Currency

The Great Currency Debate

The lively debate on China's currency regime reflects competing views of China policy

by Arie Eernisse and Tom Meehan

A March 26 letter to President George W. Bush, signed by 15 of the 24 Democratic members of the powerful House Committee on Ways and Means, makes the claim that "China's undervaluation of the yuan makes US exports to China more expensive and Chinese exports to the United States cheaper, contributing to massive US trade deficits, lost jobs, and a suppression of US economic growth." Claims such as these have pit those who view China as shirking its international obligations and deserving of punishment against those who want to avoid unnecessary tension in the increasingly important US-China relationship. Against a backdrop of rising economic uncertainty and a gradually appreciating renminbi (RMB), a wide variety of participants have joined the debate, including economists, members of Congress, the Bush administration, US industry, and associations, like the publisher of this magazine.

Though basic economics says that an undervalued Chinese currency lowers the price of imports from China and makes it harder for US manufacturers in low-skilled sectors to compete, the question remains: Does an undervalued RMB significantly harm the US economy? And equally important, would the currency-focused legislation and other punitive actions that some in Congress have called for, such as a World Trade Organization (WTO) case against China, actually speed China's currency reform?

Quick Glance

With the renminbi (RMB) appreciating against the dollar and the impact of China's exchange rate on the US economy unclear, Congressional efforts to force China's hand on currency reform should be reevaluated.
Efforts to pressure China on its currency are also hampered by widely varying estimates of RMB undervaluation and legal questions about bringing a currency-related WTO case against China.
Disagreement between the US Congress and executive branch in their approaches to currency reform has turned the RMB debate into a political issue.

The economic debate

As the CBR went to press in late April, the dollar-RMB exchange rate was $1 per ¥7, a 15.5 percent increase from July 2005, when China revalued the RMB 2.1 percent and moved from what was effectively a fixed exchange rate against the dollar to a "managed float" pegged to a basket of currencies. (The 15.5 percent increase includes the initial 2.1 percent revaluation.) Even after the switch, however, the RMB has appeared to use the dollar as its main currency of reference. From July 2005 to May 2007, the RMB fluctuated daily within a +/-0.3 percent band and has since fluctuated within a +/-0.5 percent band. In 2007, the RMB strengthened 6.54 percent against the dollar, almost double the 3.3 percent pace of 2006 but not necessarily because of the widened band. In the first quarter of 2008, the RMB rose nearly 4 percent, and UBS AG estimates that the RMB will gain another 8 percent by next April. (The RMB's standing against other currencies, such as the Euro, will not be explored here.) Given the faster appreciation recently and other economic factors, some economists have questioned the utility of even faster appreciation at this time.

Undervalued? By how much?

It is commonly accepted that, as US Under Secretary of Commerce Christopher Padilla has said, five different economists would give "five different opinions about the value of the RMB." An October 2007 study by William Cline and John Williamson of the Peterson Institute for International Economics found that the average of 16 estimates—ranging from 7 to 100 percent—made between 2000 and 2007 was 40 percent.

On the issue of what form appreciation should take, most economists fall into two camps. The first generally favors gradual, but quick annual appreciation—much like what is happening now—while the second group favors a bold, immediate revaluation of 10-25 percent, usually coupled with other measures that would allow market forces a greater role in determining the RMB's value.

Effects on the US economy

The claim made in the recent Ways and Means Committee letter that the undervalued RMB "contributes" to the US trade deficit, job losses, and suppression of economic growth is misleading because the RMB contributes only marginally, if at all, to these problems.

In evaluating the effect of the undervalued RMB on the US global trade deficit, a few key points should be noted. Nonpartisan studies such as the October 2007 Congressional Research Service report, "China's Currency: Economic Issues and Options for US Trade Policy," have concluded that low US savings, low PRC consumption, and other structural problems are more important than RMB undervaluation in explaining the $256 billion US trade deficit with China, which made up 32 percent of the global US trade deficit in 2007. In addition, it is crucial to note that East Asia's proportion of the $708.5 billion US global trade deficit (minus China) fell precipitously from 51 to 17 percent in the past 12 years, strongly suggesting that the transformation of the Asian trading landscape—with producers from countries such as South Korea and Japan moving their manufacturing facilities to China—is largely responsible for the bloated US trade deficit with China.

Projections have indicated that the US trade deficit and current account deficits would be affected minimally by a one-off 20-25 percent RMB revaluation. A January 2006 Oxford Economics study commissioned by the China Business Forum estimated that a 25 percent RMB revaluation would only reduce the US global trade deficit by $10-$15 billion after two years because US imports from other Asian economies would correspondingly increase and result in higher US deficits with those countries. Likewise, because the RMB constitutes just 15 percent of the trade-weighted dollar, in 2006, a 20 percent appreciation of the RMB would have resulted in only a 3 percent depreciation of the trade-weighted dollar, which would have cut the US global current account deficit of $857 billion by just $40 to $55 billion, according to a June 2007 article by Morris Goldstein of the Peterson Institute. (Goldstein and other Peterson Institute economists base their support for immediate RMB appreciation partly on the appreciation they say would occur in other undervalued Asian currencies, which in turn would help reduce the US global current account deficit.)

On the question of job losses, although China's exchange rate policy has accelerated manufacturing job losses in some sectors, US productivity gains are far more important in explaining job losses. In a March 2006 Federal Reserve Bank of New York report, Richard Deitz and James Orr show that while employment in lowand mid-skilled manufacturing jobs fell by 3.3 million from 1983 to 2002, high-skilled manufacturing jobs rose by 1.2 million, up 37 percent. This transformation has created a manufacturing workforce that is "leaner and more skilled" and therefore capable of higher output. Consistent with this finding, data from the US Bureau of Economic Analysis show that the decline in manufacturing employment in the United States from 1998 to 2007 occurred at the same time that the US share of global manufacturing output rose from 22.3 to 24.7 percent, suggesting that the smaller manufacturing workforce is more productive. China's share of global manufacturing output, meanwhile, remained well below that of the United States at 11.4 percent in 2007, according to estimates from the United Nations Industrial Development Organization.

The claim that China's currency regime has suppressed US economic growth must be evaluated in light of the dramatic increase in US exports to China and the beneficial aspects of Chinese imports. Despite an undervalued RMB, US exports to China have quadrupled since 2000, rising from $16.3 billion to $65.2 billion in 2007, and, just this year, China surpassed Japan to become the third-largest US export market. Chinese imports have supported many US jobs in services, wholesale and retail trade, and other sectors and have given US businesses and consumers access to less expensive goods for inputs and consumption.

Effects on China's economy

Economists who acknowledge the limited effect of RMB revaluation on the USeconomy often frame the currency debate in terms of the potentially significant negative impact of a bold revaluation on China's economy. The Oxford Economics report mentioned above predicted that, in the event of a 20 to 30 percent RMB revaluation, "Chinese exporters to the United States are likely to do their best to protect their market share...even if that means cutting their profits and/or squeezing their costs, including labor costs." Jonathan Anderson of UBS has noted that "a large, unannounced revaluation would... catch exporters off-guard, with potentially devastating near-term effects on profits and earnings." Yet Anderson and other economists who oppose bold, immediate revaluations, such as Pieter Bottelier of Johns Hopkins University-School of Advanced International Studies, do not necessarily oppose steady appreciation. Bottelier has argued that faster appreciation would help China to address macroeconomic imbalances, such as overdependence on exports and investment.

Congressional attempts to legislate Chinese currency

Despite the uncertainty surrounding the RMB's valuation and the effects of RMB appreciation on the US economy, Congress has become increasingly active on the issue, with 10 currency-related bills introduced since the 110th Congress convened in January 2007. The surge of legislation targeting the RMB started in 2003 when Sens. Chuck Schumer (D-NY) and Lindsey Graham (R-SC) introduced a bill that would have imposed a 27.5 percent tariff on all Chinese goods imported into the United States unless China allowed significant and lasting RMB appreciation. (The 27.5 percent was the average of two economists' estimates, 15 percent and 40 percent.) Schumer and Graham then reintroduced the bill in 2005 and stepped up their efforts to bring it to a vote. While political pressure, including a direct appeal from President Bush, kept both of the bills from the Senate floor for a vote, the wave of attention stirred by the controversial bills showed that legislation attacking China's exchange rate regime could gain traction with members of Congress, the press, and, most important, voters.

This, and a new Democratic majority, set the stage for China's currency to become a prime legislative target in the new Congress. Of the 10 bills directed at China's currency, one House bill and two Senate bills merit discussion (see Table). In the Senate, Schumer and Graham were joined by Sens. Charles Grassley (R-IA) and Max Baucus (D-MT), the Republican and Democratic leaders, respectively, of the Senate Finance Committee, in introducing their third attempt at currency legislation, S. 1607 (the Finance bill). Sens. Chris Dodd (D-CT) and Richard Shelby (R-AL), chair and ranking Republican, respectively, on the Senate Banking Committee, also introduced their own currency bill, S. 1677 (the Banking bill). Meanwhile, in the House, Reps. Tim Ryan (D-OH) and Duncan Hunter (R-CA), who have joined together on China-focused currency legislation in the past, introduced H.R. 2942.

All three bills include provisions that would reform the US Department of the Treasury's semiannual report on international economic and exchange rate policies (see Box). Each bill revises the standards and language in the current authorizing statute for the report to force Treasury to designate China as a "currency manipulator"—an important step in bringing China to the World Trade Organization (WTO) over its currency, a provision in all three bills. In its 2007 report, published in December, Treasury refrained from designating the RMB as manipulated because it found no "intent" on the part of China to manipulate its currency for the benefit of trade. The bills' drafters aim to remove the intent requirement and expand congressional oversight, thus making it easier for Treasury to designate the RMB as either "manipulated" (the language in the Banking bill), "fundamentally misaligned" (the Finance bill), or "fundamentally and actionably misaligned" (the House bill).

Currency Bills in Congress
	Senate Finance Bill (S. 1607) Baucus-Grassley Schumer-Graham	Senate Banking Bill (S. 1677) Dodd-Shelby	House Bill (H.R. 782) Hunter-Ryan
Reforms to the annual Treasury report	Treasury must determine whether a currency is "fundamentally mis-aligned," defined as "significant and sustained undervaluation of the prevailing real effective exchange rate, adjusted for cyclical and transitory factors, from its medium-term equilibrium level." If misalignment is driven by explicit government policy, then it must be designated for "priority action."	If it causes unfair trade advantage, excessive US dollar reserves, or prevents balance of payment adjustments, Treasury must determine whether a country "manipulates" its exchange rate, regardless of intent.	Adds the determination of "fundamentally misaligned" to the existing standard of defining a country as a "currency manipulator" and creates the designation of "fundamental and actionable misalignment," which would initiate enforcement actions.
Key enforcement provisions	If a country is designated for priority action, Treasury must engage the International Monetary Fund (IMF) for advice and support. If, after 180 days, there are no results, the United States should: Adjust antidumping (AD) calculations to reflect "misalignment;" Ban Federal procurement from the designated country; Request the IMF to consult the designated country; and Oppose Overseas Private Investment Corp. and multilateral bank financing to US companies operating in that country. If the country does not comply after 360 days, the United States should initiate a World Trade Organization (WTO) case and consider possible remedial intervention in markets with the IMF.	If a country is designated as a "manipulator," Treasury must within 30 days request consultations with that country in the IMF under article IV and use its voting power against that country if necessary. Treasury must also submit a plan of action with specific benchmarks for correcting manipulation. If the country does not comply within 300 days, Treasury has the authority to initiate action at the WTO under General Agreement on Tariffs and Trade Article XV.	Considers exchange rate misalignment a countervailable subsidy for both market and nonmarket economies. In the case of "fundamental and actionable misalignment" the United States should: Adjust AD calculations to reflect "misalignment;" Request the IMF to consult the designated country; and Oppose Overseas Private Investment Corp. and multilateral bank financing to US companies operating in that country. If the country does not comply after 360 days, the United States should initiate a WTO case and consider possible remedial intervention in markets with the IMF.
Source: The US-China Business Council

The administration's view on currency legislation

The Bush administration has so far rejected calls from Congress to take punitive action against China. Rather, it has advocated an approach of open dialogue and constructive engagement to encourage China to allow the RMB to appreciate. Treasury, which, along with the Federal Reserve, has authority over exchange rate issues within the administration, leads these efforts.

The administration has not been shy in opposing currency legislation. Mark Sobel, deputy assistant Treasury secretary, has said that proposed legislation could harm the US economy by increasing the cost of consumer goods, lowering US exports to China, and cutting off the inflow of capital on which the United States so heavily relies. Padilla has referred to the pending legislation as a "blunt instrument" that would simply reduce imports from China rather than address the underlying root causes of the US trade deficit and other financial woes.

Treasury does not deny that the RMB is undervalued and noted in its most recent report on international economic and exchange rate policies, published in December 2007, that the "substantial undervaluation of the renminbi" is harming the PRC economy and contributing to China's growing trade surplus, leading to rising tensions among China and its major trading partners. The same report, however, concludes that neither China nor any other major trading partner met the requirements for designation as a "currency manipulator." In fact, no country has received this designation since China, Taiwan, and South Korea were cited in 1994 by the Clinton administration.

Treasury's Exchange Rate Report

The Omnibus Trade and Competitiveness Act of 1988 requires the US Department of the Treasury to analyze the exchange rate policies of foreign countries and consider whether countries manipulate the exchange rate between their currencies and the US dollar to prevent balance of payments adjustments or gain unfair competitive advantage in international trade.

Treasury must submit two reports annually—on October 15 and April 15—to the House Financial Services Committee and the Senate Banking, Housing, and Urban Affairs Committee. The report analyzes the relationship between the US dollar and the currencies of its major trading partners, developments in bilateral trade and capital flows, and currency intervention or other actions undertaken to adjust the actual exchange rate of the dollar. It then recommends changes to US economic policy to attain a more appropriate and sustainable balance in the current account.

If the report designates a country as a "manipulator," the secretary of Treasury must initiate negotiations with the country at the International Monetary Fund or in a bilateral forum. Treasury, however, already maintains open and regular dialogue with China on its currency. A "manipulator" designation therefore would only be a political move, likely to strain relations between the two countries.

—Tom Meehan

Taking a currency case to the WTO

All of the punitive provisions in the three bills would almost certainly lead to a WTO dispute settlement case. Some of the provisions call directly for a WTO case, but others, such as the antidumping and countervailing duty (CVD) provisions in the Senate Finance and Hunter-Ryan bills, would likely wind up before a WTO dispute settle- ment panel eventually. Three different routes could lead to a face-off between the United States and China at the WTO over currency, though most observers believe the likelihood of success for the United States in any of these cases is small.

First, the United States could bring a case to the WTO under Article XV(4) on exchange arrangements of the General Agreement on Tariffs and Trade (GATT). Article XV(4) states that "Contracting parties shall not, by exchange action, frustrate the intent of the provisions of this Agreement...." Several experts, such as Arvind Subramanian of the Peterson Institute, believe the wording of the provision is too vague to predict with any certainty how a WTO dispute settlement panel would rule. According to Subramanian, "it is highly unlikely that WTO dispute settlement panels would be willing to rule against undervalued exchange rates on this tenuous basis."

Moreover, because the WTO defers to the judgment of the International Monetary Fund (IMF) on exchange rate issues, a ruling against China in a GATT Article XV(4) case would almost certainly require the IMF to first designate China as a currency manipulator. In past staff reports, the IMF has acknowledged that the RMB is undervalued but has refrained from using the term "manipulator." In addition, according to Michael Mussa of the Peterson Institute, of the roughly 50,000 consultations held since Article IV—which states that the IMF shall ensure that its members "avoid manipulating exchange rates"—was ratified over 30 years ago, the IMF Executive Board has never concluded that a "member was out of compliance with its obligations regarding its exchange rate policies...."

Second, the United States could bring a case to the WTO under Article 3 of the Agreement on Subsidies and Countervailing Measures (ASCM), which would require the United States to prove that an undervalued RMB is a "prohibited export subsidy." To be characterized as a subsidy under the ASCM, a public measure must represent a "financial contribution" from the government that is "specific" to an enterprise or industry, or a group of enterprises and industries. Proponents of currency legislation argue that an undervalued RMB confers a direct benefit to PRC exporters and harms US exporters, but it would be difficult to prove that national exchange rates are specific policies designed to boost the exports of one company or even one industry.

The third route—requiring the US Department of Commerce to consider an undervalued RMB a subsidy for the purposes of calculating countervailing or antidumping duties—would not immediately launch a WTO case. First, an affected US industry must prove to Commerce (which makes subsidy determinations) and the International Trade Administration (which makes injury determinations) that an undervalued RMB is a "prohibited export subsidy" under the same "specificity" and "financial contribution" guidelines as those of the ASCM. Though this would initially be a domestic case, China can, and almost certainly would, challenge any counter- vailing and antidumping duty determinations involving currency at the WTO. For example, when Commerce announced in 2007 that it would reverse a decades-long policy of not applying CVDs to nonmarket economies such as China, Beijing filed a WTO case against the first CVD determination the United States released. This case concerned coated free sheet paper, a good commonly subject to CVD laws. China's response to a CVD determination on a topic as controversial as currency would almost certainly be a WTO case.

Padilla has spoken out against the antidumping and CVD provisions in currency legislation, citing several technical and operational obstacles to implementing them, specifically the difficulty determining the actual amount of undervaluation. He has also voiced his concern that legislative attempts to address currency undervaluation would require Commerce to consider only how currency affects the final price of products from China, without taking into account the fact that a weak currency increases the price of imported inputs for those same products. Moreover, the bills consider currency undervaluation to be a foreign problem and provide no offsetting effect when the dollar is relatively weak compared to foreign currencies. All of these factors, Padilla says, would leave the United States vulnerable to appeals and retaliatory cases in the WTO and US Court of International Trade.

An end to the debate in sight?

Proponents of currency reform legislation and currency-related WTO cases would do well to consider several factors that significantly weaken their case. First, the RMB is already appreciating at about 8 percent per year against the dollar, and faster appreciation might prove hazardous to the US and PRC economies. Second, the RMB undervaluation's impact on the US economy is far outweighed by other factors, including US manufacturing productivity gains, a dramatic shift in the Asian trading landscape, and growing US exports to China. Third, the uncertainty surrounding the RMB's exact amount of undervaluation against the dollar and the likely unsuccessful outcome of a currency-related WTO case against China undermine the ability of congressional legislation to elicit any real change in China's exchange rate policy. Last, and perhaps most important, attempts to force China's hand on currency reform would likely do more harm than good by incurring possible retaliatory actions against Washington and damaging bilateral relations.

Arie Eernisse is manager, Publications, and Tom Meehan is manager, Government Affairs, at the US-China Business Council.

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