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43–597—PDF 2007

S. HRG. 110–458

RISKS AND REFORM: THE ROLE OF CURRENCY

IN THE U.S.- CHINA RELATIONSHIP

HEARING

BEFORE THE

COMMITTEE ON FINANCE

UNITED STATES SENATE

ONE HUNDRED TENTH CONGRESS

FIRST SESSION

MARCH 28, 2007

(

Printed for the use of the Committee on Finance

COMMITTEE ON FINANCE

MAX BAUCUS, Montana, Chairman

JOHN D. ROCKEFELLER IV, West Virginia

KENT CONRAD, North Dakota

JEFF BINGAMAN, New Mexico

JOHN F. KERRY, Massachusetts

BLANCHE L. LINCOLN, Arkansas

RON WYDEN, Oregon

CHARLES E. SCHUMER, New York

DEBBIE STABENOW, Michigan

MARIA CANTWELL, Washington

KEN SALAZAR, Colorado

CHUCK GRASSLEY, Iowa

ORRIN G. HATCH, Utah

TRENT LOTT, Mississippi

OLYMPIA J. SNOWE, Maine

JON KYL, Arizona

CRAIG THOMAS, Wyoming

GORDON SMITH, Oregon

JIM BUNNING, Kentucky

MIKE CRAPO, Idaho

PAT ROBERTS, Kansas

RUSSELL SULLIVAN, Staff Director

KOLAN DAVIS, Republican Staff Director and Chief Counsel

(II)

C O N T E N T S

OPENING STATEMENTS

Page

Baucus, Hon. Max, a U.S. Senator from Montana, chairman, Committee

on Finance ............................................................................................................ 1

Grassley, Hon. Chuck, a U.S. Senator from Iowa ................................................. 3

CONGRESSIONAL WITNESSES

Schumer, Hon. Charles E., a U.S. Senator from New York ................................. 4

Graham, Hon. Lindsey, a U.S. Senator from South Carolina .............................. 7

WITNESSES

Roach, Stephen S., managing director and chief economist, Morgan Stanley,

New York, NY ...................................................................................................... 9

Prasad, Eswar S., Nandlal P. Tolani senior professor of trade policy, Cornell

University, Ithaca, NY ......................................................................................... 11

Goldstein, Morris, Dennis Weatherstone senior fellow, Peter G. Peterson Institute for International Economics, Washington, DC ...................................... 13

Makin, John H., visiting scholar, American Enterprise Institute, Washington,

DC .......................................................................................................................... 15

ALPHABETICAL LISTING AND APPENDIX MATERIAL

Baucus, Hon. Max:

Opening statement ........................................................................................... 1

Goldstein, Morris:

Testimony .......................................................................................................... 13

Prepared statement .......................................................................................... 37

Graham, Hon. Lindsey:

Opening statement ........................................................................................... 7

Grassley, Hon. Chuck:

Opening statement ........................................................................................... 3

Makin, John H.:

Testimony .......................................................................................................... 15

Prepared statement .......................................................................................... 60

Prasad, Eswar S.:

Testimony .......................................................................................................... 11

Prepared statement .......................................................................................... 66

Roach, Stephen S.:

Testimony .......................................................................................................... 9

Prepared statement .......................................................................................... 75

Schumer, Hon. Charles E.:

Opening statement ........................................................................................... 4

Prepared statement .......................................................................................... 89

COMMUNICATIONS

National Retail Federation ..................................................................................... 93

US-China Business Council .................................................................................... 96

(III)

(1)

RISKS AND REFORM: THE ROLE OF

CURRENCY IN THE U.S.-CHINA RELATIONSHIP

WEDNESDAY, MARCH 28, 2007

U.S. SENATE, COMMITTEE ON FINANCE, Washington, DC.

The hearing was convened, pursuant to notice, at 10:02 a.m., in

room SD–215, Dirksen Senate Office Building, Hon. Max Baucus

(chairman of the committee) presiding.

Present: Senators Schumer, Stabenow, Salazar, Grassley, Smith,

and Bunning.

OPENING STATEMENT OF HON. MAX BAUCUS, A U.S. SENATOR

FROM MONTANA, CHAIRMAN, COMMITTEE ON FINANCE

The CHAIRMAN. The hearing will come to order.

Senator Grassley is currently testifying over on the House side,

so he cannot be here at this moment. We will include his full statement in the record, and he will come over and join us as soon as

he possibly can.

Welcome to the Finance Committee’s second hearing on China.

Today we examine China’s currency exchange regime. I am pleased

to welcome some of the world’s sharpest minds to discuss it.

During World War II, when Mike Mansfield was a young Congressman, he had an encounter with China’s currency exchange regime, back during World War II.

President Roosevelt had asked Mansfield to travel to China as

his emissary. Before Mansfield departed, American officials briefed

him on China’s exchange rate. They advised him to bring $1,000

in $50 and $100 bills. They counseled him to exchange those dollars on the black market in China. At all costs, they told him, he

should avoid the ‘‘unrealistic’’ government-imposed exchange rate.

Sixty years later, China’s exchange rate still draws criticism. But

today the value of China’s currency affects every American.

Currency markets are global. Financial markets are international. No country can insulate itself from global markets, but

countries and individuals can seize the opportunities that those

markets create.

Some say that we cannot expect China to increase the value of

its currency. Some say that we cannot expect the Treasury Department to cite China as a currency manipulator. Some say that we

cannot expect China to accelerate financial market reforms. And

some say we cannot expect America to pressure China’s reformers.

But Americans are tired of hearing this litany of impossibilities.

We want to know what China can do. We want to know what

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America can do. And we want to know what both countries can do

together.

Let us ask: How can China make the reforms that it needs to?

How can China take the actions that are in the interests of China,

America, and the world? And how can America help China to do

so?

China can, and must, do more to let its currency appreciate and

begin to allow market forces to determine its exchange rate. Some

will say that China’s currency has appreciated against the dollar

a bit. But overall, on a trade-weighted basis, the value of China’s

currency remains largely unchanged since 2005 levels.

China can, and must, do more to liberalize capital flows and

strengthen its financial sector. We know that China is nervous

about the risks associated with these reforms. But China cannot

learn to manage such risks in a vacuum. America—its public and

private sectors—stands ready to help China develop the tools it

needs to embrace flexible markets.

And China can, and must, give its citizens and companies greater flexibility to participate in global markets and in all of the opportunities they present. China has shown some creativity—such

as its newly established $200-billion reserve fund. But it must use

such tools in a way that brings stability, rather than uncertainty,

to the global economy.

At the same time, America can do more to help China to deal

with the potential pitfalls of reforms. America can do more to share

our vast financial expertise. And, most importantly, America can do

more to strengthen a relationship that holds so much promise for

our own future.

China and America need to act on the possible. Postponing reform imperils China’s growth and stability. Postponing reform carries deep risks for the world economy. And postponing reform will

needlessly cloud the Sino-American relationship.

Senators Grassley, Schumer, Graham, and I are working together to reform America’s approach to global exchange rates. Last

fall, we pledged to work together to find a solution that is firm but

fair and consistent with our World Trade Organization obligations.

We are continuing that work.

Back during World War II, we do not know whether Senator

Mansfield exchanged his dollars on the Chinese black market. The

notes from his trip do not say.

We do know, however, that Mike Mansfield went to China. We

do know that Mike Mansfield saw the possibilities. During World

War II, Congressman Mike Mansfield said, and I quote: ‘‘We must

awaken from our lethargy about the Orient. . . . We must not forget

our future lies, in large part, in the Pacific. A friendly . . . China

will be a safeguard for us in that area.’’ Again, written back during

World War II.

Senator Mansfield saw the possibility for a strong relationship

between China and America, and he worked to realize that possibility.

Let us not forget that our future lies, in large part, in the Pacific.

Let us deal firmly and fairly to advance Chinese currency reform.

And let us work to develop the strong relationship with China that

will be a safeguard to both our countries’ futures.

3

OPENING STATEMENT OF HON. CHUCK GRASSLEY,

A U.S. SENATOR FROM IOWA

Senator GRASSLEY. I want to thank the Chairman for convening

this important hearing on the role of currency in our economic relationship with China. And, I want to thank our witnesses for their

participation.

This hearing is part of a process that I agreed to last September

with Chairman Baucus, Senator Graham, and Senator Schumer.

After working on separate tracks in the last Congress, we agreed

to try to work together this year to develop new legislation to address currency exchange rates.

The only pre-condition that we set was that any new legislation

would have to be consistent with the obligations of the United

States as a member of the World Trade Organization.

I look forward to today’s testimony and to any written comments

that may also be submitted to the Committee. Such testimony and

commentary will help inform our joint effort.

I’m anxious to get started, because two things are apparent to

me. First, there’s a significant issue with respect to the artificial

undervaluation of China’s currency relative to the U.S. dollar. And

second, our laws pertaining to oversight of currency exchange rates

are in need of overhaul to better address the economic landscape

of the 21st century.

With respect to the first point, why should we be concerned

about China’s undervalued currency? I’m concerned because of the

risks and distortions that ensue. Most economists would say that

in response to mounting bilateral and global trade surpluses, the

Chinese currency should appreciate. But that’s not happening. Instead, China has engaged in large-scale intervention to restrict appreciation of its currency.

I look forward to hearing what our witnesses think about the

risks and distortions associated with such intervention. For example, to what extent does it create an incentive within China to overinvest in export-related production? To what extent does it make

U.S. products and exports less competitive? Does it create the potential for higher inflation in China? Does it create an incentive for

speculative investment and increase the risk of asset price bubbles

in China? Over time, does it leave China more vulnerable to domestic and/or external economic shocks? Does it leave the United

States more vulnerable to a sharp, disruptive movement in the

value of the U.S. dollar? From a longer-term perspective, to what

extent does it impede necessary reform of China’s financial services

sector? Those are some of the points I’m interested in exploring as

we engage in this fact-finding exercise.

Now, I don’t want to leave the impression that the issues lie entirely at China’s doorstep. During yesterday’s hearing on our economic relations with China, I noted that our trade deficit with

China is very much a function of U.S. consumption, because we’re

producing more and exporting more than ever before.

When we purchase imports, we provide the foreign reserves that

allow China to intervene in currency markets. In 2006, U.S. consumption of consumer goods accounted for almost 40 percent of our

total trade deficit in goods. So there’s clearly room for U.S. consumers to purchase less and save more.

4

At the same time, I think we should be able to rely on market

forces to balance out the pressures of fluctuating international

trade flows and differential interest rates on major currencies.

China is a major beneficiary of our open system of international

trade, so they should be no different. That’s not to say that China

should act overnight. But I do think the Chinese government can,

and should, be moving more quickly in that direction. It’s in everyone’s best interest that they do.

As for my second point, I note that our currency oversight laws

date to 1988. Back then, our primary concern was with respect to

the Japanese yen. Today it’s with respect to China. Tomorrow, who

knows?

We need to overhaul our laws so that the Treasury Department

is generally empowered to respond more forcefully to significant

currency imbalances. So, I intend to work on legislation that is not

specific to any particular country or currency. It will be broader

than that.

Finally, I invite comments from our witnesses with respect to the

role that the International Monetary Fund can or should play in

future oversight of currency exchange rates. I would further ask,

to what extent is the IMF equipped to handle that role? Is reform

of the IMF needed to ensure that it remains relevant to the needs

of the global economy in the 21st century? And if so, how?

These are important questions that also need to be addressed as

we move forward in developing new legislation.

Thank you, Mr. Chairman.

The CHAIRMAN. Now I would like to turn to our two eminent witnesses. I will begin with you, Senator Schumer.

STATEMENT OF HON. CHARLES E. SCHUMER,

A U.S. SENATOR FROM NEW YORK

Senator SCHUMER. Well, thank you, Mr. Chairman. Thank you so

much for your leadership on all of these issues and for scheduling

this hearing. I know you said some of the greatest minds will be

here to discuss this issue, and I think you meant on the second

panel.

The CHAIRMAN. When I mentioned that, I saw the two of you kibitzing a little bit over that point. I knew that was the point you

were making. [Laughter.]

Senator SCHUMER. Anyway, we look forward to hearing the great

minds on the second panel as well.

Thank you and Ranking Member Grassley for holding these 2

days of hearings on our economic relationship with China and allowing Senator Graham and I to make a statement as a team. I

know it is unusual for a member of the committee—and I am proud

to be on the committee—to address the committee as a witness, but

I felt it was important for me to sit here with my policy partner

on this issue for 5 years now. Lindsey and I have been a trade tag

team for a long time, and we look forward to developing a new currency bill with you and Senator Grassley over the next few months.

And the fact that we have a whole separate hearing on currency

both shows the importance of this issue—first day, all the other

China issues; second day, currency—but it also shows the fact that

5

you, Mr. Chairman, are aware and involved in how to solve this

problem. And we very much appreciate that.

Now, last year, as you know, Senator Graham and I ruffled a few

feathers with our tariff bill, which we set aside at the very end of

the Congressional session because we wanted to work with the

Chairman and Ranking Member on a new currency bill that was

WTO compliant. Senator Graham and I were both surprised when

our bill received 67 votes on the floor in April of 2005. Yet we are

convinced that the support for strong legislation on Chinese currency manipulation and other illegal trade practices has actually

grown significantly in the 2 years since.

We never intended for our original bill to become law. It was a

shot across the bow. As a result, having achieved some small measure of success, the 6-percent growth which we believe would not

have happened, the 6-percent revaluation of the yuan which we believe would not have happened without our bill, we withdrew it

and instead agreed to work with you and Senator Grassley to come

up with new legislation.

The possibility for legislation in the 110th Congress is real because the number of people who will vote for strong legislation

even exceeds the number who would have voted for our tariff bill

last year. In other words, well-crafted legislation, WTO compliant

and strong and effective, is likely to pass with a veto-proof margin

during this Congress. And I say that not just to my colleagues here

who are aware of the strength of this issue, but to the White House

and to the Chinese.

That is the message I hope that the Chinese and the Bush administration take away from these hearings. The desire to pass

tough legislation that is WTO compliant is very strong in this committee and in this Congress. I see one of our cosponsors of our legislation, Senator Bunning, here today.

Our goal in the 110th Congress should be to find a tough but fair

bill that can pass the House, pass the Senate, and be presented to

the President. And Senator Baucus, Chairman Baucus, Ranking

Member Grassley, we look forward to working with you to craft

such a bill. We believe it will happen this year, this session of Congress.

Let me say that there is no doubt China is making some progress

in various areas. China has recently decided to permit foreign

banks greater access to its domestic market for credit card and

other everyday services. China is also making efforts to administratively reduce the trade deficit, for example, by changing export tax

incentives.

What the Chinese should recognize, however, is that taking these

steps only reinforces the notion that the pace of currency appreciation could be faster without harming their domestic economy. In

other words, the same economic defect that these government policies are designed to achieve could be attained more broadly without

cherry-picking and looking at specific areas by merely revaluing

the yuan. Why they refuse to do so is still a mystery to all of us.

Although the pace of appreciation quickened slightly at the end

of 2006, it froze to a standstill over the past month or so. Nearly

all the experts still agree that the Chinese yuan remains significantly undervalued, that this undervaluation is the result of delibVerDate 11-MAY-2000 14:41 Aug 13, 2008 Jkt 000000 PO 00000 Frm 00009 Fmt 6633 Sfmt 6633 43597.000 SFIN1 PsN: SFIN1
6

erate intervention by the Chinese government in world currency

markets, and that this policy gives Chinese products a tremendous

advantage in the United States market.

In fact, even though the currency has appreciated by about 6.6

percent since Senator Graham and I started our crusade, some

would argue that the currency is even more undervalued now than

it was when we started. Since the Chinese economy has grown so

quickly over that time and our trade deficit with them continues

to explode—over $232 billion in 2006 alone—the Treasury Department has repeatedly used a technical and legalistic dodge to determine that China does not manipulate its currency. We all know

they intervene, on the order of $200 billion a year, to keep the

yuan’s value artificially low, yet our government cannot call a

spade a spade. And the President wonders why the bipartisan consensus for free trade has eroded. As long as the administration

sticks to this position, it is our view we have to proceed without

them.

Treasury Secretary Paulson, a man I have great respect for, is

trying to talk to the Chinese. Like his predecessors, he is learning

that you will get a lot of talk and very little action. We have to

take some action.

Now, let us leave aside for a moment what word we want to use

to describe what the Chinese are doing and focus on its effects. I

will be chairing in a few minutes the Joint Economic Committee

hearing with Fed Chairman Bernanke. He has said that Chinese

currency practices amount to an export subsidy. There is an emerging consensus that this is simply a fact, regardless of what our official reports may say.

Let me be perfectly clear, Mr. Chairman. The real protectionists

in the debate over China’s trade practices are those who argue we

should do nothing or that we should continue to wait or that rapid

change would upset the so-called harmonious society of China.

These apologists are protectionist in a different sense. They are

protecting China. Those of us who care deeply about American

workers, who care about upward mobility for middle-class families,

who care about our economic future, and who believe in free trade

understand that free trade benefits America when our major trading partners follow the rules. And we know that pushing China is

the right thing to do.

When I talk about this issue now, I feel a little bit like Vice

President Gore must feel when he talks about global climate

change. When he first started, he was regarded as a little bit out

of the mainstream. But over time public opinion has evolved, and

the overwhelming majority of the public is with him. The currency

issue is similar on not so broad a scale. Senator Graham and I

were focused on it before most people thought it was a real issue.

Nearly 5 years later, every Senator might not agree on how to address it, but I think there is an overwhelming consensus that something needs to be done.

One other thing I would say, Mr. Chairman, before concluding,

and I would ask unanimous consent that my entire statement be

put in the record.

The CHAIRMAN. Without objection.

7

Senator SCHUMER. I do not believe the Bush administration can

be counted on to protect American industry and workers from China’s unfair trade practices. The President has four times rejected

recommendations from the U.S. International Trade Commission

under section 421 to grant import relief to U.S. industries. USTR

has three times rejected 302 petitions to take action against China’s currency. The Treasury Secretary has refused to cite China for

manipulation in Treasury’s semiannual report. Proceedings before

the WTO, of course, are time-consuming and not getting us very far

until we change the law.

So the bottom line is this, Mr. Chairman: If not now, when? If

not us, who? The American public is waiting for us to take strong,

fair action that will be effective. And I thank you for the opportunity.

The CHAIRMAN. Thank you very much, Senator.

[The prepared statement of Senator Schumer appears in the appendix.]

The CHAIRMAN. Senator Graham?

STATEMENT OF HON. LINDSEY GRAHAM,

A U.S. SENATOR FROM SOUTH CAROLINA

Senator GRAHAM. Well, thank you, and I just would like to add

to the litany of his closing comments: Where? If not now, when? If

not us, who? Where? Here in this committee.

This committee is a great opportunity for Republicans and Democrats to come together and speak with one voice when it comes to

China currency manipulation—not a draconian voice, not a voice of

rhetoric to make a political point, but a reasoned voice that this is

a world economy, a global economy, and there are rules that we all

should play by.

The China currency issue depends on whose eyes you look

through, and apparently when you look from New York and South

Carolina, if you are in the manufacturing business, you see an advantage given to Chinese products 20 to 40 percent based on the

currency alone. You see other business practices that make it almost impossible for you to compete in the global economy if you are

from South Carolina and New York when it comes to China.

The 67 votes, Mr. Chairman, was an awakening of a sleeping

giant called the Congress. I never will forget—and it has been a

real pleasure working with Chuck on this—we started, you know,

well, maybe we could do a resolution. And 5 years later, we are in

the middle of what I think is a defining moment for a U.S.-Chinese

relationship. The currency has come to define our relationship, for

bad or worse. But Senator Durbin and Senator McConnell came to

us after the vote and said, ‘‘What do you want?’’ Well, we did not

think we would win. Honestly, we thought we would get into the

40s with Senator Bunning. We did not want to get embarrassed.

The truth is that we tapped into a growing resentment in this body

toward Chinese business practices that is bipartisan.

To my friends in the administration, I have enjoyed working with

you. You have gone and you have spoken, and we have tried to

play the good cop/bad cop. It is obvious what we have been trying

to do, and we have had some small success. But now we need to

come together as a country. The Congress and the administration

8

need to get behind some legislation that will be WTO compliant,

and that, Mr. Chairman, is where you and Senator Grassley become the key players.

I think there is a bipartisan support network on this committee

that could be used to change the Chinese-American relationship for

the better. And when you look at our legislation, yes, it was tough.

How do you get people’s attention in this world? You have to be

tough. The Chinese are tough. You know, that is the only way we

got their attention: to threaten to put a tariff on their products if

they did not change—something we do not want to do, something

I am sure they do not want to have happen to their business enterprises. But that vote did bring some attention to this issue, and 6.5

percent is not nearly enough, but it is a beginning. And 10-percent

GDP growth has occurred during this appreciation, so it can continue. But also the trade deficit has continued to grow.

To our Chinese friends, if you are watching and listening, which

I hope you are, you better understand that this is the one issue—

there may be a few others, but this is one issue where Republicans

and Democrats are together, and we are going to act because this

affects all Americans. And we want to act in a way where it is a

win-win for both countries, but it takes two partners to act to make

it a win-win. And I am here to tell you, unfortunately, after 5

years, the progress has been slow, it has been painful, it has taken

a lot of time and resources, and it needs to accelerate or worse

things can happen.

Finally, the legislation was tough. Was it draconian? Yes, in

many ways it was. But here is my question for this body: What is

the effect of the status quo on the American business community?

Draconian. If you are out there trying to compete in the global

economy, playing by the rules, and this currency manipulation is

allowed to continue to exist, it is devastating to you and your business. You can compete on cheap labor. You can compete when it

comes to technology and innovation. But when the Chinese government gets in the game, you cannot beat them.

So to do nothing, Mr. Chairman, is just as draconian as a 27.5-

percent tariff. The tariff may be off the table, but one thing is for

sure from this hearing and this committee’s support: The China

currency issue is on the table, and it will be acted upon in a bipartisan fashion, and we will get relief. I hope it is a win-win. That

is up to the Chinese.

Thank you for having this hearing.

The CHAIRMAN. Thank you, Senators, very, very much. You have

been leaders on this issue. You have worked very hard for a long

time, and we thank you very much for your contribution.

Now I will turn to our other experts, who include Stephen Roach,

chief economist and managing director, Morgan Stanley, in New

York. He will be followed by Eswar Prasad, who is a senior professor of trade policy at Cornell University in Ithaca. The third witness is Mr. Morris Goldstein, who is the Dennis Weatherstone senior fellow at the Peter G. Peterson Institute for International Economics. And, finally, we welcome John Makin, who is a visiting

scholar at the American Enterprise Institute in Washington, DC.

Mr. Roach, you are first.

9

STATEMENT OF STEPHEN S. ROACH, MANAGING DIRECTOR

AND CHIEF ECONOMIST, MORGAN STANLEY, NEW YORK, NY

Mr. ROACH. Thank you, Mr. Chairman, and I would certainly

echo the comments of Senators Schumer and Graham that you are

to be commended for holding these important hearings. I do concur

with both the Senators on one aspect of their comments, and that

is, getting China right could well be the most important challenge

that the United States faces in the international economic policy

arena in the 21st century.

As I see it, the truth of the matter is that, while there is no denying the strength of the U.S. and Chinese economies, we also have

major problems in our economy and China has problems in its

economy. I think the question before this committee today is

whether a currency fix is the appropriate remedy to resolve these

problems.

My answer, not to keep you in suspense—and it is detailed in my

statement—is an unequivocal, no. In making the case, I start with

the basic premise that a currency fix involves a shift in the relative

prices between one nation and another, and in this case between

China and the United States. And in considering the currency fix

as a remedy for a massive bilateral imbalance between the United

States and China, you must, therefore, consider the implications on

both our economy and their economy. Let me make just three

points in my summary in that regard.

Number one is America’s macro context. I was disappointed not

to even hear a word out of Senators Schumer’s or Graham’s mouth

in that regard. The United States, whether we like it or not, has

a huge savings problem, the likes of which the world has really

never seen before. I have talked to you about this before, Mr.

Chairman, but the numbers speak for themselves. We have had a

1-percent net national savings rate for the past 3 years—that is,

the combined savings of individuals, businesses, and the government sector—adjusted for depreciation, and it is a record low for

us. And so, lacking in domestic savings, we must import surplus

savings from abroad in order to keep growing and run massive current account and trade deficits to attract the capital. That biases

the United States toward a steady stream of trade deficits, whether

it is with China or anyone else. The risk is, if you do something

to alter the trade deficit with China without improving our national savings rate, the deficit just goes somewhere else. Most likely it would go to a higher-cost producer, which, in my opinion,

would be the functional equivalent of a tax hike on the very American consumer you are trying to help out.

I think you heard a similar argument yesterday from Professor

Bhagwati of Columbia University, and I certainly agree with him

on that aspect of his testimony. I would ask you: How does a shift

in the bilateral foreign exchange rate between the U.S. and China

fix this aspect of America’s macro problem? All too often you have

experts come into these rooms, and they pay lip service to our savings problem, but then they go on to be very explicit in going after

the Chinese. You cannot sweep the savings shortfall in the United

States under the rug. This is a critical part of the relative problem

between the United States and China.

10

Let me offer some brief comments on China’s macro context.

China is a poor but rapidly growing and transitional economy. It

has made spectacular progress on the economic development front

over the last 3 decades. There is no mistaking that. China, as a result of its unique economic model, though, has now a very unbalanced economy. Eighty percent of its GDP is in only two sectors:

fixed investment and exports. Only 35 percent of its economy is in

private consumption.

China knows it cannot stay this course. I was in Beijing last

week, and I heard Premier Wen Jiabao say that very directly at

the conclusion of the National People’s Congress. I heard him echo

it again in some private meetings that I and a few others attended

with him as part of the China Development Forum. In his words,

and I quote, the state of the Chinese economy is ‘‘unstable, unbalanced, uncoordinated, and unsustainable.’’ The sustainability issue,

by the way, is focused directly on China’s huge environmental problems and excess energy consumption. And the Chinese government

is putting policies in place right now that I think will ultimately

lead to a pro-consumption rebalancing of the Chinese economy.

That has two important benefits for China and for us.

Number one, it ultimately provides great opportunities for U.S.

exports and would be more of a Chinese-led cure of our bilateral

trade imbalance. It will shift the focus of Chinese trade flows from

exports to imports.

And, number two—and this is critically important to all of us in

the world—it will start to alleviate China’s environmental threats

and shift the structure of its economy away from an industrial

production-driven model to more of a commodity-lite growth model,

focused on private consumptions and services. That will take pressure off oil and commodity prices and will be a big plus also for

us in the United States and in the world economy.

In terms of the point that Senator Graham just made, yes, China

does compete on the basis of currency. There is no question about

it. It also competes very effectively on the basis of labor costs, technology, infrastructure, and massive investments in R&D. Moreover,

the numbers show very clearly, when you are looking at the socalled Chinese export threat, that over 60 percent of the export

growth coming out of China in the last decade has been driven by

Chinese subsidiaries of multinationals largely located in the West.

So who is China? Is China newly indigenous Chinese companies

that are competing unfairly with us? Or is China subsidiaries of

our companies that are there for economic, cost-efficiency reasons?

And I ask you: Would a currency fix really alter this dynamic?

Would it change the structural imperatives of China’s transformation that is now going on? I would say that the answer to

that at this point is no.

The final point, if I could have another minute?

The CHAIRMAN. Sure.

Mr. ROACH. The final point I would make is this is not to say

that we do not face real problems in the United States. I certainly

agree with Senator Schumer in that regard, that there are extraordinary pressures bearing down on the U.S. middle class, and we do

have a widening disparity between record returns to capital, the

record-high corporate profitability, and sharply declining rewards

11

to labor. We also have serious problems within the U.S. income distribution. But that raises a critical question: Are we really correct

in pointing the finger at China for these problems, or do we want

to take a long and hard look in the mirror and accept our own responsibility for this state of affairs?

So, again, the currency issue is an issue of relative prices. There

are aspects of this issue that we need to address. There are aspects

of this issue that China needs to address. There are issues that we

need to collectively address. I have some thoughts and ideas as to

what would be appropriate as policy recommendations, but I would

reserve them for the question-and-answer session.

Thank you for your time.

The CHAIRMAN. Thank you, Mr. Roach, very much.

[The prepared statement of Mr. Roach appears in the appendix.]

The CHAIRMAN. Mr. Prasad?

STATEMENT OF ESWAR S. PRASAD, NANDLAL P. TOLANI SENIOR PROFESSOR OF TRADE POLICY, CORNELL UNIVERSITY,

ITHACA, NY

Mr. PRASAD. Chairman Baucus and honorable members of the

Senate Finance Committee, thank you for the opportunity to share

with you my views on this very important bilateral economic relationship between China and the United States.

China’s tightly managed exchange rate regime has clearly become a major thorn in this relationship, and the manner in which

this matter is handled will have implications not just for the U.S.

and China, but also for the smooth functioning of the global trade

and financial systems.

I for one strongly believe that a confrontational approach calling

for drastic policy actions, combined with threats of retaliatory steps

if these actions are not taken, is not the way to make progress.

This approach is unlikely to have a large or lasting impact on the

U.S. trade deficit or, for that matter, imbalances in the Chinese

economy that we have just heard about. It could also have unintended adverse consequences for the global trading system.

But Chinese currency reform need not be a zero sum game.

There is a better way to help China in a few years to float its currency, free up capital flows, and put in place a better monetary policy framework. This would in turn boost consumption growth in

China, increase demand for imports, and facilitate inflows of capital and financial expertise, including from the U.S. This would be

win-win international financial diplomacy. It would improve Chinese macroeconomic performance and foster a more balanced relationship with the U.S. economy.

So why are the Chinese authorities reluctant to permit exchange

rate flexibility if, as Steve Roach and various others have argued,

it is in their own interest? They are, of course, concerned about

short-term disruptions to the economy that could result from a currency appreciation. The merits of those arguments may be open to

debate, but, more importantly, they have chosen to focus their energies on banking reforms and broader financial market development which they view as far more important priorities than currency reform. And therein lies a very big window of opportunity for

12

the international community, including the U.S., to catalyze substantive changes in the Chinese exchange rate regime.

There is an excellent basis, I believe, for translating the authorities’ own policy priorities into a strong case for exchange rate flexibility. This is my core point: that the case for a more flexible exchange rate, which I think is an important one, should be made on

the basis of a deeper set of policy priorities with the ultimate objective being balanced and sustainable growth in the longer term.

So let us trace the connections among different policies to see

where currency reform fits in. As the Chinese economy becomes

more complex and more connected to the global economy, it will become more exposed to more shocks externally and harder to manage through command-and-control methods. An independent monetary policy is a key tool for better macroeconomic management, as

we have seen in the U.S. Monetary policy independence is, however, but a mirage if the central bank is mandated to attain an exchange rate objective.

Independent monetary policy in turn is essential for financial

sector reforms. Using market instruments, such as interest rate

policy, rather than government directives to guide credit expansion

is essential to train state-owned banks in China to respond to market signals and become more robust financial institutions. In the

absence of such instruments, the central bank has to revert to its

old practice of telling state banks how much to lend and to whom,

which hardly gives banks the right incentives to behave like commercial entities.

And then, for developing the domestic financial sector, opening

up of the capital account to both inflows and outflows could also

be beneficial. Indeed, the Chinese have begun opening the door to

foreign strategic investors, including U.S. banks, to improve corporate governance and efficiency in their banks. However, there is

a very clear lesson from history that opening the capital account

while maintaining a fixed exchange rate could pose serious risks.

Let us now put these links together. Stable policies and a welldeveloped and efficient financial sector are crucial ingredients for

balanced and sustainable growth. In turn, these two intermediate

objectives would be helped by effective monetary policy and cautious capital account liberalization, and a flexible exchange rate is

an absolute prerequisite for both of these. Thus, exchange rate policy has an important role to play, not in itself but in achieving

these deeper policy reforms and also the ultimate objectives in

terms of growth and welfare.

This leaves an important question on the table: What monetary

framework could take the place of the fixed exchange rate? Marvin

Goodfriend of Carnegie-Mellon University and I have developed a

very specific package of proposals for a new monetary framework,

and we think that this particular framework, which I am happy to

talk about during the Q&A session, would, in fact, provide a basis

for increasing currency flexibility and allow exchange rate reform

to become integrated into an overall reform strategy.

Finally, framing the issue in this manner will serve as a basis

for a more constructive engagement between the U.S. and Chinese

economies. The U.S. in my view can indeed play a helpful catalytic

role in the Chinese reform process, not through threats but by proVerDate 11-MAY-2000 14:41 Aug 13, 2008 Jkt 000000 PO 00000 Frm 00016 Fmt 6633 Sfmt 6633 43597.000 SFIN1 PsN: SFIN1
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viding technical guidance and reorienting the discussion in a fashion that makes the linkages between currency and other reforms

on which there is much broader consensus within China clearer.

This is not to say that the U.S. should display infinite patience for

reforms to take root. It will be very important to work with the

Chinese to develop specific guidelines for intermediate goals, and,

in fact, these could serve as concrete guideposts for the reform

process, help break down internal resistance within China to the

reforms, and generate momentum to help the forces within China

that are predisposed towards making reforms. And as Steve Roach

indicated, these forces are very much present.

To summarize, exchange rate flexibility is not an end in itself,

but I believe it is a key piece of the puzzle. Ultimately, it is deep

and enduring reforms that promote balanced and sustained growth

in China rather than ad hoc actions at the behest of internal or external forces that will be serve the interests of the Chinese and

U.S. economies and those of the global economy at large.

Thank you, Mr. Chairman.

The CHAIRMAN. Thank you very much. This is very, very interesting.

[The prepared statement of Mr. Prasad appears in the appendix.]

The CHAIRMAN. Mr. Goldstein?

STATEMENT OF MORRIS GOLDSTEIN, DENNIS WEATHERSTONE SENIOR FELLOW, PETER G. PETERSON INSTITUTE

FOR INTERNATIONAL ECONOMICS, WASHINGTON, DC

Mr. GOLDSTEIN. Mr. Chairman, I appreciate the opportunity to

testify before this committee on the important issue of China’s exchange rate policies. I want to highlight four points that are developed more fully in my written testimony.

First, over the past 5 years things have gotten much worse, not

better, on China’s external imbalance and its exchange rate policies. China’s global current account surplus has grown without

interruption, mushrooming from about 1 percent of GDP in 2001 to

roughly 9 percent of China’s GDP in 2006. China now has the largest global current account surplus in the world in absolute dollar

terms, and for the first 2 months of 2007, China’s trade balance

ran 225 percent above the pace for the first 2 months of 2006. In

short, the Chinese government has been allowing China’s global external imbalance to expand out of control.

China’s real effective exchange rate, widely regarded as a much

better measure of China’s overall competitive position than the

nominal exchange rate between the U.S. dollar and the Chinese

RMB, has actually depreciated since the dollar’s peak in February,

2002. Some would have you believe that because the RMB-U.S. dollar rate has appreciated by about 6.5 percent since June of 2005,

we must be making progress on the exchange rate front. The sad

truth is that the RMB is now grossly undervalued, on the order of

30 percent or more against an average of China’s trading partners

and 40 percent or more against the U.S. dollar. The appreciation

of the RMB that has taken place to date against the dollar is completely inadequate to make a real dent in this huge surplus.

When it launched its much-heralded currency reform in July,

2005, the Chinese authorities said they intended to increase the

14

role of market forces in the determination of the RMB. No such

thing has happened. The Chinese authorities have continued to intervene in the foreign exchange market in massive amounts to

keep the RMB from rising.

Second point, the international community is now operating

without an enforced international code of conduct on exchange rate

policies. Although China is a member of the IMF, the Chinese authorities continue to assert that they do not accept the concept of

currency manipulation. Simultaneously, the Fund’s managing director has maintained repeatedly that he rejects a role for the

Fund as global ‘‘umpire’’ of exchange rate policies. Meanwhile, the

U.S. Treasury has ruled repeatedly in recent reports to Congress

that it cannot find China guilty of currency manipulation because

it cannot prove ‘‘intent’’ to manipulate. The practical upshot of this

is that we now have a free-for-all on exchange rate policy. Indeed,

it is as if a new IMF charter has been informally agreed under

which there are two guidelines. Guideline number 1 covers the obligation of countries; it states, ‘‘member countries shall do as they

wish on exchange rates.’’ Guideline number 2 covers the obligations

of the IMF for exchange rate surveillance; it says, ‘‘Sorry, it is not

our job.’’

Point number 3, this lack of progress on improving China’s exchange rate policies is bad news for China, the United States, and

for the international monetary and trading system. China’s seriously undervalued and manipulated exchange rate makes it much

harder for China to move to a more balanced and consumptiondriven growth path and to implement a more independent monetary policy. From the U.S. perspective, the failure of the RMB to

appreciate significantly has limited the helpful contribution that

exchange rate changes in Asia could make to bring about improvement in the U.S. global current account deficit and to reduce the

risk of a dollar crash and a hard landing for the U.S. economy. And

China’s currency manipulation could lead to retaliatory trade responses in the U.S. and perhaps in Europe and Japan as well,

much to the disadvantage of all parties concerned.

Point number 4, China should deliver right away a meaningful

downpayment of a 10- to 15-percent appreciation of the RMB from

its current level. Because China has waited so long to take decisive

action, the undervaluation of the RMB can no longer be eliminated

in one go. A sizable up-front adjustment is needed if China is to

escape from being so far behind the curve. A modest upward rate

of crawl of the RMB relative to the dollar—by, say, 5 percent a

year—is not going to get the job done in an environment where the

dollar itself is likely to be falling to help reduce the U.S. current

account. The U.S. Treasury should press for putting the exchange

rate issue at the very top of the agenda for the May, 2007 meeting

of the Strategic Economic Dialogue and for keeping it there until

greater progress is made.

Failure by China to drastically reduce its large-scale, one-way

intervention in the exchange market should result in a finding of

currency manipulation in the Treasury’s May, 2007 report to the

Congress. It is regrettable that, at least so far, U.S. Treasury Secretary Paulson has given higher priority to policy proposals that lie

outside the realm of exchange rate policy, such as reforming ChiVerDate 11-MAY-2000 14:41 Aug 13, 2008 Jkt 000000 PO 00000 Frm 00018 Fmt 6633 Sfmt 6633 43597.000 SFIN1 PsN: SFIN1
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na’s capital markets. To ensure that the U.S. approach to correcting global payments imbalances is evenhanded, the U.S. should

indicate it is prepared to offer a new longer-term plan for greater

and more durable fiscal consolidation in the U.S. Finally, the IMF

should return to its roots by taking in earnest the role that its

founders set out for it as the global umpire for exchange rate policies. The U.S. should marshal support from both industrial and

large emerging economies to see that this happens. The problem

with the IMF’s existing guidelines for surveillance is not in their

design but in their enforcement.

I look forward to answering your questions.

The CHAIRMAN. Thank you, Mr. Goldstein.

[The prepared statement of Mr. Goldstein appears in the appendix.]

The CHAIRMAN. Mr. Makin?

STATEMENT OF JOHN H. MAKIN, VISITING SCHOLAR,

AMERICAN ENTERPRISE INSTITUTE, WASHINGTON, DC

Mr. MAKIN. Thank you, Senator Baucus, and thank you for inviting me to testify. My prepared testimony is submitted for the

record.

You know, I guess we only have 5 minutes, and it is——

The CHAIRMAN. You can take 6.

Senator BUNNING. Or 7 or 8.

Mr. MAKIN. But, you know, I only have one point to make, but

a lot of things follow from that, and that is simply this—and that

is what I have tried to cover in some of the written testimony that

I have submitted. The point is this: Certainly, China’s policy of setting its currency at an undervalued level is unmistakably happening. You cannot accumulate $250 billion a year in foreign exchange reserves without doing that, so I do not know what the

Treasury is thinking when they say that the Chinese are not manipulating their currency. They are.

However, currency manipulation is not the main issue. There has

been much intransigence on the currency issue. More important is

the question of where can we find some common interests, some

things that everybody ought to worry about? And there I think it

is clear that the financial risks that are entailed by China’s policy

of undervaluing its currency are substantial. You can set the price

of your money or you can set the quantity, but you cannot do both.

If you set the price of your money too low, as China is doing, you

are going to have a huge increase in the quantity of money. Incipient and actual inflation are going to grow, and eventually you are

going to have massive financial instability.

My main point today is that China is heading for a major financial crisis because they have allowed annualized growth of the

money supply of 20 percent. So far the faster money growth is not

showing up in goods inflation. It is showing up in asset market inflation. I suppose I could have a chart of the Shanghai stock market, but I can assure you it goes up very fast—well over 100 percent this year alone.

In February, we saw the first example of volatility in the market.

Shanghai shares dropped by 9 percent in a single day. It has since

come back, but we are seeing increasing signs that China cannot

16

sterilize the massive liquidity inflow resulting from their intervention policy. In other words, they have lost control of liquidity inside

China. That is a lethal combination with China’s poorly structured

financial sector and a banking sector that is insolvent and run by

a group of people who know little about how to manage assets.

So now that China is suggesting that they actually ought to diversify their reserves, I am even more nervous because now we will

have the people who have mismanaged asset allocation start thinking about how to diversify $1 trillion in Chinese reserves. That is

not the right way to go.

The right way for China to go is gradually to move toward allowing the private citizens in China who have accumulated tremendous wealth in the course of China’s very rapid growth to diversify

their own savings. Right now the Chinese government does it on

behalf of the Chinese by buying Treasury securities. That is very

convenient for the United States. And at some point, I think if they

transition toward allowing more of the capital, more of the wealth

that is growing in China to flow out, the currency problem would

take care of itself. That is, we would have a situation where there

would be less—you would have inflows and outflows. Right now

China is like a goose that is being stuffed with liquidity. The central bank buys foreign exchange. It creates a tremendous increase

in liquidity. It allows some of it to go out into global capital markets, but there is a tremendous growth of liquidity inside China

that eventually is going to cause a financial bubble-then-collapse on

the scale that we saw in 1997 and 1998 in Asia. The Chinese largely escaped that crisis in the late 1990s, but our next financial crisis

is going to come from China.

While it is certainly true that there are trade issues, and my fellow panelists have covered them well, there is rising tension surrounding the massive increase in Chinese exports that is part and

parcel of an undervalued currency. When exports are rising—I

think Morris Goldstein said it—220 percent per year over the first

2 months of this year, it is ridiculous to suggest that the Chinese

currency is not misaligned. But I am saying that there is a bigger

danger than rising trade tension. The financial instability that is

going to follow from this policy will spread to the rest of the world.

I do not know what Chairman Bernanke is saying today to the

Joint Economic Committee, but if the U.S. economy is simultaneously slowing, as I think the Fed is hinting it is, the finanical

instability/rising trade tension problem is going to get worse.

We have seen it before, in the Asian tigers in 1997–98, and we

saw a similar pattern in Japan through the 1970s and 1980s, when

Japan had a huge domestic investment boom built on the back of

an export surge, built in turn on the back of an undervalued currency. In the 1980s, the Japanese proved that the private sector

can invest too much, and the stock market collapsed in 1990. And

in the 1990s, the Japanese proved that the public sector could invest too much, after and during which they had a very long recession.

The Chinese are playing the same dangerous over-investment

game that other Asian currencies have played of undervaluing the

currency and pursuing export-led growth. The very least that the

U.S. Treasury could do would be to increase the pressure on the

17

Chinese to stop interviewing and exacerbating the destabilizing

over-investment trend.

Unfortunately, the Chinese are not going to change. Perhaps I

should be more hopeful, but, remember, China is a single-party

system; the Communist Party is in charge. The leaders of the Communist Party are people anxious to maintain the status quo. They

do not really understand financial markets very well. And they are

not going to allow China’s very capable bureaucrats to make these

radical changes. So I am very concerned that what we will see

going forward is continued Chinese intransigence. Probably there

will be some action from the Congress. Given what is happening

in the trade sector, it would be understandable but perhaps unfortunate. But there it is.

That said, when I go to China and I talk to the very competent

people who are actually doing the day-to-day work of running the

system, I say, ‘‘Look, you have to start to allow money to flow out,

you have to start to let the currency move, you have to upgrade

your financial system.’’ And they acknowledge that, yes, there is a

lot to do here, but they are very much constrained by the powers

that be, those who essentially make the big decisions in China. The

big decision in China that has not been made is to allow the Chinese citizens who have gotten very wealthy very fast to invest globally. And so the money piles up; the currency continues to have tremendous incipient pressure and actual pressure to appreciate. And

until we can convince the Chinese that it is really in their interest

to let their citizens diversify their assets and not have the government do it, as is currently being proposed and discussed on the

front page of the Financial Times today, we are going to have a serious problem and one that is probably worthy of great concern.

Thank you.

[The prepared statement of Mr. Makin appears in the appendix.]

The CHAIRMAN. Thank you, all of you. It has been very stimulating, very constructive, all four of you.

The basic question I have is, what are your thoughts on how to

deal constructively with the inherent tension—you have touched on

it, Mr. Makin—between free market forces in the world today in

globalization that are just so vast and strong, on the one hand, and

a centrally controlled economy on the other. Some of you suggested

in your testimony that you have some ideas you might bring out

in the Q&A on what regulatory reforms can be taken or what other

reforms can be taken in China to help address the underlying problems, which are concomitant with the currency peg problem. But

the question, for me, anyway, is how do we get from here to there?

How can we as Americans be constructive in helping make all this

happen a little more quickly? In some sense, China is a 3,000-yearold country. In another sense, it is only a 50-year-old country. I

think when Secretary Summers was here not too long ago, he

pointed out that in the 19th century, the Industrial Revolution, Europeans’ incomes doubled in a lifetime. In China, they are increasing a hundred-fold in a lifetime. It is such a new and expansive

country, and a lot of market forces have been unleashed, but it still

is all controlled by Premier Wen Jiabao and President Hu and others.

18

So your thoughts on how we manage this in a solid and constructive way. Back in the 1990s, when the Asian tigers’ currencies fell,

I can remember this front-page photograph, a cover story of Time

magazine. I think it was Summers and Rubin and the Fed Chairman all together working with countries to kind of control it, talking to bankers and so on and so forth. But I just sense there is not

a lot of back-channeling communication between the U.S. policymakers, Chairman Bernanke, for example, and the head bankers

and the President of China and so forth and developing trust in

how to get from here to there.

So I would appreciate your thoughts on just how we can be effective here, some of the ideas that you have, and I will just go down

the table here and start with you, Mr. Roach.

Mr. ROACH. Thank you. I think that there are a number of things

that we can do in our approach in dealing with the Chinese that

need to be carefully considered. I do think that we need constructive as opposed to destructive engagement with the Chinese, given

the important role that they play in funding our massive external

imbalance. I think we have to be very careful that we do not do

anything that would significantly alter their appetite for showing

up at the next Treasury auction. Their absence would, I think,

have significant consequences for the U.S. dollar, real interest

rates, and broader world financial markets.

I would argue that we need to do three things in particular in

engaging the Chinese on a constructive basis.

Number one, do everything we can to help them encourage the

pro-consumption rebalancing that I alluded to in my opening remarks. This shifts the Chinese trade dynamic from exports to imports, alleviates the external imbalance, and provides significant

opportunity for U.S. industries who are engaged in exporting the

types of products that the Chinese actually do have a voracious appetite for.

Number two, I think we really need to get off the currency fixation, which is understandably an outgrowth of our legacy of a manufacturing society, and look much more carefully at the intellectual

property rights issue, which is right at the core of who we are

today as a knowledge-based, information service-dominated society.

There are huge issues with respect to China that need to be addressed and addressed aggressively, and I would urge you on this

committee to look at this very carefully. This is not only in our best

interest as the world’s leading knowledge-based economy, but it is

increasingly in China’s best interest as they migrate from manufacturing to services.

And, thirdly, the issue has been pointed out repeatedly on the

areas of Chinese WTO compliance. If there are issues there, if they

have not lived up to the letter of the accession agreement that was

signed several years ago, they must be held accountable for that,

and we do have a WTO compliance mechanism that should be used

more aggressively to deal with those issues if we do think that

there are issues.

And, finally, I would be remiss in not saying, again, this is not

just about us getting China to behave in a way that alleviates the

tensions; we need to look at what we as a Nation need to do to alVerDate 11-MAY-2000 14:41 Aug 13, 2008 Jkt 000000 PO 00000 Frm 00022 Fmt 6633 Sfmt 6633 43597.000 SFIN1 PsN: SFIN1
19

leviate those tensions by focusing on our very serious shortfall of

national saving.

The CHAIRMAN. My time has expired, but very briefly, if any one

of the remaining three want to answer—yes, Mr. Goldstein?

Mr. GOLDSTEIN. Well, I think there are three things that we can

do.

First of all, we have to put much more emphasis on rules of the

road for currencies, and those have to go through the IMF. We

have such rules, and the problem is they are not being enforced.

The IMF should be at the center of this. This is their job. I worked

at the IMF for 25 years, so I am a little bit familiar with what

their mandate is.

The CHAIRMAN. Why are they not doing it?

Mr. GOLDSTEIN. I do not know. Mr. de Rato says he does not

want to do it. It is as if he wants to be a coach. He does not want

to be an umpire. But we have enough coaches. What we need in

this game is an umpire. That is the only way. You are not going

to get globalization and keep market access where you want if people feel that they are getting totally unfair treatment. And this manipulation is unfair treatment, and it needs to stop, and someone

needs to call it. And the agency that has to do that is the IMF.

The CHAIRMAN. Do they have the power to be the umpire?

Mr. GOLDSTEIN. They do. I think they can certainly make a ruling. A problem you have is right now I think this currency issue

comes off as a difference of opinion between the U.S. and China.

We want them to go fast; they want to go slow.

It cannot be a difference of opinion. What they are doing is illegal, and it has to be seen that way, and then it has to be negotiated.

The CHAIRMAN. Well, thank you very much.

Senator Bunning?

Senator BUNNING. Thank you, Mr. Chairman.

First of all, it seems to me—and I deeply appreciate all four of

you being here—that there is a basic difference in my approach

with China than all four of your approaches. One, Mr. Makin made

the suggestion that they are a controlled economy. They are not

free to do what they want. Most of the people who are bureaucrats

over there are bureaucrats only because they make the decision

that the higher-ups tell them to make. In other words, they do not

have the option of adjusting their exchange rate like somebody over

here does.

I find it unbelievable that we think we can deal with China as

a non-Communist country, that there is free and open exchange. I

can tell you this: six members of this committee’s Trade Subcommittee took a trip to China to visit with their Trade Minister,

and they refused to meet us. Refused to meet with us, sent some

other bureaucrat to give us about 21⁄2 hours. The congressional delegation was led by my good friend Senator Smith here, and they

could care less what we thought as legislators.

This Strategic Economic Dialogue that was started is nothing

more than talk, talk, talk; talk, talk, talk; never get anything done.

I do not care if the President of the United States is dealing with

the President of China or the Prime Minister or whoever it might

be. We cannot get through and will not break through. And that

20

is one reason why the International Monetary Fund is not doing

their job. They do not want to upset the Chinese government. And

for us to sit here and expect them to comply with the WTO, that

is one of the most hilarious things I have ever heard.

They passed all the laws; when they got to the WTO they said

we are going to do X, Y, and Z; now they have not enforced one

of them. Not one of them. You can walk down any street in Beijing,

as we have, and you can buy anything you want, illegally made by

the Chinese. Intellectual property laws are just being ignored completely by the Chinese government, even though the law is on the

books.

So all your wonderful suggestions on how we are going to get this

done legitimately and without any upset of the Chinese government—and we do not want to upset them because they own so

much of our dollar assets—in my opinion is not the way to do it.

We have to take action. The government of this country has to take

action through its legislative body. The legislative body is the only

one that is going to act because, obviously, our administration is

frightened to do anything, either the Secretary of the Treasury or

the Trade Representative or anybody who has anything to do with

trade or banking or anything else. All good suggestions are not

being taken seriously by the other side.

And I do not blame them. Right now they have the best of both

worlds going for them. They cannot see past 1 year or 2 years. Unfortunately, looking 10 years down the road or 15 years down the

road, we are going to have a tsunami of problems in China and

U.S. relationships. And I can tell you this: I for one am so sick of

listening to everybody make excuses for China and our relationship

with that country, that I for one want to do anything I can, along

with Senator Stabenow, to give us a remedy—a remedy for our relationship with the manipulation of their currency.

Thank you.

The CHAIRMAN. Thank you, Senator.

Senator Stabenow?

Senator STABENOW. Thank you, Mr. Chairman, very much for

this hearing, and just to add to what Senator Bunning indicated,

I am pleased to be joining with Senator Bunning in legislation that

would take out the requirement to show intent when we are looking at currency manipulation. Every 6 months when the Treasury

Secretary comes forward, he says, ‘‘Well, we all know that this is

happening, but it does not quite meet the definition of the law.’’

And the question seems to be intent, as was raised by the panelists. And so we would take out the word ‘‘intent’’ and would allow

this to be viewed as a subsidiary, which it is. We have had overall,

because of China’s policies, a loss of over 1.5 million jobs in the

United States, and over 800,000 of those jobs, good-paying jobs, are

pegged to the currency policy, which is what I keep going back to,

that it is an important discussion we are having. It is much more

than theoretical. It is affecting real people’s lives every day by

what is happening.

I did want to go in a little bit different direction, though, Mr.

Chairman. I appreciate all of the witnesses, and I appreciate your

inviting Mr. Goldstein, who included in his comments not only

about the Chinese RMB but also the Japanese yen. And I did want

21

to follow up specifically because I concur with my colleague’s concern about China, but I also want to speak from the standpoint of

Japan where we see something similar happening. And, in fact, we

have seen—not to advertise a book—in John Taylor’s book called

‘‘Global Financial Warriors,’’ where he stated that the U.S. actually

has supported what Japan has been doing. He did not mean it as

a criticism. He was just stating it as fact. But he did indicate that

our policy toward exchange rate intervention in Japan was—and

this is during 2001 to 2005—part of our effort to be supportive of

quantitative easing. By not registering our strong objections to the

intervention, effectively allowing it to happen, we made it easier on

the Japanese to pump up their money supply. Unfortunately, the

result, according to the Economist, has been the fact that the yen

is undervalued by as much as 40 percent right now. And certainly

coming from the great State of Michigan where 2.2 million vehicles

came in from Japan, more than were built here last year, when you

put a 40-percent discount on that, you are creating the most

unlevel playing field I can imagine. And that does not even account

for the fact that our automakers are paying for health care and

pensions, et cetera. It certainly starts with an incredibly unlevel

playing field.

The other concern that I have is that we are told that an increase of 1 yen to the dollar adds anywhere from $160 million to

$260 million in operating profits of Japanese auto companies,

which is fine, but since that is done in what I would argue is an

illegal manner, we are creating a way for them, Mr. Chairman, to

invest in alternative advanced battery technology or do other

things to compete with us by taking those dollars and investing

them and having more opportunity to do that than those in the

United States are able to do.

So I did want to ask specifically about that. I have, in fact, introduced a bill today dealing with the Japanese currency situation. It

is a very reasonable bill. It comes out of great concern that when

we look at the last G–7 conference, the European members wanted

to talk about the Japanese yen situation. It was only the United

States and Japan that did not want to do it. And I believe that we

need to put in place a series of report mechanisms and requirements to work with the IMF, to work with Japan, to require that

we bring this to the G–7, so that we can begin to address what

clearly not only has been identified but put into a book that it was

conscious American policy.

So after those comments, let me just ask particularly Mr. Goldstein if you might speak to what is happening with the Japanese

yen and how you see that, as well as the Chinese situation, being

of concern.

Mr. GOLDSTEIN. Senator, I think there are some elements in common and some important differences between the yen and the

RMB. Both are undervalued. I think you are right that the yen is

substantially undervalued. The question is: What is Japan doing

that is illegal to make that happen?

In China’s case, we have large-scale, one-way, prolonged intervention year after year, 10 percent of GDP. This is robbing the car

right in front of the police station. This is the most obvious case

of manipulation you can get.

22

Now, you referred to the John Taylor book. Japan was involved

in very heavy intervention, massive, in 2003 and the first quarter

of 2004. Since then, they have stopped. So making the case that

somehow Japan is manipulating I think is a much harder one than

for China. You might argue that the interest rate should be a little

higher given where that economy is going, but this is not a case

of intervention being the tool for manipulation.

Senator STABENOW. If I might just intercede and just ask, would

you not agree that the Bank of Japan has sent many messages

that, in fact, they are open and willing to do this again, and as a

result of that the yen’s real effective exchange rate has been at the

lowest in 20 years? So they certainly have sent every indication,

every message. Even though you are right it is indirect, it is not

as obvious in what they are doing, the effect is the same in terms

of what is happening right now.

Mr. GOLDSTEIN. Well, were they to start doing it again, then I

would say they are manipulating. And if they do it for a prolonged

period—the three adjectives that, you know, one looks at with manipulation on intervention are ‘‘large scale,’’ ‘‘prolonged,’’ and ‘‘one

way.’’ That is what we have had in China. If Japan starts doing

it again, I think that they also ought to come under very high scrutiny. But I have not seen it since the first quarter of 2004.

Senator STABENOW. Yes, sir?

Mr. ROACH. Just one thing. Do not forget, Japan has been

through a period of rolling recessions and deflation for 15 years. It

is debatable whether they have come out of that. So to deal just

with the currency in isolation I think overlooks a key aspect of Japan’s own economic conundrum.

Senator STABENOW. And I appreciate that. Let me just say in

conclusion, though, that the reality is that we are looking at an

undervaluation of up to 40 percent which is affecting Americans

and American jobs and American businesses. And so to that extent,

while it is different and less obvious, I would argue that, again,

going back to the question of intent, we need to look at what is

happening as well as intent or how obvious it is that there are impacts.

Thank you, Mr. Chairman.

The CHAIRMAN. Thank you.

Senator Smith?

Senator SMITH. Thank you, Mr. Chairman.

Gentlemen, thank you for your presence here today. I could echo

many of the comments my colleagues have made. I could certainly

point out the amazement, you know, that I shared with Senator

Bunning when seven members of the United States Senate Finance

Committee went to Beijing, and they did not want us to meet with

their Trade Minister. But it gave us time to wander the streets of

Beijing and see all the flagrant, frankly, violations of Chinese law,

Chinese agreements, international law, in terms of the theft of intellectual property.

I could dwell on those things, but I will not. I guess I really want

to focus on a question that our Chairman touched on. I would like

you to speak to it in a little more depth, and that is, on a macro

level, are we in a place now where we lend so much—or the Chinese buy so much—of our currency, so much of our debt, that they

23

are now our financier so that we do not have leverage to change

their behavior through pressure because, if we did, it would lead

in this country to high inflation, punitive interest rates, collapsing

stock and housing prices? Are we at that point in our relations

with China and in terms of just immutable economics that that is

where we are?

Mr. PRASAD. First of all, Senator, let me say that rather than

thinking about China as having a sort of choke hold on the U.S.,

I think one could flip it around and think about exactly how it is

that the U.S. could help itself in this relationship. And I think this

is where the issue of constructive engagement comes into play.

Senator Bunning spoke about how China is a command-and-control economy, and that is in a sense very valid. But one thing that

is very important for the Chinese leadership is still to maintain

high and relatively stable growth, because to them that is a very

important part of being able to maintain the current status quo.

So in a sense, reorienting the dialogue in a way that makes these

sorts of connections I was talking about clear to them and how this

is very important for the longer-term growth, not just outward

growth but employment growth, I think is very important. And

once you start working through the connections, then two things

become very apparent. One is that through these mechanisms you

will improve Chinese consumption growth because right now

growth is very heavily biased towards investment growth and exports, so getting the Chinese consumer to consume more is very important. Second, getting the capital account more open will give

U.S. financial firms and other financial firms from abroad more of

a foothold in China. And for this, again, I think exchange rate flexibility should be seen as a part of the story.

So I think there is a very important element of getting this into

the dialogue that basically by making these connections, you

achieve what is in the Chinese interest, and that I think is ultimately going to benefit the U.S. as well.

Senator SMITH. I agree with you. I think clearly we can demonstrate a community of interest with us and the Chinese. But I

guess really the question is: Who goes into chaos first—us or them?

Mr. ROACH. Just briefly, the short answer to your question is,

yes, we are at a point where we have been asleep at the switch in

dealing with the link between not saving at home and building up

these massive current account deficits in the United States. At today’s level of the current account deficit, we need $3.5 billion of

inflows from abroad every business day of the year. The Chinese

are playing a big role in this. If we close them down, we are going

to have to lean on somebody else.

So we are in a much more precarious place from a macroeconomic point of view for precisely the reasons that you address.

This is our problem that we need to address. There are issues with

China that we can deal with, but we cannot lose sight of the question you just raised.

Senator SMITH. All right. You other gentlemen, real quick. I do

not want to take my colleagues’ time, but it is a very important

question.

Mr. MAKIN. Let me offer a comment. You know, I remember in

terms of who is in control here—and I want to echo a comment that

24

was made before. I recall an experience in August of 1971 when the

United States was under a great deal of pressure about its currency policy. People were very unhappy with the U.S. for not doing

more to adjust, and the Nixon administration took unilateral action, which in effect caused the dollar to depreciate a great deal.

And then-Treasury Secretary Connally very effectively negotiated,

because the foreign governments were all saying the dollar needs

to go down, it is terrible, blah, blah, blah. And he said, ‘‘Well, how

about 20 percent?’’ And they all shut up real fast, because if the

dollar goes down by 20 percent, our friends in Asia, who are very

dependent on exports to the U.S., will find themselves in a much

more difficult position. Furthermore, access to our wealth storage

markets—i.e., the Treasury market—is very valuable. I am always

amazed to hear the U.S. current account balanced called

‘‘unsustainable.’’ Something that has been going on for 4 or 5 years

has to have some element of sustainability, and it is that, where

else are the Chinese going to store hundreds of billions of dollars

if not in the U.S.?

So I think we have considerable leverage with the Chinese, and

in terms of what to do, we could start by having the Treasury acknowledge that they are manipulating the currency and then try

to engage with the government to get them to move faster on financial deregulation, including more presence of sophisticated financial

managers in China from Western financial institutions, like Goldman Sachs, I suppose, and allow the Chinese citizens, again, to invest more abroad. Let them choose.

That said, I go back to what I admitted before. The people you

are talking to are not the people in charge.

Senator SMITH. We tried to talk to them, too.

Mr. GOLDSTEIN. Senator, I agree here with Mr. Makin. I think

the idea that we cannot do anything on the currency, we cannot

call a spade a spade because we have to worry that if we do so,

interest rates will soar here because of Chinese holdings of Treasuries, I think that is very much overdone. I think this is a large

liquid market. The Chinese understand they have multiple objectives. We bring cases before the WTO, other things. We criticize

human rights, military build-up, other kinds of things. It does not

lead to a massive sell-off of U.S. Treasuries every time we criticize

China. So I think these are exaggerated fears.

The CHAIRMAN. Thank you very much, Senator.

Senator Grassley?

Senator GRASSLEY. Thank you very much, and I want to explain

to the committee and to the witnesses that I was gone the first

hour because I was testifying before the Government Oversight

Committee of the House of Representatives on a GSA issue that I

have been investigating.

I am going to start with Mr. Roach. In your testimony, you acknowledge that China needs to develop and implement new technologies that would lead to cleaner GDP. China has already made

a heavy investment in advanced industrial gasification technology

which will substantially reduce particulate emissions and allow for

carbon capture. Dow, Shell, General Electric, and Siemens have announced almost 60 major projects that have either been built or are

25

under contract in China. Ironically, advanced industrial gasification technology is still a start-up technology in this country.

In the Energy Policy Act of 2005, we provided that this technology is eligible for both government loan guarantees and investment tax credits, but yet the chemical and fertilizer industries continue to be concerned over the apparent lack of available investment from the United States financial markets.

From your perspective, where you sit at Morgan Stanley, can you

comment on how China can engage in such extensive investments

when the exact same technology in the United States struggles to

find investors?

Mr. ROACH. That is a very tough question. China has a huge environmental problem. In my prepared statement, I outlined some

of that. And I noted that the Chinese are now more focused on

moving to a cleaner GDP than I have ever seen them. The Chinese

admitted, Senator Grassley, that last year they failed to hit their

emission reduction targets as well as their energy conservation targets. They cannot tolerate another failure.

Why can’t we in the United States galvanize public support into

dealing with environmental issues in the way that the Chinese

have? You would know the answer to that better than I do. It is

discouraging, and I think it does reflect the fact that there is not

a broad political consensus in this country, a bipartisan coalition,

behind these issues.

China can, of course, do a lot of things because of the nature of

its system, but let me be very clear that they are a single-party

system and at least last year did not make the progress that they

wanted to make. They are redoubling their efforts this year. I think

a year from now you will see more progress from China. They are

much more at a crisis point on the pollution area than we are.

Senator GRASSLEY. But you just answered my question in the

sense of a political body making a decision. What is there about

Dow, Shell, General Electric, and Siemens investing in that country that we cannot get the same investment in this country?

Mr. ROACH. They have the opportunity and perhaps the incentives to do so. They can also partner with the government, an option that is not available in the United States.

Senator GRASSLEY. All right. Professor Prasad, in your testimony

you state that the international community can be helpful in putting the exchange rate issue in a broader context. How, specifically,

do you envision that working? And, specifically, is there a role for

the International Monetary Fund? And if so, is the IMF properly

equipped to handle this role? Or is reform of the IMF needed?

Mr. PRASAD. Senator, I was the IMF’s Division Chief for China

until recently, and I have just started at Cornell University, so I

feel it would not be appropriate for me to talk about what the

IMF’s role should be. But I think the substance is very important,

and I think the substance is really that we need to think about

putting this discussion in the framework that will allow progress

to be made.

I had spoken during my remarks about what monetary framework could really enable progress to be made, so, as I said, Marvin

Goodfriend of Carnegie-Mellon University and I have argued that

China should adopt an inflation objective which is basically a longVerDate 11-MAY-2000 14:41 Aug 13, 2008 Jkt 000000 PO 00000 Frm 00029 Fmt 6633 Sfmt 6633 43597.000 SFIN1 PsN: SFIN1
26

run target range for the inflation rate and an explicit acknowledgment that low inflation is a priority for monetary policy.

So what does this do? What it does very critically is take the emphasis away from the exchange rate. It allows the exchange rate

to become more flexible in the context of a broader reform package.

But it focuses on what monetary policy can really achieve in the

context of getting better growth and more sustained growth.

So, over time, the inflation objective would provide a basis for increasing currency flexibility, financial sector reforms, capital market opening and so on. So one could essentially set up very specific

guideposts in terms of each of those steps that lead towards an objective, and this has been used in the past. For instance, when the

Chinese agreed to WTO accession, they put in place a few commitments. There are questions about whether they have fully met the

commitments or not, but they did use it very effectively to effect

internal change by getting the resistance to reforms broken down

and getting some more power on the side of those who did care

about the reforms.

Senator GRASSLEY. Thank you, Mr. Chairman.

The CHAIRMAN. Thank you.

Senator Schumer?

Senator SCHUMER. Well, thank you, Mr. Chairman, and I thank

both of you for having this hearing and working with us. And I

apologize to the witnesses for not being here. I read their testimony

before, but I am chairing the Joint Economic Committee where Mr.

Bernanke is, so I am going to have to get back there soon.

Anyway, Professor Prasad, you argue that a flexible currency is

a prerequisite for China to have a modern financial sector, not the

other way around. It is interesting, because Secretary Paulson actually makes the opposite argument. He argues the Chinese cannot

possibly float their currency before they reform their financial system, and that is what the Chinese government says as well.

Could you elaborate a little on the contradiction between what

they say and you say?

Mr. PRASAD. This is a hugely important point, Senator. By flexibility, let me be clear that one does not mean a complete float of

the currency. So if the currency were to float completely, you would

need a completely open capital account, and that in my view is

where the risk arises. Because if you open up the capital account

fully without having exchange rate flexibility in place, then money

could flow out at the merest whiff of danger. And this is a serious

concern because in China the financial system is still not in good

shape.

So if you allow a route for capital to flow out very quickly at the

first sign of trouble, and if your exchange rate is being tightly managed at the same time, you run into trouble. And this is where, in

fact, I think there is some educational element to making it clear

to the Chinese that exchange rate flexibility is not the same thing

as capital account opening, that it ought to come first.

Senator SCHUMER. It is sort of an escape valve. It relives some

of the—I do not mean an escape valve, but like that anti-pressure

valve on the pressure cooker, it allows some of the steam out.

27

Mr. PRASAD. It is a prerequisite, so if you did have capital desiring to flow out, having a flexible exchange rate would take some

of the pressure off.

Senator SCHUMER. Exactly. All right.

Mr. Goldstein, in your testimony you state that we lack an international code of conduct on exchange rate policy. That is for sure,

as the Chinese show. This allows the IMF and Treasury to dodge

conclusions that China is a currency manipulator. I agree with

both of those things.

Could you just give us a little idea what a well-designed code of

conduct would look like? You can answer briefly now, but I would

ask unanimous consent that maybe Mr. Goldstein be given the

ability to answer that in writing in some more elaborate way.

The CHAIRMAN. Without objection.

Mr. GOLDSTEIN. Sure, Senator. Well, actually, we have a code.

We have surveillance guidelines at the Fund that talk about things

that countries can and cannot do, and one of the things they are

not supposed to do is engage in large-scale, prolonged, one-way

intervention in the exchange market. That is what China has been

doing. And then there are other things dealing with trade policy

and capital account measures and a number of others.

But it is not that we do not have the code. The problem is there

is no enforcement of the code.

Senator SCHUMER. Right.

Mr. GOLDSTEIN. So when someone is doing something in obvious

noncompliance, nobody says anything about it.

Senator SCHUMER. What do you suggest?

Mr. GOLDSTEIN. Well, I think as much pressure as can be

brought to bear, both on the Fund and on the U.S. Treasury, to

start calling those things straight. For example, I would not support any initiatives by this Managing Director until they get back

in the business that they were created for, namely, to do the exchange rate surveillance. We certainly should not have voted for a

quota increase for certain countries, for China when they were

doing this.

So we have the WTO on trade policy as the umpire. Now we need

something else on currencies, and the Fund is the place. If they

were doing their job, the Congress would not have to be involved.

Senator SCHUMER. You are right. So you believe in ratcheting up

the pressure using other economic levers to get that to be done?

Mr. GOLDSTEIN. Yes. I think it is not a second-order, arcane

issue.

Senator SCHUMER. No, it is not.

Mr. GOLDSTEIN. What the Fund does is really important because,

if the Fund were to rule that the Chinese are manipulating, it

would have a lot more weight than the U.S. Treasury.

Senator SCHUMER. I would just ask you to elaborate on an enforcement mechanism.

Finally, a last question to Mr. Makin. You state that China is

spending up to 15 percent of its GDP just to keep the yuan’s value

at below-market levels. Do you have any surmise at what point this

becomes unsustainable? At what level of GDP does this reach a crisis with far-reaching consequences for the global economy? Or does

it never?

28

Mr. MAKIN. Senator Schumer, I think my full testimony suggests

that we are close to that crisis. I certainly agree with your comments on intervention, but I tried to emphasize that the consequences of the intervention are to create a huge burst of liquidity

inside China that threatens instability on the scale that we probably saw in the 1997–98 Asian crisis. So I think we are close to

a financial crisis inside China. We got a hint of that in the Shanghai market last month. We are seeing a lot of volatility there.

Let me just add a suggested reply to your question to Morris

Goldstein. You know, I think that the behavior of Asian countries—

and others, but mostly Asian countries—in the currency markets

over the last decade has been inappropriate and counterproductive.

The Japanese stopped only after having massive intervention. The

Chinese are intervening at a level that is absolutely ridiculous and

counterproductive for them. That is one of the points I have tried

to make to the Chinese, and many of the Chinese bureaucrats

agree.

I think two steps are called for. One, the Treasury simply has to

cite China as a currency manipulator; and, secondly, the Secretary

of the Treasury should say that we believe that exchange rates

should be determined in the market, period. And I think that

would go a long way toward getting exchange rates back to the

level——

Senator SCHUMER. I would make a quick comment, with the

Chairman’s indulgence. I agree with you. When we visited China,

Senator Graham and I, we found a lot of the economic people

agreed. But the political people are so afraid of change, or at least

change that they cannot control, that they reject doing it. I do not

know if you agree with that.

Mr. MAKIN. I agree.

Senator SCHUMER. Thank you, Mr. Chairman.

The CHAIRMAN. Thank you, Senator.

I would like you, Mr. Prasad—and others who want to can chime

in here—to help us better understand the degree to which China’s

initiative in the QDII—that is, the Qualified Domestic Institutional

Investor program—is working. As I understand it, certain Chinese

insurance companies as well as the national Social Security fund

can invest in overseas debt and money markets, open up a little bit

the private sector, slightly. In addition the QFII, or the Qualified

Foreign Institutional Investor, actions that China is starting to

take to ‘‘liberalize,’’ how much of an effect is that? And is that

something we should encourage?

Mr. PRASAD. Senator Baucus, some progress has been made on

that front. There has not been that much of a take-up of those and

other schemes to allow capital to flow abroad, because there has

been a fairly restrictive amount of asset classes that these QDIIs

and so on can invest in. But the broader issue again comes to what

this is meant to achieve.

At one level, allowing capital to flow out either through QDIIs or

through allowing individual investors to take money out is a good

thing. It helps individual investors and the economy to diversify its

portfolio internationally. But the problem is that, if that is seen as

primarily a route to avoid doing the right thing, which is moving

29

towards greater flexibility, then I think it does not really accomplish its objective. So as a substitute, it does not really work.

In terms of allowing QFII in, again, I think it is a very important

part of the overall reform strategy to, in a controlled way, allow

capital in to achieve what they think is very important, which is

domestic financial market development. And on that, I think the

emphasis is exactly right. They need to not only improve the domestic banking system, but to broaden financial markets, to get the

equity markets in better shape, and the bond markets.

The CHAIRMAN. I would ask each of the four of you: What would

happen if China were to move to a free market flexible exchange

rate, say within a period of 1 year? What if a year from today it

is 100 percent and they just move up fully? What would happen?

What are the benefits and what are the costs? What is good and

what is not so good? You raised your hand first, Mr. Makin, and

both the pluses and the minuses, what do you expect? What would

happen?

Mr. MAKIN. Well, there certainly would be some choppiness in

currency markets and financial markets, but I think the bottom

line is ultimately it would be a good thing. There are big problems

in China right now. There are far too many resources in the traded

goods sector, which shows up in their need to subsidize exports.

Too many companies are not focused on the domestic economy, so

that message would be to move toward a more balanced allocation

of resources inside China.

The Chinese individuals who now have—you know, I think

Americans take for granted all the ways we have to save, from

housing to mutual funds and so on. And the Chinese have very few

ways to save. So if you opened up financial markets, Chinese

households would not have to get 2.5 percent from a state bank

that is insolvent. There would be mutual funds formed, and they

could start to invest abroad, and that would be a good thing to do.

The CHAIRMAN. Mr. Roach?

Mr. ROACH. I completely disagree. So from me, you get the typical lack of consensus for the economic experts. China is not a market-based economy. It is a blended economy. They are moving to

marketize their economy, and they are actually moving at amazing

speed. But to impose a market-based foreign exchange mechanism

on a blended economy I think would be a recipe for disaster. The

Chinese will not do it.

The CHAIRMAN. For example, what would happen?

Mr. ROACH. I think the financial system, which has made baby

steps in the area of reform, especially the banks, would be very destabilized. I think the lack of capital markets in China, especially

the bond market, would be set back significantly in China. And I

think it would be an unmitigated disaster for the Chinese equity

market. I would not recommend this as a prudent course of policy

in any way whatsoever.

The CHAIRMAN. And what effect would that have on the United

States?

Mr. ROACH. The Chinese could certainly cease to be a significant

purchaser of U.S. Treasuries, which would have consequences for

the dollar and real interest rates. I am less certain of that because

another international lender may fill the void. But if you are askVerDate 11-MAY-2000 14:41 Aug 13, 2008 Jkt 000000 PO 00000 Frm 00033 Fmt 6633 Sfmt 6633 43597.000 SFIN1 PsN: SFIN1
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ing me what would this mean for China, I think it would be a

source of huge instability.

The CHAIRMAN. Mr. Prasad?

Mr. PRASAD. I used to be a bureaucrat, so let me give you a

middle-of-the-road, consensus-building answer. [Laughter.]

I think that exchange rate flexibility by itself would be a very

good thing for China. A pure float of the currency, which would

mean a very open capital account, would expose the——

The CHAIRMAN. That is what I am talking about.

Mr. PRASAD. A pure float I think would be risky for the reasons

that Steve Roach is talking about. But I do not think they need a

free float right now. What they need is a more flexible exchange

rate so that they have a better monetary policy so they can control

the economy better. That should come first. The rest can come

later. I think the rest is very important as well, but it should come

next.

The CHAIRMAN. I am sorry. I do not quite understand the difference between free float and more flexibility. What do you mean?

Mr. PRASAD. So you can have the currency floating and responding to market forces, but without capital being allowed to freely

come into and out of an economy.

The CHAIRMAN. All right.

Mr. PRASAD. So if you have capital coming into and out of an

economy, that allows an additional dimension to which the exchange rate has to adjust. But you can have the exchange rate adjusting in response to trade, productivity, and other fundamental

forces. You do not have a pure float, and for that you need an open

capital account, which I think China is not ready for.

The CHAIRMAN. Mr. Goldstein?

Mr. GOLDSTEIN. Well, I think the effects would be mostly good.

The exchange rate would appreciate because they would no longer

be intervening to hold it down. Their current account would start

to fall. They would be able to move interest rates up to help restrain investment. They would start to have less excess capacity in

those export industries where it is now very large.

Yes, there would be some job loss in traditional export industries

in China that have low margins, but on the whole, this would be

a very good thing. And there would be less calls for trade retaliation in this country and others because they would begin to play

by the rules.

So this would be a good thing. It would not be a disaster for the

financial system.

The CHAIRMAN. Mr. Makin?

Mr. MAKIN. I just wanted to add that I think the Chinese would

prefer a free-floating system. If you just allow the currency to float

without opening up the capital account, there will be a strong tendency for it to appreciate, which is what they do not want. I think

if you had a free float with free capital markets, it could go either

way, which is what is supposed to happen in a free currency market.

It is very dangerous to constrain the exchange rate system between a float and a fixed rate because you bring in an element of

arbitrariness that we see leads to ad hoc intervention programs. So

I think you have to kind of go either to a floating system or a fixed

31

system. Again, you can control the price of money or the quantity.

It has to be a clean move.

The CHAIRMAN. Does anybody else want to comment on that

question now that you have reflected on it further?

Mr. ROACH. Well, you asked within 1 year, though, right?

The CHAIRMAN. Yes, a year.

Mr. ROACH. Again, I just reiterate my point that for a blended

transitional economy, 1 year would introduce huge new risk into

the Chinese reform equation, which would have significant implications for them, and for the global economy—an outcome which

could really wreak havoc on world financial markets.

Mr. GOLDSTEIN. Senator, I would just say that I think the main

problem is the RMB is too low. We need it to go up. It can go up.

Either they can do a step revaluation like they did in July—but

they only did it by 2.1; they need to do it by 10 or 15—or they can

stop intervening and it will float up. Either way, the key thing is

to get the price of the currency up. That is the main problem. Later

on, we can talk about exactly how they——

Mr. ROACH. But, Morris, even you said right now you would not

recommend a big move within a short period of time.

Mr. GOLDSTEIN. Well, I would recommend 10 or 15 percent in a

short period of time.

Mr. ROACH. But that was not his stipulated scenario.

Mr. GOLDSTEIN. I would not go 40 in 1 year, but I would go 10

or 15 to get the thing moving because this——

The CHAIRMAN. I am sorry for taking your time, Senator Grassley. But what rate of appreciation do you think makes sense? What

rate over what period of time? Very quickly.

Mr. MAKIN. Nobody knows.

The CHAIRMAN. Well, your best guess. Come on. [Laughter.]

Mr. MAKIN. I do not have to guess if you float the currency. Let

the markets decide.

The CHAIRMAN. What is the right policy? Let us say you are a

Chinese policymaker. You are the top guy. You are the one in

charge. What would you do if you really wanted——

Mr. MAKIN. If you cannot float the currency——

The CHAIRMAN. Pardon me?

Mr. MAKIN. You cannot float the currency, so you have to pick

a number, right?

The CHAIRMAN. No. I will rephrase my question. Just all things

considered, the United States and China, our relationship and so

forth, we all agree it is a problem: the currency peg, manipulation.

So I am asking how do we, just that alone—well, if we start to appreciate the currency, if China starts to appreciate its currency and

there is more flexibility in the exchange rate, I assume they will

move more quickly in opening up the capital markets at the same

time and put pressure on to do so, or they will realize they have

to do so. So what rate do you think we as Members of Congress

and the United States of America should reasonably push to accomplish our objective here?

Mr. MAKIN. Senator, I am not going to cooperate on this. In a

sense, one of the main reasons that China’s currency policy is bad

is it puts the U.S. Congress in a position of needing to advocate a

particular rate of movement. What they need to do is get out of the

32

intervention business and let the currency move at whatever rate

the market decides.

The CHAIRMAN. So you would just open it up now today.

Mr. MAKIN. Yes.

The CHAIRMAN. All right. Mr. Goldstein?

Mr. GOLDSTEIN. Well, I would favor 10 or 15 percent immediately, and keep controls on the capital outflows. I think that is

the main danger, given the weak financial system, that capital

could flow out. But as long as you keep controls on the outflows

pretty much, then after you have done the 15, then you can start

to stop the intervention and let the market start to take it up. But

you need that downpayment.

The CHAIRMAN. Mr. Prasad?

Mr. PRASAD. Now I will put on my professor’s hat and say, ‘‘It

depends.’’ But, really, the fact is the objective, as you put it, is the

key issue, and I think the exchange rate should be seen as a relative price, which is not crucial to the objective except through

these indirect channels. The objective is: How do you get Chinese

domestic demand rising so they can suck in more U.S. imports?

How do we get them to open up their financial markets so that

U.S. firms can have more of a presence there? And for that, flexibility again is very important, not a particular level of the exchange rate. As an economist, it is very hard to tell what the right

level is.

The CHAIRMAN. Mr. Roach?

Mr. ROACH. I will be the outlier. Stay the course, 3 to 5 percent

a year, push on other issues—IPR and America’s savings agenda.

The CHAIRMAN. Thank you. I have gone way, way over my time.

Senator Grassley?

Senator GRASSLEY. Mr. Goldstein, in your testimony you make a

number of recommendations regarding the actions that the IMF

should take with respect to currency oversight. How do you propose

that we induce IMF to take those actions? And what steps can this

committee take?

Mr. GOLDSTEIN. Well, as I suggested earlier, I would not approve

any other initiatives by this Managing Director, this Fund management, until such a time as the Fund got back seriously into the exchange rate surveillance business. They ought to be issuing their

own report indicating which currencies are being manipulated.

They ought to activate this special consultations tool, which they

have not used in about 20 years, where you just have a special mission devoted to the exchange rate, and one can put pressure.

I think it is also important that the Treasury take the first step

by naming them as manipulators if they do not change their behavior. It is hard to ask the IMF to do this if Treasury in its own report to the Congress says, you know, ‘‘not guilty.’’ Then you are

asking the IMF to find them guilty after its largest shareholder has

just let them off the hook.

So you have to start with your own house. Call it as it is, and

start putting whatever pressure we can on the IMF to do what it

was created for. As a colleague of mine puts it, it is one thing to

be a conscientious objector; it is another thing if you are Commandant of the Marine Corps. And they are the Commandant of

33

the Marine Corps when it comes to currencies. That is what they

need to be doing, in everybody’s interest.

Senator GRASSLEY. In regard to your statement about this downpayment of appreciation 10 to 15 percent, are there risks associated

with the approach, particularly in terms of fostering speculative

capital flows and anticipation of further currency appreciation as

opposed to the market?

Mr. GOLDSTEIN. Well, the best thing, you know, of course, would

have been to do it in 2003, 2004. That is when some of us were

talking about it, and then the misalignment was smaller. Then you

could do it all in one go.

The problem, when it gets very big and you cannot do it in one

go, is when you start to do it by anything more than a trivial

amount, people come to expect it and then they realize they can

make money on the appreciation. So then you start to get a big

capital flow.

But given where we are, I would say the best we can do, let us

do 10 or 15 and then try to float the currency after that. But in

a way, we are already in the world of the second best. They let it

get very big, and we cannot do it all at once, so we have to now

break it up. But doing 4 or 5 percent a year is just not going to

cut it because the dollar is falling as well.

Senator GRASSLEY. Thank you very much, Mr. Chairman.

The CHAIRMAN. Thank you, Senator Grassley.

As you all heard, Senator Grassley and myself and Senators

Schumer and Graham have agreed to put together legislation addressing Chinese currency problems, and we want to do it right,

certainly WTO consistent, something that advances the ball, helps

us get to more flexible exchange rates more quickly. Your advice

as to what should or should not be in our legislation? What teeth,

what leverage should be in and what should not be in, in your

judgment? We want to be effective here. We certainly want to act.

We are a little bit impatient. We want to be responsible, but yet,

you know, be fair but firm.

Your thoughts on what should be in the bill. Some of you said,

sure, call a spade a spade, a manipulator. The next question is: All

right, saying that, what do we do? What should the legislation provide?

Who wants to go first?

Mr. ROACH. Well, correct me if I am wrong, but you and Senator

Grassley did propose a framework to deal with many of these

issues last year, Senator.

The CHAIRMAN. Yes.

Mr. ROACH. And I personally was very much in favor of the

framework the way you laid it out. As I understand it, since you

recognized that the U.S. Treasury did not have the staff to go

through a full-blown exercise twice a year, you would turn that

over to the economists at the IMF.

You also argued—and I think this is a very good point—to

change the concept of currency concern, away from the politically

contentious issue of manipulation, which implies intent and motive,

to one of misalignment, which is more of an analytically objective

framework.

34

I thought those were excellent proposals. You also addressed the

issue of the current foreign exchange review process by the Treasury. Actually, today, if you find a trading partner guilty of manipulation, there are no consequences. All the U.S. is required to do

under those circumstances is to enter into negotiations. Under the

bill that you introduced last year, there would be direct consequences that would flow from an IMF adjudication of a currency

misalignment.

So I like the framework. I think you are going down the right

road here. But, again, please do not think that the currency fix is

the silver bullet that will address all the deeper issues that we

have discussed today.

The CHAIRMAN. Other thoughts?

Mr. PRASAD. Chairman Baucus, first of all, I would like to support your emphasis again on taking the issue away from manipulation, which I think is not really economically terribly well-defined

or constructive, in this context especially.

I think putting exchange rate flexibility in a broader context is

important, and, in that context, things like the Strategic Economic

Dialogue might have a role. But I think it is very important also

to put more teeth into them in terms of thinking about the very

specific intermediate steps that could be used as guideposts for

this. The Chinese are very effective at using deadlines when they

see the process as being in their own interest, and I think, again,

the WTO accession example indicates that the reformers do use

this quite effectively. So I think coming up with very specific guideposts is going to be important in this process, but within the context of a much broader framework.

The CHAIRMAN. Any ideas what some appropriate teeth might

be?

Mr. PRASAD. One can think about very specific measures in

terms of how much flexibility you allow, how much you open up the

capital account, what sort of inflows and outflows you allow, and

so forth. But, again, this has to be thought of in terms of a framework. If you thought of setting in place an inflation objective over

a period of 5 years or 3 years, it immediately backs into a number

of implications for the exchange rate and for capital account opening.

The CHAIRMAN. Thank you.

Mr. Goldstein?

Mr. GOLDSTEIN. Mr. Chairman, I would base it still on the IMF

exchange rate surveillance guidelines. That is, as best we can, I

think we do not want to have two sets of criteria, one in the IMF

and one in the Congress. I actually think it is not a good idea to

go to misalignment in the sense that many currencies are misaligned, but it does not tell you whose fault it is. You really need

to have something that affects conduct, like intervention.

For example, a lot of people think the dollar is overvalued, but

you would not say that we are manipulating, I do not think.

So I would go with the guidelines. I would have some teeth by

saying countries who are found to be manipulating do not get market economy status; they cannot have quota increases in the Fund.

And I think ultimately, although it should not be the first consequence, but down the road market access to the U.S. market has

35

to come up because you have to have something in the back that

says if you persistently keep doing the manipulation, you will pay

something in terms of market access.

The CHAIRMAN. What kind of market access?

Mr. GOLDSTEIN. Well, the U.S. market. Either it is going to be

some kind of trade measure—I think in the end if you have persistent noncompliance after you have already ruled them to be manipulators, after you have tried the market economy and the other

things, you have to have something that has consequences. I hope

that does not happen, but if we get real recalcitrance just going on

and on, then I think you have to do something along SchumerGraham lines or something like that.

The CHAIRMAN. Mr. Makin?

Mr. MAKIN. Senator Baucus, first, I certainly want to commend

your constructive attitude toward this process. I think it is important to keep that in mind.

The currency issue is about how you divide up the pie, and in

addressing it, you do not want to make the pie smaller. And that

is very difficult to do. Again, if you start limiting access to U.S.

markets or undertaking some punitive measures that are unilateral, I do not think the U.S. Congress can legislate for China with

regard to what they do with capital flows and so on.

This is a very difficult and touchy problem. I do not know the

answer. I would ask that you would allow me to think about it and

come back to you with some written comments.

The CHAIRMAN. That would be very helpful. In fact, in that regard I am going to keep the hearing record open until the propitious date of April 13th, Friday the 13th. I would appreciate any

additional comments from any of you by that date.

In addition, I and other Senators will have questions for all of

you right away. Hopefully you can answer those questions on a

timely basis.

I have to run here, but this has been very helpful. It is very constructive. Thank you very, very much for taking the time and for

your thoughts. You have helped advance the ball.

Thank you very much.

[Whereupon, at 11:57 a.m., the committee was adjourned.]

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