China's Currency: A Summary of the Economic Issues
China’s Currency:
A Summary of the Economic Issues
Wayne M. Morrison
Foreign Affairs, Defense, and Trade Division
Marc Labonte
Government and Finance Division
Summary
Many Members of Congress charge that China’s policy of accumulating foreign
reserves (especially U.S. dollars) to influence the value of its currency constitutes a form
of currency manipulation intended to make its exports cheaper and imports into China
more expensive than they would be under free market conditions. They further contend
that this policy has caused a surge in the U.S. trade deficit with China and has been a
major factor in the loss of U.S. manufacturing jobs. Although China made modest
reforms to its currency policy in 2005, resulting in a modest appreciation of its currency
many, Members contend the reforms have not gone far enough and have warned of
potential legislative action. This report summarizes the main findings CRS Report
RL32165, China’s Currency: Economic Issues and Options for U.S. Trade Policy, by
Wayne M. Morrison and Marc Labonte and will be updated as events warrant.
From 1994 until 2005, China maintained a policy of pegging its currency, to the1
U.S. dollar at an exchange rate of roughly 8.28 yuan to the dollar. The Chinese central
bank maintained this peg by buying (or selling) as many dollar-denominated assets in
exchange for newly printed yuan as needed to eliminate excess demand (supply) for the
yuan. As a result, the exchange rate between the yuan and the dollar basically stayed the
same, despite changing economic factors which could have otherwise caused the yuan to
either appreciate or depreciate relative to the dollar. Under a floating exchange rate
system, the relative demand for the two countries’ goods and assets would determine the
exchange rate of the yuan to the dollar. Many economists contend that for the first several
years of the peg, the fixed value was likely close to the market value. But in the past few
years, economic conditions have changed such that the yuan would likely have
appreciated if it had been floating. The sharp increase in China’s foreign exchange
1 The official name of China’s currency is the renminbi (RMB), which is denominated in yuan
units. Both RMB and yuan are used to describe China’s currency.
reserves (which grew from $403 billion in 2003 to $1.9 trillion as of September 2008) and
China’s large trade surplus with the world ($262 billion in 2007) are often viewed by
critics of China’s currency policy as proof that the yuan is significantly undervalued.
China Reforms the Peg. The Chinese government modified its currency policy
on July 21, 2005. It announced that the yuan’s exchange rate would become “adjustable,
based on market supply and demand with reference to exchange rate movements of
currencies in a basket” (it was later announced that the composition of the basket includes
the dollar, the yen, the euro, and a few other currencies) and that the exchange rate of the
U.S. dollar against the yuan was adjusted from 8.28 to 8.11, an appreciation of 2.1%.
Unlike a true floating exchange rate, the yuan would be allowed to fluctuate by 0.3%
(later changed to 0.5%) on a daily basis against the basket.
Since July 2005, China has allowed the yuan to appreciate steadily, but very slowly.
It has continued to accumulate foreign reserves at a rapid pace, which suggests that if the
yuan were allowed to freely float it would appreciate much more rapidly. The current
situation might be best described as a “managed float” — market forces are determining
the general direction of the yuan’s movement, but the government is retarding its rate of
appreciation through market intervention. From July 21, 2005, to November 20, 2008,
the dollar-yuan exchange rate went from 8.11 to 6.83, an appreciation of nearly 19%. The
impact of the yuan’s appreciation is unclear. From January-September 2008, U.S. imports
from China rose by 6.6% over the same period in 2007, while U.S. exports to China rose
by 17.5%. The price index for U.S. imports from China from September 2007 to
September 2008, rose by 4.8% (compared to 14.5% for all imports).
U.S. Concerns Over China’s Currency Policy
Many U.S. policymakers and business and labor representatives have charged that
China’s currency is significantly undervalued vis-à-vis the U.S. dollar (even after the
recent revaluation), making Chinese exports to the United States cheaper, and U.S.
exports to China more expensive, than they would be if exchange rates were determined
by market forces. They further argue that the undervalued currency has contributed to the
burgeoning U.S. trade deficit with China (which was $256 billion in 2007) and has hurt
U.S. production and employment in several U.S. manufacturing sectors that are forced to
compete domestically and internationally against “artificially” low-cost goods from
China. Furthermore, some analysts contend that China’s currency policy induces other
East Asian countries to intervene in currency markets in order to keep their currencies
weak against the dollar in order to compete with Chinese goods. Critics contend that,
while it may have been appropriate for China during the early stages of its economic
development to maintain a pegged currency, it should let the yuan freely float today, given
the size of the Chinese economy and the impact its policies have on the world economy.
China’s Concerns Over Modifying Its Currency Policy
Chinese officials argue that its currency policy is not meant to favor exports over
imports, but instead to foster economic stability through currency stability, as many other
countries do. They have expressed concern that floating its currency could spark an
economic crisis in China and would especially be damaging to its export industries at a
time when painful economic reforms (such as closing down inefficient state-owned
enterprises) are being implemented. They further contend that the Chinese banking
system is too underdeveloped and burdened with heavy debt to be able to deal effectively
with possible speculative pressures that could occur with a fully convertible currency.
Concerns have also been raised over the effects an appreciating yuan would have on
farmers (due to lower-priced imports). Chinese officials view economic stability as
critical to sustaining political stability; they fear an appreciated currency could reduce
employment and lower incomes in various sectors, and thus could cause worker unrest.
However, Chinese officials have indicated that their long-term goal is to adopt a more
flexible exchange rate system and to seek more balanced economic growth through
increased domestic consumption and the development of rural areas, but they claim they
want to proceed at a gradual pace to ensure economic stability. These concerns have been
further strengthened by the effects of the current global financial crisis.
Implications of China’s Currency Policy for its Economy
If the yuan is undervalued vis-à-vis the dollar (estimates rage from 15% to 40% or
higher), then Chinese exports to the United States are likely cheaper than they would be
if the currency were freely traded, providing a boost to China’s export industries (and, to
some degree, an indirect subsidy). Eliminating exchange rate risk through a managed peg
also increases the attractiveness of China as a destination for foreign investment in export-
oriented production facilities. However, an undervalued currency makes imports more
expensive, hurting Chinese consumers and Chinese firms that import parts, machinery,
and raw materials. Such a policy, in effect, benefits Chinese exporting firms (many of
which are owned by foreign multinational corporations) at the expense of non-exporting
Chinese firms, especially those that rely on imported goods. This may impede the most
efficient allocation of resources in the Chinese economy. Another major problem is that
the Chinese government must expand the money supply in order to keep purchasing
dollars, which has promoted the banks to adopt easy credit policies. In addition, “hot
money” has poured into China from investors speculating that China will continue to
appreciate the yuan. At some point, these factors could help fuel inflation, overinvestment
in various sectors, and expansion of nonperforming loans by the banks — each of which
could threaten future economic growth.
Implications of China’s Currency Policy for the U.S. Economy
Effect on Exporters and Import-Competitors. When exchange rate policy
causes the yuan to be less expensive than it would be if it were determined by supply and
demand, it causes Chinese exports to be relatively inexpensive and U.S. exports to China
to be relatively expensive. As a result, U.S. exports and the production of U.S. goods and
services that compete with Chinese imports fall, in the short run. (Many of the affected
firms are in the manufacturing sector.)2 This causes the trade deficit to rise and reduces
aggregate demand in the short run, all else equal.3
2 U.S. production has moved away from manufacturing and toward the service sector over the
past several years. U.S. employment in manufacturing as a share of total nonagricultural
employment fell from 31.8% in 1960, to 22.4% in 1980, to 10.2% in 2007. This trend is much
larger than the Chinese currency issue and is caused by numerous other factors.
3 Putting exchange rate issues aside, most economists maintain that trade is a win-win situation
(continued...)
Effect on U.S. Consumers and Certain Producers. A society’s economic
well-being is usually measured not by how much it can produce, but how much it can
consume. An undervalued yuan that lowers the price of imports from China allows the
United States to increase its consumption through an improvement in the terms-of-trade.
Since changes in aggregate spending are only temporary, from a long-term perspective the
lasting effect of an undervalued yuan is to increase the purchasing power of U.S.
consumers. Imports from China are not limited to consumption goods. U.S. producers
also import capital equipment and inputs to final products from China. An undervalued
yuan lowers the price of these U.S. products, increasing their output.
Effect on U.S. Borrowers. An undervalued yuan also has an effect on U.S.
borrowers. When the U.S. runs a current account deficit with China, an equivalent
amount of capital flows from China to the United States, as can be seen in the U.S.
balance of payments accounts. This occurs because the Chinese central bank or private
Chinese citizens are investing in U.S. assets, which allows more U.S. capital investment
in plant and equipment to take place than would otherwise occur. Capital investment
increases because the greater demand for U.S. assets puts downward pressure on U.S.
interest rates, and firms are now willing to make investments that were previously
unprofitable. This increases aggregate spending in the short run, all else equal, and also
increases the size of the economy in the long run by increasing the capital stock.
Private firms are not the only beneficiaries of the lower interest rates caused by the
capital inflow (trade deficit) from China. Interest-sensitive household spending, on goods
such as consumer durables and housing, is also higher than it would be if capital from
China did not flow into the United States. In addition, a large proportion of the U.S.
assets bought by the Chinese, particularly by the central bank, are U.S. Treasury
securities, which fund U.S. federal budget deficits. According to the U.S. Treasury
Department, China holds $585 billion in U.S. Treasury securities as of September 2008,
making China the largest foreign holder of such securities. If the U.S. trade deficit with
China were eliminated, Chinese capital would no longer flow into this country on net, and
the government would have to find other buyers of U.S. Treasuries. This could increase
the government’s interest payments.
Net Effect on the U.S. Economy. In the medium run, an undervalued yuan
neither increases nor decreases aggregate demand in the United States. Rather, it leads
to a compositional shift in U.S. production, away from U.S. exporters and import-
competing firms toward the firms that benefit from Chinese capital flows. Thus, it is
expected to have no medium or long run effect on aggregate U.S. employment or
unemployment. As evidence, one can consider that the U.S. had a historically large and
growing trade deficit throughout the 1990s at a time when unemployment reached a three-
decade low. However, the gains and losses in employment and production caused by the
trade deficit will not be dispersed evenly across regions and sectors of the economy: on
balance, some areas will gain while others will lose. And by shifting the composition of
3 (...continued)
for the economy as a whole, but produces losers within the economy. Economists generally
argue that free trade should be pursued because the gains from trade are large enough that the
losers from trade can be compensated by the winners, and the winners will still be better off.
U.S. output to a higher capital base, the size of the economy would be larger in the long
run as a result of the capital inflow/trade deficit.
Although the compositional shift in output has no negative effect on aggregate U.S.
output and employment in the long run, there may be adverse short-run consequences.
If output in the trade sector falls more quickly than the output of U.S. recipients of
Chinese capital rises, aggregate spending and employment could temporarily fall. This
is more likely to be a concern if the economy is already sluggish than if it is at full
employment. Otherwise, it is likely that government macroeconomic policy adjustment
and market forces can quickly compensate for any decline of output in the trade sector by
expanding other elements of aggregate demand. The deficit with China has not prevented
the U.S. economy from registering high rates of growth since 2003.
The U.S.-China Trade Deficit in the Context of the Overall U.S. Trade
Deficit. While China is a large trading partner, it accounted for only 16.5% of U.S.
merchandise imports in 2007 and 29% of the sum of all U.S. bilateral trade deficits. Over
a span of several years, a country with a floating exchange rate can consistently run an
overall trade deficit for only one reason: a domestic imbalance between saving and
investment. Over the past two decades, U.S. saving as a share of gross domestic product
(GDP) has been in gradual decline. On the one hand, the U.S. has high rates of
productivity growth and strong economic fundamentals that are conducive to high rates
of capital investment. On the other hand, it has a chronically low household saving rate,
and recently a negative government saving rate as a result of the budget deficit. As long
as Americans save little, foreigners will use their saving to finance profitable investment4
opportunities in the United States; the trade deficit is the result. The returns to foreign-
owned capital will flow to foreigners instead of Americans, but the returns to U.S. labor
utilizing foreign-owned capital will flow to U.S. labor.
More than half of China’s exports to the world are produced by foreign-invested
firms in China, many of which have shifted production to China in order to gain access
to low-cost labor. (The returns to capital of U.S. owned firms in China flow to
Americans.) Such firms import raw materials and components (much of which come
from East Asia) for assembly in China. As a result, China tends to run trade deficits with
East Asian countries (such as Taiwan, South Korea, and Japan) and trade surpluses with
countries with high consumer demand, such as the United States. If China’s trade with
the United States is excluded, China’s total trade surplus was $12 billion (2007). These
factors imply that much of the increase in U.S. imports (and hence, the rising trade deficit
with China) is largely the result of China becoming a production platform for many
foreign companies, rather than unfair Chinese trade policies.
Congressional Legislation
Many Members contend that the pace of China’s currency reforms and level of the
yuan’s appreciation against the dollar have been too slow, and some have introduced
legislation to put further pressure on the Chinese to speed reforms or to enable U.S.
4 Most economists believe that the United States runs a trade deficit because it fails to save
enough to meet its investment needs and must obtain savings from other countries with high
savings rates. China has one of the world’s largest savings rate.
producers to use U.S. trade law to address the impact of China’s undervalued currency.
!H.R. 321 (English) would increase tariffs on imported Chinese goods if
the Treasury Department determined that China manipulated its currency,
and would require the United States to file a WTO case against China
over its currency policy and to work within the WTO to modify and
clarify rules regarding currency manipulation. H.R. 1002 (Spratt) would
impose 27.5% in additional tariffs on Chinese goods unless the President
certifies that China is no longer manipulating its currency.
!S. 364 (Rockefeller) would apply U.S. countervailing laws (dealing with
government subsidies) to products imported from non-market economies
(such as China), and would make currency manipulation actionable under
this measure. H.R. 782 (Tim Ryan) and S. 796 (Bunning) would make
exchange rate “misalignment” actionable under U.S. countervailing duty
laws, require the Treasury Department to determine whether a currency
is misaligned in its semi-annual reports to Congress on exchange rates,
prohibit the Department of Defense from purchasing certain products
imported from China if it is determined that China’s currency
misalignment has disrupted U.S. defense industries, and would include
currency misalignment as a factor in determining safeguard measures on
imports of Chinese products that cause market disruption.
!H.R. 2942 (Tim Ryan) would apply countervailing laws to nonmarket
economies, make an undervalued currency a factor in determining
antidumping duties, require Treasury to identify fundamentally
misaligned currencies and to list those meeting the criteria for priority
action. If consultations fail to resolve the currency issues, the USTR
would be required to take action in the WTO.
!S. 1607 (Baucus) would require the Treasury Department to identify
currencies that are fundamentally misaligned and to designate such
currencies for “priority action” under certain circumstances. Such action
would include factoring currency undervaluation in U.S. anti-dumping
cases, banning federal procurement of products or services from the
designated country, and filing a case against in the WTO. S. 1677
(Dodd) would require the Treasury Department to identify countries that
manipulate their currencies regardless of their intent and to submit an
action plan for ending the manipulation, and gives Treasury the authority
to file a case in the WTO. S. 2813 (Bunning) would also require the
Treasury Department to identify currency manipulators and to submit an
action plan to end the manipulation.
Some U.S. policymakers have expressed hope that China will increase its U.S. debt
holdings in order to help the Federal government pay for its financial rescue plan and
future stimulus packages, while others have expressed concerns that doing so would
lessen pressure on the Chinese government to appreciate the yuan.