this context, it is not clear that an IMF announcement that China was violating its
rules would help or hinder the current discussions aimed at persuading China to raise
the value of the yuan.
Third, how fast could China revalue the yuan if it wanted to? Theoretically,
the People’s Bank of China could raise the exchange value of the yuan to any
specified level overnight. However, Chinese officials are concerned about the
growth and employment effects any change in the value of the yuan may have on
their economy. A too-rapid increase might have serious negative effects on
employment, output and growth. Some also worry that “hot money” could complicate
the process of revaluation and may require China to delay any changes until the
perceived speculative pressure abates. Many experts believe that a gradual and
measured approach to currency revaluation is appropriate for China. The IMF says,
for example, that emerging market countries generally do not handle rapid and large
exchange rate movements well and that serious dislocations can occur. Others
believe, however, that basic fairness to other countries requires China to raise the
value of its currency. Some analysts believe China could suffer serious damage to
its economy if it does not change is economic strategy. Its heavy reliance on export-
led growth makes it vulnerable, for example, to a slowdown in world demand.
Higher currency values would stimulate growth of its domestic economy.
Fourth, has China “cooked the books” in terms of its trade surplus? Some
analysts believe that China’s actual net income from trade is many times larger than
that which China’s publishes in its official trade statistics. Data published by the
IMF show that, while China reports that it had a net trade surplus of $41 billion in
2004, its trading partners report that they had a combined trade deficit of $267 billion
with China. Some people say that a trade surplus this large is proof that China’s
currency is substantially undervalued.
Others would ask, however, where — if China is accruing an extra $200 billion
annually in trade income beyond the amounts accounted for in its balance of
payments figures — that money might be. It might be hard, for example, for China
to hide all this additional income year after year in secret undeclared foreign
exchange reserves without somebody discovering that it exists.
Trade data for other countries also show (though on a smaller scale) this same
mismatch between the amount reported by exporter countries and the amounts
reported by those who import their products. Bad data collection by individual
countries and methodological problems in the reporting system seem to be better
explanations for these discrepancies than is the uniform prospect that exporters fudge
their data while importers report their incoming trade data correctly.

Fifth, would the U.S. economy benefit if China revalued the yuan?
Correcting the international value of the yuan may improve the efficiency of
international trade. But will it reduce the U.S. trade deficit and strengthen the U.S.
manufacturing sector? Most economists believe not. The U.S. and Chinese
economies have become increasingly interdependent in recent years. China is
pursuing a policy of export-led growth and the United States provides a ready market
for its goods. Meanwhile, the United States imports large quantities of capital from
abroad (by borrowing or by opening its economy to foreign investment) and — in
order (more money chasing the same quantity of goods) to avoid turning that
imported money into inflation — it must also import goods and services for the
imported money to buy. If China raised the value of the yuan, its exports to the
United States would likely shrink and the amount of money it could place in the U.S.
economy would decline.
Multinational firms based in the United States are a major presence in the
Chinese economy and a large share of China’s exports to the United States are
produced by or mediated through those firms. For them, the undervalued yuan
provides major benefits because it keeps down their production costs and it enables
them to produce things which might be too costly to produce in the United States.
U.S. consumers who purchase the output from these facilities in China are able to get
more product at a lower cost than they would be able to get if the products were
produced domestically or if the value of the yuan were higher. These firms say they
need to produce some of their output in low-cost places such as China and they
would move their facilities elsewhere (but not back to the United States) if China
were no longer available to them.
On the other hand, many U.S.-based small and medium size enterprises cannot
or wish not to move their operations abroad. For them, the undervalued yuan is a
major threat to their commercial viability and their bottom line. To compete with
goods produced in China, they must reduce their costs (perhaps by economizing on
labor or lowering their profit margins), find non-price based reasons for consumers
to prefer their products to those produced abroad, merge some of their operations
with similarly affected domestic firms, or seek some type of political remedy to
shield them from the foreign competition.
Temporarily, if exports from China were restricted because of trade legislation,
U.S. producers might be able to take over some of the market (albeit at higher prices)
previously supplied by China. From a longer perspective, though, it is likely that
multinational firms would shift much of their production to other low-cost countries
and these would ramp up their exports in order to supply the U.S. market previously
supplied by Chinese goods. The inflow of foreign goods might decline and U.S.
manufactured goods might be more competitive in U.S. and foreign markets if the
U.S. savings rate increased, the United States borrowed less and received fewer
investments from abroad, and the international value of the dollar declined.²

² For a further discussion of the effects of the undervalued yuan on the U.S. economy, see
CRS Report RS21625, China’s Currency Peg, and CRS Report RL32165, China’s
Exchange Rate Peg, both by Wayne M. Morrison and Marc Labonte.

However, this would require major changes in American economic behavior which
cannot be easily legislated.
It is difficult to know on a net basis whether the U.S. economy benefits or
whether on a net basis it is hurt from the low cost of products it imports from China.
The interests of the large and small-to-medium sized firms appear to conflict and the
interests of U.S. consumers seem to conflict in some ways with the interests of some
U.S. producers of products which compete with Chinese exports. From an economic
point of view, the profit margins realized by the Chinese exporters appear to be
relatively small whereas the profit margins earned by the distributors of those
products in the United States may be higher. Meanwhile, though the data are not
clear, many experts believe that on a trade-weighted basis, the U.S. producers benefit
more from their exports to China than Chinese exporters do on their sales to the
United States. At the same time, China’s investments in the United States provide
badly needed capital which helps spur growth in the American economy at the same
time that the growing volume of debt owed to foreigners increases the international
exposure of the U.S. economy. Weighing all of these factors together in order to
determine on an overall basis whether the undervalued yuan is a benefit or burden to
the U.S. economy is a difficult task.
Three Dilemmas for China. The third section of this report looks at some
of the monetary and financial dilemmas which affect China’s views about exchange
rate policy. First, what should China do about its foreign exchange (forex) reserves?
China has $819 billion in foreign exchange reserves (rough 70% in dollars). These
are an important source of income, influence, and future spending power. However,
they are also a problem. For one thing, the growth in China’s forex reserves fuels
domestic inflation. For every dollar the People’s Bank of China buys (to hold down
the value of the yuan and to increase its reserves), it injects 8 yuan into China’s
economy. China’s reserves grew by $100 billion in 2005, so this is a lot of new
“printing press” money. The central bank has tried with limited success to bottle up
the inflationary effect of this money with public debt transactions and tight monetary
policy. If China raised the value of the yuan, the growth in its foreign exchange
reserves would slow or stop and — if it relaxed its monetary policy — the growth
and reform prospects of its internal economy might be enhanced.
On the other hand, revaluation would cost China a great deal of money. If the
yuan increased in value by 20%, the purchasing power of China’s foreign reserves
would go down corresponding. It would lose, from China’s perspective, about 1.3
trillion yuan (about $200 billion) in purchasing power. If China began withdrawing
assets from the U.S. market and converting them to other currencies, in order to
reduce its exposure, it would lose money because its actions would push down the
value of the securities and the dollars it sold. When it purchased other currencies and
foreign assets to replace its former U.S. holdings, it would lose money again because
its actions would also push up their prices. Chinese officials may want to reduce the
inflationary pressure which comes from growth in their foreign exchange reserves but
they may not be happy about the prospect of major financial losses if they revalue or
if they move their current assets elsewhere.
Second, where is the money coming from that fuels those growing reserves?
Many people believe that exports and incoming foreign investment account for most

of the increase in China’s foreign exchange reserves. Some suggest, however, that
“hot money” — speculative inflows of foreign funds seeking to profit from
revaluation of the yuan — may account for most of the growth in China’s reserves.
Depending on the source of the money, the policy implications for China are
very different. If trade and investment are the main source of the funds, then — if
Chinese officials want to slow the growth in reserves — they should raise the value
of the yuan. However, if speculative inflows are the primary source, then China’s
policy choices are more difficult. A large quick revaluation would stop the
speculative pressure but it might also damage China’s economy. Gradual increases
would allow the Chinese economy to adjust but it might also encourage speculators
to bring more money into China in hopes of profiting as the currency goes up in
value. A refusal to consider any change in the value might discourage the speculators
over a long period of time. But if the status quo prevailed during that period, this
would also make China’s trading partners angry and give them reasons to doubt
whether Chinese officials are sincere when they say they want to revalue the yuan.
Third, would revaluation strengthen or weaken China’s banking system?
China’s banks are riddled with bad debt and their competitiveness weakened by years
of state control. If the yuan were increased in value, would the shock cause Chinese
banks to strengthen their procedures or would it put the system at risk? A change in
exchange rates which weakened the export sector without simultaneously stimulating
domestic commerce could hold bad news for China’s banks.
Some experts point out that Chinese banks hold only a small portion of their
assets in foreign currencies and the government has recently established asset
management companies (similar to the mechanisms the U.S. Government used in the
1980s to resolve the U.S. savings and loan crisis) to take bad debt off the books of
the banks. However, export-related activities account for a major share of the
customers in China’s banking system. Nevertheless, most experts agree that bad
debts (non-performing assets) account for perhaps 30% of the assets of Chinese
banks and they say the government will need to spend hundreds of billions of dollars
in yuan to recapitalize and restructure the major banks. The IMF says that the
strength of China’s banking system should not be an impediment to a gradual
increase in the value of the yuan. However, Chinese officials have expressed
reservations and may not be willing to revalue the yuan very quickly until their
concerns about the impact on their national banking system have been alleviated.
External pressure to revalue rapidly might be seen as an effort by foreigners to create
more opportunities for their firms to buy ailing Chinese banks.
Policy Options for the United States. The fourth part of this report
identifies five major options which U.S. policy-makers might consider if they want
to encourage China to revalue the yuan. They are not mutually exclusive, though it
might be difficult for some of them to be pursued simultaneously.
First, the United States could continue pressing China publicly for further
changes in its foreign exchange system, in order that the yuan’s value would better
reflect market conditions and economic realities. If Chinese reformers need outside
pressure to help them persuade other officials to consider reform, this strategy might
help. Second, as a reciprocal of the first option, U.S. policy-makers might refrain

from pressing China to move more quickly with its reforms. This might be an
effective strategy if the Chinese proponents of change find that outside pressure
strengthens the hand of those resisting reform.
Third, the United States could levy special tariffs on Chinese imports in an
effort to encourage China to be more accommodating in their discussions with the
United States about the yuan. However, such duties may violate WTO rules. Also,
Chinese exporters may be able to absorb some of the cost of the new duties. Further,
if the yuan were revalued, the price of Chinese exports would need not increase by
the same rate as did the yuan. Chinese exports include a high proportion of inputs
imported from other countries. The price of those inputs would not change if the
yuan went up in value. To break even, producers in China would only need to
increase the price of their exports by an amount which reflects the higher dollar-
equivalent cost of Chinese-produced inputs and labor paid in yuan.
Fourth and fifth, the United States might refer the dollar-yuan controversy to the
IMF or the World Trade Organization. As noted above, this issue has been discussed
at the IMF for some time. Proposed changes in the power of the IMF might give it
more authority over country exchange rate policies, including authority to address
problems of manipulation. Whether China would be the main country affected,
whether the United States and other countries would allow the IMF to determine their
exchange rates, and what impact these rule changes might have on the policies of the
countries with the world’s largest economies are matters for speculation.
An appeal to the WTO might be based on the grounds that China’s undervalued
currency allegedly constitutes a subsidy to its export sector. The WTO can evaluate
trade disputes and it can authorize countries to levy trade penalties in order to enforce
its decisions. However, it has no authority to judge exchange rate issues. The WTO
and IMF have an agreement, though, specifying that any exchange rate issues which
arise in WTO deliberations shall be referred to the IMF and the IMF’s decision shall
be final. In effect, the WTO would be the enforcer if the IMF decided that a country
was manipulating its currency to gain unfair trade advantage.
Issues and Events
Yuan-Dollar Exchange Rate Issue
The Controversy. In 1994, the People’s Bank of China (PBC) lowered the
value of its currency from 5.8 to about 8.7 yuan to the dollar. The rate gradually
settled by 1997 to 8.3 and was locked at that rate during the Asian financial crisis.
In the past dozen years, China’s economy has grown substantially, both in size and
in the level of modernization, and the proportion of its economy oriented towards
exports has increased considerably. One might expect that these changes would have
had an impact as well on the relative exchange value of China’s currency, particularly
its rate compared to the U.S. dollar as the United States became China’s most
important single export market. However, the value of the yuan remained largely
unchanged during most of that period and it remained fixed at 8.3 yuan to the dollar

after 1997 as the People’s Bank of China (PBC) sold yuan into the market in order
to keep the yuan’s value constant. Many argue that this constitutes manipulation.
Arguments Pro and Con. Many argue that China is manipulating the value³
of its currency in order to gain unfair trade advantage. They believe this has
seriously injured the manufacturing sector in the United States and contributed
significantly to the U.S. trade deficit.
The act of currency manipulation is often hard to see. However, the effect of
manipulation on currency prices is more apparent. Critics of China’s exchange rate
policies argue that China’s currency is perhaps 25% to 50% undervalued compared
to the U.S. dollar. They cite various studies which support their view. They say the
undervalued yuan adds to the U.S. trade deficit and hurts U.S. output and
employment. Many have urged the Administration to put pressure on China in order
to make it stop manipulating the yuan. They say China should either raise the value
of the yuan by official action (“revalue”) or let it trade freely in foreign exchange
markets (“float”) so that the free market can determine its real international value.
The issue of manipulation is controversial. The IMF says, in its Articles of
Agreement (Article IV), that countries shall “Avoid manipulating exchange rates or
the international monetary system in order to prevent effective balance of payments
adjustment or to gain an unfair competitive advantage over other members.”⁴
Member countries are supposed to comply with this requirement. In addition, the
U.S. Omnibus Trade and Competitiveness Act of 1988 requires that the Secretary of
the Treasury determine whether other countries “manipulate the rate of exchange
between their currency and the United States dollar for the purpose of preventing
effective balance of payments adjustments or gaining unfair competitive advantage
in international trade.”⁵
Chinese officials say they are not trying to gain unfair trade advantage with their
foreign exchange policies. Rather, they are seeking economic stability. China is
experiencing rapid and far-reaching economic changes, they say. Major reforms in
China’s economic policies and institutions have taken place, in this view, but more
are yet needed. The economy has grown rapidly in the past decade, they say, but the
distribution of the benefits has been uneven and the strains between the needs of the
old economy and the new economy are great. Meanwhile, they say, the export sector
is the engine of growth for the Chinese economy.
Chinese officials acknowledge that China’s foreign exchange policies stimulate
economic growth. However, they say, the goal is not the attainment of unfair trade
advantage but rather continued growth in the export sector. Many Chinese export

³ See, for example, a report and data published by the China Currency Coalition. Chinese
Currency Manipulation Fact Sheet, April 2005. The Coalition is a group of U.S. industrial,
service, agricultural, and labor organizations seeking change in the yuan exchange rate. In
addition to labor unions, most of its members appear to represent import-sensitive products.
Available at [http://www.chinacurrencycoalition.com/factsheet.html].
⁴ Articles of Agreement of the International Monetary Fund. 60 Stat. 1401, TAIS 1501.
⁵ The Omnibus Trade and Competitiveness Act of 1988, P.L. 100-418, Section 3004.

industries operate on very thin profit margins, they report, and an increase in the
value of the yuan would lead to widespread bankruptcies. China’s export sector is
the engine driving the growth and modernization of China’s national economy. A
downturn in that sector would lead to a slowdown in growth or even a decline in the
national economy as a whole. This could lead to widespread instability, they say,
with potentially serious consequences. Thus, they believe, China’s exchange rate
policy is aimed at promoting stability in the country’s export sector and economy as
a whole. Achieving trade advantages through undervaluation of the currency is only
an instrumental means towards the achievement of this goal. From this point of
view, efforts by foreigners to raise the exchange rate for China’s currency are aimed
not merely at the elimination of this trade advantage but at undercutting China’s
economic and political stability and at thwarting its emergence as a great power.
Chinese officials have not entered into the debate concerning the “real” value
of China’s currency, though some say there is no convincing evidence that the yuan
is undervalued. They could cite econometric studies (see below) which support the
view that China’s currency is slightly overvalued or perhaps only a little undervalued
compared to the dollar.
Many economists doubt that China’s actions have had any appreciable impact
on the long-term value of the dollar. The dollar plays a broad role in international
finance and the amount of dollars in circulation globally is very large. A recent
survey by the world’s leading central banks indicated that the daily trading of foreign
currencies totals more than $1.9 trillion, 90% of which is in dollars.⁶
China Announces a Change. On July 21, 2005, China’s central bank
announced a new exchange rate system for China’s currency. First, it increased the
value of the yuan, which rose from 8.28 to 8.11 to the dollar.⁷ Second, the yuan
would be referenced, not just to the dollar but to a basket of currencies, and it would
be allowed to vary by 0.3% each day above or below a central parity. Third, the
central bank said that “the closing price of...the US dollar traded against the RMB
[yuan]...after the closing...of the market each working day” would become “the⁸
central parity for the...following working day.” This seemed to be an exchange
system which economists call a “crawling peg.”

⁶ Triennial Central Bank Survey: Foreign Exchange and Derivatives Market Activity in
2004. Bank for International Settlements, March 2005, pp. 1-2. A copy of this report is
available at [http://www.bis.org/publ/rpfx05t.pdf]. The 2001 survey is: Central Bank
Survey of Foreign Exchange and Derivatives Market Activity in April 2001: Preliminary
Global Data. Bank for International Settlements, October 2001.
⁷ A currency is said to “rise” in value compared to the U.S. dollar when one dollar buys a
smaller amount of that currency than before. By convention, it is said that the yuan or
renminbi rose in value by a little over 2% (even though the number gets smaller) when it
went from Rmb 8.28 to Rmb 8.11 to the dollar on July 21, 2005.
⁸ The new procedure was widely discussed in the press. See, for example, “2% Solution:
China lets Yuan Rise vs. Dollar, Easing Trade Tensions Slightly,” Wall Street Journal, July

22, 2005, p. 1; Richard McGregor et al., “China revalues the renminbi.” Financial Times,

July 22, 2005, p. 1; and Peter Goodman, “China Ends Fixed-Rate Currency,” Washington
Post, July 22, 2005, p. 1.

If the new procedure had been allowed to function as announced, the yuan could
have increased in value by 30% in five months. On July 27, 2005, however, the
central bank announced that no further changes in the value of the yuan should be
expected. Rather, it said, China’s new system would be a “managed float.” The
central bank would compare the value of the yuan to a “basket” of currencies issued
by its major trading partners. However, the Chinese authorities made it clear that
they would decide what the value of the yuan would be and they would determine
when and how liberalization might occur. The yuan might fluctuate compared to
other currencies, but they said its dollar value would be fixed.
Too Small? To many observers, the 2% increase in the value of the yuan
announced in July 2005 was too small and the process for possible future increases
was too obscure and uncertain. Some might argue that the changes in the new
system reflect the current debate about economic policy within the Chinese
leadership. Some Chinese officials may believe that reform, including liberalization
of the yuan, is in China’s best interest. Others may believe that China must continue
the policy of export-led growth and the advantages of the old system should not be
disposed of lightly.
From this perspective, some might say the new system was adopted in order to
buy time, to delay reform, and to forestall outside pressure. China was scheduled to
discuss its exchange rate policies with the IMF executive board in August 2005 and
the advent of a new system gave the Chinese something new to present. The IMF
board was critical of China’s exchange rate policies in 2004 and IMF staff had
strongly urged China in mid-2005 to introduce market forces into China’s exchange
rate regime. The change was also announced just before Congress was scheduled to
consider several bills which sought to put pressure on China if it did not revalue its
currency. Arguably, a series of ambiguous steps which seemed to herald change
might buy China time to consider its options and lay its plans. It might give the IMF
board a reason not to press for faster action and it might persuade Congress to⁹
postpone action on the pending bills.
Alternatively, instead of seeing the new system as the product of internal debate,
one might say that it is obscure because it seeks to confuse and frustrate speculators.
The inflow of speculative “hot money” is serious. An official with China’s State
Administration of Foreign Exchange reportedly observed that “Whether we [can]
effectively refrain speculation on yuan is the key to the success or failure of the
reform.”¹⁰ If China wants to avoid instability and sharp changes in currency prices,
its actions must not invite speculators to bring in more foreign currency and buy more
yuan. In effect, China faces a challenge of doing what the speculators expect —
increase the value of the yuan — without encouraging them to capitalize on their
expectations.

⁹ See, for example: “Richard McGregor. “Aim is to allow greater flexibility while still
keeping firm control” and “Making Sense of China’s Choice,” Financial Times, July 22,

2005, pp. 2 and 4.

¹⁰ “Chinese Bank Reaffirms Revaluation Policy,” BBC Monitoring Asia Pacific, September

21, 2005.

The old system offered speculators a one-way, no-risk bet, since there was little
chance the yuan would fall in value whereas there seemed a real possibility that the
value would eventually rise, perhaps substantially. This offered potentially large
rewards to those who owned yuan or yuan-denominated assets.¹¹ The inflow of
speculative money puts pressure on China to revalue the yuan to reduce the flow.¹²
However, if the increase were not sudden and massive, speculators might be
encouraged to buy more yuan in hopes of profiting as it goes up in value. As long as
there is a general expectation that the yuan is underpriced and as long as these
speculative flows continue, Chinese officials are reluctant to allow the market to
determine the yuan’s value. They worry that it might increase too much in value
(“overshoot”) if it were opened suddenly to market forces and this could also have
negative consequences for the Chinese and world economies.
New Initiatives Since July 2005. More recently, the Chinese authorities
have taken other steps that could allow market forces to eventually play a role in the
valuation of the yuan. In mid-2005, they created a system of non-deliverable
forward contracts which let individuals take positions and make predictions as to the
future value of the yuan.¹³
In January 2006, China’s State Administration of Foreign Exchange (SAFE)¹⁴
authorized 13 local and foreign banks to buy and sell yuan for dollars in the yuan
spot market. An experiment allowing some banks to trade yuan for euros and Hong
Kong dollars had begun in 2005. The new arrangement is supposed to improve
liquidity and allow market forces a role in the valuation of the yuan. Under the new
rule, the opening price for the yuan would be determined by the average closing price
of the 13 banks (with the two most extreme eliminated.) In principle, this would
allow yuan to move up or down in value in response to market forces. However,
observers assert that the central bank remains the biggest trader in the yuan-dollar
market and any bank which quotes too high a rate will be vulnerable if it floods the
market with yuan in order to keep the rate at its preferred price.

¹¹ See, for example, Morris Goldstein and Nicholas Lardy, “China’s Revaluation Shows Size
Really Matters,” Financial Times, July 22, 2005, p. 13.
¹² This argument is the author’s synthesis of conversations he and other members of his
group had with Chinese and U.S. officials and other persons in January 2006 during a
congressional staff visit to China and Hong Kong.
¹³ Patrick Higgins and Owen F. Humpage, “Nondeliverable Forwards: Can We Tell Where
the Renminbi Is Headed?,” Economic Commentary, September 1, 2005. Federal Reserve
Bank of Cleveland. Settlement on these contracts is in dollars, not in yuan. Keith
Bradsher, “China Loosens Limits on Trading Against Other Currencies but Keeps Rein on
Dollar,” New York Times, September 24, 2005, p. C6.
¹⁴ These included five foreign banks (ABN Amro Holding NV, Bank of Montreal, Standard
Chartered PLC, Citigroup Inc. and HSBC Holdings PLC) and eight Chinese banks (Bank
of China, China Construction Bank, Industrial & Commercial Bank of China, Agricultural
Bank of China, Bank of Communications Co., China Merchant’s Bank Co., Citic Bank Co.
and Industrial Bank Co.) Jane Lanhee Lee. “International Investor: China Approves Banks
as Renminbi Market Makers; Move Is Set to Bring More-active Trading of Domestic
Currency,” The Wall Street Journal Asia (Hong Kong), January 3, 2006, p. 32.

In December 2005, the Chinese authorities took two additional steps that would
either reduce the demand for yuan or increase the demand in China for dollars. The
central bank announced that it was raising the interest rate for deposits held in U.S.
or Hong Kong dollars, widening the gap between those rates and those paid for
accounts denominated in yuan.¹⁵ This was aimed at discouraging speculators from
buying yuan in hopes they can turn a profit by converting them back into dollars if,
in the near future, the yuan should increase substantially in value.
The central bank also announced that it would soon scrap the existing limits on
the amounts that Chinese firms could take out of the country.¹⁶ This could marginally
push down the value of the yuan when Chinese firms sold their national currency in
order to purchase the dollars needed to expand their overseas operations.
Market Expectations. The dollar exchange rate for the yuan has changed by
only a little more than one-half of 1% since the new system was introduced, going
from Rmb 8.11 to the dollar on July 21, 2005 to Rmb 8.0424 to the dollar on
February 26, 2006. The People’s Bank of China retains firm control of the exchange
rate through its transactions in foreign exchange markets. In January 2006, futures
contracts suggested that traders believed the value of the yuan would rise 2.1% (to
Rmb 7.86 to the dollar) in six months and 4.3% by the end of 2006. A global
markets analyst for Goldman Sachs predicted, by contrast, that the value of the yuan
would increase by 9% (to Rmb 7.34) by the end of the year.¹⁷ The Economist
Intelligence Unit said the yuan would rise 4.4% in 2006 (to Rmb 7.9) and 3.7% in

2006 (to Rmb 7.6.)¹⁸

These predictions assume that the People’s Bank of China will bring these
results about through its exchange market transactions or (to say the same thing) that
it will not act to prevent market forces from generating these rates of exchange.
International Views
Efforts by the IMF. The IMF staff proposed, in its June 2005 report on its
recent Article IV consultations, that China should revise its foreign exchange policies¹⁹
and allow the market to play a larger role in the valuation of the yuan. The IMF
executive board had the report prior to its formal review of China’s policies, though
the actual document was not published until September.

¹⁵ Prashant Rao. “Rates Ease Pressure on Yuan to Strengthen,” International Herald Tribune
(Paris), December 29, 2005, p. 17.
¹⁶ Shai Oster. “Beijing Hints at a Shift in its Foreign Holdings; Desire to Diversify May Hurt
the Dollar; Controls to Be Eased,” The Wall Street Journal Asia (Hong Kong), January 6,

2006, p. 1.

¹⁷ Both cited in Steve Johnson, “Traders Price in Surging Renminbi,” Financial Times
(London), January 6, 2006, p. 38.
¹⁸ EIU ViewsWire, New York, December 8, 2005.
¹⁹ Article IV of the IMF Articles of Agreement require it to meet annually with member
countries to discuss their economic and foreign exchange policies.

The IMF executive board discussed China’s new exchange rate policies during
its August 2005 annual Article IV consultation review. Many people believe that
China announced its new policies two weeks before that meeting in order to show
they were addressing the issue. The previous year, during its August 2004 review of
China’s policies, the board had said that greater exchange rate flexibility was in
China’s best interests.²⁰ It also welcomed China’s statement that it would “introduce,
in a phased manner, greater exchange rate flexibility.” Some observers suggest that
it might have been awkward for China to go to the 2005 meeting and report that it
had done nothing.
In its August 2005 review, the IMF executive board “welcomed the change in
the exchange rate regime — an important move toward greater exchange rate
flexibility — and encouraged the authorities to utilize the flexibility afforded by the
new arrangement.” It reiterated its earlier point that greater exchange rate flexibility
was both necessary and in China’s best interests.²¹ It also said that “a more flexible
exchange rate, not simply a revaluation, is the key to providing scope for monetary
policy independence and enhancing the economy’s resilience to external shocks.”
According to the summary of the board discussion, most directors supported a
gradual and cautious approach but many others recommended that China move
quickly to a foreign exchange level which reflects underlying market forces.
Other Countries’ Views. No other country has taken as strong a public
position on the Chinese exchange rate issue as has the United States, even though the
low cost of Chinese exports has been a source of concern to interests in their
countries as well. Nevertheless, some other countries reportedly have been vigorous
in their private discussions with Chinese officials, urging them to give market forces
a larger role in determining the value of the yuan. Their public statements have
tended to show patience with China’s concerns. Some observers suggested that they
preferred to let the United States do the “heavy lifting.”
Some countries have spoken out. In early June 2005, for example, David
Dodge, Governor of the Bank of Canada, called on China to free its currency from
the fixed rate against the U.S. dollar or to risk sparking U.S. and European trade
protectionism.²² At the same time, Japan’s finance minister urged China to reform

²⁰ International Monetary Fund, IMF Concludes 2004 Article IV Consultation with the
People’s Republic of China, August 25, 2004. Public Information Notice 04/99. It appears
from context that “greater flexibility” meant an upward valuation of the yuan. The
statement by China is taken from the IMF’s summary of the board discussion.
²¹ International Monetary Fund, IMF Concludes 2005 Article IV Consultation with the
People’s Republic of China, September 12, 2005. Public Information Notice 05/122.
Available from the China page of the IMF website as well as in an annex (pp. 69-72) to the
2005 Article IV staff report. See IMF, People’s Republic of China: Staff Report for the
2005 Article IV Consultation, July 8, 2005, p. 14. Available from the China page on the
IMF website.
²² Paul Brent. “Dodge’s Call to Free the Chinese Yuan Has Strong Backing,” National Post
(Don Mills, Ontario), June 6, 2005, p. FP2.

its tight currency peg on grounds that the current yuan-dollar exchange rate was
hurting the Chinese economy and causing it to overheat.²³
European ministers reportedly have been more accommodating in their remarks.
For example, Chinese Premier Wen Jiabao told an Asia-Europe ministerial meeting
in June 2005 that China would adopt a more flexible currency policy only when it
believed itself ready. European ministers replied, in their public statements, that they
hoped it would not take too long²⁴ but they agreed that China should not be pressured
and it had the right to determine when and how it would reform its currency.²⁵
Since July 2005, observers have been waiting for an announcement by China
that it would further liberalize its exchange rate policy. The IMF executive board
urged this at its discussion of China’s policies in August 2005. The governing boards
of the IMF and World Bank urged it at their joint annual meetings in late September

2005. Treasury Secretary Snow urged it during his October 2005 trip to China.

President Bush reiterated the point during a state visit to China in November 2005.
In September 2005, the finance ministers of the G-7 countries said, in the
communique following a meeting in Washington, D.C., that “we welcome the recent
decision by the Chinese authorities to pursue greater flexibility in their exchange rate
regime.”²⁶ This was the first time a G-7 communique had called on China by name
to take action. “We expect the development of this more market-oriented system to
improve the functioning and stability of the global economy and the international
monetary system,” they added. China’s President told the G-8 leaders that China
wanted to base the yuan’s value on market forces but it would do this on its own time
and not as a result of foreign pressure.²⁷

²³ “Tanigaki Says Quick Action on Yuan Needed,” Economic Times of India, The Electronic
Times Online, July 9, 2005. See the Economic Times of India website at
[http://economictimes.indiatimes.com/articleshow/1165902.cms]. By contrast, Japan
previously had called for China to take immediate action. The Japanese Finance Minister
told the G7 finance ministers in February 2003 meeting, that change was urgently needed
and “Too much importation of China’s cheap goods” was “the root-cause of the global
economic depression.” Yang Jian and Melinda Moore. “Renminbi” Eurobiz Magazine, July

2003, found at [http://www.sinomedia.net/eurobiz/v200307/rmb.html].

²⁴ Kervin Yao and Yoko Nishikawa. “Yuan Dominates Asia-europe Meeting,” Reuters, June

26, 2005, reported at [http://www.aardvarkbusiness.net/chat/viewtopic.php?t=6237]

²⁵ Cindi Sui. “Europe Backs off on Yuan Value,” The Australian, June 27, 2005, at
[http://theaustralian.news.co m. a u / c o mmo n / story_page /0,5744,15741709%255E31037,00
.htm]. Cary Huang. “World Clamours for Beijing to Revalue Yuan; but There Is Agreement
That China Should Dictate Timing of Any Currency Reforms,” South China Post (Hong
Kong), June 27, 2005, p. 5.
²⁶ “G-7 Ministers Urge China to Make More Progress on Exchange Rate.” Bloomberg
News, September 26, 2005, available from Bloomberg News at
[http://www.bloomberg.com/apps/news?pi d=10000080&sid=a86iuRuMx.4g&r efer=asia].
“G7 Demands More Flexible Yuan Regime,” The Daily Yomiuri, September 25, 2005, p. 1.
²⁷ Scott Hills. “China’s Hu Sidesteps Yuan Debate in G8 Address,” Reuters, July 1, 2005,
at [http://entertainment1.sympatico.msn.ca/Music/MusicNews/Live8+Coverage].

The G-7 finance ministers were even more specific in their communique
following their meeting in London on December 3, 2005. They said that “further
implementation of China’s currency system would improve the functioning and
stability of the global economy and the international monetary system.” They said,
in language not directly mentioning China, that such disparities, along with high oil
prices, were a threat to a “solid” world economy.²⁸ They also said that “exchange
rates should reflect economic fundamentals” and that they would monitor exchange
markets closely. This was much stronger language than the “welcome” the ministers
had expressed three months earlier.
Individual leaders were even more specific in their remarks. European Central
Bank president Jean-Claude Trichet said at the time that the G-7’s public comments
were “in continuity with the message that we have been giving.” He also said,
referring to Asia, that “this part of the world has to contribute to the solution of
global imbalances.”²⁹ Japan’s finance minister, Sadakazu Tanigaki, said, at the same
time, that “we believe China needs some time to get accustomed to their new
currency regime, but a considerable time has already passed. I expect China to make
its currency a bit more flexible.”³⁰ Treasury Secretary Snow said, on this occasion,
that “this rigidity constrains exchange rate flexibility in the region and thus poses
risks to China’s economy and the global economy.” Jin Renqing, China’s finance
minister, did not comment directly but did say that China would over time allow
market forces to play a greater role in determining the value of the renminbi.
U.S. Views. In the United States, both the Administration and Congress have
spoken to the issue of China’s currency.
Action by the Executive Branch. In January 2004, President George W.
Bush told a crowd in Toledo, Ohio that “we expect countries like China to
understand that trade imbalances mean that trade is not balanced and fair. They have
got to deal with their currency.”³¹ On July 21, 2005, responding to China’s
announcement that it was adopting a new exchange rate system, Treasury Secretary
John Snow said that he welcomed the announcement but “we will monitor China’s
managed float as their exchange rate moves to alignment with underlying market
conditions.”³² He agreed that the initial 2% change was small, but he said the
important thing was China’s willingness to change. “This is the start of a process,”

²⁸ Simon Kennedy and Gonzalo Vina. “G-7 Prods China to Let Yuan Rise; Beijing Is
Accused of “Rigidity” as Currency Appreciates Little,” International Herald Tribune
(Paris), December 6, 2005, p. 20.
²⁹ Jane Wardell. “Economic Officials Chide China,” (Associated Press) Deseret News,
December 4, 2005, p. A12; “G-7 prods...” Ibid.
³⁰ Gonzolo Vena and Simon Kennedy. “G7 Pushes China on the Yuan; Rates ‘Should
Reflect’ Fundamentals, it Says,” International Herald Tribune, December 5, 2005, p. 15.
³¹ White House. “President Discusses Job Training and the Economy in Ohio.” January 21,

2004. See [http://www.whitehouse.gov/news/releases/2004/01/20040121-2.html].

³² Snow Welcomes China’s Currency Reforms, at [http://www.treas.gov/news/index1.html].

he said, “and the Chinese have indicated they want to get their currency based on
markets rather than a peg.”³³
The United States has urged the IMF to press China to introduce market forces
in its foreign exchange process more quickly. (This is discussed further, below.) In
January 2006, at the World Economic Forum in Davos, Switzerland, Under Secretary
Tim Adams told Bloomberg Television that China was not doing enough. “China
needs to undertake serious reforms. They’re on the road to reform but they need to
move faster.”³⁴ He also told a panel at the Forum that the United States had never
asked China to float its currency as it does not think the Chinese financial system
could withstand it. Rather, he said, the United States had urged China to allow more
flexibility in their exchange rate. “All we’ve asked them to do is what they’ve agreed
to do and what they know is in their best interest to do,” he said.³⁵
The Omnibus Trade and Competitiveness Act of 1988 (sec. 3004) requires the
Secretary of the Treasury to determine, in consultation with the International
Monetary Fund, whether countries are manipulating their currency in order to gain
unfair trade advantage. In May 2005, Treasury reported that China was not
manipulating its currency.³⁶ Some observers said the Treasury Department was more
critical of China in this report than earlier in part due to congressional pressure. “If
current trends continue without substantial alteration [i.e., revaluation],” the report
said, “China’s policies will likely meet the statute’s technical requirements” for
designating China as a country which unfairly manipulates its currency value.
Nevertheless, the report said that Chinese authorities had assured Treasury Secretary
Snow that they were laying the groundwork for a future revaluation of the yuan. It
was on this basis that the Department found that China was not manipulating its
currency. Snow reportedly gave China six months to rectify the situation and he
called for an immediate 10% revaluation.³⁷ No such change occurred.

³³ Susie Gharib. “Secretary of State John Snow Sounds-off On China’s Money Move.”
Nightly Business Review, July 21, 2005. Interview, available at
[http://www.nbr.com/archive/transc ript/2005/transcript072105.html ].
³⁴ Bloomberg News. “Dickering at Davos: Which Way Yuan; Pace of China Yuan Reform
Takes Center Stage at World Economic Forum,” January 25, 2006: 2:17 PM EST. Available
at [http://207.25.71.61/2006/01/25/news/international/bc.davos.china.reut/index.htm].
³⁵ World Economic Forum Annual Meeting 2006, Fixing Up Fixed Exchange Rates,
summary of discussion, January 1, 2006. Available by searching Google by title or at
[ h t t p : / / www.we f o r u m. o r g/ s i t e / k n o w l e d g e n a v i g a t o r . n s f / C o n t e n t / _ S 15322?open&event_id=].
³⁶ U.S. Department of the Treasury. Report to Congress on International Economic and
Exchange Rate Policies, May 2005. Obtained from [http://www.treas.gov], the Treasury
Department website. See especially pp. 11-14.
³⁷ See, for example Andrew Balls, “US sets out revaluation deadline for China,” Financial
Times, USA edition, May 18, 2005, p. 1. See also Edmund L. Andrews, “Bush’s Choice:
Anger China or Congress over Currency,” The New York Times, May 17, 2005, p. 1; and
Andrew Balls, “FT.com site: China told to revalue by 10% by US,” Financial Times, May

24, 2005, p. 1.

In November 2005, Treasury reported that China’s actions “are not sufficient
and do not represent fulfillment of the Chinese authorities’ [earlier] commitment.”³⁸
It said, though, that Chinese authorities had pledged in October 2005 “that they
would enhance the flexibility and strengthen the role of market forces in their
managed floating exchange rate regime.” It also said that “President Hu told
President Bush that China would unswervingly press ahead with reform in its
exchange rate mechanism.” Therefore, by implication, they were not manipulating
the yuan. The Chinese authorities should act, the report concluded, “by the time this
report is next issued” (i.e., in six months).
In May 2006, in its most recent six-month report, the Treasury Department
reported that “too little progress has been made in introducing exchange rate
flexibility for the renminbi.”³⁹ The Department determined once again, however, that
China’s foreign exchange policies did not violate the terms of the Omnibus Trade
and Competitiveness Act of 1988. Whatever the effects of China’s policies might
be, the Department said it was unable to determine, from the evidence at hand “that
China’s foreign exchange system was operated during the last half of 2005 for the
purpose (i.e., with the intent) of preventing adjustments in China’s balance of
payments or gaining China an unfair competitive advantage in international trade.”
Therefore, without a demonstration of intent, “the technical requirements for China
to be designated under the terms of the Act have not been met.” The report cited the
various initiatives China had introduced in the past six months. It also reported that
China’s President Hu told President Bush in April 2005 that China would reduce its
trade balance in the future by boosting demand and stimulating domestic growth.
Action by Congress. In late 2005, Congress passed legislation which urged
the President to create a comprehensive plan to address diplomatic, military and
economic issues relating to China.⁴⁰ In particular, it said the Administration should
encourage China to revalue its currency further against the U.S. dollar by allowing
the yuan to float against a trade-weighted basket of currencies. Congress is currently
considering several bills which would require the United States to limit trade with
China if it does not revalue the yuan or direct the President to take the yuan-dollar
exchange rate issue to the IMF or WTO for action.
Three bills are prominent among this legislation. In July 2005, the House of
Representatives passed legislation (H.R. 3283) introduced by Representative Phil
English which would make imports from non-market economies (such as China)

³⁸ U.S. Department of the Treasury. Report to Congress on International Economic and
Exchange Rate Policies, November 2005. Available from [http://www.treas.gov], the
Treasury Department website. See especially pp. 17-21.
³⁹ U.S. Department of the Treasury. Report to Congress on International Economic and
Exchange Rate Policies, May 2006. Available from the Treasury Department website. See
especially pp. 1-2.
⁴⁰ The fiscal 2006 defense appropriations act, H.R. 1815, approved by Congress in
December 2005 and signed into law (P.L. 109-163) on January 6, 2006. The relevant
language is found in Section 1234 of that act.

subject to U.S. countervailing duty.⁴¹ Exports from China which were found to be
subsidized on account of exchange rate manipulation might be subject to these trade
rules and monetary penalties could be assessed which would raise the price of those
goods in U.S. markets. The bill also required the Treasury Department to define the
term “currency manipulation” for the purpose of U.S. law and to report periodically
on China’s implementation of its new exchange rate regime.⁴²
The House is also considering another bill (H.R. 1498), introduced by
Representatives Tim Ryan and Duncan Hunter, that would make it clear under U.S.
law that exchange rate manipulation by China would make goods imported from that
country actionable to U.S. countervailing duties.⁴³ Proponents argue that the
language of H.R. 3283, though seemingly aimed at China, would actually make it
more difficult for firms to levy countervailing duty claims against China. No action
has been taken on H.R. 1498, though it currently has 169 co-sponsors.
The Senate is also considering legislation that would limit China’s access to the
U.S. market if it does not stop manipulating the value of its currency. Senators
Charles Schumer and Lindsey Graham proposed on April 6, 2005, for example, that
Congress enact a 27.5% tariff on all Chinese products entering the United States if
China does not raise the value of its currency.⁴⁴ This is deemed to be the average
degree of undervaluation identified by several studies. The Senate voted 67-33 for
this proposal, as a rider on another bill, but it was later introduced as a separate bill
(S. 295). Originally scheduled for consideration in mid-2005, action was postponed.
The bill is expected to come up again for consideration sometime in 2006.
Five Key Questions
Is the Yuan Undervalued? By How Much?
The IMF said in its 2004 evaluation of the Chinese economy that it was
“difficult to find persuasive evidence that the renminbi [yuan] is substantially
undervalued.”⁴⁵ Since then, many economic studies have been published seeking to
determine the yuan’s “equilibrium” exchange rate. (This is the exchange rate that
would prevail if the value of the yuan was not controlled and if the U.S. and Chinese
economies were both at macroeconomic equilibrium.) The results of these studies

⁴¹ H.R. 3283, passed by the House (255 to 168) on July 27, 2005. Senator Susan Collins
introduced a similar bill (S. 1421) in the Senate in July 2005 but no action has been taken.
⁴² For more on the issue of countervailing duties and nonmarket economies, see CRS Issue
Brief IB10148, Trade Remedy Legislation: Applying Countervailing Action to Nonmarket
Economy Countries, by Vivian C. Jones and Vladimir N. Pregelj.
⁴³ H.R. 1498, the Chinese Currency Act of 2005, introduced April 9, 2005.
⁴⁴ Greg Hitt. “Senate Slams China’s Currency Policy,” Wall Street Journal, April 7, 2005,
p. 1.
⁴⁵ International Monetary Fund. People’s Republic of China: Staff Report for the 2004
Article IV Consultation, July 6, 2004, p. 12. This report is available from the China page in
the country section of the IMF website at [http://www.imf.org].

differ widely. Consequently, there is sufficient research available to support any
position about the value of the yuan that one might wish to take.
The IMF’s China experts found in their 2005 evaluation that the yuan is
undervalued and the rate of undervaluation is increasing. More flexibility is needed,
they said, to avoid disruption of the domestic economy.⁴⁶ The difficulty, however,
one expert told CRS, is the lack of any reliable way of knowing how large the
distortion may be or how its effects can be separated from the other factors (such as
labor costs and productivity) which affect the international price of Chinese goods.
In a market economy, the exchange rate of a currency (vis-a-vis another
currency) can be affected by many things. These including interest rates, trade
relationships, institutional arrangements the international flow of money between
currency markets, and interventions (purchases or sales of currency) by the central
bank. Market forces will balance these factors and establish an exchange rate which
is supposed to reflect the actual value of goods and services in one country compared
to those in another country but sometimes — depending on other considerations
affecting the economy of either country — it does not.
The task of assessing exchange rates is more difficult when market forces are
constrained and currency values are set by official action. A simple method would
have one look at the price of a single product in world markets, on the theory that
properly functioning currency markets should adjust to equalize product costs. One
example is the Economist’s well known “Big Mac Index,” a light-hearted procedure
which compares the cost of McDonald’s hamburgers around the world.⁴⁷ By its
calculation, based on the price of hamburgers sold in both markets, the yuan is 59%
undervalued compared to the U.S. dollar. Most economists agree that this index
provides only a general suggestion of the relative valuation of currencies.⁴⁸ The
disparity in hamburger prices around the world can also be read as a comment on the
valuation of the U.S. dollar. The Economist says that the index shows that the U.S.
dollar is more overvalued now, compared to most other currencies, than at any time
since measure was introduced 16 years ago.⁴⁹
A more substantive effort to calculate the equilibrium value requires
construction of an econometric model for the countries whose currencies are being
compared. Much statistical information is required as well as a clear concept of the
way the institutions and sectors relate to each other. Often, information is not

⁴⁶ IMF, 2005 Article IV Staff Report, footnote 21.
⁴⁷ See [http://www.economist.com/markets/bigmac/displayStory.cfm?story_id=5389856].
See also [http://www.stanford.edu/class/msande247s/bigmac02.htm] for a reference to the
“light hearted” nature of the measure.
⁴⁸ For one thing, consumption patterns for this product vary from country to country. Also,
while the hamburgers are the same worldwide, most of their inputs are supplied locally. Few
hamburgers are exported from China to the United States. Labor, rent and paper products
are cheaper in China, for instance, than in the United States. Other factors besides currency
valuation can influence the cost of these local components.
⁴⁹ See the first source cited in footnote 47.

available and analysts have to substitute data based on their understanding as to how
each economy works and what the correct number would be if it were available.⁵⁰
In 2005, the Chinese Currency Coalition published a report citing eight reports
or statements (in addition to the Big Mac Index) which said that, to varying degrees,
the yuan was substantially undervalued.⁵¹ Two of the sources dated from 1998 or
2000. The others dated from 2002 or 2003. These included (in addition to the
hamburger index) a reference saying that the World Bank thought the yuan was 75%
undervalued and other studies, statements or testimony to Congress saying the yuan
was priced 10% to 40% below its “real” value.⁵²
The IMF published a paper in late 2005 which compared eight major studies
released in 2004 and 2005 that sought to calculate China’s “real” exchange rate on
the basis of macroeconomic and econometric analysis.⁵³ One scholar found, in two
studies using 2003 data, that the yuan was either slightly undervalued or slightly
overvalued that year. He found in a later study (using the next year’s data) that the
yuan was 5% overvalued in 2004. Another analyst found, using the same data, that
the yuan was only slightly undervalued in 2004. By contrast, other scholars have
found, using essentially the same statistics, that the yuan has been substantially
undervalued in recent years. One team concluded, for example, that the yuan was
pegged (in a study using 2002 data) at a rate that 18%-49% and (in another study
using 2003 data) 23% below its “real” value. Another researcher found, in a study
using 2000 data, that the yuan was undervalued by 35% that year. Yet another
scholar concluded, on the basis of 2004 data, that the official rate that year was 15%-

30% below its “real” market equilibrium value.

Meanwhile, Funke and Rahn, two scholars from Hamburg University in
Germany, found “compelling evidence that the renminbi is not substantially
undervalued.”⁵⁴ They seem to have employed the same econometric equilibrium
modeling techniques used by scholars cited in the recent IMF paper. The claims by

⁵⁰ For a simple guide to the process of calculating equilibrium exchange rates, see Sergio Da
Silva. Classroom Guide to the Equilibrium Exchange Rate Model. It is available at
[http://ideas.repec.org/ p/wpa/wuwpif/0405019.html ].
⁵¹ See Chinese Currency Manipulation Fact Sheet, cited in footnote 3.
⁵² The full names and citations to sources were not provided. Many economists would argue
that the World Bank data were misconstrued, as the Bank’s figures are not measures of the
extent to which currencies are over- or undervalued compared to the dollar but rather two
ways that per capita income levels in poor countries may be compared internationally. The
question whether the World Bank’s purchasing power parity index can be used to measure
deviations in exchange rates is also discussed in CRS Report RL32165, China’s Exchange
Rate Peg, by Wayne M. Morrison and Marc Labonte.
⁵³ Steven Dunaway and Xiangming Li. Estimating China’s “Equilibrium” Real Exchange
Rate, IMF Working Paper WP/05/202, October 2005. Available from the China page in the
country section of the IMF website: [http://www.imf.org]. The eight studies referenced in
the IMF report were by Virginie Coudert and Cécile Couharde (2 studies), Tao Wang (3),
Morris Goldstein, Jeffrey Frankel, and J. Lee. Full citations may be found in the report.
⁵⁴ Michael Funke and Jörg Rahn. “Just How Undervalued is the Chinese Renminbi?,” The
World Economy, 28:4 (April 2005), pp. 465-489.

some that China’s currency is grossly undervalued are incorrect, they argue. Rather,
they say, it seems in some circles to be “politically expedient to scapegoat the
Chinese currency for economic difficulties elsewhere.” Higgins and Humpage, two
economists with the Federal Reserve Bank of Cleveland, report that it “is next to
impossible”to determine the equilibrium exchange rate for developing countries
through econometric modeling. ⁵⁵ China is particularly difficult, they say, because
institutions and patterns of economic activity are changing very rapidly.
Data on the Chinese economy are incomplete, uncertain or unreliable. In late
December 2005, China announced that — when services previously omitted from
official statistics were taken into account — its gross domestic product (GDP) was
17% larger than expected. This was like discovering a province the size of Turkey
or Indonesia that was previously not counted in national statistics. The new data
make the Chinese economy the sixth largest in the world in dollar terms. If it grows
by 10% in 2006 and its currency appreciates by a like amount, China could surpass
Germany, Britain and France to become the world’s third largest economy.⁵⁶ All the
previous macroeconomic ratios — investment to GDP, exports as a share of GDP,
rate of growth, etc. — changed with the advent of the new data. None of the studies
cited above used the new data. Thus, even if they are correct in their use of the old
data, their calculations do not reflect this more recent data on the Chinese economy.
The variations in the conclusions of the 17 studies mentioned above may be due
in large part to the way scholars define the relationships among the different
segments of the Chinese economy and the different assumptions they use to fill in
gaps when they lack adequate information. Without careful analysis of the
methodology and assumptions used in each study, there is no way of knowing
whether the results of any of these studies are more accurate than others.⁵⁷
It appears that few of the participants in the debate about the value of China’s
currency have studied the methodologies or the assumptions of the various studies.
Rather, it seems that advocates select the studies they quote more because they like
their conclusions than because they believe they are the best research available. Few
of the participants in the debate cite findings which support conclusions other than
those they support or provide reasons why their preferred studies are superior on
substantive grounds to others which disagree.

⁵⁵ Patrick Higgins and Owen Humpage. “The Chinese Renminbi: What’s Real, What’s Not,”
August 1, 2005, at [http://www.clevelandfed.org/Research/Com2005/0815.pdf].
⁵⁶ See, for example, Clifford Coonan. “Services Sector Plays Major Role in Surging Chinese
Economy,” Irish Times (Dublin), December 27, 2005, p. 16. The calculation that China
could move from sixth to third place was made by the Congressional Research Service using
data in this and other newspaper reports.
⁵⁷ Some prominent studies which argue that the yuan is substantially undervalued seem to
have been based on back-of-the-envelope calculations rather than on systematic econometric
analysis. Others use questionable assumptions or weak economic logic. For a discussion,
see CRS Report RL32165, China’s Exchange Rate Peg, by Wayne M. Morrison and Marc
Labonte.

Is China Manipulating Its Currency?
The IMF and Exchange Rate Policy. In the past thirty years, the role of
the IMF in the international financial system has changed. Until the early 1970s, the
IMF had a central role in determining world exchange rates. All currencies had a
fixed value (“par value”) compared to the U.S. dollar and the U.S. dollar was worth
a specified amount of gold. If countries wanted to change their par value compared
to the U.S. dollar, the IMF had to first approve. Since 1976, however, with passage
of the Second Amendment to the IMF Articles of Agreement, each country is free to
determine the exchange rate system it will use. Some countries have floated the
value of their currency in world money markets, others have fixed the value of their
currency to that of another major country, and others have pursued a mixed strategy.
IMF Surveillance. The IMF is no longer the arbiter of world exchange rates.
Rather, in the modern world, it exercises surveillance over exchange rates in order
to encourage and to help countries comply with the basic rules. Article IV of the IMF
charter prohibits countries from manipulating their exchange rates in order to gain
unfair trade advantage. It also says that “the Fund shall exercise firm surveillance
over the exchange rate policies of members, and shall adopt specific principles for
the guidance of all members with respect to those policies.” Its current principles for
surveillance were adopted by the IMF executive board in 1979 and have been revised⁵⁸
periodically since. The principles say that countries may peg the value of their
currency to another currency but they cannot do this in ways which violate the
requirements of Article IV. Basically, the pegged rate needs to reflect a country’s
underlying economic realities. These include, for example, changes in the volume
and composition of its domestic output, in the size, composition and direction of its
foreign trade, in its domestic rates of growth and national income, in the size of its
reserves and in shifts in its domestic fiscal and monetary policies, relative rates of
productivity and of change and technological advance.
Countries are allowed, under the guidelines, to use their exchange rates to
promote growth and development. The IMF rules for surveillance say the Fund’s
appraisal of country policies “shall take into account the extent to which the policies
of a member, including its exchange rate policies, serve the objectives of the
continuing development of orderly underlying conditions that are necessary for
financial stability, the promotion of sustainable economic growth, and reasonable
levels of employment.” However, countries are also required to “take into account
in their intervention policies the interests of other members, including those of the
countries in whose currencies they intervene.” In other words, countries can use
exchange rate policy to help sustain growth and employment in their domestic
economy but they cannot use an unrealistic exchange rate to prevent balance of
payments (BOP) adjustment or to gain unfair trade advantages. Adjustment includes

⁵⁸ These are published in the IMF’s Selected Decisions and Selected Documents of the
International Monetary Fund, 24^th issue. Washington, D.C. June 30, 1999, pp. 10-29.
Reference here is to the General Principles, Principles for the Guidance of Members’
Exchange Rate Policies, and Principles of Fund Surveillance over Exchange Rate Policies
specified in the IMF board decision Surveillance over Exchange Rate Policies: Review,
Decision No. 6026-(9/13), January 22, 1979, as amended, pp. 10-16.

such things as increased imports, capital inflows to fund BOP deficits or outflows to
offset BOP surpluses, increased domestic interest rates or price levels, and the
accumulation of excess reserves. If one country does not adjust its BOP imbalance,
the burden of adjustment will be thrown upon its trading partners through monetary
contraction, unemployment and the like.
China and Manipulation. The IMF has six criteria which might be used to
identify situations where countries are manipulating their currencies in order to gain
unfair trade advantage. Any one of the criteria would be sufficient to note the likely
presence of manipulation. It appears that China’s foreign exchange practices are⁵⁹
congruent with at least four of the IMF criteria.
Persistent Intervention. The IMF says (its criterion number 1) that
“protracted large-scale intervention in one direction in the exchange market” is one
indication that a country may be manipulating the value of its currency. Countries
may intervene in foreign exchange markets to counter short-term disorderly
conditions that cause disruptive short-term movements in the exchange value of their
currencies. However, the IMF guidelines say that persistent one-way
intervention”might indicate the need for discussion with a member.”⁶⁰
If China’s currency were properly priced and the goal were exchange rate
stability, the central bank would intervene in the market in both directions, buying
and selling yuan in order to dampen the effect of temporary shocks and to spread the
effects of change over a longer period of time. Instead, China routinely sells yuan in
order to keep the market price from rising. It rarely buys yuan to keep the market
price from sinking too low. This would seem to be the kind of “protracted large-
scale intervention in one direction” which the IMF specified in its first operational
definition of manipulation.
An Unchanging Peg. The IMF’s second criterion which indicates that a
country might be manipulating its currency is “behavior of the exchange rate that
appears to be unrelated to underlying economic and financial conditions including
factors affecting competitiveness and long-term capital movements.” Countries may
peg the value of their currency to another currency but the pegged rate needs to
reflect the country’s economic realities. These include, for example, changes in the
volume and composition of its domestic output, in the size, composition and
direction of its foreign trade, in its domestic rates of growth and national income, in
the size of its reserves and in shifts in its domestic fiscal and monetary policies,
relative rates of productivity and of change and technological advance.
The yuan-dollar exchange rate was largely unchanged from1994 to 2005. Since
reforms were announced in mid-2005 it has changed very little. Some might argue
that the fact that China held its exchange rate constant during this period is evidence

⁵⁹ In addition to the four cited here, the other IMF criteria include numbers three (a
prolonged reductions or incentives for BOP purposes affecting current transactions or the
inflow or outflow of capital) and six (unsustainable flows of private capital).
⁶⁰ IMF. Selected Decisions, footnote 56. See “Principles of Fund Surveillance over
Exchange Rate Policies,” pp. 12-15, section 2(i), (iv) and (v).

that China was not manipulating the yuan through fine-tuning of its valuation.
However, manipulation can be as much a lack of change as an act of change.⁶¹
Whether an unchanging exchange rated is a violation of Article IV depends on
the way the country holds the rate constant. China did not have to micro-manage the
daily rate for its currency in order to maximize its export opportunities. They merely
sold yuan whenever the yuan-dollar exchange rate increased beyond the level the
central bank desired. Chinese authorities used domestic monetary policy and other
domestic economic practices to offset the effects of the fixed yuan-dollar rate.
Economic conditions have changed markedly in China since 1994. Production
and consumption patterns changed. Import and export patterns changed. The
relative value of goods and services and the relative value of labor, capital and other
factors of production changed. The international value of China’s currency should
have changed as well to reflect these changes. Among other things, this would have
produced price signals that could have changed consumption and production patterns,
promoted efficient and effective utilization of resources, and improved the Chinese
people’s standard of living and level of real income. The behavior of the yuan-dollar
exchange rate after 1994 “appears to be unrelated to underlying economic and
financial conditions” and is therefore consistent with the IMF’s second criterion for
identifying currency manipulation.
Prolonged Foreign Lending. The IMF’s fourth criterion says that
“excessive and prolonged short-term official or quasi-official lending for balance of
payments purposes” can be evidence that currency manipulation is taking place.
Prolonged borrowing for the same purpose is also evidence of manipulation.
Since 1994, China’s foreign exchange reserves have grown sixteen-fold, from
$53 billion to $819 billion. Some of the funds in China’s foreign exchange reserves
are equity investments. Most, however, are loans to foreign governments or private
borrowers. For example, China’s investment in U.S. Government debt has more than
tripled in the past five years, from $71 billion in 2000 to $242 billion in 2005. By
definition, these are loans to the U.S. Government and they are short-term, in the
sense that they can be liquidated at any time through sales in security markets. They
help the United States cover its balance of payments (current account) deficit and
they help China adjust its balance of payments in a way which does not require it to
spend its international income on purchases of goods and services from abroad. At
least on the part of China, this appears to be the kind of behavior “to prevent
effective balance of payments adjustment” (in the words of Article IV) that meets the
IMF’s fourth test for currency manipulation.
Influence on Capital Movements. The IMF’s fifth criterion says that a
conversation with a country might be in order if it evidences “the pursuit, for balance
of payments purposes, of monetary and other domestic policies that provide abnormal

⁶¹ See, for example, Morris Goldstein’s argument to that effect. “China and the Renminbi
Exchange Rate” in C. Fred Bergsten and John Williamson, eds. Dollar Adjustment: How
Far” Against Whom?, Washington, D.C.: Institute for International Economics, November

2004. Special Report 17.

encouragement or discouragement to capital flows.” Many observers say that the
growing size of China’s reserves shows that its government is promoting an
abnormal outflow of capital for BOP purposes.
The Chinese government purchases large amounts of foreign exchange in order
to maintain the price of its currency. Thus, foreign money is less available to
Chinese citizens and firms than it might be otherwise. Consequently, instead of
being cleared on the current account through imports and other current activity,
China’s balance of payments is cleared through the capital account by large additions
to China’s foreign exchange reserves.
Many analysts agree that China’s reserves are larger than its normal trade or
financial needs would require. They are larger, for example, than any need China is
likely to face if its international income suddenly declined — as a result, for instance,
of an economic shock originating elsewhere in the world economy — and it needed
money for a while to pay for imports or to service debt. In this light, many would
argue with reference to the IMF criterion noted above, that continued expansion of
China’s foreign exchange reserves is not just an encouragement for the outward flow
of capital but an encouragement for “abnormal” flows as well.
Some would argue in addition that the continued growth of China’s reserves is
inconsistent with provisions of the IMF charter. Article IV also stipulates that all
members shall “seek to promote stability by fostering orderly underlying economic
and financial conditions and a monetary system that does not tend to produce erratic
disruptions.” Every dollar that China adds to its reserves is a dollar that some other
country adds to its foreign debt. Arguably, the accumulation of large reserves and
large debts does not enhance the stability of the world financial and trading system.
Countries with large foreign exchange reserves do not import as much as they could
and debtor countries have difficulty retiring their foreign obligations by trade. In that
sense, high reserves are not a formal trade barrier but they have the same effect.
They hamper “the expansion and balanced growth of international trade” (one of the
purposes, stated in its Articles of Agreement, for which the IMF was created.) China
is not the only country accumulating large reserves but many would argue that its
practices are a source of concern.
China’s View. Chinese officials say they are not seeking unfair trade
advantage. They only want exchange rate stability to protect their economy from
destabilizing change. The result, however, is the same. Chinese officials say that,
whatever the technicalities might be, the economic benefits of stability are important
and are shared by many countries. Moreover, they could argue, their efforts to
influence exchange rates through intervention in currency markets differ little in
their effect from similar action which countries with floating exchange rates take to
influence their currencies’ exchange rates — changes in interest rates and other
policies, for example. Furthermore, they might say, Japan and other Asian countries
also buy dollars in order to keep down the value of their currencies and to stimulate
their exports. Arguably, they would argue, it is unfair to single out China in this

regard when others do the same thing and their trade impact on the U.S. economy is
at least as great as that of China.⁶²
How Fast Should China Revalue?
If China can continue to contain the inflationary pressures caused by rapid
growth in its economy and its foreign exchange reserves, it can probably delay for
some time any need for a major change in the dollar value of its currency. Unlike
countries with overvalued currencies, it will not run out of foreign exchange if it
postpones the decision. Rather, its foreign exchange reserves will grow.
China could increase the value of the yuan overnight to a much higher level if
it wished to do so. However, Chinese officials are concerned that too-fast and too-
steep an increase could hurt the growth rate, employment rate, and reform prospects
of the Chinese economy. Chinese officials say they want to shift away from export
led growth towards an economic program focused more on growth in the internal
economy. However, they do not want to slow down the export sector until their
internal economy is able to provide the growth they need to continue the
transformation process now underway. These considerations seem to suggest that
revaluation should take place gradually. However, if speculative capital flows are
a problem, as discussed below, they may want to delay the process considerably.
Most experts agree that China’s current situation is not sustainable and they
cannot postpone revaluation of the yuan indefinitely. If nothing is done to slow the
growth of China’s foreign exchange reserves, for instance, inflation may eventually
push up domestic prices in China and raise its export prices. Experts differ, though,
as to how quickly China should move towards a market-based exchange system. The
IMF says a gradual approach is needed. In July 2005, the IMF staff proposed that
China adopt a phased approach in moving towards full exchange rate flexibility.⁶³
More recently, the director of the IMF’s research department urged a deliberate
pace.⁶⁴ Experience has shown, he said, that emerging markets do not handle large,
rapid exchange rate movements well. In China, he suggested, rapid change might
disrupt or bankrupt major segments of the economy — particularly the banking
system — and make reform a long, drawn-out and painful process.
Other experts believe that policy reform must occur more quickly. Some say
that China’s undervalued currency is hurting other countries and fairness requires
rapid action to remedy the situation. Some suggest that China risks a financial crisis

⁶² For discussion of Japan’s efforts at currency manipulation, see CRS Report RL33178,
Japan’s Currency Intervention: Current Issues, by Dick K. Nanto. See also J.T. Young.
“Japan’s Subtle Subsidy,” The Washington Times, December 5, 2005, p. A19. Japan’s
foreign exchange reserves are larger than those of China and its exports have had a greater
impact arguably on the U.S. manufacturing sector than have those of China.
⁶³ Ibid., p. 14.
⁶⁴ Raghuram Rajan. Remarks on Global Current Account Imbalances and Financial Sector
— Reform with Examples from China. Address to the Cato Institute, November 3, 2005.
Available from the China page on the IMF website.

if it does not revalue soon.⁶⁵ One says that rapid revaluation is needed because
China’s emphasis on export-led growth makes it vulnerable to any slowdown in
global demand.⁶⁶ Otherwise, they say, China risks being another “Asian miracle”
country, like those that went bust during the Asian financial crisis in the 1990s.
Many also believe quick action is needed because the current economic
relationship between the United States and China is unstable and harbors serious risk.
Roubini and Setser argue, for instance, that change is inevitable and the only question
is how it will take place.⁶⁷ A smooth landing is possible, they say, if Chinese
officials lessen China’s emphasis on exports and the accumulation of reserves and
U.S. policy makers reduce their country’s dependence on foreign loans and capital.
Otherwise, they believe, some unforseen event may trigger a crisis which could have
serious negative consequences for both countries.
Is China Hiding its Real Trade Surplus?
Some people argue that China’s trade surplus is many times larger than the
amount which China publishes in its official statistics. The China Currency Coalition
says, for instance, that China’s trade balance was nearly six times larger in 2003 than
its official statistics suggest.⁶⁸ IMF data show that in 2004 the 156 countries it
categorized as “world” had a combined trade deficit with China of $267 billion,
roughly six and one-half times more than trade surplus of $41 billion that China
reported that year.⁶⁹ If China’s trade income were the larger of these figures, this
would be strong evidence the yuan is undervalued.
In theory, the net trade figures reported by exporter and importer countries
should match. In practice, the data are often inconsistent. There is strong reason to
believe that methodological reasons account for much of the discrepancy in data.
Perhaps countries keep better count of their imports than their exports. Perhaps the
figures are confused and intermingled when products are imported and re-exported
or when inputs from several sources are channeled through a final exporter countries.
The IMF’s Direction of Trade Statistics (DOTS) shows, in any case, that —
when the exports of all countries to every country are subtracted from the imports
every country receives from all countries, the world had a $269 billion trade deficit

⁶⁵ See, for example, the argument to this effect in Chinese Currency Manipulation, footnote

⁶⁶ Brad Setser. The Chinese Conundrum: External Financial Strength, Domestic Financial
Weakness. October 31, 2005. Available (with registration) from the RGEmonitor website
at [http://www.rgemonitor.com/redir.php?sid=1&tgid=10000&cid=108028].
⁶⁷ Nouriel Roubini and Brad Setser. The sustainability of US external deficits and Chinese
external surpluses. November 22, 2005. PowerPoint Slides. Available (with registration)
from the RGEmonitor website at [http://www.rgemonitor.com/redir.php?sid=1&t
gi d=10000&cid=108683].
⁶⁸ See the Chinese Currency Coalition factsheet cited in footnote 3.
⁶⁹ For a discussion of China trade data, see CRS Report RL31403, China’s Trade with the
United States and the World, by Thomas Lum and Dick K. Nanto. IMF figure cited.

with itself in 2004.⁷⁰ Other countries show similar disparities between the trade
balances they report and those reported by their trade partners.⁷¹ In 2005, the IMF
executive board noted weaknesses in China’s BOP statistics in its annual Article IV
review in 2005 and it urged the Chinese authorities to take advantage of Fund’s
technical assistance to help improve them.⁷²
The China Currency Coalition says, however, that China is “hiding the ball” by
deliberately reporting incorrect trade statistics. It believes the figure reported by
importer countries more accurately reflects China’s net income from trade. This is
further evidence, the Coalition says, that the yuan is seriously overvalued.
If this is correct, China must be receiving over $200 billion more each year from
trade income than it reports. In that case, the money must be somewhere. China
could not have spent this money on imports, as it would have then shown up in the
trade statistics of the exporter countries. It seems unlikely that Chinese exporters
would have brought this additional foreign currency back into China. If they had,
the People’s Bank of China would have had to spend three times more yuan than the
amount officially announced to keep the yuan at the pegged rate. The inflationary
impact of these additional yuan would be substantial and would have manifested
itself through rapidly increasing domestic price levels.
Alternatively, the presumed $200 billion in extra annual revenue might have
been held abroad. This would require the cooperation of Chinese officials, since it
would mean that roughly 80% of China’s trade income each year does not come back
to China. It seems unlikely that China has been giving the money away, since this
would make it the world’s largest foreign aid donor (ten times the size of the United
States) and international effects of its generosity would be evident. Possibly, if the
money exists and is not the product of a methodological flaw, the government of
China might have accumulated it annually into secret foreign exchange reserves.
This would mean, again if the money exists, that China has perhaps $1 trillion in
clandestine funds invested in other countries (over and above its announced official
reserves.) Even if China were only using this money to acquire revenue, not
influence, it would be difficult to hide. If the assets were registered as Chinese at the
time of purchase, for instance, they would likely show up in host country statistics.

⁷⁰ IMF. Direction of Trade Statistics, 2005 yearbook, p. 2. The DOTS data are computed on
a somewhat different basis than are those for individual countries. On this table, industrial
countries are net exporters and developing countries are net importers. For purposes of this
table, China has a net trade deficit of over $300 billion.
⁷¹ China reported net exports of $80.29 billion to the United States for 2004 while the
United States reported net imports of $176.8 billion from China. India reported a net trade
surplus of $6.86 billion with the United States while the United States reported a net deficit
of $10.56 billion with India. France reported a surplus of $6.28 billion while the U.S.
figures show a $11.06 billion deficit. Malaysia reported a surplus of $8.49 billion while the
United States reported a $18.15 billion deficit with Malaysia. Senegal reported a deficit of
$89 million while the United States reported a surplus of $86 million. Direction of Trade,

2005, pp. 133, 203, 252, 322, and 431.

⁷² See IMF Article IV 2005 staff report, p. 73.

As another possibility, if the government of China does not control the money,
then it might be held by Chinese citizens and companies. In any other country, the
fact that people prefer to hold foreign currencies rather than their own currency might
be taken as evidence of capital flight. It might suggest that people “in the know”
believe the yuan is overpriced and likely to crash. Keeping their assets in foreign
currencies would be a way of protecting themselves against that eventuality. For
China, however, the general view is one suggesting that the yuan will be going up in
value and foreign currencies will go down in value compared to it. It seems unlikely
that Chinese insiders would see the situation so differently from the common view
or that they would have been able to hold a secret this big for so long.
The above scenarios are not be impossible, but they seem unlikely. It seems
more likely that the $200 billion difference in the trade data reported by China and
its trade partners is not real money. Rather, it is probably the result of
methodological and procedural error. China’s real export figures may be higher or
its trading partners’ import figures may be lower than the reported amounts. We do
not know. Caution in the use of published data would seem appropriate. It is
probably not a good idea, though, to ignore or discard the existing body of world
trade and finance statistics just because some of the data do not match. The IMF and
its member countries might scrutinize their procedures to see whether errors and
inaccuracies of this sort can be reduced or eliminated over time.
Would Revaluation Help the U.S. Economy?
A Symbiotic Relationship. The dollar-yuan exchange rate is not determined
in a vacuum. Rather, the relationship between the two currencies reflects the broader
relationship between the countries which issue them. The rates are the consequence
of each country’s economic priorities and the way those priorities interact. The
United States needs to import capital from abroad to finance its present level of
economic activity without incurring higher interest rates. Consequently, the
international value of the dollar must be relatively high in order to encourage the
inflow of capital. China needs to encourage exports in order to stimulate economic
growth and facilitate economic reform. Therefore, for China’s purpose, the value of
the yuan must be low enough to encourage export growth. So long as these are the
main issues on each country’s economic agenda, major changes in yuan-dollar
exchange rate or the U.S. trade deficit are unlikely.
The U.S. Imports Capital. The United States does not save enough
domestically to finance simultaneously its preferred levels of consumption and
investment and to cover the Federal budget deficit. By contrast, other countries
(including several in Asia) save more than their economies can effectively absorb.
The United States needs more capital than it can generate on its own to sustain the
U.S. economy and foreigners need safe and profitable ways to invest their surplus
funds. This generates a continual inflow of foreign funds into the United States. The
inflow of funds, in turn, helps generate more demand for imported goods. The U.S.

current account deficit equals about 6% of GDP and requires the United States to
import more than $2 billion daily from abroad.⁷³
This capital inflow pushes up the exchange value of the dollar, which lowers the
relative price of imports and generates a corresponding inflow of foreign goods. It
is a basic principle of economics that countries which are net borrowers of money
from the world must be net importers of goods and services as well.⁷⁴ If the value
of the yuan increased, the volume of Chinese exports and Chinese capital flows to
the United States would likely decrease.⁷⁵ In the short run, U.S. producers would
probably take over a share of the market previously supplied by Chinese goods,
though consumers would likely have to pay more for those goods than they did for
Chinese imports. Profits and employments in those firms would likely increase. If
China’s trade balance declined, under this scenario, its rate of investment in the
United States would also likely decline. In that case, many economists believe, U.S.
interest rates would probably increase. This would likely have a negative impact,
they expect, on the housing market and (with interest taking a larger share of
household income) on consumer purchases.
Over the longer run, foreign production is likely to shift from China to other
low-cost countries. As their exports to the United States increase, producers in these
other countries would likely recover much of the market previously supplied by the
Chinese. On the other hand, higher interest rates in the United States might stimulate
an inflow of capital from other foreign sources. One can only speculate whether
interest rates would eventually decline to their former level and what the impact these
changes would have on the U.S. economy.
China Wants Growth. China, for its part, also has priorities other than an
accurate valuation of the yuan. Chinese officials believe they need to pursue a policy
of export-led growth. They believe their domestic economy is too inefficient to
generate the levels of employment and resources needed for economic reform and
conversion of the economy from a state-directed to a market-based system. They
worry that the domestic economy cannot otherwise absorb the unemployment being
generated by reform in the rural sector and state-owned enterprises. They also worry
that their banking system would be unable to allocate capital effectively or to cope
with the speculative pressure that might follow the introduction of a more flexible
exchange rate system and more open capital markets.

⁷³ See, for example: Geoff Dyer and Andrew Balls. “Questions grow over China’s forex
strategy,” FT.com. (London) January 6, 2006, p. 1.
⁷⁴ For a further discussion of the causes of the U.S. trade deficit, see CRS Report RL31032,
The U.S. Trade Deficit: Causes, Consequences, and Cures, by Craig Elwell.
⁷⁵ Not all would agree with this view. One manufacturer notes, for example, that labor and
other Chinese content account for no more than 30% of total operating costs for Chinese
exporters and — with most materials costs denominated in dollars — content priced in yuan
accounts for only about 20% of total costs. If China’s currency were to increase in value,
the cost of the imported components would be unchanged and the price of China’s exports
would need to be increased only marginally to recover the higher local costs. See, for
example, Kathrin Hille, “China’s currency shift frays nerves.” Financial Times, August 7,

2005, p. 1, available from its website at [http://www.FT.com].

China’s economy has been growing at a rate of about 9% annually for the past
decade. Most experts believe this rate cannot be sustained indefinitely, given both
the present levels of productivity and the strain and inflationary pressure such growth
places on the economy. Many believe China needs to slow down its growth rate in
order to consolidate recent gains and to correct imbalances. Increasing the value of
the yuan would help, they say, by slowing the growth in reserves, lowering
inflationary pressures, reducing the cost of imports, raising per capita income,
reducing distortions and encouraging the flow of resources from the export sectors
to the domestic economy. However, Chinese officials are reluctant to shift from a
policy of export-led growth to one based more on internal growth until they believe
their domestic economy is more efficient and productive and economic reform has
further progressed.
According to the IMF, most Chinese officials believe they eventually need to
liberalize the yuan and shift more to a policy of domestic led growth.⁷⁶ Senior
Chinese officials told the press in December 2005 that the value of the yuan would
be increasingly influenced by the market and the trend is for China’s currency to
appreciate over time.⁷⁷ Yu Yongding, a member of the central bank’s policy
committee, said at the time that there is a risk that inflation could be ignited if the
exchange rate is not allowed to appreciate. He also said that China’s foreign
exchange reserves had been growing too fast.
Many in the Chinese leadership believe their country is not yet ready for
substantial changes in the value of the yuan. In any case, they say, efforts to resolve
the imbalances in the world economy will require concerted action by many nations
and China should not be expected to solve them alone.⁷⁸
Three Dilemmas For China
Intervention and Reserves
The People’s Bank of China intervenes in the market to buy foreign exchange
and sell yuan in order to hold the value of its currency at a relatively constant level.
As a result, China has accumulated foreign exchange reserves which now total more
than $819 billion. At the present rate of growth, its reserves will surpass those of
Japan and total $1 trillion by the end of 2006.⁷⁹ If the bank did not sell yuan, the
value of China’s currency would rise and its volume of exports would fall. Many of

⁷⁶ Cited in the IMF’s staff report on the 2005 Article IV consultation.
⁷⁷ “Beijing Officials Signal Support for Higher Yuan.” The Wall Street Journal Asia (Hong
Kong), December 13, 2005, p. 9.
⁷⁸ Ibid., pp. 14-16.
⁷⁹ “China’s Currency Reserves Hit $819bn,” The Times (London), January 16, 2006, p. 39.

China’s export industries reportedly operate on very slim profit margins and many
might go bankrupt if the yuan rose substantially in price.⁸⁰
Much attention has been paid to the size of China foreign exchange reserves.
Many see them as a potential financial threat to other countries. Many believe the
growth in China’s reserves proves that its currency is undervalued and manipulated.
However, the growth in China’s reserves causes problems as well. For one
thing, it puts great pressure on China’s monetary system. China cannot have an
independent monetary policy, since its domestic money supply grows at the size of
its foreign reserves expands. For every dollar bought by the central bank to maintain
the peg, the People’s Bank of China creates 8 yuan which it gives to the seller. The
PBC has reportedly intervened in the currency market at a rate equal to about 12%
of China’s GDP.⁸¹ The IMF says that only about half the liquidity caused by the
increase in reserves has been sterilized (that is, removed from circulation through
sales of government bonds.)⁸² Thus, the central bank has had to hold down the
growth of credit and lending by state banks in order to keep this excess liquidity from
causing inflation. The June 2005 IMF Article IV staff report urged China to wring
more excess liquidity from the system and to tighten monetary policy still further.
The growth in China’s reserves also creates another problem. Roughly 70% of
its reserves are held in dollars or dollar-denominated securities. If the yuan should
go up in value compared to the dollar, the value of China’s reserves will go down and
China would lose a great deal of money.⁸³ If a change in the value of the yuan vis-a-
vis the dollar is inevitable, then Chinese officials might want to act quickly to revalue
the yuan because the problem will only get worse the longer they wait. On the other
hand, if they raise the value of the yuan too much, they will lose large amounts of
money unnecessarily. Further, if the change in the value of the yuan is a gradual
process, China might reduce the size of its exposure if it gradually shifted some of
its present dollar-denominated assets into other currencies.
The State Agency for Foreign Exchange announced in mid-January 2006 that
it would be “actively exploring more efficient use of our FX [foreign exchange]
reserve assets” and “widening the foreign exchange reserves scope.” It said it wanted
to “optimize the currency and asset structure” of China’s reserves and to “actively
boost investment returns.”⁸⁴ Some market analysts thought this meant that China

⁸⁰ “Revised Growth Figures Send Mixed Signals,” South China Morning Post (Hong Kong),
December 27, 2005, p. 1.
⁸¹ Brad Setser. The Chinese Conundrum,
⁸² IMF. Staff Report for the 2004 Article IV Consultation, footnote 44, p. 9.
⁸³ China keeps its books in yuan. The dollar value of the Chinese assets would not change
but their value from the Chinese perspective would decline. Likewise the international value
of assets denominated in yuan would increase.
⁸⁴ The Associated Press. “China might diversify investments: U.S. mortgage industry
worried; Drop in Treasury purchases could hurt home buyers.” Columbian (Vancouver,
Washington), January 11, 2006. “Forex reserves could be used to set up national investment
(continued...)

intended to sell some of its dollar-denominated assets.⁸⁵ Their alarm abated,
however, when it became clear that China simply planned to invest a smaller portion
of its new reserves in dollars and more in the currencies of other trading partners.
Where’s the Money Coming From?
Hot Money or Trade? China’s foreign exchange reserves are growing
because the country’s central bank is buying dollars and other foreign currencies in
order to stabilize the market price of the yuan. The question is where the foreign
currency is coming from. Many argue that the growth in China’s reserves is the
result of its trade policies as well as the inflow of foreign investment. Recent
research suggests, however, that speculative inflows (“hot money”) may be
responsible for over three-quarters of the net increase in China’s foreign exchange
reserves since 1998.
Table 1. Composition of China’s Buildup in Foreign Exchange
Reserves
(billions of U.S. dollars)
(1)(2)(3)
Average Average Amount of
Foreign reserve increase ^a8.5122.8114.3
Current Account balance23.742.218.5
Capital Account Balance0.369.369.0
Of which FDI ^b net38.546.68.1
Of which other-38.222.760.9
Errors and Omissions-15.411.426.8
Non-FDI* capital account balance ^c-53.634.187.7
^Source:^P^r^as^{ad an}^{d W}^e^i.
^a.^Foreigⁿ^res^e^rv^{e in}^creas^{e is}^th^{e s}^u^m^of^th^{e cu}^rren^t^accouⁿ^t^an^{d capital accou}ⁿ^t^balan^ces^plu^s^errors
^an^{d om}ⁱ^s^sⁱ^on^s^.
^b^.^FD^Iⁱ^s^Fo^r^eⁱ^{gn D}ⁱ^r^e^c^t^I^nve^st^m^e^nt^.
^{c. In}^clu^d^es^errors^an^{d om}^is^sⁱ^on^s^.

⁸⁴ (...continued)
trust firms.” South China Post (Hong Kong), January 16, 2006, p. 5.
⁸⁵ To dampen concern, the governor of the People’s Bank of China personally met with press
to affirm that China had no plans to reduce its dollar holdings or to use them to buy other
assets, such as oil. See “Forex reserves could be used....” (footnote 83.) Many analyst
predict that, if China reduces its rate of investment in the United States, U.S. interest rates
will increase. A large sale of China’s dollar assets could also drive down U.S. security
prices.

Accounting the BOP. Table 1 shows (based on IMF data) the size and
amount of change which took place in China’s foreign exchange reserves and balance
of payments (BOP) during the period 1998 to 2004. Foreign exchange reserves and
alternative BOP figures have been discussed above. The balance of payments is a
comprehensive picture of a country’s international financial and commercial
transactions. It has three parts: the current account balance, the capital account
balance and the total for errors and omissions. The current account balance is the net
sum of a country’s exports and imports of goods and services plus its net income
from foreign investment. The capital account balance is the net sum of all the
monetary flows to or from a country — net foreign investments, loans made or
received, transfers by individuals (remittances from migrant workers, for example)
and other transactions needed to finance activity in the current account.
Conceptually, the current account and capital account balances should cancel
each other out, one being positive and the other negative. Imports which are not paid
for with current revenue, for example, would have to be financed directly or
indirectly by capital from abroad. In fact, however, some financial and commercial
transactions are not recorded and the current account or capital account is often larger
than the other. To make the two parts of the BOP match, economists add a third
figure, called “errors and omissions” (E&O), which acknowledges that for
unexplained reasons more money is in one account or the other. This may reflect
income from illegal trade, mis-measurement, or undisclosed movement of money by
individuals (“capital flight”) seeking to protect their assets from an expected change
in the exchange rates or by speculators hoping to profit from that change.
Analyzing China’s BOP
Table 1 breaks China’s balance of payments figures into these three
components. It also provides separate figures, in the capital account, for foreign
direct investment. Prasad and Wei, the authors of the table, identified the annual
changes in China’s foreign exchange reserves and the amounts recorded for each
element of China’s balance of payments and they present the average annual amounts
for each item for the first three and the last four years of the 1998 to 2004 period.⁸⁶
From that data, they derive the amount of change which occurred in each instance
between the first and the last halves of that seven-year period.
On first inspection, looking only at the middle column, it seems that most of the
growth in China’s reserves was due to trade and investment. Between 2001 and

2004, Prasad and Wei note, China’s net annual current account balance was $42.2⁸⁷

billion while the net inflow from FDI was $46.6 billion. It appears, therefore, that

⁸⁶ Eswar Prasad and Shang-Jin Wei. The Chinese Approach to Capital Inflows: Patterns and
Possible Explanations. National Bureau of Economic Research. NBER Working Paper
Series, Working Paper 11306, April 2005.
⁸⁷ The sources of FDI coming to China have changed over the years. In 2004, the major
sources were Hong Kong (32%), Virgin Islands (12%), Korea (11%), Japan (9%), European
Union (7%), United States (7%), Taiwan (5%), Western Samoa (2%) and Singapore (2%).
The sources for the Virgin Islands and Western Samoa money are unknown. The five Asian
(continued...)

the $88.8 billion from these two sources accounted for most of the $128 billion
average annual increase in China’s foreign exchange reserves during that period.
Prasad and Wei find, however, that other factors — particularly the inflow of
“hot money” were more important. As Table 1 also shows, comparing the first and
second columns, that the average annual level of China’s foreign exchange reserves
grew by $8.5 billion from 1998 to 2000 and by $122.8 billion from 2001 to 2004.
In column 3, Prasad and Wei found that the annual change in China’s trade receipts
($18.5 billion) and FDI ($8.1 billion), shown in column three, were not sufficient to
account for the average $114.3 billion in China’s reserves. On the other hand, the
swing in flows from non-FDI investment and E&O were substantial.
Between 1998 and 2000, they observe, capital flowed out of China openly (non-
FDI) or covertly (E&O.) They speculate that initially Chinese firms and families
moved money abroad to take advantage of favorable investment and exchange rate
opportunities. After 2001, however, they suggest, Chinese firms and families and
foreign speculators began moving money back into China in hopes of profiting from
the expected increase in the value of the yuan. They observe that, as Table 1
indicates, the net flow of funds from non-FDI investment and E&O between the two
periods amounted to an average $87.7 billion a year, nearly 77% of total change in
China’s foreign exchange reserves during the 1998-2004 period.
Policy Implications. The policy prescriptions are different, depending on the
source, if one wants to reduce the inflow of foreign currencies and to lessen the
central bank’s incentive to sell yuan in foreign exchange markets. If trade-related
factors are the major reason why foreign exchange is flowing to China, then changes
in the country’s trade policies and exchange rate would help diminish the flow.
China’s government would need to take steps, in this scenario, to shift resources and
employment from the export sector to the domestic economy.
On the other hand, if “hot money” is responsible for the buildup in reserves,
then a gradual appreciation in the value of the yuan might encourage further inflows
of speculative funds. In that case, the central bank might cool the inflow of “hot
money” by holding the value of the yuan constant for a sustained period of time.
The Economist reported in late January 2006 that the delay and uncertainty of
the new Chinese exchange rate system may have had this effect.⁸⁸ The flow of
portfolio capital investment, one form of “hot money,” declined to about $1 billion
a month in late 2005, it reported, from the average level of $8 billion a month seen
from late 2003 through mid-2005. It appears, the Economist suggests, that “the
speculators who have been furiously pumping money into China for the past three
years have at last given up and gone home.” The magazine predicts that China’s
trade surplus may also start to fall and import growth may revive.

⁸⁷ (...continued)
countries accounted for 60% of the total. See Prasad and Wei, p. 79.
⁸⁸ “Portfolio Investment in China: Cooling Down.” The Economist, January 28, 2006, p. 73.

If the data for the last part of 2005 are correct and if the Economist’s predictions
are right — and it is much too soon to know whether these are so — then the
People’s Bank of China may have an easier time managing monetary policy in the
future. There would be less need, for example, for it to print yuan in order to keep
down the value of the yuan by buying up the inflow of dollars. This would make it
easier, if the PBC wishes to do so, for the central bank to relax its control and to
allow market forces more influence on the yuan-dollar exchange rate.
Would Revaluation Hurt China’s Banks?
Many believe China needs to reform its financial system before the yuan can
rise appreciably in value. If revaluation occurs first, they say, the banking system
may not be able to cope and this might have negative effects on economic growth.
Others believe, however, that — while more reform is needed — China’s banking
system should be able to accommodate more flexibility in the value of the yuan.
Nevertheless, there is serious worry on the part of many that a floating exchange rate
system could lead to destabilizing capital outflows.⁸⁹
The IMF says that major steps have been taken to restructure the banking system
(even though further action is required) and the condition of the banking system is
no longer an obstacle to exchange rate reform. As a result of recapitalization, sales
of nonperforming loans, and other reform efforts, the IMF staff reported, the capital
strength, asset quality and operating results for China’s banks have significantly
improved. In the old days, state banks made loans to state industry with little
expectation those loans would be repaid. Thus the savings of Chinese individuals
were sunk into subsidizing these money-losing firms.
Most of these “legacy” loans have been transferred to four government-owned
asset management corporations (AMCs), so the government budget rather than the
banking system will bear the cost of those bad loans. Consequently, the IMF reports,
bad loan ratios for the major commercial banks (the four largest state banks and 14
joint stock commercial banks) have fallen from about 24% of loans in 2002 to about
13% in September 2005.⁹⁰ These institutions account for about three-quarters of total
bank assets. They say that efforts to tighten the banks’ balance sheets and to
strengthen their internal controls and risk management procedures are still needed.
The IMF does not report figures for the ratio of bad loans (non-performing
loans) in the banking system as a whole because the procedures for reporting bad
loans by small banks are different from those for large banks. Two IMF economists,
Prasad and Wei, reported in their 2005 article that non-performing loans in the
banking system amounted to 30% of GDP in 2003.⁹¹ IMF staff indicates that this
larger figure calculates the bad loan ratio for smaller banks in the same way that bad

⁸⁹ As noted earlier, though China has announced that it will soon relax its controls over
capital outflows, it is unclear if this is a precursor for greater future exchange flexibility or
merely a means to limit growth in China’s forex reserves.
⁹⁰ Author’s interview with IMF staff, December 2005.
⁹¹ Prasad and Wei, footnote 85, p. 13.

loans are calculated for the larger banks. Prasad and Wei suggest that a major share
of China’s foreign exchange reserves may need to clear up the accumulated bad debt.
Setser asserts that conditions in the Chinese banking system are grim and the
costs of reform will be great.⁹² He says the banking system is not ready yet for a
more flexible currency. Bad debt in the banking system is equivalent to 20% or 30%
of GDP, he says. Officials estimates reported that 40% of all loans in 2002 were
non-performing, he indicates, and “legacy” bad loans (debt owed by state firms)
totaled $400 billion. Other estimates put the figure at $650 billion, he says, or about
50% of China’s 2002 GDP. The recent boom in bank lending may have reduced the
level to 25% or so, he says. However, he suggests, the total volume of bad debt may
be higher once the bad loans made since 2002 are included in the total.
Setser says that many analysts believe that the government will need to buy out
the bad “legacy”debt if it wants to improve the soundness of the banking system.
The IMF’s statement (see above) that some bad loans were transferred out of the
banking system seems to confirm this view. Setser says the government will also
need to provide large amounts of money to stabilize its undercapitalized state banks.
Some estimates report, he says, that the cost of cleaning up the financial system could
equal 20% of national GDP (about $340 billion of China’s 2004 GDP) and nearly
all of it will be borne by the national government. This could push the national debt-
to-GDP ratio, he says, from 33% in 2004 to perhaps 50% overall.
IMF experts say that China does not need to resolve the problem of bad debt in
its banking system before its currency can be liberalized. They argue that — so long
as capital controls continue — the yuan-dollar exchange rate could be more flexible
without harming the Chinese banks. The Chinese banks know how to trade
currencies and manage their foreign exchange exposure, the IMF staff reports. They
already do this in their worldwide operations. Some economists believe that China
cannot have a flexible currency until it ends capital controls.⁹³ IMF experts argue,
however, that China’s banks cannot handle full liberalization of the capital account
at this juncture. If capital controls were removed, they assert, a substantial outflow
of capital from the banks would likely occur and this would be very destabilizing.⁹⁴
Options for the United States
There are several ways the United States might encourage China to move more
quickly towards increasing the value of the yuan. These options or policy tools are

⁹² See Chinese Currency Manipulation, footnote 3.
⁹³ See, for example, comments by Gail Foster, chief economist for the Conference Board,
in Peter Bartram, “Insight — Yuan Weak Link,” Financial Director, September 30, 2005,
p. 14.
⁹⁴ See, for example, Edward Prasad, Thomas Rumbaugh, and Qing Wang. Putting the Cart
Before the Horse? Capital Account Liberalization and Exchange Rate Flexibility in China.
IMF Policy Discussion Paper PDP/05/01, January 2005. Available from the IMF website.

not mutually exclusive, but it might be difficult or awkward for the United States to
pursue some of them simultaneously. ⁹⁵
First, the U.S. government might continue pressing China publicly for additional
changes in its foreign exchange system in order to make the international value of the
yuan better reflect market conditions and economic realities. This assumes either that
China is reluctant to change or that reformers in China will be helped by external
stimulus. Second, the U.S. Government might stop pressing China publicly for
change. This option is predicated on the expectation that reformers will be able to
move China more rapidly towards currency liberalization if China is not pressured
from abroad. Third, the United States could enact legislation restricting Chinese
exports to the United States if the value of the yuan is not increased. This assumes
that China will change its exchange rate policies only if forced to do so. Fourth, the
U.S. government might refer the question to the IMF, asking the international agency
to determine whether China has been manipulating its currency in violation of IMF
rules. This assumes that technical findings and persuasion by the IMF and its major
member countries may have effect. Fifth, the U.S. government might refer the issue
to the World Trade Organization (WTO), alleging that the United States has been
injured by unfair trade practices linked to the undervaluation of China’s currency. If
the WTO found that the U.S. petition had merit, it could authorize trade remedies to
correct the allege abuse. This assumes that exchange rate issues and questions of
general system-wide subsidy will fall within the purview of the WTO rules.
Continue Public Pressure
Continued public pressure is one method the United States might use to
encourage China to adopt further reforms in its foreign exchange procedures. This
might include official findings by the Treasury Department that China is a
manipulator or strong exhortations by high-level U.S. officials. Among other things,
U.S. officials might press Chinese officials to provide them more information as to
the ways they intend to link reform of their domestic economy to reform in their
exchange rate regime and the criteria they might use for discerning progress.
In evaluating this option, it would be helpful to know whether Chinese officials
really intend to move towards a market-based valuation of the yuan or whether they
intend to drag the process out as long as possible. If China adopted the reforms
announced to date mainly in response to foreign pressure, then it is possible that
further pressure might persuade them to go faster. However, if Chinese officials
adopted these reforms because they believe that market-based reform is in China’s
best interests, foreign pressure may complicate this process. China has a long
tradition of not giving in to foreign pressure. Foreign pressure might strengthen the
hand of the reformers, but it might also stiffen resistence by the opponents of reform
and make it harder for the reformers to achieve their ends.
It also might be helpful if U.S. officials and legislators had more information
about China’s internal decision making process. How strong are the reformers?

⁹⁵ Some of these options are also discussed, with similar conclusions, in CRS Report
RL32165, China’s Exchange Rate Peg, by Wayne M. Morrison and Marc Labonte.

What key choices do Chinese officials believe they face as regards the economy and
value of the yuan? How do they think China and other countries can best determine
what the true international value of the yuan might be? What criteria do they believe
are relevant for determining currency value and their timetable for change?
Given their most recent statements, other G-7 countries will likely support the
United States if it continues to press China for more rapid action. However, they
may also back away and leave the United States on its own if they believe U.S.
efforts are potentially counterproductive.
Pursue a Policy of Restraint
Instead of pressing China publicly for reform, the United States might decide
on a policy of restraint. This is not an option in favor of the status quo. Rather, it
accepts the premise that Chinese officials want to proceed with their reform program
as rapidly as economic conditions and the policy consensus in China permits. This
option assumes that overt foreign pressure may be counterproductive if it slows the
process and strengthens the hand of those in China who oppose reform. Arguably,
the Treasury Department has shown restraint of this sort when it said, in its recent
reports, that China was not manipulating the value of its currency.
Some might argue that the United States should view the trade and currency
dispute within the context of its overall relationship with China. While economic
issues are important, this view would suggest, it is also important not to raise
tensions to the point where China becomes reluctant to cooperate with the United
States on other issues, such as North Korea’s policies on nuclear weapons. Pressing
the yuan-dollar exchange rate issue to the exclusion of other important U.S. interests
might be seen, from this perspective, as counterproductive. Others might respond,
however, that China will cooperate with the United States in other areas when it
believes that this serves its interests.
China may have strong reasons for wanting change in its foreign exchange
system. As noted before, China faces the prospect of serious inflation if it does not
slow or stop the growth in its foreign exchange reserves. An increase in the value of
its currency would be a key way of accomplishing that goal.
Ironically, some kind of external encouragement may still be needed to help
China accomplish its plans. Even if Chinese authorities want to move forward with
their reform program, they may need some external pressure — if only in the form
of agreed deadlines and benchmarks — to help them overcome inertia when they
encounter difficult choices as they put their currency reform policies into effect.
Restrict Exports to the United States
Instead of exerting public and mostly verbal pressure, the United States could
adopt legislation restricting China’s access to the U.S. market until it raises the value
of its currency. There are several ways this could be done. The English bill (H.R.
3282), Ryan-Hunter bill (H.R. 1498) and Schumer/Graham bill (S. 295), all
mentioned above, would have this effect. By raising the U.S. price of Chinese

imports, they would presumably reduce the flow of Chinese exports to the United
States, raise the prices paid by U.S. consumers (perhaps helping some U.S.
producers) and stimulate the growth of export industries in other countries that would
take China’s place.
Similar effects would likely occur if the U.S. government invoked the
provisions of Section 301, authorizing the U.S. Trade Representative to respond to
unreasonable or discriminatory practices that burden or restrict U.S. commerce. ⁹⁶
Likewise, if the Treasury Department found in its semi-annual report that China was
manipulating the value of its currency to the detriment of the United States,
consultations with China and trade actions would also be required. Under the
Section 301 mechanism, the United States could impose trade sanctions against
Chinese goods if China does not change its trade or foreign exchange policies. The
United States could also use other U.S. trade laws to impose special “safeguard”
restrictions on Chinese goods if the growth in Chinese imports is found to have
caused (or threatens to cause) market disruption to U.S. domestic produce.⁹⁷
Measures of this sort are allowable under WTO rules on a temporary or limited basis
but it is less clear that they may be used across the board or for longer periods.
It is not clear how much the price of Chinese goods would need to increase, or
the volume of Chinese exports to the United States would decrease, though, if the
value of the yuan increased. Components purchased from other countries account for
a major share of the value of exports bearing the label “Made in China.” The cost of
Malaysian or Thai inputs would not change for the producer in China if the value of
the yuan increased. The price of the final product would only need to increase by an
amount sufficient to recover the higher cost of the producer’s that were denominated
in yuan. Depending on the products and methods of production, it is possible that the
overall increase in product costs would be modest and the volume of Chinese exports
to the United States would be large even after the value of the yuan increased.
It is uncertain what the Chinese authorities and Chinese firms would do if faced
with restrictive import legislation of this sort. They might cut prices and trim profits
in order to keep unchanged their share of U.S. markets. They might retaliate against
U.S. exports, setting off a trade war between the United States and China. They
might also ask the WTO for authority to levy trade sanctions, on grounds that the
United States was not complying with the WTO rules on international trade.
Alternatively, they might raise the value of the yuan in hopes that this will eliminate
the new U.S. tariffs on their goods.
The WTO trade rules allow countries to levy countervailing duties to offset any
subsidies foreign exporters might receive from their home governments. WTO rules
do not allow countries to impose tariffs or restrictions merely for the purpose of

⁹⁶ Section 301 to 309 of the Trade Act of 1974, as amended. See also CRS Report 98-454,
Section 301 of the Trade Act of 1974, as Amended: Its Operations and Issues Involving its
Use by the United States, by Wayne M. Morrison. See, for example, China Currency
Coalition factsheet, footnote 3.
⁹⁷ See CRS Report RS20570, Trade Remedies and the U.S.-China Bilateral WTO Accession
Agreement, by William H. Cooper.

excluding foreign goods. If the United States hopes to persuade other countries that
its special levies on Chinese imports are fair and compensatory, it will likely need to
show that the size of the levies match the degree of subsidy which Chinese producers
receive through the undervalued yuan. It might be helpful in this regard if there were
more agreement among scholars and the affected countries as to whether and by how
much China’s currency is undervalued.
If the United States put special levies on Chinese goods, China might ask the
WTO to rule that the United States acted in a manner inconsistent with its
obligations.⁹⁸ The countervailing duties and anti-dumping penalties allowed under
WTO rules are usually applied to specific goods rather than to all exports coming
from a particular country. Exchange rate manipulation might be seen as a type of
general across-the-board subsidy for a country’s exports. Nevertheless, there is little
precedent (but see below) at the WTO for considering exchange rates from this
perspective. The WTO may be concerned that the rules governing world trade would
be harder to enforce if countries were free to impose countervailing duties whenever
they decided unilaterally that the currencies of other countries were undervalued.
If the WTO agreed with China’s petition, it could authorize China to retaliate
by withdrawing tariff concessions on U.S. goods. The WTO dispute settlement
process is adjudicated with reference to the WTO rules and there seems little room
for political pressure by the United States and other countries. Other countries could,
however, submit briefs in support of the U.S. or the Chinese position. Countries
likely will give some thought to the potential impact that a trade dispute between the
United States and China might have more broadly on world trade negotiations.
If the volume of Chinese exports to the United States declines because of new
trade legislation, the profits of foreign firms located in China which produce those
goods will likely go down as well. Exporters could shift their production facilities
further to the west in China, where labor costs are lower than on the coast. This
might reduce costs enough for Chinese exporters to pay the new tariff and leave their
prices unchanged. Alternatively, Chinese companies and international firms might
shift production to other countries where the costs of production have become lower
than those in China because of yuan revaluation. In that case, these countries might
replace China as major suppliers of manufactured products to the United States.
If the United States wants to keep out foreign products (not just Chinese
products) which undersell U.S. manufactures, then new legislation would be needed
to penalize other countries as they ramp up to take China’s place. This would violate
WTO rules and the terms of international trade agreements to which the United
States is a party. Because the U.S. economy needs to import foreign goods of similar
value to the foreign capital it imports each year, it may be hard for the U.S.
government to stop countries from expanding their exports to the United States.
role. If the volume of imports declines, however, prices for manufactured products
in the United States may increase, giving U.S. producers some relief. U.S.

⁹⁸ For a discussion of the WTO dispute resolution mechanism, see CRS Report RS20088,
Dispute Settlement in the World Trade Organization, by Jeanne J. Grimmett.

consumers would likely need to spend a larger portion of their income in this case to
purchase the goods which were previously produced abroad.
Take It to the IMF
The United States could also pursue the issue of China’s exchange rate policy
at the International Monetary Fund. The key issue is whether China is complying
with the requirements of Article IV of the IMF Articles of Agreement and, if not,
what steps it should take to comply. Though other countries seem to have preferred
that the United States take the lead and break the ice for them, they are also affected
by China’s trade policies. Arguably, international meetings where representatives
of the major countries may speak with Chinese officials at the same time will be
more persuasive than scattered bilateral talks where the only strong public statements
come from the United States.
There continues to be debate as to what, if anything, the outside world can do
to accelerate the reform process in China. In late September 2005, Treasury Under
Secretary Adams demanded that the IMF crack down on countries that violate the
prohibition in Article IV against currency manipulation, though it is not clear what
tools he thought the IMF should use.⁹⁹ The IMF was, he said, “asleep at the wheel”
and it should confront China concerning the deficiencies in its exchange rate policies.
IMF Managing Director Rodrigo de Rato rejected that charge.¹⁰⁰ The IMF was
addressing all aspects of the issue, he replied. The IMF had already investigated and
rejected suggestions that China’s currency policies warrant the use of “special
consultations.” Rather, he suggested, the United States should act more vigorously
to straighten out its own budget and economic policies rather than blaming other
countries for its problems.
According to IMF sources, special consultations between IMF management and
a country have occurred twice previously in response to formal complaints by another
country that it was manipulating its currency. In the 1990s, the United States made
a complaint about Korea and Germany filed a complaint about Sweden. The two
countries eventually adjusted their currency values, though they may have done this
for their own reasons rather than in response to IMF consultations.
In January 2006, Adams maintained that the IMF should play a stronger role
enforcing exchange rates and preventing currency manipulation.¹⁰¹ The IMF should
demonstrate strong leadership on multilateral exchange rate surveillance, he said. “A
strong IMF role in exchange rate issues is central to the stability and health of the
international economy,” he remarked. The IMF’s leaders “should endorse such an

⁹⁹ Paul Blustein. “IMF Chief Pressured on Trade Imbalances,” The Washington Post,
September 29, 2005, p. D1.
¹⁰⁰ Ibid.
¹⁰¹ U.S. Department of the Treasury. “Remarks by Under Secretary for International Affairs
Tim Adams at AEI Seminar Working with the IMF to Strengthen Exchange Rate
Surveillance.” February 2, 2006, JS-4002. Available from the Treasury Department website
at [http://www.treas.gov/press/releases/js4002.htm].

enhanced role for the IMF, restoring its central role on exchange rates.” While
Adams did not mention China by name, he said the IMF should identify countries
“whose exchange rate policies might not be in accord with Fund principles” and it
should “seek to identify problematic or inappropriate exchange rate behavior.”
However, IMF Managing Director Rato told a session at the World Economic
Forum in Davos, Switzerland that he does not consider China to be a currency
manipulator. He rejected proposals that the Fund should put greater pressure on
China. He said “there is a trade-off between our role as confidential adviser in our
surveillance work and our role as a transparent judge.”¹⁰² He noted that the IMF had
been the first international body to urge China to move from its fixed peg to a more
flexible exchange rate process. Rato also said the IMF should not take a proactive
role on exchange rates, in response to Adam’s question what the IMF should do
about countries “that are attempting to thwart balance of payments adjustments.”
On February 9, 2006, Rato outlined his future plans for the IMF. He said the
IMF should put more emphasis on surveillance but he raised several reservations
about the Fund’s taking the central policing role Adams had proposed.¹⁰³
The IMF is a place where the views of affected countries can be presented to
China and efforts can be made to press China to revalue its currency. The IMF
cannot force countries to have exchange rate policies which mirror underlying
economic conditions, even if they might be non-compliant with IMF rules. However,
continuing discussion at the IMF and at other international meetings serves to focus
attention on the issue. At the least, it puts Chinese officials in a situation where they
need to explain or justify their policies and to respond in some way to international
pressure. Arguably, it has caused them to take steps towards liberalization that they
otherwise might be reluctant to take — or they might have taken more slowly — if
these conversations had not taken place.
If the IMF were given the broader authority contemplated by Adams and others,
the fundamental structure of the world exchange rate system would change and many
countries, in addition to China, would have to seriously revise their domestic and
international economic policies. China might not be willing to make fundamental
changes in its foreign exchange and economic policies unless other major countries
make fundamental changes in their policies as well.
Refer It to the WTO

¹⁰² Chris Giles and Krishna Guha. “Interview with Rodrigo de Rato.” Financial Times
(London), January 28, 2006, p. 8
¹⁰³ Rodrigo de Rato. The IMF’s Mid-Term Strategy: New Priorities, New Directions,
Remarks at the Aspen Institute, Rome Italy, February 9, 2006. Available from the IMF
website at [http://www.imf.org/external/np/speeches/2006/020906.htm]. Some analysts
speculate that, if the IMF was given the power to police exchange rates and BOP policies,
it would probably start with the industrial countries whose policies have the greatest impact
on the world economy rather than middle-income countries such as China.

Another option might be for the United States to refer the issue of China’s
undervalued currency to the World Trade Organization (WTO). In 2004, the China
Currency Coalition and 30 Members of Congress petitioned the U.S. Trade
Representative separately asking the Administration to take action of this sort. The
undervalued exchange rate for the yuan is a kind of subsidy for Chinese exports, they
argue. It lowers the cost of production in China and enables Chinese exporters to sell
products abroad at prices lower than their real costs of production should allow.
They believe this is an unfair practice which is inconsistent with the rules of the
world trading system and they appear to believe that a WTO dispute settlement panel
would support that view if the issue were put before it. The Administration rejected
the two petitions, however.¹⁰⁴ Officials expressed doubt that the United States could
win a case of this sort in the WTO, though they did not detail the reasons for their
doubt. They also said that action to challenge China’s exchange rate and trade
policies in the WTO might be “more damaging than helpful at this time.”¹⁰⁵
The WTO and IMF have a formal agreement between them which specifies that
certain kinds of international finance issues shall be referred to the IMF for judgment,
if they come up in the context of WTO deliberations, and the IMF’s findings will be
considered conclusive.¹⁰⁶ The scope of the agreement is discussed below. China’s
critics acknowledge that the WTO has no authority to adjudicate exchange rate
issues. Some believe, however, that if the United States complained to the WTO that
China was manipulating its currency in order to gain unfair trade advantage and the
IMF agreed, the WTO could authorize the United States and other countries to put
special tariffs on Chinese goods. These would stay in effect until China raised the
value of its currency.
This section discusses whether appealing this issue to the WTO is a feasible
alternative. First, this section examines the question whether export subsidies
arranged through exchange rate manipulation are a “subsidy” as the WTO defines the
term. The WTO’s list of prohibited practices is specific and limited in scope.
Complaints that China is subsidizing its exports through currency manipulation are
actionable in the WTO dispute settlement process if currency manipulation is not
considered to be covered by the agreement. Second, this section discusses two ways
the United States might seek to change the rules of the world trading system so as to
make currency manipulation actionable in the WTO context. There are several
contexts within the WTO where the United States could raise the issue and seek

¹⁰⁴ Under U.S. law, the U.S. Trade Representative has the final authority to determine
whether cases should be taken to the WTO. See 19USC Secs. 2171(c), 2411-2412. WTO
rules do not permit individuals or private groups to initiate dispute settlement proceedings
in the WTO. Section 301 of the Trade Act of 1974 allows groups and individuals to
petition the USTR for action concerning harmful trade practices.
¹⁰⁵ U.S. Trade Representative. Statement from USTR Spokesperson Neena Moorjani
Regarding a Section 301 Petition on China’s Currency Regime, November 12, 2004
Available from the USTR website.
¹⁰⁶ See Arrangement for Consultation and Cooperation with the Contracting Parties of
GATT, September 9, 1948, and Guidelines/Framework for Fund Staff Collaboration with
the World Trade Organization, April 21, 1995. Both are included in the IMF’s Selected
Decisions, footnote 57, pp. 546-9 and 552-9.

international agreement to revise the rules and obligations of members of the
organization. In some cases, consensus or unanimity is required. In one instance,
however, a very large majority can change the requirements of the WTO in way that
applies the changes so that new requirements apply to all member countries, even
those which did not approve its adoption.
The WTO’s dispute settlement process is a quasi-judicial procedure that is
intended to resolve trade disputes between countries which cannot be resolved
through conciliation or negotiation. If a complaining country so requests, a three
member panel is appointed. The panel reviews the facts and arguments in the case
and renders judgment based on the facts and WTO rules.¹⁰⁷ The WTO Appellate
Body may review the initial panel’s findings and, unless the panel and Appellate
Body’s findings are set aside by the WTO membership by consensus, the disputing
parties are expected to implement the panel decision, together with any modifications
made by the Appellate Body. If a country does not comply within a reasonable
period of time, the WTO may authorize the complaining country to impose
retaliatory duties on the non-compliant country’s goods or take other retaliatory
action the complainant proposes. Those duties or barriers remain in force until the
country complies or until the disputing parties otherwise resolve the issue.¹⁰⁸
There are several issues with the China scenario discussed above. First, some
critics may misconstrue the nature and extent of the agreement between the IMF and
the WTO. The agreement has to do with temporary trade restrictions, not with
exchange rate policies or currency manipulation. The General Agreement on Tariffs
and Trade (GATT) and the General Agreement on Trade in Services (GATS) include
provisions which allow countries to impose temporary trade barriers in order to
safeguard their external financial situation. Certain financial and balance of
payments conditions must be present, however, in order for countries to be justified
in taking these steps. The IMF has the final word as to whether those conditions
prevail.¹⁰⁹ Currency manipulation for the purpose of gaining unfair trade advantage

¹⁰⁷ WTO rules include not only rules adopted by the WTO but also the body of
international trade agreements – which were in force at the time the WTO was created in

1994 and were subsumed by reference into its regulatory structure.

¹⁰⁸ For further information on the WTO’s dispute settlement procedures, see CRS Report
RS20088, Dispute Settlement in the World Trade Organization: An Overview, by Jeanne J.
Grimmett.
¹⁰⁹ Articles XI and XII of the GATS and Articles XII and XVIII (paragraph 9) of the GATT
allow countries to erect temporary trade barriers and restrictions on payments or transfers
in order to safeguard their external financial position and balance of payments in periods of
crisis or when their reserves are inadequate for the implementation of their economic
development plans. Article XV of the GATT rules says, meanwhile, that whenever the
WTO is dealing with “problems concerning monetary reserves, balance of payments or
foreign exchange arrangements, it shall consult fully with the International Monetary Fund.”
The IMF’s findings as to the size of a country’s reserves or the relative stability of its
external financial situation shall be taken as final, Article XV says, when the WTO is
judging whether a country should be allowed to establish these temporary trade or payment
barriers. Exchange arrangements are the procedures which central banks use to authorize
their national currency to be exchanged for a foreign currency and vice versa. During a
(continued...)

and exchange rate policy are not mentioned in the interagency agreement between the
WTO and IMF or in the text of the GATT itself. ¹¹⁰
Second, the key issue is not so much whether China’s exchange policy gives it
unfair advantages in international trade but whether this is a kind of subsidy which
is prohibited by WTO rules. When Chinese officials say they need to keep their
currency at roughly its present rate because an increase might bankrupt large sectors
of China’s export economy, they are admitting that their exchange rate subsidizes
exports. However, the WTO has a specific definition as to the types of things which
are subsidies and therefore prohibited under its rules. Currency manipulation is not
included among them.
When the core rules and obligations of the world trading system were laid down
in 1947, with the adoption of the GATT, the world was on a fixed-parity exchange
rate system managed by the IMF. It was difficult, during this period, for countries
to manipulate their exchange rates in order to gain unfair trade advantage. During
the 1970s, the fixed rate system broke down and the rules of the IMF were changed
to allow countries to have floating, fixed or whatever other types of exchange rate
systems they desire.¹¹¹ The IMF was given the task of monitoring (“surveillance”)
exchange rates but, as discussed above, it was given no effective means of enforcing
its rule (Article IV) against currency manipulation. For its part, the GATT did not
amend its rules when the IMF procedures changed to take into account the possibility
that countries might use exchange rate manipulation as a trade policy tool. The WTO
likewise took no steps when it was formed to fill this apparent lacuna in the rules and
obligations of the world trading regime.
The WTO defines the concept “subsidy” in very specific terms. If a
government’s actions do not meet the terms of the definition, even if they benefit
exporters or cause trade injury, they are not actionable (subject to challenge) for
purposes of the WTO dispute adjudication process. Further, to be actionable,
subsidies must be specific to an industry (“specificity.”) The WTO Agreement on

¹⁰⁹ (...continued)
balance of payments crisis, countries may restrict such transactions even if it interferers with
commercial payments or capital transfers. There is no indication in the rules that the WTO
would accept as final a determination by the IMF that a country was manipulating its
currency or, indeed, that the WTO would have any obligation to refer questions about
exchange rate policy to the IMF for its evaluation. See General Agreement on Tariffs and
Trade, established in 1947 and revised 1994. General Agreement on Trade in Services,

1994. Both entered into force January 1995.

¹¹⁰ A law review article written by a Senior Counsel in the IMF Legal Department discusses
several ways in which the work of the IMF and WTO intersect but does not mention
exchange rate policy or currency manipulation. See Deborah E. Siegel, Legal Aspects of the
IMF/WTO Relationship: the Fund’s Articles of Agreement and the WTO Agreements. The
American Journal of International Law 96:3 (July 2002), pp. 561-599.
¹¹¹ Second Amendment to the IMF Articles of Agreement, approved April 30, 1976 and
entered into force April 1, 1978. The only exchange rate system prohibited by the new
language of the IMF Articles is the one where countries defined the value of their currency
in terms of gold. The gold/dollar system had been the key feature of the fixed parity
exchange system.

Subsidies and Countervailing Measures (ASCM) expressly prohibits¹¹² export
subsidies, which are defined as “subsidies contingent...upon export performance.”
The ASCM deems export subsidies to be per se specific. Domestic subsidies are not
prohibited but may be challenged if they cause trade injury, as specified in the
ASCM.
Subsidies that are not directly export contingent are also not allowed if (1) the
government makes a financial contribution and (2) it benefits the recipients.
Government financial support can take a variety of forms, such as direct payments
to the exporter, the waiver of tax payments or other revenue that would otherwise be
collected from the exporter, or special government purchases or the provision of low-
cost goods and services (other than general infrastructure) which lowers the cost of
production. Tax subsidies to broad categories of exporters, through mechanisms
such as foreign sales corporations, also meet the test for specificity.
The WTO agreement makes no mention of subsidies provided through exchange
rate practices or monetary policy. All of the subsidies mentioned in the agreement
occur on the fiscal side of the government’s ledger and involve a direct cost to the
government. Some legal analysts believe that, though doing so would be difficult,
it might be possible to challenge China’s actions in the WTO.¹¹³ Benitah suggests,
for instance, that if the United States were able to show that China’s fixed exchange
rate is a de facto export subsidy it could take advantage of the per se specificity
language. He also suggests that China’s fixed rate might be viewed as a form of “in
kind” subsidy similar to that prohibited by the ASCM. Other legal commentators
believe, however, that the likelihood that the WTO would view China’s exchange
rate practices as a prohibited subsidy are at best very slim.¹¹⁴
Some critics of China’s exchange rate policies have sought to circumvent this
difficulty by arguing that China pays a direct subsidy to Chinese exporters through
its exchange rate policy. The direct financial support occurs, they say, because
Chinese exporters receive more yuan in exchange for the dollars they earn from trade
than they would if the yuan were valued correctly. An exporter might receive 8 yuan
from the central bank today when it exchanges its dollars for yuan, whereas it might
receive 7 yuan instead if the yuan were valued appropriately. That extra yuan is a
subsidy to exporters, the theory holds, and it is therefore a direct violation of WTO
trade agreements.¹¹⁵

¹¹² Agreement on Subsidies and Countervailing Duties, Articles 1 to 3.
¹¹³ See, for example, Marc Benitah. “China’s Fixed Exchange Rate for the Yuan: Could the
United States Challenge It in the WTO as a Subsidy?” ASIL Insights. October 2003. The
American Society of International Law web page, at [http://asil.org/insights/insight117.htm].
¹¹⁴ See, for example, the rejoinder to Benitah by Eric Denters, “Manipulation of Exchange
Rates in International Law.” ASIL Insights. November 2003. The American Society of
International Law web page, at [http://asil.org/insights/insight118.htm].
¹¹⁵ See, for example, testimony by David A. Harquist, on behalf of the China Currency
Coalition, in hearings before the U.S.-China Economic and Security Review Commission,
April 4, 2006. Text provided by the China Currency Coalition.

The idea that exports can be subsidized in this fashion seems to contradict the
normally accepted concepts about international monetary transactions. Moreover,
the effects on the world trading system would be considerable if the idea were
accepted and applied to all countries. The Chinese are perhaps more blatant in the
way their official actions effect currency values, but most governments do things
from time to time which influence the value of their national currency. If a central
bank lowers interests rates and the exchange value of its currency declines, one could
argue that the central bank is making its national exports more competitive and
increasing the amount (in local currency) that its national exporters earn from trade.
Likewise, an increase in exchange rates might be seen as an effort to purchase goods
from other countries for less than their true value or to reduce the price that a
country’s foreign investors would need to pay in real terms for foreign acquisitions.
If every change in the exchange rate for a currency is deemed to provide a subsidy or
raise a barrier to trade, then the current rules of the world trading system would be
unworkable in a world of floating (or inaccurately fixed) exchange rates.
Some would also argue that the concept that exchange rate differences can
provide a subsidy to exporters is fundamentally flawed. Regardless of the exchange
rate, the exporter receives a dollar’s worth of its local currency whatever the current
rate might be. When the local currency goes up in value, the exporter receives less
local currency but each unit is more valuable than before. Imported goods would
also be cheaper and a dollar’s worth of local currency would buy more foreign goods
than before. Firms that use imports as part of their commercial process would see
their costs decline proportionally.
In any case, the presumed subsidy implicit in the yuan exchange rate is not paid
solely to exporters, as likely would be necessary for it to be found in violation of the
direct payment and export contingency provisions of the ASCM. Anybody –
exporters, tourists, banks, or persons wishing to buy yuan in order to make foreign
investments in China – receives the same exchange rate for their money.
It is also not clear that the exchange rate “subsidy” is paid by the government
or at the government’s behest. Many organizations in China buy and sell currency
and – while the central bank continues to have a substantial effect on currency prices
– market forces determine the context in which the central bank exerts its influence.
If an exporter sells dollars to a commercial bank, the implicit subsidy in the
transaction would be paid by the bank and not the government. If Chinese exports
were priced in yuan, the purchaser would have to sell dollars and buy yuan in order
to settle its bill. In that case, the purchaser would pay any subsidy that is implicit in
the transaction.
It appears that a strict interpretation of the WTO’s current rules would provide
little latitude for a finding that China’s exchange rate practices constitute a “subsidy”
for exports insofar as that term is used within the WTO. The United States has taken
a “strict construction” view of the WTO rules. Special Trade Representative Susan
Schwab told Congress in May 2006, for example, that “the United States has
emphasized the necessity for strict adherence to the Rules negotiating mandate ...
which requires that the effectiveness and basic principles of the WTO Antidumping

and Subsidies Agreements must be preserved.”¹¹⁶ Efforts by other countries to
interpret the rules more broadly or flexibly have been met, she said, by vigorous U.S.
attacks.
Schwab also said that “initiating a WTO case on this matter [currency
manipulation] would place China in the position of defending, rather than reforming,
its currency regime.”¹¹⁷ This would be the first occasion where the WTO was asked
to resolve a currency dispute, she said, and it “would therefore have an unpredictable
outcome and take a relatively long time to reach completion.” Some suggest that a
WTO decision against the U.S. position could have the effect of making currency
manipulation an implicitly acceptable practice under the WTO, a result quite contrary
to U.S. goals. Schwab said that continued dialog with China about its currency
regime would likely be a more constructive means for resolving this concern.
Article IV of the IMF charter prohibits countries from manipulating their
exchange rates for the purpose of gaining an unfair trade advantage. Giving the IMF
the authority to enforce that provision of its charter would be one way of addressing
the currency manipulation problem. However, as noted above, this could require
major changes in the structure of the world financial system and it could give the
IMF new authority over the economic policies of its member countries. Many
countries might be reluctant to adopt far-reaching changes of this sort merely to
address the exchange rate aspects of a controversy about international trade.
It might be possible to address this issue through adjustments in the rules
governing world trade. It could be argued, for example, that restrictions on currency
manipulation should be included in the rules of the WTO in order to make its
procedures consistent with the requirements of the Articles of Agreement of the IMF.
The IMF may not have the effective authority to enforce the prohibition in its
Articles of Agreement against currency manipulation for the purpose of unfair trade
advantage. This does not mean, however, that the world must live with the problem
of currency manipulation and contrary effects it may have on the relative efficiency
of international production and the patterns of international trade. The WTO could
choose instead to incorporate this same prohibition against currency manipulation
into its own text in order to take deleterious trade effects into account.
There are two ways the United States might seek to make exchange rate
manipulation actionable within the WTO dispute settlement framework if it wished
to pursue the issue. First, it could raise the issue during the Doha Round trade
negotiations. Second, it could raise the issue separately at the WTO Governing
Council or the WTO Ministerial Conference in hopes of garnering a sufficient
majority to reinterpret the WTO rules or to amend the trade agreements. In both
cases, the goal would be adoption of changes in the WTO language in order to make
exchange rate manipulation a prohibited trade practice.

¹¹⁶ “Written Responses to Senate Finance Committee Questions for the Record; the
Honorable Susan Schwab.” May 17, 2006, p. 31, available at
[ ht t p: / / www.gl obal s er vi cesnet wor k.com/ schwab-quest i ons.pdf ]
¹¹⁷ Ibid., p. 40.

First, the United States might broach the issue in the current world trade
negotiations. The Doha Round of trade negotiations is currently discussing major
changes in the basic ground rules for world trade as well as possible adjustments in
tariff rates. The United States could ask that the currency manipulation issue should
be added to the agenda. There are already many difficult subjects on the agenda,
however, and the WTO members have not yet agreed on a framework for negotiating
the most contentious issues before them. Adding another controversial issue to the
agenda may not make the task of the negotiators any easier. On the other hand,
nobody knows at this point how many countries might want to make currency
manipulation actionable under WTO rules.
Alternatively, the United States could raise the issue of currency manipulation
in the WTO’s Governing Council and in the biannual meeting of its Ministerial
Conference. The Doha round negotiations seem to be in trouble and it may be too
late, as a practical matter, to add another controversial issue to the agenda. The
Ministerial Conference consists of the trade ministers of all the WTO member
countries. These are the top policy making bodies of the WTO. Positive action by
them could lead to a change in WTO treatment of the exchange rate issue, either
through reinterpretation of the existing WTO rules or through amendment to the
international agreements themselves.¹¹⁸
Article IX of the Agreement Establishing the World Trade Organization (WTO
Agreement) says that decisions shall be made by consensus. However, it says, when
consensus cannot be achieved, decisions shall be made on the basis of a majority of
the votes cast, each country having one vote. Interpretation of the charter and of
international trade agreements and amendments to those documents require a higher
majority, however, to be effective. Article IX of the WTO charter says that the
General Council and Ministerial Conference have exclusive authority to adopt
interpretations of the WTO Agreement and the multilateral trade agreements such as
the GATT, GATS, TRIPS, ASCM, etc. Interpretations are to be based on
recommendations of the Council and require an affirmative vote of three-quarters of
the entire WTO membership.
In theory, a three-quarters vote of the General Council and Ministerial
Conference could interpret the existing trade rules in such a way as to make exchange
rate manipulation for the purpose of gaining unfair trade advantage actionable under
WTO rules. However, Article IX says that the interpretation clause should not be
used to undermine the amendment clause (Article X) of the WTO charter. The
procedural difficulties of using Article IX are daunting. A three-quarters vote of the
entire membership is required, yet at most meetings of the WTO less than that share
of the membership is in attendance at any one time. Nevertheless, there are sections
of the GATT which might be considered anew in terms of their contemporary
relevance. Article XV says, for instance, that the contracting parties “shall not, by
exchange action, frustrate the intent of the provisions of this Agreement, nor, by trade

¹¹⁸ Articles of Agreement of the WTO, Articles IX and X. See also an explanation of these
procedures in John H. Jackson, William J. Davey and Alan O. Sykee, Jr. Legal Problems^th
of International Economic Relations: Cases, Materials and Text. 4 ed. St. Paul, MN: West
Publishing Company, 1995, pp. 224-5.

action, the intent of the Articles of Agreement of the International Monetary Fund.”
Whether this could be interpreted as meaning that members of the WTO should not
violate Article IV of the IMF charter by manipulating their currency might be a
matter for debate.
The United States could also propose that the WTO Agreement should be
amended. Article X of the WTO Agreement says that any country may propose to
the Ministerial Conference that the WTO charter or the multilateral trade agreements
should be amended. Amendments can also be proposed by the WTO General
Council or its subsidiary bodies. The Ministerial Conference may adopt amendments
to these documents by consensus. If consensus is not reached, then the Conference
may recommend by a two-thirds vote of the entire membership to submit a proposed
amendment to the WTO’s member countries for their consideration. Generally,
amendments become effective if they are ratified by two-thirds of the WTO’s
member countries. Amendments to a few articles of the WTO charter and the
multilateral trade agreements require a unanimous vote. However, none of these
seem to involve exchange rate issues or questions of export subsidy. The impact of
any amendment to the WTO Agreement or the multilateral trade agreements may be
limited, however. Article X says that any amendment which affects member rights
and obligations shall apply only to the countries which ratified it. One prominent
WTO legal scholar, John H. Jackson, says that, in practice, this means that any
changes of a substantive nature would apply only to the countries which endorsed
them.¹¹⁹ It would seem likely, then, that an amendment which said that currency
manipulation for the purpose of achieving unfair trade advantage was not an
acceptable trade practice would apply only to the countries which endorsed it.
The Ministerial Conference can also decide by a three-quarters vote of the entire
membership, however, that an amendment shall apply to all countries even if all
countries have not ratified its adoption. Article X says that the Ministerial Conference
may decide that a country which does not accept an amendment within a time period
specified by the Conference “shall be free to withdraw from the WTO or to remain
a Member with the consent of the Ministerial Conference.” Presumably, serious
negotiations would predate any decision that a country would be allowed to remain
a WTO Member without accepting the application of a new amendment to itself.
It cannot be known in advance whether the United States and other countries
that are concerned about the trade effects of currency manipulation would succeed
in gaining the votes necessary to reinterpret or amend the trade rules. This is a very
steep requirement. While the United States and its associates were lobbying the
membership to consider the change, China and other countries which employ that
practice would presumably be lobbying the membership to vote the other way. The
result would likely depend on the strength of the arguments brought forth in support
of the initiative and the number of countries that believe that currency manipulation
for the purpose of gaining unfair trade advantage is injuring their interests or is
otherwise undesirable.

¹¹⁹ Telephone conversation between the author and John H. Jackson, professor of
international law, Georgetown University Law Center, July 11, 2006.

It may not be possible to achieve the three-quarters positive vote needed to
reinterpret the WTO agreement or to adopt amendments which are mandatory for all
member countries. Nonetheless, discussion of this issue within the WTO may have
salutary effects. It would require the countries which favor use of this trade practice
to defend their policies and to explain why they believe currency manipulation is an
appropriate tool of trade policy. The countries which might be amenable to changes
in the WTO rules might also be identified. This information may be useful if the
United States decides to seek a negotiated arrangement during a later phase of the
Doha trade negotiations or in some future round of talks.
A strategy of taking the Chinese currency issue to the WTO is not likely to lead
to a prompt resolution of the controversy. It seems doubtful that adequate grounds
can be found, given the current language of the WTO agreement and the
accompanying multilateral trade agreements, to successfully address the question in
the WTO dispute settlement process. Addressing the question in the WTO policy
process may offer opportunities for building support for changing the rules and
guidelines used by organization, however. Discussion in the General Council and
Ministerial Conference would offer the United States an opportunity to discuss why,
as a general principle, currency manipulation should not be a legitimate tool of
national trade policy. It need not be discussed, in this context, as an issue affecting
only China. Obtaining the three-quarters vote to change the language or prevailing
interpretation of the WTO agreements would be difficult. Discussion in this context
may help identify potential supporters and lay the groundwork for possibly including
currency manipulation as an additional agenda item in future trade negotiations.