China’s Currency: Economic Issues and Options for U.S. Trade Policy
Released: 2008-05-22T00:00:00

Introduction

From 1994 until July 21, 2005, China maintained a policy of pegging its currency to the U.S. dollar at an exchange rate of roughly 8.28 yuan to the dollar. The Chinese central bank maintained this peg by buying (or selling) as many dollar-denominated assets in exchange for newly printed yuan as needed to eliminate excess demand (supply) for the yuan. As a result, the exchange rate between the yuan and the dollar basically stayed the same, despite changing economic factors which could have otherwise caused the yuan to either appreciate or depreciate relative to the dollar. Under a floating exchange rate system, the relative demand for the two countries' goods and assets would determine the exchange rate of the yuan to the dollar. Many economists contend that for the first several years of the peg, the fixed value was likely close to the market value. But in the last few years of the peg, economic conditions changed such that the yuan would likely have appreciated if it had been floating.

The Chinese government modified its currency policy on July 21, 2005. It announced that the yuan's exchange rate would become "adjustable, based on market supply and demand with reference to exchange rate movements of currencies in a basket," (it was later announced that the composition of the basket includes the dollar, the yen, the euro, and a few other currencies), and that the exchange rate of the U.S. dollar against the yuan would be immediately adjusted from 8.28 to 8.11, an appreciation of about 2.1%. Unlike a true floating exchange rate, the yuan would (according to the Chinese government) be allowed to fluctuate by 0.3% (later increased to 0.5%) on a daily basis against the basket, it remained not fully convertible in international markets, and China continued tight restrictions and controls over capital transactions. The current situation might be best described as a "managed float"—market forces are determining the general direction of the yuan's movement, but the government is retarding its rate of appreciation through market intervention.

Since July 2005, China has allowed the yuan to appreciate steadily, but slowly. It has continued to accumulate foreign reserves at a rapid pace, which suggests that if the yuan were allowed to freely float, it would appreciate more rapidly. China's foreign exchange reserves grew from $403 billion at the end of 2003 to $1.7 trillion at the end of March 2008, and China's large trade surplus totaled $262 billion in 2007. Since the 2005 reforms, there has been a significant shift in the economic environment in China and the United States. The yuan has risen 16% against the dollar—far more than the Japanese yen during the same period, for example. The overall value of the dollar has fallen significantly, to the point where some economists and policymakers fear that a further fall could be destabilizing to the U.S. economy. (By definition, any rise in the yuan is equivalent to a fall in the dollar.) Partly as a result of the falling dollar, total U.S. exports are the fastest growing sector of the economy, and the growth rate of imports from China appears to have slowed recently.

Nevertheless, the increase in the value of the yuan to date has done little to ease concerns raised in the United States. But China, with concerns about its own economy, has been reluctant to make significant changes to their currency. This paper reviews the various economic issues raised by China's present currency policy. Major topics surveyed include

The economic concerns raised by the United States over China's currency policy and China's concerns over changing that policy. How China's fixed exchange rate regime works and the various economic studies that have attempted to determine China's real, or market, exchange rate. Trends and factors in the U.S.-China trade imbalance. (What is causing it? Is China's currency policy to blame?) Economic consequences of China's currency policy for both China and the United States. China's massive accumulation of foreign exchange reserves and purchases of U.S. federal debt instruments. Policy options on how the United States might induce China to reform its present currency policy, including current legislation introduced in Congress.

U.S. Concerns Over China's Currency Policy and Recent Action

Many U.S. policymakers, business people, and labor representatives have charged that China's currency is significantly undervalued vis-à-vis the U.S. dollar by as much as 40%, making Chinese exports to the United States cheaper, and U.S. exports to China more expensive, than they would be if exchange rates were determined by market forces. They further argue that the undervalued currency has contributed to the burgeoning U.S. trade deficit with China, which has risen from $30 billion in 1994 to $256 billion in 2007, and has hurt U.S. production and employment in several U.S. manufacturing sectors (such as textiles and apparel and furniture) that are forced to compete domestically and internationally against "artificially" low-cost goods from China. Furthermore, many analysts contend that China's currency policy induces other East Asian countries to intervene in currency markets in order to keep their currencies weak against the dollar to remain competitive with Chinese goods. Several groups are pressing the Bush Administration to pressure China either to revalue its currency or to allow it to float freely in international markets. These issues are addressed in more detail later in the report.

President Bush and Administration officials have criticized China's currency policy on a number of occasions, stating that exchange rates should be determined by market forces. Initially, the Bush Administration rejected calls from several Members of Congress to apply direct pressure on China to force it to abandon its currency peg. Instead, the Administration sought to encourage China to reform its financial system—under the auspices of a joint technical cooperation program agreed to on October 14, 2003, for example—and take other measures that would pave the way toward adopting a more flexible currency policy.

The Administration's position on China's currency peg appears to have toughened beginning around April 2005 when then-U.S. Treasury Secretary John Snow asserted at a G-7 meeting (on April 16, 2005) that "China is ready now to adopt a more flexible exchange rate." This was likely driven in part by growing complaints from Members over China's currency policy and the introduction of numerous currency bills. For example, during the 109 th congressional session, the Senate on April 6, 2005, failed (by a vote of 33 to 67) to reject an amendment ( S.Amdt. 309 ) attached by Senator Schumer to S. 600 (a foreign relations authorization bill), which would have imposed a 27.5% tariff on Chinese goods if China failed to substantially appreciate its currency to market levels. In response to the outcome of the vote, the Senate Republican leadership negotiated an agreement with the supporters of the bill to allow a vote on S. 295 (which was sponsored by Senator Schumer and which has same language as S.Amdt. 309 ) at a later date as long as the sponsors of the amendment agreed not to offer similar amendments to other bills for the duration of the 109 th Congress. Supporters of S. 295 threatened to bring the bill up a vote on the bill on two separate occasions in 2006, but were convinced not to by Administration and Chinese officials. Numerous other currency bills were introduced as well.

Most Recent Events

Over the past year, some of the most significant events concerning China's currency policy have included the following:

On May 13, 2008, the U.S. Bureau of Labor Statistics reported that, from April 2007 to April 2008, import prices from China increased 4.1%—the largest 12-month increase recorded since the index was first published in December 2003. On May 9, 2008, the U.S. Census Bureau reported that U.S. imports from China over the first three months of 2008 had risen by only 1.8% over the same period in 2007. On May 8, 2008, the Bank of China reported that the exchange rate with the dollar was 7.00 yuan, an appreciation of 15.9% since the July 2005 were introduced. On April 14, 2008, the Bank of China reported that China's foreign exchange reserves reached $1.68 trillion at the end of March 2008. On September 29, 2007, the Chinese government officially launched the China Investment Corporation (CIC), stating that the new entity was created to better manage its foreign exchange reserves. With an initial capitalization of $200 billion, CIC is one of the world's largest state-owned funds. On December 15, 2007, the CIC announced it would invest $5 billion in Morgan Stanley. On August 13, 2007, China's Xinhua News Agency reported that China had no plans to sell off its dollar assets. The statement appeared to be in response to an article that appeared in the Daily Telegraph (August 10, 2007) in which high level Chinese government officials reportedly claimed that China would sell off its dollar assets if the United States imposed sanctions against China over its currency policy. In addition, the government announced the elimination of regulations requiring domestic firms to convert part of their current-account foreign exchange holdings into yuan. In June 2007, the International Monetary Fund clarified its definition of currency manipulation as "engaging in policies that are targeted at—and actually affect—the level of the exchange rate...in order to increase net exports." To discourage currency manipulation, the IMF announced it "must be prepared to deliver clear and sometimes difficult policy messages to members...." On May 17, 2007, 42 House Members filed a Section 301 petition with the U.S. Trade Representative's office over China's currency practices and requested that a trade dispute case be brought to the World Trade Organization (WTO). On June 13, 2007, the USTR's office announced that it had declined the petition.

Treasury Department Reports on Exchange Rates

The 1988 Omnibus Trade and Competitiveness Act requires the Treasury Department to annually report on the exchange rate policies of foreign countries that have large global current account surpluses and large trade surpluses with the United States and to determine if they "manipulate" their currencies against the dollar in order to prevent "effective balance of payment adjustments" or to gain an "unfair competitive advantage in international trade." If currency manipulation is found, Treasury is required to negotiate an end to such practices. Over the past several years, Treasury has issued a Report on International Economic and Exchange Rate Policies on a semi-annual basis, focused mainly on major U.S. trading partners. China was cited under this report for manipulating its currency five times from May 1992 to July 1994, largely because of its use of a dual exchange rate system (which it unified in early 1994) and restrictions that were imposed on access to foreign exchange by domestic firms. Neither China nor any other country has been designated as a currency manipulator since 1994. However, over the past few years, the Treasury Department reports have increased their focus on China and have stepped up criticism of China's currency policy and the pace of its reforms. Since China reformed its currency in July 2005, Treasury has made the following observations:

The November 28, 2005 report praised China's July 2005 currency reforms, but stated that it had failed to fully implement its commitment to make its new exchange rate mechanism more flexible and to increase the role of market forces to determine the yuan's value. The report further stated that China's new managed float exchange rate regime, which Chinese officials described as "based on market supply and demand with reference to a basket of currencies," did not appear to play a significant role in determining the daily closing level of the yuan, and that trading behavior since the reforms strongly suggested that "the new mechanism remains, in practice, a tightly managed currency peg against the dollar." However, Treasury stated that it decided not to cite China as a currency manipulator under U.S. trade law because of assurances it had received from Chinese officials that China was committed to "enhanced, market-determined currency flexibility" and that it would put greater emphasis on promoting domestic sources of growth, including financial reform. The Treasury Department's June 2007 report stated that although China's central bank continued to heavily intervene in currency markets and that China's currency was significantly undervalued, it did not meet the technical requirements under U.S. law regarding currency manipulation. However, the report stated that "Treasury forcefully raises the Chinese exchange rate regime with Chinese officials at every available opportunity and will continue to do so." The Treasury Department's December 2007 report stated that China should significantly accelerate the appreciation of the RMB's effective exchange rate in order to minimize the risks that are being created for China itself as well as the world economy.

Many Members have been critical of Treasury's decision (since 1994) not to cite China as a currency manipulator, despite its large scale currency interventions to control the exchange rate with the dollar, its large global current account surpluses, and large and growing trade surpluses with the United States. Many Members have called for enactment of legislation to revise the criteria Treasury uses to make its currency manipulation determination or to require it to estimate the level of the yuan's misalignment against the dollar (see the " Legislation in the 110 th Congress " section below).

China's Concerns Over Changing Its Currency Policy

Chinese officials argue that its currency policy is not meant to promote exports or discourage imports. They claim that China adopted its currency peg to the dollar, a policy that is practiced by a variety of developing countries, in order to foster economic stability and investor confidence. Chinese officials have expressed concern that abandoning the current currency policy could spark an economic crisis in China and would especially be damaging to its export industries at a time when painful economic reforms (such as closing down inefficient state-owned enterprises and laying off millions of workers) are being implemented. In addition, Chinese officials also appear to be worried about the rising level of unrest in the rural areas, where incomes have failed to keep up with those in urban areas and public anger has spread over government land seizures and corruption. Chinese officials contend that appreciating the currency could reduce domestic food prices (because of increased imports) and agricultural exports (by raising prices in overseas markets), thus lowering the income of farmers and further raising tensions. They further contend that the Chinese banking system is too underdeveloped and burdened with heavy debt to be able to deal effectively with possible speculative pressures that could occur with a fully convertible currency, which typically accompanies a floating exchange rate.

The combination of a convertible currency and poorly regulated financial system is seen to be one of the causes of the 1997-1998 Asian financial crisis. Prior to the crisis, Chinese officials were reportedly considering moving towards reforming their currency policy, but the severe negative economic impact among several East Asian countries that had a floating currency appears to have convinced officials that China's currency peg was one of the main reasons why China's economy was relatively immune from crisis, and that gradually implementing reforms to make the currency more flexible was the best way to maintain stable economic growth.

U.S. officials counter that they are not asking China to immediately adopt a floating currency system, but to move more quickly to reform the financial sector and to make the currency more flexible (including allowing faster appreciation of the yuan, widening the band, and decreasing the level of intervention in international currency markets).

The Economics of Fixed Exchange Rates

Fixed exchange rates have a long history of use, including the Bretton Woods system linking the major currencies of the world from the 1940s to the 1960s and the international gold standard before then. To understand how China's currency policy works, it is easiest to start with an explanation of how a fixed exchange rate works, which China operated until July 2005. Under the fixed exchange rate, the Chinese central bank bought or sold as much currency as was needed to keep the yuan-dollar exchange rate constant at level (formerly about 8.28 yuan per dollar). The primary alternative to this arrangement would be a floating exchange rate, as the United States maintains with economies like the Euro area, in which supply and demand in the marketplace causes the euro-dollar exchange rate to continually fluctuate. Under a floating exchange rate system, the relative demand for the two countries' goods and assets determines the exchange rate of the euro to the dollar. If the demand for Euro area goods or assets increased, more euro would be demanded to purchase those goods and assets, and the euro would rise in value (if the central bank kept the supply of euro constant) to restore equilibrium.

When a fixed exchange rate is equal in value to the rate that would prevail in the market if it were floating, the central bank does not need to take any action to maintain the peg. However, over time economic circumstances change, and with them change the relative demand for a country's currency. If the Chinese had maintained a floating exchange rate, appreciation would likely have occurred in the past few years for a number of reasons. For instance, productivity and quality improvements in China may have increased the relative demand for Chinese goods and foreign direct investment in China. For the exchange rate peg to be maintained when economic circumstances have changed requires the central bank to supply or remove as much currency as is needed to bring supply back in line with market demand, which it does by increasing or decreasing foreign exchange reserves. This is shown in the following accounting identity, used to record a country's international balance of payments:

Net investment income and net unilateral transfers between the United States and China are relatively small, so the current account balance is close to the trade balance (exports less imports). Thus, anytime net exports (exports less imports) or net private capital inflows (private capital inflows less outflows) increase, foreign exchange reserves must increase by an equivalent amount to maintain the exchange rate peg.

For the past several years, there has been excess demand for yuan (equivalently, excess supply of dollars) at the prevailing exchange rate peg. The central bank maintained the peg through 2005 by increasing its foreign reserves by buying dollars from the public in exchange for newly printed yuan. Rather than hold U.S. dollars, which earn no interest, the Chinese central bank mostly holds U.S. financial securities—primarily U.S. Treasury securities, but also U.S. Agency securities (e.g., the obligations of Fannie Mae and Freddie Mac). A peg can be maintained as long as the central bank is willing to accumulate more foreign exchange reserves.

Since July 2005, China has continued to accumulate foreign reserves at a rapid pace (see Figure 1 ), and in 2006, China overtook Japan to become the world's largest holder of foreign exchange reserves. As seen in Table 1 , foreign reserves grew from $75 billion in 1995 to $168 billion in 2000 to $1.53 trillion in 2007. From 2006 to 2007, China's foreign exchange holdings rose by $463 billion, or 43%. But, unlike a fixed exchange rate regime, it has no longer purchased enough foreign reserves to entirely prevent the yuan from appreciating against the dollar. After an initial revaluation of 2% in July 2005, the yuan has appreciated steadily. By the end of April 2008, it had appreciated by about 16% to 7 yuan per dollar (see Figure 2 ). The current situation might be best described as a "managed float"—market forces are determining the general direction of the yuan's movement, but the government is retarding its rate of appreciation through market intervention (and thus, to some extent, is still pegging the yuan to the dollar). Some of China's neighbors also maintain managed floats (such as Malaysia) or have intervened in currency markets from time to time to keep its currency low against the dollar (such as Japan from 1998-2004). The continued rapid accumulation of foreign reserves suggests that if the yuan were allowed to freely float, it would appreciate more rapidly.

Preventing the yuan from appreciating against the dollar is not the only reason the Chinese government could be accumulating foreign exchange reserves. Foreign exchange reserves are necessary to finance international trade (in the presence of capital controls) and to fend off speculation against one's currency. A country would be expected to increase its foreign reserves for these purposes as its economy and trade grew. However, Table 1 illustrates that the increase in foreign exchange reserves in China has significantly outpaced the growth of GDP or imports in the last few years. When China accumulates foreign reserves that are non-U.S. assets, it does not influence the yuan's value against the dollar. Little public information is available on the nature of China's foreign reserves, so it is not known what share of China's reserves are held in U.S. assets. It is also not known what share of the annual increase in reserves is due to new accumulations, as opposed to valuation changes, exchange rate effects, or the reinvestment of earnings.

Economic activity, including the level of imports and exports, is not determined by the nominal exchange rate, but by the real (inflation-adjusted) exchange rate. Because the United States and China had roughly similar increases in the overall price levels from 1994 to 2003 (39% in China vs. 31% in the United States), the difference between the real and nominal rate was small. However, China had much higher inflation than the United States from 1994 to 1997, so the real and nominal exchange rates diverged considerably during that time. The real exchange rate appreciated from China's perspective, making their exports more expensive and U.S. imports cheaper. From then until 2003, the real and nominal exchange rates converged because China's inflation rate was lower than U.S. inflation. This can be seen in Figure 3 . In 2003, the Chinese exchange rate reached its lowest level since 1994 in real terms, from the Chinese perspective, making their exports progressively less expensive since 1997. Since then, the value of the yuan has risen. Appreciation in the nominal exchange rate has brought the yuan almost back to its 1998 level in real terms.

In the long run, real (inflation-adjusted) exchange rates return to their market value whether they are (nominally) fixed or floating. Imagine that the demand for Chinese goods and services were to increase. If the yuan were floating, it would appreciate, as more yuan were acquired to purchase Chinese goods. It would continue to appreciate until the excess demand for Chinese goods was exhausted (since they are now more expensive in terms of foreign currency), at which point the trade balance would return to its equilibrium level. With a fixed exchange rate, the real exchange rate returns to its market value through price adjustment instead, which takes time. If the exchange rate were fixed below the level that would prevail in the market, Chinese exports would be relatively inexpensive and U.S. imports would be relatively expensive. As long as this situation prevailed, the trade surplus with the United States would persist. The trade surplus (plus net remittances) is equal to the capital flowing from China to the United States. Part of this capital consists of the purchase of U.S. assets by private Chinese citizens. The other portion consists of the accumulation of dollar reserves by the Chinese central bank. By increasing its dollar reserves, the central bank is also increasing the supply of yuan. This causes the inflation rate in China to rise, all else equal. Over time, as prices rise, exports will become more costly abroad and imports less costly. At that point, the trade surplus will return to its equilibrium value. Although the nominal exchange rate never changed, because of the rise in prices, the real exchange rate would now equal the market rate that would prevail if the exchange rate had been floating. Thus, undervaluing a fixed exchange rate does not confer any permanent competitive advantage for a country's exporters and import-competing industries. However, because price adjustment takes time, floating exchange rates return to the equilibrium value much more quickly than fixed exchange rates.

Thus, when a country uses its monetary policy to influence the value of it currency, it can no longer use its monetary and fiscal policy to counteract changes in the business cycle (the U.S. loses no policy flexibility from China's peg). For example, a peg would prevent a country from lowering its interest rates to offset an economic downturn. If it did, capital would flow out of the country to assets with higher interest rates in the rest of the world, and the country would find its currency peg under pressure (since investors would sell the country's currency and buy foreign currency to transfer their capital abroad) until it raised its interest rates.

This loss of monetary autonomy is relatively unimportant for small countries that fix their exchange rate to large neighbors that share the same business cycle, since the large neighbor would also likely be affected by the downturn and lower its interest rates. But the loss in autonomy is costly when a country is tied to a partner to whom it is not closely linked and does not experience similar business cycles, as is arguably the case between the United States and China.

However, China loses less monetary autonomy than most countries with a fixed exchange rate through its use of capital controls (legal barriers restricting access to foreign currency). The currency is convertible on a current account basis (such as for trade transactions), but not on a capital account basis (for various types of financial flows, such as portfolio investment). In addition, nearly all Chinese enterprises are required to turn over their foreign currency holdings to China's state bank in exchange for yuan, and purchases of foreign exchange by individuals and firms in China are closely regulated. Because capital cannot easily leave China when interest rates are lowered, China retains some flexibility over its monetary and fiscal policy despite the fixed exchange rate.

A Critique of Various Estimates of the Yuan's Undervaluation

Although it is certain that the yuan would appreciate if the central bank were not increasing its foreign reserves, since the value of the yuan has changed little since 1994, there is no direct way to determine how much it would appreciate—even if there was a consensus about what China's current account balance should be, there are no observations until June 2005 to estimate how sensitive its imports and exports would be to changes in the exchange rate. Estimates of the extent of the yuan's undervaluation have been cited in many articles and interviews. This report attempts to evaluate only those estimates in which the author explains how the estimate was derived. It should be noted that many of the estimates were made some time ago, when the value of the yuan and China's trade surplus were lower, so the yuan may be more or less undervalued at this point. The estimates are grouped below into two broad methodological categories: the "fundamental equilibrium exchange rate" method and the "purchasing power parity" method.

Estimates Based on Fundamental Equilibrium Exchange Rates

One method for estimating misalignments in exchange rates is referred to as the fundamental equilibrium exchange rate (FEER) method. It is based on the belief that current account balances at the present are temporarily out of line with their "fundamental" value, either because of unsustainable forces in the economy or government intervention. Once an estimate has been made of what the fundamental current account balance should be, one can calculate how much the exchange rate must change in value to achieve that current account adjustment. As will be discussed below, this is not an uncontroversial method. Many economists would reject the notion that current account balances worldwide are misaligned, or that economists can predictably determine how much they must be adjusted to come back into alignment. Thus, the following estimates are only valid if one accepts the assumptions underlying them.

Ernest Preeg, senior fellow at the Manufacturers' Alliance, estimated that the yuan was undervalued by 40% in 2003. While this claim is not based on any formal analysis, he uses several rule-of-thumb estimates to reach this conclusion. His first observation is that the increase in Chinese foreign exchange reserves equaled 100% of the Chinese trade surplus less net foreign direct investment (FDI) flows in the first six months of 2002. He concludes that the entire trade surplus less net foreign direct investment would be zero in the absence of the increase in foreign exchange reserves. His second observation is a rule-of-thumb estimate that a 1% decline in the dollar leads to a $10 billion decline in the trade deficit in the United States He then observes that the dollar would need to decline by 40% according to that rule of thumb to eliminate the trade deficit since the U.S. trade deficit equaled about $400 billion in 2002. Since the Chinese trade surplus plus net FDI flows equaled 100% of the increase in foreign exchange reserves, he concludes that if the central bank no longer increased its foreign exchange reserves by letting the yuan float, the surplus less FDI would be zero and the yuan would appreciate by 40%, based on the U.S. ratio.

The Institute for International Economics (IIE) estimates that the yuan was 15%-25% undervalued in 2003. It argues that the "underlying" current account surplus was 2.5%-3% of GDP in 2003, larger than the actual surplus (1.5%) (it does not explain why). It then argues that the surplus should be reduced by $50 billion (or 4% of GDP) to return to equilibrium, which would leave China with a deficit of 1%-1.5% of GDP in equilibrium. It believes that the revaluation required to achieve this reduction in the current account surplus is unusually large because of the extensive use of imports in the production of Chinese exports. IIE Fellow Morris Goldstein testified that

These estimates of [yuan] misalignment can be obtained either by solving a trade model for the appreciation of the RMB that would produce equilibrium in China's overall balance of payments, or by gauging the appreciation of the RMB that make a fair contribution to the reduction in global payment imbalances, especially the reduction of the U.S. current-account deficit to a more sustainable level.

Goldman Sachs Economic Research Group has estimated that the yuan was 9.5%-15% undervalued in 2003. They argue that the current account less FDI should be zero in equilibrium (which means that China would have a current account deficit equal to FDI), which could be accomplished with a 9.5%-15% revaluation. This is based on their elasticity (i.e., the degree to which demand changes due to price changes) estimates that exports would fall 0.2% and imports would rise 0.5% when the exchange rate rose 1%.

Virginie Coudert and Cecile Couharde use the most sophisticated analysis to estimate their parameters. They argue that China has an underlying current account deficit of between 1.5% and 2.8% of GDP. The smaller number comes from a cross-country regression of the current account balance based on variables such as per-capita income, demographics, and the budget deficit; the larger number is an estimate of the largest current account deficit that would stabilize China's debt-to-GDP ratio. They estimate that the yuan was 44%-54% undervalued against the dollar in 2003.

All of these estimates are based on a similar logic, so a few general observations can be made about all of them. First, none of the estimates are the product of theoretically grounded, econometrically estimated economic models. Rather, they are "back of the envelope" estimates based on a few simple "rule of thumb" assumptions. "Rules of thumb" such as the Preeg 10%-$1 billion estimate or the Goldman Sachs import and export elasticities may not be accurate over time or over large changes in the exchange rate.

The main source of contention in all of the estimates of the yuan's undervaluation is the definition of an "equilibrium" current account balance. All of the estimates are based on the appreciation that would be required for China to attain "equilibrium" in the current account balance. But there is no consensus based on theory or evidence to determine what equilibrium would be; rather, the authors base equilibrium on their own personal opinion, with some using arbitrary assumptions and others more sophisticated ones. Yet this assumption is crucial—Dunaway et al. demonstrate that changing the assumed equilibrium current account balance by 2 percentage points of GDP changes the estimated undervaluation by as much as 25 percentage points. Some economists argue that the current account balance would always be close to zero in equilibrium, but this neglects the fact that countries with different saving and investment rates may willingly lend to and borrow from one another for long periods of time.

In fact, the Preeg, IIE, and Goldman Sachs estimates use an assumption of equilibrium less favorable to China than the current account balance. These studies actually call for balance only in official and portfolio borrowing. They still allow for foreign direct investment (FDI) inflows, which means their estimate of China's overall "equilibrium" current account position is actually a deficit. If they had chosen balance (the traditional "equilibrium" measure with a fixed exchange rate) instead of a deficit as their equilibrium benchmark, their estimates of the yuan's undervaluation would have been smaller. Even if portfolio flows are essentially limited by capital controls at present, it is not clear why requiring the Chinese to borrow from the rest of the world is any less unsustainable than the current arrangement where China is lending to the rest of the world. With capital controls and net FDI inflows, increasing foreign reserves is the only way that China can keep its net foreign indebtedness from increasing. And all measures rule out any accumulation of foreign official reserves for reasons other than to influence the exchange rate.

It is particularly difficult to determine the equilibrium current account balance in China because of the presence of capital controls. If China were to maintain capital controls after currency reform (if, for example, they revalued the peg rather than let the yuan float), current account balance may be a reasonable assumption. But if capital controls were eliminated, as is typically the case with a floating exchange rate, the economic situation would change entirely—"equilibrium" could now involve persistent borrowing from or lending to the rest of the world by private Chinese citizens, which would result in a corresponding persistent trade deficit or surplus, respectively. If private citizens lent as much to the United States in equilibrium as the Chinese central bank is currently lending (and U.S. lending to China remained unchanged), then the equilibrium market exchange rate would be equal to the current fixed rate, and the trade deficit would remain unchanged. If private capital outflows exceeded the current increase in foreign reserves, the yuan would depreciate. Since China is a country with both a high national saving rate and a high investment rate, it is not clear whether China would be a net borrower (in which case it would run a current account deficit) or lender (current account surplus) if their currency floated and capital controls were abolished. This issue is particularly relevant when the equilibrium exchange rate is defined as "market determined," since capital controls currently prevent portfolio investment flows from being market determined. Bosworth argues that China's high internal saving rate is more than sufficient to finance its investment, so it makes sense for China to offset FDI inflows with official outflows in the form of foreign reserve accumulation rather than run a current account deficit. Therefore, he argues, foreign reserve accumulation should not be considered proof of undervaluation. Wang argues that, based on estimates derived from other developing economies, China's equilibrium current account surplus may be even larger than the actual surplus, so the yuan is overvalued.

The FEER approach is also based on a belief that the overall U.S. trade deficit is unsustainable, and revaluing the yuan would reduce it. This goes beyond an argument that China has fixed the yuan at an artificially low level, and argues that the dollar, which is market determined against most of its trading partners, is incorrectly valued. For example, the Coudert and Couharde estimate that the yuan is 54% undervalued is based on a corresponding estimate that the dollar was 35% overvalued, the yen 37% undervalued, and the euro 27% undervalued in 2003. If trade and financial markets are rational over the medium run, then the value of the dollar and the size of the trade deficit are never unsustainable—if they were, investors would be unwilling to hold U.S. assets and would sell the dollar, and the trade deficit would decline. There is no widely accepted theoretical approach to determining trade deficit sustainability, and prima facie evidence does not suggest the U.S. trade deficit is unsustainable over the next few years—it has lasted several years, it did not prevent the U.S. economy from achieving record growth and low unemployment in the late 1990s, U.S. investment income paid to foreigners is not large, and there have not been any unusually large or sudden declines in the dollar since the trade deficit emerged.

Further, if the Chinese central bank stopped buying U.S. assets, and hence reduced its bilateral trade deficit with the United States, it is unlikely that the overall U.S. trade deficit would fall by a corresponding amount. Other foreigners would still be free to lend to the United States, which could cause its other bilateral trade deficits to widen. Thus, it is not clear that a "fair share" of a reduction in the U.S. trade deficit can be apportioned to China. And even if China's overall trade surplus were eliminated, it might still run a bilateral trade surplus with the United States. Even countries with overall trade deficits, including the United States, have some trading partners with whom they run surpluses and some with whom they run deficits.

Does international experience suggest what the Chinese current account balance would be in equilibrium? The closest comparison is probably to other East Asian countries, which also grew rapidly and maintained high saving rates in recent decades. The experience of these countries is mixed. From 1980 to 1997, South Korea, Malaysia, Philippines, Indonesia, and Thailand typically ran current account deficits, while Hong Kong, Singapore, Taiwan, and Japan (which had already industrialized) typically ran current account surpluses. Since the Asian financial crisis in 1997, all of these countries have run large current account surpluses. This may suggest that the current economic environment is not conducive to developing world borrowing.

As seen in Table 2 , the same combination of large foreign exchange reserves and a large current account surplus can be seen in several other countries in the region, even though these countries range in their exchange rate regimes from a float (Japan and South Korea) to a currency board (Hong Kong). Although large compared to other regions, China's current account balance does not seem out of line with its neighbors.

Estimates Based on Purchasing Power Parity

There are other estimates of the yuan's undervaluation based on the theory of purchasing power parity (PPP)—the theory that the same good should have the same price in two different countries. If it did not, then arbitrageurs could buy it in the cheaper country and sell it in the more expensive country until the price disparity disappeared.

One of the simplest estimates based on PPP is the Economist magazine's Big Mac Index, which estimated that China's currency was undervalued by 56% in February 2007. The Economist portrays the Big Mac Index as a "light hearted guide" to exchange rates, and there are important drawbacks to relying too heavily on it. The Big Mac Index compares the price of a McDonald's Big Mac in China and the United States. Since a Big Mac in China was 56% cheaper than in the United States, the index concludes that the yuan is undervalued by that much. But purchasing power parity only applies to tradeable goods, and a Big Mac is not tradeable. In fact, Li Ong estimates that 94% of the value of a Big Mac comes not from the hamburger itself, but the services associated with the hamburger. These include the wages of employees serving the Big Mac and the rent of the restaurant in which it is eaten, both of which are determined by local factors. Since the hamburger itself is the only tradeable portion of the Big Mac, only a small fraction of the Big Mac's value should be determined by purchasing power parity. As a result, a Big Mac in New York City is more expensive than a Big Mac purchased in the U.S. rural south. Taken literally, the Big Mac Index would imply that a dollar in the rural south is undervalued compared to a dollar in New York City.

While PPP is a simple idea that is powerful in theory, it has been proven to be unreliable in reality: prices are consistently lower in developing countries than industrialized countries. Some economists have tried to estimate what the yuan's value would be by attempting to control for predictable divergences from PPP. Still, these estimates should be considered with caution—even when sophisticated modifications have been made, PPP has been shown to help predict exchange rates only over the long run. Estimates based on PPP would identify any country's currency as overvalued or undervalued, except the country to which it is being compared. Another drawback to the PPP approach is that the estimate will not tend to change much over time (if prices are relatively stable), even if the trade deficit is significantly changing.

Economist Jeffrey Frankel argues that income level can be regressed on the exchange rate using a cross-sample of countries to find a predictable relationship between a country's income level and its equilibrium exchange rate based on PPP. By this measure, he estimates that China's exchange rate was undervalued by 36% in 2000. He speculates that, if anything, the undervaluation has increased since then. Coudert and Couharde make a similar calculation for 2003 and estimate the yuan to be undervalued by 41%-51%, depending on what countries are included in their sample. Frankel acknowledges a number of caveats to this analysis. First, PPP only holds over the long run, at best, and financial flows can cause even market-determined exchange rates to significantly diverge from PPP for several years. Second, the regression does not control for other factors and only explains 57% of the variation in the data. Third, he argues that any adjustment in the exchange rate should be gradual so as not to be economically disruptive. He also warns that "It is not even true that an appreciation of the renminbi against the dollar would have an immediately noticeable effect on the overall U.S. trade deficit or employment...."

There should be some theoretical rationale for linking income levels to exchange rate values; otherwise, the results may represent nothing more than spurious correlation. One rationale is called the "Balassa-Samuelson" effect: as countries get richer, their exchange rates are predicted to appreciate because productivity growth will be more rapid for tradeable goods than non-tradeable goods. Since these differences in productivity growth cannot easily be measured directly, income levels can be used as a proxy. But if the proxy is not an accurate one, then neither will be the results. Another proxy is the ratio of the consumer price index to the producer price index. When Coudert and Couharde used this proxy over time with a smaller sample, they estimated that the yuan was 18% undervalued in 2003. Benassy-Quere et al. regressed this proxy and net foreign assets on a panel of the G20 countries and found the yuan to be undervalued by 47% in 2003. Wang also uses this proxy (for China only), as well as net foreign assets and openness to trade, in a regression, and finds evidence that the yuan was only modestly undervalued in 2003. However, the authors cautioned that the price index proxy could be inaccurate for China since many consumer prices are not market determined. In addition, they observed that restrictions on the mobility of labor and capital in China may interfere with the Balassa-Samuelson effect.

Cheung et al. are able to replicate others' results that the yuan is significantly undervalued, but point out that these estimates do not meet generally accepted standards of statistical inference. Specifically, the undervaluation estimates are not statistically significant, which means that the results are not robust enough to be sure that the yuan is undervalued at all. Moreover, when they adjust their specification to take into account serial correlation (the fact that this year's exchange rate is influenced by last year's), the estimated undervaluation becomes much smaller. Dunaway et al. demonstrate that when additional explanatory variables are added to the PPP model, such as openness to trade, the estimated undervaluation becomes much smaller. They also show that the estimate changes greatly when seemingly insignificant changes are made to the model, such as changing the time period or omitting one country from the sample.

Treasury Department Assessment of Economic Models

The Treasury Department's December 2006 report on exchange rates discusses the use of economic models and methodology to estimate a currency's "misalignment" or what the fair market rate exchange rate should be. The report noted that there is no single model that accurately explains exchange rate movements, that such models rarely, if ever, incorporate financial market flows, and that their conclusions can vary considerably, based on the variables used. However, Treasury stated that examining such models can produce useful information in understanding exchange rate movements if they: focus only on serious misalignments; use real effective, not bilateral, exchange rates; utilize several different models, recognizing that no one model will provide precise answers; focus only on protracted misalignments where currency adjustments are not taking place; supplement judgments about misalignment with analysis of empirical data, indicators, policies and institutional factors; and verify whether there are any market-based reasons for a currency's misalignment. Treasury points out that most models (including the two classes analyzed above) estimate equilibrium exchange rates in terms of trade flows, while in reality trade flows are swamped by financial flows.

Trends and Factors in the U.S.-China Trade Deficit

Critics of China's currency peg often point to the large and growing U.S.-China trade imbalance as proof that the yuan is significantly undervalued and constitutes an attempt to gain an unfair competitive advantage over the United States in trade. However, bilateral trade balances reflect structural causes as well as exchange rate effects. There are a number of other factors at work that are also important to consider when analyzing the bilateral trade deficit.

First, although China (according to U.S. statistics) had a $256 billion merchandise trade surplus with the United States in 2007, its overall trade surplus was $262 billion (Chinese data), indicating that China had a small ($6 billion) trade surplus in its trade with the world excluding the United States (see Table 3 ). If the yuan is undervalued against the dollar, it should also be undervalued against other currencies, yet China runs trade deficits with several countries. For example, according to Chinese data, it had a $77.5 billion trade deficit with Taiwan, a $47.9 billion deficit with South Korea, and a $38.1 billion deficit with Japan.

Second, the sharp rise in the U.S. trade deficit with China diverts attention from the fact that, while U.S. imports from China have been rising rapidly, U.S. exports to China have been increasing sharply as well. Table 4 lists U.S. exports to its top 10 major export markets in 2007. These data indicate that U.S. exports to China from 2001-2007 rose significantly faster than those to any other major U.S. trading partner. In 2007, total U.S. exports rose 18.1% over the previous year (they increased by 32.0% in 2006). In 2007, China overtook Japan to become the third largest U.S. export market.

Finally, there is strong evidence to suggest that a significant share of the growing level of imports (and hence U.S. trade deficit) from China is coming from export-oriented multinational companies, especially from East Asia, that have moved their production facilities to China to take advantage of China's abundant low-cost labor (among other factors). Chinese data indicate that the share of China's exports produced by foreign-invested enterprises (FIEs) in China has risen dramatically over the past several years. As indicated in Table 5 , in 1986, only 1.9% of China's exports were from FIEs, but by 1996, this share had risen to 40.7%, and by 2007 it had risen to 57.1% A similar pattern can be seen with imports: FIEs accounted for only 5.6% of China's imports in 1986, rose to 47.9% by 2000, and to 58.5% in 2007. FIEs import raw materials and components (much of which come from East Asia) for assembly in China, after which point, much of the final product is exported. As a result, China tends to run trade deficits with East Asian countries and trade surpluses with countries with high consumer demand, such as the United States. These factors have led many analysts to conclude that much of the increase in U.S. imports (and hence, the rising U.S. trade deficit with China) is a result of China becoming a production platform for many foreign companies (who are the largest beneficiaries from this arrangement), rather than unfair Chinese trade policies. The rising importance of FIEs may represent a fundamental change in trade between China and the United States that could affect the bilateral trade deficit independently of the exchange rate regime.

The sharp rise in the share of China's trade by FIEs appears to be strongly linked to the rapid growth in foreign direct investment (FDI) in China, which grew from $1.9 billion in 1986 to $74.8 billion in 2007, much of which went to export-oriented manufacturing, a large share of which was exported to the United States. Table 5 indicates that the U.S. trade deficit with China began to increase rapidly beginning in the early 1990s; a significant rise in FDI and exports by FIEs in China occurred at roughly the same time. By comparing exports and imports in Table 5 , one can see that FIEs have little effect on China's overall trade balance, since the FIEs import roughly 80% as much as they export.

Table 6 provides an illustration of how foreign multinational companies have shifted a significant level of production from other (mainly) East Asian countries to China in one industry. In 2000, Japan was the largest foreign supplier of U.S. computer equipment (with a 19.6% share of total shipments), while China ranked 4 th (with a 12.1% share). In just seven years, Japan's ranking fell to 4 th , the value of its shipments dropped by over half, and its share of shipments declined to 7.0% (2007). China was by far the largest foreign supplier of computer equipment in 2007 with a 51.5% share of total U.S. imports. While U.S. imports of computer equipment from China rose by 436% over the past seven years, the total value of U.S. imports from the world of these commodities rose by only 26%. A large share of the increase in Chinese computer production has reportedly come from foreign computer companies that have moved manufacturing facilities China.

Economic Consequences of China's Currency Policy

If the yuan is undervalued against the dollar, as many critics charge, then there are benefits and costs of this policy for the economies of both China and the United States.

Implications for China's Economy

If the yuan is undervalued, then Chinese exports to the United States are likely cheaper than they would be if the currency were freely traded, providing a boost to China's export industries (which employ millions of workers and are a major source of China's productivity gains). An undervalued currency also increases the attractiveness of China as a destination for foreign investment in export-oriented production facilities, much of which comes from U.S. firms. Foreign investment is an important source of technology transfers, which contribute to economic development. However, an undervalued currency makes imports more expensive, hurting Chinese consumers and Chinese firms that import parts, machinery, and raw materials. Such a policy, in effect, benefits Chinese exporting firms (many of which are owned by foreign multinational corporations) at the expense of non-exporting Chinese firms, especially those that rely on imported goods. This may impede the most efficient allocation of resources in the Chinese economy in the long run.

In the short run, a revaluation of the yuan could reduce aggregate spending in China by raising imports and reducing exports. Whether this would be desirable depends on the current state of the Chinese economy. Some observers argue that the Chinese economy is currently overheating, and revaluation would help place it on a more sustainable path and prevent inflation from rising. Others argue that there is a large pool of underemployed labor in rural China that the undervalued yuan is helping to absorb. In this view, revaluation could be economically and socially disruptive.

Many economists note that China's currency policy essentially denies the government the ability to use monetary policy (such as interest rates) to promote stable economic growth (e.g., fighting inflation). Secondly, they contend that the currency policy has skewed the economy into becoming overly dependent on fixed investment and net exports for economic growth, which, in the long run can not be sustained. Thirdly, they maintain that China's currency policy may actually be undermining the financial viability of the banking system by expanding the level of easy credit, which has made the banks more prone to extend loans to risky and/or speculative ventures, and thus may increase the level of bank-held non-performing loans. In addition, the policy has contributed to an inflow of "hot money" into short-term speculative ventures (such as real estate and the stock market) by investors hoping to cash in on future appreciation of the currency. Banks are restricted from using interest rate policies to better regulate investment decisions because raising interest rates beyond a certain level could increase flows of foreign capital into the country. Keeping interest rates low in a booming economy may prevent the most efficient allocation of capital and could lead to overproduction in some sectors.

The accumulation of large foreign exchange reserves by China may make it easier for Chinese officials to move more quickly toward adopting a fully convertible currency (if the government feels the reserves could defend the currency against speculative pressures). However, the accumulation of large foreign exchange reserves also entails opportunity costs for China: such funds could be used to fund China's massive development needs (such as infrastructure improvements and pollution control), improvements to China's education system and social safety net, and recapitalization of financially shaky banks. These alternatives may have higher rates of return to the economy than U.S. Treasuries or Chinese bonds held by banks to sterilize the effects of exchange rate intervention.

Implications for the U.S. Economy

Effect on Exporters and Import-Competitors

When a foreign reserve accumulation causes the yuan to be less expensive than it would be if it were determined by market forces, it causes Chinese exports to the United States to be relatively inexpensive and U.S. exports to China to be relatively expensive. As a result, U.S. exports and the production of U.S. goods and services that compete with Chinese imports fall, in the short run. Many of the affected firms are in the manufacturing sector, as will be discussed below. This causes the U.S. trade deficit to rise and reduces aggregate demand in the short run, all else equal.

China has become the United States's second largest supplier of imports (2006 data). A large share of China's exports to the United States are labor-intensive consumer goods, such as toys and games, textiles and apparel, shoes, and consumer electronics. Many of these products do not compete directly with U.S. domestic producers—the manufacture of many such products shifted overseas several years ago. However, there are a number of U.S. industries (many of which are small and medium-sized firms), including makers of machine tools, hardware, plastics, furniture, and tool and die that are expressing concern over the growing competitive challenge posed by China. An undervalued Chinese currency may contribute to a reduction in the output of such industries.

On the other hand, U.S. producers also import capital equipment and inputs to final products from China. For example, U.S. computer firms use a significant level of imported computer parts in their production, and China was the largest foreign supplier of computer equipment to the United States in 2007. An undervalued yuan lowers the price of these U.S. products, increasing their output and competitiveness in world markets. And many imports from China are produced by U.S.-invested enterprises (as discussed above), which benefit from an undervalued exchange rate.

Effect on U.S. Borrowers

An undervalued yuan also has an effect on U.S. borrowers. When the United States runs a current account deficit with China, an equivalent amount of capital flows from China to the United States, as can be seen in the U.S. balance of payments accounts. This occurs because the Chinese central bank or private Chinese citizens are investing in U.S. assets, which allows more U.S. capital investment in plant and equipment to take place than would otherwise occur. Capital investment increases because the greater demand for U.S. assets puts downward pressure on U.S. interest rates, and firms are now willing to make investments that were previously unprofitable. This increases aggregate spending in the short run, all else equal, and also increases the size of the economy in the long run by increasing the capital stock.

Private firms are not the only beneficiaries of the lower interest rates caused by the capital inflow (trade deficit) from China. Interest-sensitive household spending, on goods such as consumer durables and housing, is also higher than it would be if capital from China did not flow into the United States. In addition, a large proportion of the U.S. assets bought by the Chinese, particularly by the central bank, are U.S. Treasury securities, which fund U.S. federal budget deficits. According to the U.S. Treasury Department, China held $397 billion in U.S. Treasury securities (as of September 2007), making it the second largest foreign holder of such securities (after Japan). If the U.S. trade deficit with China were eliminated, Chinese capital would no longer flow into this country on net, and the U.S. government would have to find other buyers of its U.S. Treasuries at higher interest rates. This would increase the government's interest payments, increasing the budget deficit, all else equal.

Effect on U.S. Consumers

A society's economic well-being is usually measured not by how much it can produce, but how much it can consume. An undervalued yuan that lowers the price of imports from China allows the United States to increase its consumption of both imported and domestically produced goods through an improvement in the terms-of-trade. The terms-of-trade measures the terms on which U.S. labor and capital can be exchanged for foreign labor and capital. Since changes in aggregate spending are only temporary, from a long-term perspective the lasting effect of an undervalued yuan is to increase the purchasing power of U.S. consumers. The rise of the yuan against the dollar (and other factors, such as rising prices for raw materials) may be beginning to impact the price of Chinese products sold in the United States. The U.S. Bureau of Labor Statistics reported that, from April 2007 to April 2008, import prices from China increased 4.1%—the largest 12-month increase recorded since the index was first published in December 2003. In addition, from January to March 2008, U.S. imports from China rose by only 1.8% over the previous period in 2008 (they rose by 11.7% from 2006-2007).

U.S.-China Trade and Manufacturing Jobs

Critics of China's currency policy argue that the low value of the yuan has had a significant effect on the U.S. manufacturing sector, where 2.7 million factory jobs have been lost since July 2000. While job losses in the U.S. manufacturing sector have been significant in recent years, there is no clear link between job losses and imports from China. First, only some manufacturers export to China or compete with Chinese imports. Second, manufacturing output has reached an all-time high; manufacturing employment has fallen over this time because of productivity growth, not a decline in output. Third, the growing trade deficit has not been limited to China; the overall trade deficit is still increasing.

Finally, there is a long-run trend that is moving U.S. employment away from manufacturing and toward the service sector. U.S. employment in manufacturing as a share of total nonagricultural employment has fallen from 31.8% in 1960 to 22.4% in 1980, to 10.7% in 2005, to 10.5% in 2006, to 10.2% in 2007. This trend is much larger than the Chinese currency issue, and is caused by changing technology (which requires fewer workers to produce the same number of goods) and comparative advantage. With increasing globalization, comparative advantage predicts the United States will produce knowledge- and technology-intensive goods that it is best at producing for trade with countries, such as China, who are better at producing labor-intensive goods. Since the production of some manufactured goods is labor-intensive and some services cannot be traded, trade leads to more manufacturing abroad, and less in the United States. Over time, it is likely that the trend shifting manufacturing abroad will continue regardless of China's currency policy.

Alan Greenspan, former Chairman of the Federal Reserve, testified in 2005 that "I am aware of no credible evidence that ... a marked increase in the exchange value of the Chinese renminbi relative to the dollar would significantly increase manufacturing activity and jobs in the United States."

Net Effect on the U.S. Economy

In the medium run, an undervalued yuan neither increases nor decreases aggregate demand in the United States. Rather, it leads to a compositional shift in U.S. production, away from U.S. exporters and import-competing firms toward the firms that benefit from the lower interest rates caused by Chinese capital inflows. In particular, capital-intensive firms and firms that produce consumer durables would be expected to benefit from lower interest rates. Thus, it is expected to have no medium- or long-run effect on aggregate U.S. employment or unemployment. As evidence, one can consider that while the trade deficit with China (and overall) has widened, the overall unemployment rate has fallen from 6.3% in 2003 to around 5% in 2008. However, the gains and losses in employment and production caused by the trade deficit will not be dispersed evenly across regions and sectors of the economy: on balance, some areas will gain while others will lose.

Although the compositional shift in output has no negative effect on aggregate U.S. output and employment in the long-run, there may be adverse short-run consequences. If output in the trade sector falls more quickly than the output of U.S. recipients of Chinese capital rises, aggregate spending and employment could temporarily fall. If this occurs, then there is likely to be a decline in the inflation rate as well (which could be beneficial or harmful, depending if inflation is high or low at the time). A fall in aggregate spending is more likely to be a concern if the economy is already sluggish than if it is at full employment. Otherwise, it is likely that government macroeconomic policy adjustment and market forces can quickly compensate for any decline of output in the trade sector by expanding other elements of aggregate demand.

By shifting the composition of U.S. output to a higher capital base, the size of the economy would be larger in the long run as a result of the capital inflow/trade deficit. U.S. citizens would not enjoy the returns to Chinese-owned capital in the United States. U.S. workers employing that Chinese-owned capital would enjoy higher productivity, however, and correspondingly higher wages.

The U.S.-China Trade Deficit in the Context of the Overall U.S. Trade Deficit

While China is a large trading partner, it accounted for only about 17% of U.S. imports in 2007 and 29.0% of the sum of the bilateral trade deficits (or 32% of the total U.S. trade deficit, including countries where the United States has a trade surplus). Over a span of several years, a country with a floating exchange rate can run an ongoing overall trade deficit for only one reason: a domestic imbalance between saving and investment. This has been the case for the United States over the past two decades, where saving as a share of gross domestic product (GDP) has been in gradual decline. On the one hand, the United States has high rates of productivity growth and strong economic fundamentals that are conducive to high rates of capital investment. On the other hand, it has a chronically low household saving rate, and recently a negative government saving rate as a result of the budget deficit. As long as Americans save little, foreigners will use their saving to finance profitable investment opportunities in the United States; the trade deficit is the result. The returns to foreign-owned capital will flow to foreigners instead of Americans, but the returns to U.S. labor utilizing foreign-owned capital will flow to U.S. labor.

China's situation is very different. As Table 7 shows (based on 2006 data), China's gross national saving as a percent of GDP (51.3%) is nearly five times greater than the U.S. level (13.5%). Conversely, the rate of private consumption as a percent of GDP is significantly higher in the United States (70%) than it is in China (36.8%). China maintains a higher rate of gross fixed investment as a percent of GDP than does the United States (42.8% versus 20.0%). Finally, China's gross national saving as a percent of its gross national investment is equal to 118% versus 68% in the United States. Thus, the United States must borrow from abroad to fund its investment needs while China has excess saving that it can invest overseas. The net result of these differences can be seen in the data on current account balances as a percent of GDP: 9.0% for China compared with -6.2% for the United States. These data imply that both China and the United States would need to make fundamental changes to their saving/investment patterns to reduce the overall U.S. trade deficit and China's overall trade surplus in the long run.

Some analysts contend that China is moving in this direction, based on a number of statements by high level officials that China plans to boost consumer spending. The Treasury Department's November 2005 report on International Economic and Exchange Rate Policies stated that a key factor in Treasury's decision not to designate China as a country that manipulates its currency was "China's commitment to put greater emphasis on sustainable domestic sources of growth, including by modernizing the financial sector...." However, others contend that it will take several years for China to switch its reliance on exports and domestic investment to consumption for much of its GDP growth, and government policy can, at best, only indirectly alter long run consumption patterns.

Economists generally are more concerned with the overall trade deficit than bilateral trade balances. Because of comparative advantage, it is natural that a country will have some trading partners from which it imports more, and some trading partners to which it exports more. For example, the United States has a trade deficit with Austria and a trade surplus with the Netherlands even though both countries use the euro, which floats against the dollar. Of concern to the United States from an economic perspective is that its low saving rate makes it so reliant on foreigners to finance its investment opportunities, and not the fact that much of the capital comes from China. If the United States did not borrow heavily from China, it would still have to borrow from other countries.

The Value of the Yuan in the Context of the Falling Dollar

From January 2002 to January 2008, the dollar fell in value by 24% in nominal terms and 22% in inflation-adjusted terms against the Federal Reserve's broad index of currencies. Its depreciation against the euro, pound, Canadian dollar, and other currencies with floating exchange rates has been larger. A gradually declining dollar would not be expected to disrupt economic activity since it would stimulate U.S. exports and reduce the demand for foreign imports. But some economists fear that there is a possibility that the dollar could suddenly plummet in value, and that this would cause severe dislocations for the U.S. economy. The scenario through which they envision this occurring is based on the size of the trade deficit. The trade deficit is unsustainably large, in the sense that if it were to persist at current levels, the net debt owed to foreigners would grow without bounds. Therefore, it must eventually shrink, presumably through further dollar depreciation. Some economists worry that this adjustment could happen suddenly and rapidly if investors suddenly came to realize that significant dollar depreciation was inevitable, and fled dollar assets in an attempt to avoid these losses. If this occurred, there could be significant dislocations in U.S. financial markets that could interfere with efficient financial intermediation. This scenario is seen by most economists to be highly unlikely. Since the scenario would be so costly to the economy, it may be worth guarding against in spite of its improbability, however.

The primary reason that the dollar has not depreciated more rapidly since 2002 has been because central banks in China and many other developing countries (mainly Asian and oil producing countries) have accumulated foreign reserves at times to retard the appreciation of their currency against the dollar. (By definition, any rise in the value of the yuan is matched by a fall in the dollar.) Other Asian countries may feel compelled to continue this policy as long as China does, since they view their exports as competing directly with China. The commitment by China and other developing countries to support the value of the dollar may be one reason that private investors have felt secure investing in U.S. assets despite its large trade deficit. Were China and these other countries to cease intervening in currency markets, it is possible that the dollar would fall significantly in a short time. A sudden decline in the dollar could trigger the currency crisis scenario described above.

Policy Options for Dealing with China's Currency Policy

The United States could utilize a number of options to try to put more pressure on China to make further reforms to its exchange rate policy if U.S. policymakers desired. Options for currency reform include making the yuan fully convertible, allowing the currency to appreciate by a certain amount (immediately or gradually), lessening China's intervention in currency markets, widening the band in which the currency is allowed to fluctuate, and furthering reforms to the financial sector to enable greater currency flexibility.

Determining the best approach to achieving these outcomes has sparked a lively policy debate. Options to induce China to reform its exchange rate regime (including proposed legislation) are listed below (see also section on legislation in the 110 th Congress):

Tighten Requirements on Treasury Department's Report on Currency

Several Members of Congress have expressed frustration over the Treasury Department's failure to designate China as a currency manipulator (since 1994) in its semi-annual exchange rate policies report. They contend that such a designation would itself increase pressure on China to reform its currency. (From a practical perspective, such a designation would require Treasury to negotiate with China to end such practices, something Treasury is already doing.) According to the Treasury Department's November 2005 currency report: "Reaching judgments about countries' currency practices and their relationships to the terms of the Act (i.e., currency manipulation) for the purpose of designation is inherently complex, and there is no formulaic procedure that accomplishes this objective." H.R. 782 , H.R. 2942 , S. 796 , and S. 1607 (110 th Congress) would require Treasury to identify "fundamentally misaligned currencies" rather than manipulated currencies. S. 1677 would require to Treasury to cite a country for currency manipulation regardless of the "intent" of its currency policy. These bills would increase the likelihood that China would be designated, which, some observers claim, would increase pressure on Treasury to make greater efforts to induce China to reform its currency and might make China more willing to boost reform efforts to avoid being designated. Ultimately, the discretion to label the yuan as misaligned with the dollar would still rest with the Treasury, however.

Intensify Diplomatic Efforts

The U.S. government could attempt to persuade China through direct negotiations to change or reform its exchange rate policy. President Bush and Administration officials have contended that China's currency policy is bad for China's economy, as well as that of its trading partners and world growth as a whole. The United States has attempted to assist China in reforming its financial sector to provide a foundation for further currency reforms. In addition, the United States has sought to utilize high level talks, such as the Strategic Economic Dialogue and the U.S.-China Trade Promotion Coordinating Committee to encourage (and assist) China to adopt policies to promote greater domestic consumption and lessen its dependence on exports and fixed investment.

In recognition of its growing importance as a major world economy, China (since 2004) has been invited to attend G-7 (group of seven largest economies) finance meetings. China's currency policy has been a major topic in these discussions, and the United States has sought to use the forum to bring pressure on China to quicken steps to make the currency more flexible. A February 10, 2007 joint statement of G-7 finance ministers and central bank governors stated that "In emerging economies with large and growing current account surpluses, especially China, it is desirable that their effective exchange rates move so that necessary adjustments will occur." The United States could attempt to build a greater consensus within the G-7 to put more pressure on China to reform its currency policy, including by linking China's possible future membership in the G-7 to such reforms.

Alternatively, the United States could attempt to persuade China to participate in talks with other East Asian economies (that are viewed as intervening in currency markets) in order to reach a consensus on exchange rate policy. Proponents of this approach argue that, because of China's size, other East Asian countries are afraid that their exports would be uncompetitive if they made any unilateral change in their currency's value that was not matched by a similar change by China. Finally, the United States could press the International Monetary Fund to become more active in working with China to help it understand the long-term economic risks of over-relying on exports and domestic investment for much of its growth, and promote the development of policy tools that lead to more balanced economic growth (such as more domestic consumption). A key factor in any negotiations would be to convince China that liberalization of its exchange rate system would serve China's long term economic interests and not lead to economic instability.

Raise Tariffs or Other Trade Sanctions

The U.S. government could attempt to pressure China by threatening to impose unilateral trade sanctions if it did not change its currency regime. Some Members support legislation, such as H.R. 1002 , that would impose additional tariffs of 27.5% on imports from China unless it appreciates its currency to fair market levels. Proponents of such legislation contend that congressional threats to sharply increase tariffs on Chinese goods were instrumental in moving China to reform and appreciate its currency policy in July 2005 and hence should be further utilized to press China for greater action to reform and appreciate its currency. Opponents of such legislation contend that imposing sanctions against China would violate WTO rules, and that threats of sanctions may backfire because Chinese officials would be less likely to reform its currency if they felt that such moves were seen as resulting from U.S. political pressure. Some proposals seek to impose sanctions on currency policy that would avoid violating WTO rules. For example, S. 1607 would deny certain designated countries with misaligned policies access to U.S. government procurement, direct U.S. officials to vote against any new multilateral bank loans for such countries, and cut off any new financing by the U.S. Overseas Private Investment Corporation (OPIC).

Utilize the Dispute Resolution Mechanism in the WTO

Some critics have charged that China's currency policy violates WTO rules. The United States could file a case before the WTO's Dispute Settlement Body (DSB) against China's currency peg. If the DSB ruled in favor of the United States, it would direct China to modify its currency policy so that it complies with WTO rules. If China refused to comply, the DSB would likely authorize the United States to impose trade sanctions against China. The advantage of using the WTO to resolve the issue is that it involves a multilateral, rather than unilateral, approach, although there is no guarantee that the WTO would rule in favor of the United States.

For example, it could threaten to initiate a Section 301 case, a provision in U.S. trade law that gives the U.S. Trade Representative authority to respond to foreign trade barriers, including violations of U.S. rights under a trade agreement, and unreasonable or discriminatory practices that burden or restrict U.S. commerce. U.S. obligations in the WTO would likely require the United States to pursue a Section 301 case with the WTO. If the United States failed to use the WTO dispute resolution procedures and instead imposed unilateral trade sanctions under Section 301, China might file a WTO case against the United States.

In 2004, the Bush Administration rejected two Section 301 petitions on China's exchange rate policy: one by the China Currency Coalition (a group of U.S. industrial, service, agricultural, and labor organizations) and one filed by 30 Members of Congress. Both petitions sought to have the United States bring a case before the WTO against China in the hope that the WTO would rule that China's currency peg violated WTO rules. On May 17, 2007, 42 House Members filed a Section 301 petition with the USTR's office over China's currency practices and requested that a trade dispute case be brought to the WTO. However, the USTR declined the petition in June. The Bush Administration has expressed doubts that the United States could win such a case in the WTO and contends that such an approach would be "more damaging than helpful at this time." H.R. 321 , H.R. 782 , H.R. 2942 , S. 796 , S. 1607 , and S. 1677 contain provisions that would require U.S. officials (under certain circumstances) to bring a case against China over its currency policy, and H.R. 321 also calls on the United States to work within the WTO to modify and clarify rules regarding currency manipulation for trade advantage to reflect modern day monetary policy not envisioned at the time current rules were adopted in 1947.

Apply U.S. Countervailing Trade Laws to Non-Market Economies

U.S. countervailing laws allow U.S. parties to seek relief (in the form of higher duties) from imported products that have been subsidized by foreign governments. For many years, the Commerce Department contended that countervailing laws could not be applied to non-market economies, such as China, because it would be nearly impossible to identify a government subsidy in an economy that was not market based. However, in November 2006, the Commerce Department decided to pursue a countervailing case against certain imported Chinese coated free sheet paper products. On March 30, 2007, the Commerce Department issued a preliminary ruling to impose countervailing duties (ranging from 11 to 20%) against the products in question. Commerce contends that, while China is still a non-market economy for the purposes of U.S. trade laws, economic reforms in China have made several sectors of the economy relatively market based, and therefore it is possible to identify the level of government subsidies given to the Chinese paper firms in question.

Some Members contend that China's currency policy constitutes a form of export subsidy that should be actionable under U.S. countervailing laws. H.R. 782 , H.R. 2942 , S. 364 , and S. 796 would apply U.S. countervailing laws to non-market economies and would also specify that currency misalignment or manipulation be actionable under those laws. Several Members contend that such legislation would be consistent with WTO rules (which allows countries to utilize countervailing duty procedures). However, critics contend that it would be difficult to determine the subsidy level conveyed by China's currency, and possible U.S. countervailing measures applied against China over its currency could be challenged in the WTO.

Apply Estimates of Currency Undervaluation to U.S. Antidumping Measures

U.S. antidumping laws allow U.S. parties to seek relief (in the form of increased duties) from imports that are sold at less than fair value and injure U.S. industries. Many critics of China's currency policy contend that undervaluing the yuan is a major factor affecting the price of Chinese exports to the United States and that this has harmed many U.S. industries. For example, H.R. 2942 and S. 1607 would require the government to factor in the impact of certain fundamentally misaligned currencies on export prices when determining the level of antidumping duties that should be applied. Critics of this approach contend that it would be very difficult to come up with a precise figure on how much a country's currency is undervalued, and it is not clear whether such a method would be compatible with WTO rules on trade remedies.

Utilize Special Safeguard Measures

Another option might be to utilize U.S. trade remedy laws relating to special provisions that were part of China's accession to the WTO. For example, the United States could invoke safeguard provisions (under Sections 421-423 of the 1974 Trade Act, as amended) to impose restrictions on imported Chinese products that have increased in such quantities that they have caused, or threaten to cause, market disruption to U.S. domestic producers. This option could be used to provide temporary relief for U.S. domestic firms that have been negatively affected by a surge in Chinese exports to the United States (regardless of its cause). The sharp increase in textile and apparel imports from China over the past few years led the Bush Administration on a number of occasions to invoke the special China textile and apparel safeguard to restrict imports. Eventually, the Administration sought and obtained (in November 2005) an agreement with China to limit the level of certain textile and apparel exports to the United States through the end of 2008. However, the Bush Administration on six different occasions has chosen not to extend relief to various industries under the China-specific safeguard. H.R. 782 and S. 796 would require that exchange rate misalignment by China be considered a factor in making determinations of market disruption under the China-specific safeguard.

Other Bilateral Commercial Considerations

A number of policy analysts have argued against pushing China too hard on its currency policy, either because it would not serve U.S. economic interests, or because U.S. pressure would likely be ineffective as long as the Chinese government believed changing the peg would damage China's economy. Such analysts argue that U.S. policymakers should address China's currency policy as part of a more comprehensive U.S. trade strategy to persuade China to accelerate economic and trade reforms and to address a wide range of U.S. complaints over China's trade practices. This appears to be the Administration's policy in the SED talks. U.S. officials have urged China to boost domestic consumption while making its currency policy more flexible as part of a long-term solution to global trade imbalances.

Some policymakers contend that the more immediate focus of U.S. trade policy should be on pressing China to comply with its WTO commitments. Major WTO-related issues of concern to the United States include market access, inadequate protection of U.S. intellectual property rights (IPR), industrial policies that promote domestic content over imports, and indirect subsidization of Chinese state-owned enterprises by China's banking system. Because China's WTO commitments are clear and binding, and there is a legal process within the WTO to seek compliance with trade agreements, the United States is in a stronger position to get China to liberalize its economy and open its markets than it would be if it tried to push China to reform its currency regime (where multilateral rules and options on the issue are less clear). Finally, supporters of this policy argue that China's leaders are more likely to respond to pressures to adhere to international rules of conduct than to perceived direct U.S. pressure.

China's Holdings of U.S. Federal Debt Instruments

Many U.S. policymakers have expressed concern over China's large holdings of U.S. federal debt, claiming that China could use it as a political tool against the United States. A recent article in the Telegraph ,"China Threatens 'Nuclear Option' of Dollar Sales," cited interviews with officials from two leading Chinese government think tanks who reportedly stated that China had the power to make the dollar collapse (if it chose to do so) by liquidating large portions of its U.S. Treasuries holdings if the United States imposed trade sanctions to force a yuan revaluation, and that the threat to do so could be used as a "bargaining chip." The article prompted concern among many U.S. policymakers, including Senator Charles Grassley, who, in an August 9, 2007 letter to the Chinese ambassador to the United States, asked the Chinese government to confirm that "the comments do not reflect the official position of the Chinese government." In response, the Chinese ambassador to the United States wrote to Senator Grassley on August 13 that "China does not have a plan to drastically adjust the structure of its foreign reserves." In addition, in an article in the Xinhua News Agency on August 13, an unnamed official at the People's Bank of China was quoted as saying that "dollar-denominated assets, including U.S. government securities, are an important component in China's foreign exchange reserve investment portfolio," and that China was "a responsible investor."

Although a move by China to liquidate a large portion of its dollar-denominated assets would likely have a significant impact on the value of the dollar in international currency markets, it is unlikely China would make such a move. Doing so would likely cause a sharp appreciation of the yuan against the dollar, which would result in a capital loss for China on the sale of Treasuries, lower the value of its remaining U.S. assets, and increase the cost of its exports to the United States. Secondly, such a move could reduce economic growth in the United States (especially if other foreign investors sold their U.S. asset holdings, and the U.S. was forced to raise interest rates in response), which would diminish U.S. demand for imports, including those from China.

On September 29, 2007, the Chinese government officially launched the China Investment Corporation (CIC) in an effort to better manage its foreign exchange reserves. It reportedly will initially manage over $200 billion, making it one of the world's largest state-owned funds. Some contend China might try to diversify away from dollar denominated assets, such as Treasury securities. (Since 2007, China's holding of Treasury securities have increased very little.) It is not clear to what degree such diversification, should it occur, might affect U.S. interest rates.

Changes to the Current Currency Policy and Potential Outcomes

If the Chinese were to allow their currency to be determined by private actors in the market based on the supply and demand for Chinese goods and assets relative to U.S. goods and assets. If the yuan appreciated as a result, this would boost U.S. exports and the output of U.S. producers who compete with the Chinese. The U.S. bilateral trade deficit would likely decline (but not necessarily disappear). At the same time, the Chinese central bank would no longer purchase U.S. assets to maintain the peg. U.S. borrowers, including the federal government, would now need to find new lenders to finance their borrowing, and interest rates in the United States would rise. This would reduce spending on interest-sensitive purchases, such as capital investment, housing (residential investment), and consumer durables. The reduction in investment spending would reduce the long-run size of the U.S. capital stock, and thereby the U.S. economy. In the present context of the falling dollar, some analysts fear that a sudden decline in Chinese demand for U.S. assets (if China was no longer purchasing assets to influence the exchange rate) could lead to a drop in the value of the dollar that could potentially destabilize the U.S. economy. Another concern is that, with inflation rising in the United States, a rise in the value of the yuan could cause import prices to rise and add to inflationary pressures.

If the relative demand for Chinese goods and assets were to fall at some point in the future, the floating exchange rate would depreciate, and the effects would be reversed. Floating exchange rates fluctuate in value frequently and significantly.

A move to a floating exchange rate is typically accompanied by the elimination of capital controls that limit a country's private citizens from freely purchasing and selling foreign currency. Capital controls exist in China today, and arguably one of the major reasons China opposes a floating exchange rate is because it fears that the removal of capital controls would lead to a large private capital outflow from China. This might occur because Chinese citizens fear that their deposits in the potentially insolvent state banking system are unsafe. If the capital outflow were large enough, it could cause the floating exchange rate to depreciate rather than appreciate. If this occurred, the output of U.S. exporters and import-competing firms would be reduced below the prevailing level, and the U.S. bilateral trade deficit would expand. In other words, the United States would still borrow heavily from China, but it would now be private citizens buying U.S. assets instead of the Chinese central bank. China could attempt to float its exchange rate while maintaining its capital controls, at least temporarily. This solution would eliminate the possibility that the currency would depreciate because of a private capital outflow. While this would be unusual, it might be possible. It would likely make it more difficult to impose effective capital controls, however, since the fluctuating currency would offer a much greater profit incentive for evasion.

Another option is to maintain the status quo. Although the nominal exchange rate may continue to rise only slowly in this case, over time the real rate would adjust as inflation rates in the two countries diverged. As the central bank exchanged newly printed yuan for U.S. assets, prices in China would rise along with the money supply until the real exchange rate was brought back into line with the market rate. This would cause the U.S. bilateral trade deficit to decline and expand the output of U.S. exporters and import-competing firms. This real exchange rate adjustment would only occur over time, however, and pressures on the U.S. trade sector would persist in the meantime.

None of the solutions guarantee that the bilateral trade deficit will be eliminated. China is a country with a high saving rate, and the United States is a country with a low saving rate; it is not surprising that their overall trade balances would be in surplus and deficit, respectively. At the bilateral level, it is not unusual for two countries to run persistently imbalanced trade, even with a floating exchange rate. If China can continue its combination of low-cost labor and rapid productivity gains, which have been reducing export prices in yuan terms, its exports to the United States are likely to continue to grow regardless of the exchange rate regime. As evidence, consider that the significant appreciation of the yuan since 2005 has not led to any reduction in the trade deficit.

Conclusion

The current debate among U.S. policymakers over China's currency policy has been strongly linked to concerns over the growing U.S. trade deficit with China, the sharp decline in U.S. manufacturing employment over the past few years, and the rise of China as a major economic power. Since 2005, China's exchange rate has appreciated slowly, but the cumulative change since then has been significant. Most economists agree that China's currency would likely appreciate against the dollar initially if allowed to float (barring any disruption in China's financial sector), although market forces could drive it up or down in the long run as conditions change. But the failure of the bilateral trade deficit to fall in response to the appreciation that has occurred thus far suggests that it is caused by more than just the value of the yuan.

If the yuan were to appreciate, there is considerable debate over the net effects this policy would have on the U.S. economy since it may benefit some U.S. economic sectors and harm other sectors, as well as consumers. The trade deficit with China has not prevented the United States from reaching full employment. In addition, U.S. trade with China is only one of a number of factors affecting manufacturing employment, including increased productivity growth, employment shifts to the service sector, and the overall trade deficit. It is also not clear to what extent production in certain industrial sectors has shifted to China from the United States, as opposed to shifting to China from other low-wage countries, such as Mexico, Thailand, and Indonesia. The extensive involvement of foreign multilateral corporations in China's manufactured exports further complicates the issue of who really benefits from China's trade, as well as the implications of a rising U.S. trade deficit with China (since a large share of U.S. imports are coming from foreign firms, including U.S. firms, that have shifted production from one country to China). The effects of an appreciating yuan can also be considered in the broader context of concerns about the potentially destabilizing effects of the falling dollar. By definition, increases in the value of the yuan are equivalent to decreases in the value of the dollar, so China's accumulation of U.S. assets retards the rate at which the dollar falls. Thus, there is considerable debate over what policy options would promote U.S. economic interests since changes to the current system would produce both winners and losers in the United States (as well as in China).

Chinese officials have stated they plan to make the currency more flexible in the near term and to eventually adopt a floating currency in the long run, but they insist that reforms should be gradual in order to avoid disruptions to the economy. For example, they claim they need to first implement further reforms to the banking system and to reduce the level of non-performing loans. Yet the present currency policy may be undermining these efforts by expanding the money supply (as a result of the accumulation of foreign reserves). A rising money supply promotes easy credit policies by the banks—which could result in more non-performing loans. Efforts to limit bank loans in booming sectors of the economy have mainly been the result of government administrative directives rather than market forces, which may undermine the ability to establish a market-based financial system where monetary policy is used to halt inflation and bank loans are extended to ventures that offer the highest rate of return. In addition, China's currency policy constitutes a de facto subsidy, which, while benefitting some export industries, undermines other sectors, and prevents the most efficient distribution of resources in the economy.

While U.S. officials acknowledge China's concerns over exchange rate reforms, they contend that China's exchange rate reforms are overly cautious. They further contend that China's currency policy is preventing adjustments in global trade imbalances, especially in the United States, and that this could eventually undermine world economic growth. This would hurt China's economy, given its dependence on exports. Both U.S. and Chinese officials publicly agree that China needs to undertake major economic reforms to boost domestic consumption and to obtain more even growth, and that the United States must do more to boost its level of domestic saving. China officials have stated their intention to boost economic development in the hinterland and expand spending on social security, health care, and education. However, this will likely take many years to implement.

Legislation in the 110th Congress

Currency legislation in the 110 th Congress on China's currency policy include the following:

H.R. 321 (English) would require the Treasury Department to determine if China has manipulated its currency and to estimate the rate of that manipulation (if such a determination were made), which then would require the imposition of additional tariffs on Chinese products (equal to the estimated rate of manipulation). The bill also calls on the United States to file a WTO case against China over its currency policy and to work within the WTO to modify and clarify rules regarding currency manipulation. H.R. 782 (Tim Ryan)/ S. 796 (Bunning) would apply U.S. countervailing laws (dealing with government subsidies) to products imported from non-market economies (such as China) and would establish an alternative methodology for estimating the amount of government subsidy benefit provided if information is not available on the amount of subsidies given to various industries in that country. The bills also make exchange rate misalignment actionable under U.S. countervailing law, require the Treasury Department to determine whether a currency is misaligned in its semi-annual reports to Congress on exchange rates, prohibit the Department of Defense from purchasing certain products imported from China if it is determined that China's currency misalignment has disrupted U.S. defense industries, and would include currency misalignment as a factor in determining (China-specific) safeguard measures on imports of Chinese products that cause market disruption. H.R. 1002 (Spratt) would impose 27.5% in additional tariffs on Chinese goods unless the President certifies that China is no longer manipulating its currency. H.R. 2942 (Tim Ryan) would apply countervailing laws to nonmarket economies, make an undervalued currency a factor in determining antidumping and countervailing duties, require Treasury to identify fundamentally misaligned currencies and to list those meeting that criteria for priority action. If consultations fail to resolve the currency issues, the USTR would be required to take action in the WTO. S. 364 (Rockefeller) would apply U.S. countervailing laws on non-market economies and would make exchange rate manipulation actionable under such laws. S. 1607 (Baucus) would require the Treasury Department to identify currencies that are fundamentally misaligned and to designate such currencies for priority action under certain circumstances in its semi-annual reports to Congress on exchange rates. If after consultations the country maintaining the designated currency policy fails to adopt appropriate policies within 180 days, the U.S. would make currency undervaluation a factor in determining antidumping duties, ban federal procurement of products or services from the designated country, bar financing by the U.S. Overseas Private Investment Corporation (OPIC), and would require U.S. officials to oppose multilateral financing for that country. If the designated country failed to take appropriate measures, the USTR would be required to file a case in the WTO, and the Treasury Department would be directed to consider taking remedial intervention in international currency markets. A modified version of the bill passed the Senate Finance Committee on July 31, 2007. S. 1677 (Dodd) requires the Treasury Department to identify countries that manipulate their currencies regardless of their intent and to submit an action plan for ending the manipulation; and gives Treasury the authority to file a case in the WTO. The bill was approved by the Senate Banking Committee on August 1, 2007. S. 2813 (Bunning) would also require the Treasury Department to identify currency manipulators, submit an action plan to end the manipulation, and to consult with the IMF.

A side-by-side comparison of five major currency bills: S. 1607 (as introduced), S. 1677 , H.R. 782 , and S. 796 (which are identical), and H.R. 2942 ) follows ( Table 8 ).

Appendix. Legislation in the 109th Congress

Several bills were introduced in the 109 th Congress to deal with foreign exchange rate policies. This section offers a summary of bills that saw legislative action.

S.Amdt. 309 (Schumer) to S. 600 would impose a 27.5% tariff on Chinese goods if China failed to substantially appreciate its currency to market levels. On April 6, 2005, the Senate failed (by a vote of 33 to 67) to reject the amendment, In response to the vote, the Senate leadership moved to allow a vote on S. 295 (which has same language as S.Amdt. 309 ) no later than July 27, 2005, as long as the sponsors of the amendment agreed not to sponsor similar amendments for the duration of the 109 th Congress. However, on June 30, 2005, Senator Schumer and other sponsors of S. 295 agreed to delay consideration of the bill after they received a briefing from Administration officials and were told that China was expected to make significant progress on reforming its currency over the next few months. Disappointment over China's July 2005 currency reforms led Senator Schumer to push for consideration of S. 295 (under the previous compromise). On November 16, 2005, the Senate agreed to consider the bill no later than March 31, 2006. On March 28, 2006, Senators Schumer and Graham stated that they would move to delay taking up S. 295 in the Senate, based on their assessment during a trip to China that the Chinese government was serious about reforming its currency policy. However, on September 14, 2006, Senator Schumer stated that he was disappointed with China's movement to date on currency flexibility, and requested the Senate to take up S. 295 . On September 28, 2006, Senators Schumer and Graham announced that they had been persuaded by President Bush not to pursue a vote on S. 295 in order to give Secretary of Treasury Henry Paulson more time to negotiate with China on its currency policy. H.R. 3283 (English) would (among other things) apply U.S. countervailing laws (dealing with foreign government subsidies) to non-market economies (such as China); and require the Treasury Department to define "currency manipulation," describe actions that would be considered to constitute manipulation, and report on China's new currency regime. The bill passed (255 to 168) on July 27, 2005. A similar bill was introduced in the Senate, S. 1421 (Collins).