China, the United States and the IMF: Negotiating Exchange Rate Adjustment
Released: 2006-07-19T00:00:00

Scope and Content

Overview

In recent years, there has been growing concern in the United States and elsewhere that Chinamay be manipulating the value of its currency to gain unfair trade advantages. Many believe thatChina's national currency, the yuan or renminbi (RMB), may be seriously undervalued compared tothe dollar and other major currencies. (1) The United States and other countries have urged China to raisethe value of its currency. Chinese officials say they want to make their exchange rate system moreflexible, but they say China also needs long-term stability in its currency value in order to avoidinternal dislocations. Discussion of this question has taken place at the International Monetary Fund(IMF) and at other multilateral fora such as the periodic meetings of the G-8 (the seven largestindustrial countries plus Russia.) The United States and other countries have also spoken directlyto China on a bilateral basis about this issue.

The key issue is what -- if the yuan is undervalued -- China and the world should do aboutit. China is undergoing a major shift from a state-dominated to a market-based economy. It haspursued a policy of export-led growth in order to generate the employment and income necessaryto facilitate change in the overall structure of its economy. It has priced its currency in order tofacilitate that policy.

In July 2005, China adopted reforms aimed at giving market forces a possible role in thevaluation of the yuan. Most observers say the initial changes (a 2% rise in value) were too small andthey note that little change has occurred since. Chinese officials retain firm control over themechanisms which produce the yuan-dollar exchange rate and the criteria they use in this processremain opaque. International discussions have sought to persuade China to accelerate the process but-- while the concerns of other countries may bear weight in the thinking of Chinese officials -- thereare no effective "teeth" in the International Monetary Fund that could compel China to change itspolicies and procedures more rapidly than it wishes to do so.

Many in the United States believe that the large volume of Chinese exports to the UnitedStates is damaging the U.S. manufacturing sector and feeding the U.S. trade deficit. They believethat the undervalued yuan is an important reason why China is able to price its goods socompetitively and why production in many areas is shifting to China. Other analysts believe that --by virtue of its undervalued currency -- China is damaging the world trading system and denyingexport opportunities to other countries whose currencies are more fairly priced. Congress isconsidering legislation which would place countervailing duties or special tariffs on Chinese goodsentering the U.S. in order to offset the trade benefits China presumably gains from its presentexchange rate policies.

This Report in Four Parts

Events and Issues. This report has four parts. The first part discusses the issues and events surrounding the yuan-dollar controversy. It describesthe actions which Chinese authorities have taken to revalue the yuan and, arguably, to lay thegroundwork for a larger future role for market forces in its valuation. It also describes the methodsthe Chinese authorities have used and still use to hold the value of the yuan at the level they prefer. This section discusses the efforts the International Monetary Fund, the U.S. Government and othergovernments have made to encourage or press China to revalue its currency. It also reviews the U.S.Treasury Department's discussion of China in its semi-annual report on currency manipulation andlegislation currently pending in Congress which would levy special duties on Chinese goods if theyuan is not increased considerably in value.

Five Questions which Frame the Controversy. The second part of this report looks at five central questions. First, is the yuan undervalued and,if so, by how much? This question may be harder to answer than many people assume. Mosteconomists agree the yuan is undervalued, but the 17 studies reviewed in this report show widelydifferent conclusions. Some say the yuan is slightly overvalued , others say it is 15% or 25% orperhaps 49% undervalued , while several say it is impossible to make an accurate computation. Thedata are poor, China is changing rapidly, and scholars use different assumptions in their studies. Moreover, new economic data published in December 2005 seem to render all previous studiesobsolete, as they give a very different picture of the Chinese economy than was available before. Inrecent studies, IMF experts say the yuan is undervalued but they also say it is impossible to knowhow large the distortion might be. The IMF also says that it is impossible to separate the tradeeffects of that distortion from the other factors (labor costs, productivity, etc.) which also affect theprice of Chinese goods.

Without some objective way of determining what the "real" value of the yuan might be, itmay be difficult for China and other countries to agree what size increase is "enough." Likewise,without knowing the proper rate, it might be difficult to design special U.S. tariffs which the worldwould consider fair and compensatory rather than arbitrary or punitive. It might be helpful if China,the United States and other countries could agree on criteria by which to decide how an appropriateexchange rate for the dollar and yuan might be determined.

Second, does China manipulate the value of the yuan? The IMF rules state that countriesmay not manipulate the value of their currency in order to gain unfair trade advantage. The secondsection of this report examines China's behavior in light of the five standards the IMF uses to judgewhether manipulation is taking place. The IMF has not publicly declared that China is manipulatingits currency. China's actions seem to meet four of the IMF's criteria in this regard. The IMF has noevident means other than persuasion to make countries comply with its rules. In this context, it isnot clear that an IMF announcement that China was violating its rules would help or hinder thecurrent discussions aimed at persuading China to raise the value of the yuan.

Third, how fast could China revalue the yuan if it wanted to? Theoretically, the People'sBank of China could raise the exchange value of the yuan to any specified level overnight. However, Chinese officials are concerned about the growth and employment effects any change in the valueof the yuan may have on their economy. A too-rapid increase might have serious negative effectson employment, output and growth. Some also worry that "hot money" could complicate the processof revaluation and may require China to delay any changes until the perceived speculative pressureabates. Many experts believe that a gradual and measured approach to currency revaluation isappropriate for China. The IMF says, for example, that emerging market countries generally do nothandle rapid and large exchange rate movements well and that serious dislocations can occur. Othersbelieve, however, that basic fairness to other countries requires China to raise the value of itscurrency. Some analysts believe China could suffer serious damage to its economy if it does notchange is economic strategy. Its heavy reliance on export-led growth makes it vulnerable, forexample, to a slowdown in world demand. Higher currency values would stimulate growth of itsdomestic economy.

Fourth, has China "cooked the books" in terms of its trade surplus? Some analystsbelieve that China's actual net income from trade is many times larger than that which China'spublishes in its official trade statistics. Data published by the IMF show that, while China reportsthat it had a net trade surplus of $41 billion in 2004, its trading partners report that they had acombined trade deficit of $267 billion with China. Some people say that a trade surplus this largeis proof that China's currency is substantially undervalued.

Others would ask, however, where -- if China is accruing an extra $200 billion annually intrade income beyond the amounts accounted for in its balance of payments figures -- that moneymight be. It might be hard, for example, for China to hide all this additional income year after yearin secret undeclared foreign exchange reserves without somebody discovering that it exists.

Trade data for other countries also show (though on a smaller scale) this same mismatchbetween the amount reported by exporter countries and the amounts reported by those who importtheir products. Bad data collection by individual countries and methodological problems in thereporting system seem to be better explanations for these discrepancies than is the uniform prospectthat exporters fudge their data while importers report their incoming trade data correctly.

Fifth, would the U.S. economy benefit if China revalued the yuan? Correcting theinternational value of the yuan may improve the efficiency of international trade. But will it reducethe U.S. trade deficit and strengthen the U.S. manufacturing sector? Most economists believe not. The U.S. and Chinese economies have become increasingly interdependent in recent years. Chinais pursuing a policy of export-led growth and the United States provides a ready market for its goods. Meanwhile, the United States imports large quantities of capital from abroad (by borrowing or byopening its economy to foreign investment) and -- in order (more money chasing the same quantityof goods) to avoid turning that imported money into inflation -- it must also import goods andservices for the imported money to buy. If China raised the value of the yuan, its exports to theUnited States would likely shrink and the amount of money it could place in the U.S. economywould decline.

Multinational firms based in the United States are a major presence in the Chinese economyand a large share of China's exports to the United States are produced by or mediated through thosefirms. For them, the undervalued yuan provides major benefits because it keeps down theirproduction costs and it enables them to produce things which might be too costly to produce in theUnited States. U.S. consumers who purchase the output from these facilities in China are able to getmore product at a lower cost than they would be able to get if the products were produceddomestically or if the value of the yuan were higher. These firms say they need to produce someof their output in low-cost places such as China and they would move their facilities elsewhere (butnot back to the United States) if China were no longer available to them.

On the other hand, many U.S.-based small and medium size enterprises cannot or wish notto move their operations abroad. For them, the undervalued yuan is a major threat to theircommercial viability and their bottom line. To compete with goods produced in China, they mustreduce their costs (perhaps by economizing on labor or lowering their profit margins), find non-pricebased reasons for consumers to prefer their products to those produced abroad, merge some of theiroperations with similarly affected domestic firms, or seek some type of political remedy to shieldthem from the foreign competition.

Temporarily, if exports from China were restricted because of trade legislation, U.S.producers might be able to take over some of the market (albeit at higher prices) previously suppliedby China. From a longer perspective, though, it is likely that multinational firms would shift muchof their production to other low-cost countries and these would ramp up their exports in order tosupply the U.S. market previously supplied by Chinese goods. The inflow of foreign goods mightdecline and U.S. manufactured goods might be more competitive in U.S. and foreign markets if theU.S. savings rate increased, the United States borrowed less and received fewer investments fromabroad, and the international value of the dollar declined. (2) However, this would require major changes in American economicbehavior which cannot be easily legislated.

It is difficult to know on a net basis whether the U.S. economy benefits or whether on a netbasis it is hurt from the low cost of products it imports from China. The interests of the large andsmall-to-medium sized firms appear to conflict and the interests of U.S. consumers seem to conflictin some ways with the interests of some U.S. producers of products which compete with Chineseexports. From an economic point of view, the profit margins realized by the Chinese exportersappear to be relatively small whereas the profit margins earned by the distributors of those productsin the United States may be higher. Meanwhile, though the data are not clear, many experts believethat on a trade-weighted basis, the U.S. producers benefit more from their exports to China thanChinese exporters do on their sales to the United States. At the same time, China's investments inthe United States provide badly needed capital which helps spur growth in the American economyat the same time that the growing volume of debt owed to foreigners increases the internationalexposure of the U.S. economy. Weighing all of these factors together in order to determine on anoverall basis whether the undervalued yuan is a benefit or burden to the U.S. economy is a difficulttask.

Three Dilemmas for China. The third section ofthis report looks at some of the monetary and financial dilemmas which affect China's views aboutexchange rate policy. First, what should China do about its foreign exchange (forex) reserves? Chinahas $819 billion in foreign exchange reserves (rough 70% in dollars). These are an important sourceof income, influence, and future spending power. However, they are also a problem. For one thing,the growth in China's forex reserves fuels domestic inflation. For every dollar the People's Bank ofChina buys (to hold down the value of the yuan and to increase its reserves), it injects 8 yuan intoChina's economy. China's reserves grew by $100 billion in 2005, so this is a lot of new "printingpress" money. The central bank has tried with limited success to bottle up the inflationary effect ofthis money with public debt transactions and tight monetary policy. If China raised the value of theyuan, the growth in its foreign exchange reserves would slow or stop and -- if it relaxed its monetarypolicy -- the growth and reform prospects of its internal economy might be enhanced.

On the other hand, revaluation would cost China a great deal of money. If the yuan increasedin value by 20%, the purchasing power of China's foreign reserves would go down corresponding. It would lose, from China's perspective, about 1.3 trillion yuan (about $200 billion) in purchasingpower. If China began withdrawing assets from the U.S. market and converting them to othercurrencies, in order to reduce its exposure, it would lose money because its actions would push downthe value of the securities and the dollars it sold. When it purchased other currencies and foreignassets to replace its former U.S. holdings, it would lose money again because its actions would alsopush up their prices. Chinese officials may want to reduce the inflationary pressure which comesfrom growth in their foreign exchange reserves but they may not be happy about the prospect ofmajor financial losses if they revalue or if they move their current assets elsewhere.

Second, where is the money coming from that fuels those growing reserves? Many peoplebelieve that exports and incoming foreign investment account for most of the increase in China'sforeign exchange reserves. Some suggest, however, that "hot money" -- speculative inflows offoreign funds seeking to profit from revaluation of the yuan -- may account for most of the growthin China's reserves.

Depending on the source of the money, the policy implications for China are very different. If trade and investment are the main source of the funds, then -- if Chinese officials want to slow thegrowth in reserves -- they should raise the value of the yuan. However, if speculative inflows arethe primary source, then China's policy choices are more difficult. A large quick revaluation wouldstop the speculative pressure but it might also damage China's economy. Gradual increases wouldallow the Chinese economy to adjust but it might also encourage speculators to bring more moneyinto China in hopes of profiting as the currency goes up in value. A refusal to consider any changein the value might discourage the speculators over a long period of time. But if the status quoprevailed during that period, this would also make China's trading partners angry and give themreasons to doubt whether Chinese officials are sincere when they say they want to revalue the yuan.

Third, would revaluation strengthen or weaken China's banking system? China's banksare riddled with bad debt and their competitiveness weakened by years of state control. If the yuanwere increased in value, would the shock cause Chinese banks to strengthen their procedures orwould it put the system at risk? A change in exchange rates which weakened the export sectorwithout simultaneously stimulating domestic commerce could hold bad news for China's banks.

Some experts point out that Chinese banks hold only a small portion of their assets in foreigncurrencies and the government has recently established asset management companies (similar to themechanisms the U.S. Government used in the 1980s to resolve the U.S. savings and loan crisis) totake bad debt off the books of the banks. However, export-related activities account for a majorshare of the customers in China's banking system. Nevertheless, most experts agree that bad debts(non-performing assets) account for perhaps 30% of the assets of Chinese banks and they say thegovernment will need to spend hundreds of billions of dollars in yuan to recapitalize and restructurethe major banks. The IMF says that the strength of China's banking system should not be animpediment to a gradual increase in the value of the yuan. However, Chinese officials haveexpressed reservations and may not be willing to revalue the yuan very quickly until their concernsabout the impact on their national banking system have been alleviated. External pressure to revaluerapidly might be seen as an effort by foreigners to create more opportunities for their firms to buyailing Chinese banks.

Policy Options for the United States. The fourthpart of this report identifies five major options which U.S. policy-makers might consider if theywant to encourage China to revalue the yuan. They are not mutually exclusive, though it might bedifficult for some of them to be pursued simultaneously.

First, the United States could continue pressing China publicly for further changes in itsforeign exchange system, in order that the yuan's value would better reflect market conditions andeconomic realities. If Chinese reformers need outside pressure to help them persuade other officialsto consider reform, this strategy might help. Second, as a reciprocal of the first option, U.S.policy-makers might refrain from pressing China to move more quickly with its reforms. This mightbe an effective strategy if the Chinese proponents of change find that outside pressure strengthensthe hand of those resisting reform.

Third, the United States could levy special tariffs on Chinese imports in an effort toencourage China to be more accommodating in their discussions with the United States about theyuan. However, such duties may violate WTO rules. Also, Chinese exporters may be able to absorbsome of the cost of the new duties. Further, if the yuan were revalued, the price of Chinese exportswould need not increase by the same rate as did the yuan. Chinese exports include a high proportionof inputs imported from other countries. The price of those inputs would not change if the yuan wentup in value. To break even, producers in China would only need to increase the price of their exportsby an amount which reflects the higher dollar-equivalent cost of Chinese-produced inputs and laborpaid in yuan.

Fourth and fifth, the United States might refer the dollar-yuan controversy to the IMF or theWorld Trade Organization. As noted above, this issue has been discussed at the IMF for some time. Proposed changes in the power of the IMF might give it more authority over country exchange ratepolicies, including authority to address problems of manipulation. Whether China would be themain country affected, whether the United States and other countries would allow the IMF todetermine their exchange rates, and what impact these rule changes might have on the policies of thecountries with the world's largest economies are matters for speculation.

An appeal to the WTO might be based on the grounds that China's undervalued currencyallegedly constitutes a subsidy to its export sector. The WTO can evaluate trade disputes and it canauthorize countries to levy trade penalties in order to enforce its decisions. However, it has noauthority to judge exchange rate issues. The WTO and IMF have an agreement, though, specifyingthat any exchange rate issues which arise in WTO deliberations shall be referred to the IMF and theIMF's decision shall be final. In effect, the WTO would be the enforcer if the IMF decided that acountry was manipulating its currency to gain unfair trade advantage.

Issues and Events

Yuan-Dollar Exchange Rate Issue

The Controversy. In 1994, the People's Bank ofChina (PBC) lowered the value of its currency from 5.8 to about 8.7 yuan to the dollar. The rategradually settled by 1997 to 8.3 and was locked at that rate during the Asian financial crisis. In thepast dozen years, China's economy has grown substantially, both in size and in the level ofmodernization, and the proportion of its economy oriented towards exports has increasedconsiderably. One might expect that these changes would have had an impact as well on the relativeexchange value of China's currency, particularly its rate compared to the U.S. dollar as the UnitedStates became China's most important single export market. However, the value of the yuanremained largely unchanged during most of that period and it remained fixed at 8.3 yuan to the dollarafter 1997 as the People's Bank of China (PBC) sold yuan into the market in order to keep the yuan'svalue constant. Many argue that this constitutes manipulation.

Arguments Pro and Con. Many argue that Chinais manipulating the value of its currency in order to gain unfair trade advantage. (3) They believe this has seriouslyinjured the manufacturing sector in the United States and contributed significantly to the U.S. tradedeficit.

The act of currency manipulation is often hard to see. However, the effect of manipulationon currency prices is more apparent. Critics of China's exchange rate policies argue that China'scurrency is perhaps 25% to 50% undervalued compared to the U.S. dollar. They cite various studieswhich support their view. They say the undervalued yuan adds to the U.S. trade deficit and hurtsU.S. output and employment. Many have urged the Administration to put pressure on China in orderto make it stop manipulating the yuan. They say China should either raise the value of the yuan byofficial action ("revalue") or let it trade freely in foreign exchange markets ("float") so that the freemarket can determine its real international value.

The issue of manipulation is controversial. The IMF says, in its Articles of Agreement(Article IV), that countries shall "Avoid manipulating exchange rates or the international monetarysystem in order to prevent effective balance of payments adjustment or to gain an unfair competitiveadvantage over other members." (4) Member countries are supposed to comply with this requirement. In addition, the U.S. Omnibus Trade and Competitiveness Act of 1988 requires that the Secretaryof the Treasury determine whether other countries "manipulate the rate of exchange between theircurrency and the United States dollar for the purpose of preventing effective balance of paymentsadjustments or gaining unfair competitive advantage in international trade." (5)

Chinese officials say they are not trying to gain unfair trade advantage with their foreignexchange policies. Rather, they are seeking economic stability. China is experiencing rapid andfar-reaching economic changes, they say. Major reforms in China's economic policies andinstitutions have taken place, in this view, but more are yet needed. The economy has grown rapidlyin the past decade, they say, but the distribution of the benefits has been uneven and the strainsbetween the needs of the old economy and the new economy are great. Meanwhile, they say, theexport sector is the engine of growth for the Chinese economy.

Chinese officials acknowledge that China's foreign exchange policies stimulate economicgrowth. However, they say, the goal is not the attainment of unfair trade advantage but rathercontinued growth in the export sector. Many Chinese export industries operate on very thin profitmargins, they report, and an increase in the value of the yuan would lead to widespread bankruptcies. China's export sector is the engine driving the growth and modernization of China's nationaleconomy. A downturn in that sector would lead to a slowdown in growth or even a decline in thenational economy as a whole. This could lead to widespread instability, they say, with potentiallyserious consequences. Thus, they believe, China's exchange rate policy is aimed at promotingstability in the country's export sector and economy as a whole. Achieving trade advantages throughundervaluation of the currency is only an instrumental means towards the achievement of this goal. From this point of view, efforts by foreigners to raise the exchange rate for China's currency areaimed not merely at the elimination of this trade advantage but at undercutting China's economic andpolitical stability and at thwarting its emergence as a great power.

Chinese officials have not entered into the debate concerning the "real" value of China'scurrency, though some say there is no convincing evidence that the yuan is undervalued. They couldcite econometric studies (see below) which support the view that China's currency is slightlyovervalued or perhaps only a little undervalued compared to the dollar.

Many economists doubt that China's actions have had any appreciable impact on thelong-term value of the dollar. The dollar plays a broad role in international finance and the amountof dollars in circulation globally is very large. A recent survey by the world's leading central banksindicated that the daily trading of foreign currencies totals more than $1.9 trillion, 90% of which isin dollars. (6)

China Announces a Change. On July 21, 2005,China's central bank announced a new exchange rate system for China's currency. First, it increasedthe value of the yuan, which rose from 8.28 to 8.11 to the dollar. (7) Second, the yuan would bereferenced, not just to the dollar but to a basket of currencies, and it would be allowed to vary by0.3% each day above or below a central parity. Third, the central bank said that "the closing priceof...the US dollar traded against the RMB [yuan]...after the closing...of the market each working day"would become "the central parity for the...following working day." (8) This seemed to be anexchange system which economists call a "crawling peg."

If the new procedure had been allowed to function as announced, the yuan could haveincreased in value by 30% in five months. On July 27, 2005, however, the central bank announcedthat no further changes in the value of the yuan should be expected. Rather, it said, China's newsystem would be a "managed float." The central bank would compare the value of the yuan to a"basket" of currencies issued by its major trading partners. However, the Chinese authorities madeit clear that they would decide what the value of the yuan would be and they would determine whenand how liberalization might occur. The yuan might fluctuate compared to other currencies, butthey said its dollar value would be fixed.

Too Small? To many observers, the 2% increasein the value of the yuan announced in July 2005 was too small and the process for possible futureincreases was too obscure and uncertain. Some might argue that the changes in the new systemreflect the current debate about economic policy within the Chinese leadership. Some Chineseofficials may believe that reform, including liberalization of the yuan, is in China's best interest. Others may believe that China must continue the policy of export-led growth and the advantages ofthe old system should not be disposed of lightly.

From this perspective, some might say the new system was adopted in order to buy time, todelay reform, and to forestall outside pressure. China was scheduled to discuss its exchange ratepolicies with the IMF executive board in August 2005 and the advent of a new system gave theChinese something new to present. The IMF board was critical of China's exchange rate policies in2004 and IMF staff had strongly urged China in mid-2005 to introduce market forces into China'sexchange rate regime. The change was also announced just before Congress was scheduled toconsider several bills which sought to put pressure on China if it did not revalue its currency. Arguably, a series of ambiguous steps which seemed to herald change might buy China time toconsider its options and lay its plans. It might give the IMF board a reason not to press for fasteraction and it might persuade Congress to postpone action on the pending bills. (9)

Alternatively, instead of seeing the new system as the product of internal debate, one mightsay that it is obscure because it seeks to confuse and frustrate speculators. The inflow of speculative"hot money" is serious. An official with China's State Administration of Foreign Exchangereportedly observed that "Whether we [can] effectively refrain speculation on yuan is the key to thesuccess or failure of the reform." (10) If China wants to avoid instability and sharp changes incurrency prices, its actions must not invite speculators to bring in more foreign currency and buymore yuan. In effect, China faces a challenge of doing what the speculators expect -- increase thevalue of the yuan -- without encouraging them to capitalize on their expectations.

The old system offered speculators a one-way, no-risk bet, since there was little chance theyuan would fall in value whereas there seemed a real possibility that the value would eventually rise,perhaps substantially. This offered potentially large rewards to those who owned yuan oryuan-denominated assets. (11) The inflow of speculative money puts pressure on China torevalue the yuan to reduce the flow. (12) However, if the increase were not sudden and massive,speculators might be encouraged to buy more yuan in hopes of profiting as it goes up in value. Aslong as there is a general expectation that the yuan is underpriced and as long as these speculativeflows continue, Chinese officials are reluctant to allow the market to determine the yuan's value. They worry that it might increase too much in value ("overshoot") if it were opened suddenly tomarket forces and this could also have negative consequences for the Chinese and world economies.

New Initiatives Since July 2005. More recently,the Chinese authorities have taken other steps that could allow market forces to eventually play a rolein the valuation of the yuan. In mid-2005, they created a system of non-deliverable forwardcontracts which let individuals take positions and make predictions as to the future value of theyuan. (13)

In January 2006, China's State Administration of Foreign Exchange (SAFE) authorized 13local and foreign banks (14) to buy and sell yuan for dollars in the yuan spot market. Anexperiment allowing some banks to trade yuan for euros and Hong Kong dollars had begun in 2005. The new arrangement is supposed to improve liquidity and allow market forces a role in thevaluation of the yuan. Under the new rule, the opening price for the yuan would be determined bythe average closing price of the 13 banks (with the two most extreme eliminated.) In principle, thiswould allow yuan to move up or down in value in response to market forces. However, observersassert that the central bank remains the biggest trader in the yuan-dollar market and any bank whichquotes too high a rate will be vulnerable if it floods the market with yuan in order to keep the rateat its preferred price.

In December 2005, the Chinese authorities took two additional steps that would either reducethe demand for yuan or increase the demand in China for dollars. The central bank announced thatit was raising the interest rate for deposits held in U.S. or Hong Kong dollars, widening the gapbetween those rates and those paid for accounts denominated in yuan. (15) This was aimed atdiscouraging speculators from buying yuan in hopes they can turn a profit by converting them backinto dollars if, in the near future, the yuan should increase substantially in value.

The central bank also announced that it would soon scrap the existing limits on the amountsthat Chinese firms could take out of the country. (16) This could marginally push down the value of the yuan whenChinese firms sold their national currency in order to purchase the dollars needed to expand theiroverseas operations.

Market Expectations. The dollar exchange ratefor the yuan has changed by only a little more than one-half of 1% since the new system wasintroduced, going from Rmb 8.11 to the dollar on July 21, 2005 to Rmb 8.0424 to the dollar onFebruary 26, 2006. The People's Bank of China retains firm control of the exchange rate throughits transactions in foreign exchange markets. In January 2006, futures contracts suggested thattraders believed the value of the yuan would rise 2.1% (to Rmb 7.86 to the dollar) in six months and4.3% by the end of 2006. A global markets analyst for Goldman Sachs predicted, by contrast, thatthe value of the yuan would increase by 9% (to Rmb 7.34) by the end of the year. (17) The EconomistIntelligence Unit said the yuan would rise 4.4% in 2006 (to Rmb 7.9) and 3.7% in 2006 (to Rmb7.6.) (18)

These predictions assume that the People's Bank of China will bring these results aboutthrough its exchange market transactions or (to say the same thing) that it will not act to preventmarket forces from generating these rates of exchange.

International Views

Efforts by the IMF. The IMF staff proposed, inits June 2005 report on its recent Article IV consultations, that China should revise its foreignexchange policies and allow the market to play a larger role in the valuation of the yuan. (19) The IMF executive boardhad the report prior to its formal review of China's policies, though the actual document was notpublished until September.

The IMF executive board discussed China's new exchange rate policies during its August2005 annual Article IV consultation review. Many people believe that China announced its newpolicies two weeks before that meeting in order to show they were addressing the issue. The previousyear, during its August 2004 review of China's policies, the board had said that greater exchange rateflexibility was in China's best interests. (20) It also welcomed China's statement that it would "introduce, ina phased manner, greater exchange rate flexibility." Some observers suggest that it might have beenawkward for China to go to the 2005 meeting and report that it had done nothing.

In its August 2005 review, the IMF executive board "welcomed the change in the exchangerate regime -- an important move toward greater exchange rate flexibility -- and encouraged theauthorities to utilize the flexibility afforded by the new arrangement." It reiterated its earlier pointthat greater exchange rate flexibility was both necessary and in China's best interests. (21) It also said that "a moreflexible exchange rate, not simply a revaluation, is the key to providing scope for monetary policyindependence and enhancing the economy's resilience to external shocks." According to thesummary of the board discussion, most directors supported a gradual and cautious approach butmany others recommended that China move quickly to a foreign exchange level which reflectsunderlying market forces.

Other Countries' Views. No other country hastaken as strong a public position on the Chinese exchange rate issue as has the United States, eventhough the low cost of Chinese exports has been a source of concern to interests in their countriesas well. Nevertheless, some other countries reportedly have been vigorous in their privatediscussions with Chinese officials, urging them to give market forces a larger role in determiningthe value of the yuan. Their public statements have tended to show patience with China's concerns. Some observers suggested that they preferred to let the United States do the "heavy lifting."

Some countries have spoken out. In early June 2005, for example, David Dodge, Governorof the Bank of Canada, called on China to free its currency from the fixed rate against the U.S.dollar or to risk sparking U.S. and European trade protectionism. (22) At the same time, Japan'sfinance minister urged China to reform its tight currency peg on grounds that the current yuan-dollarexchange rate was hurting the Chinese economy and causing it to overheat. (23)

European ministers reportedly have been more accommodating in their remarks. Forexample, Chinese Premier Wen Jiabao told an Asia-Europe ministerial meeting in June 2005 thatChina would adopt a more flexible currency policy only when it believed itself ready. Europeanministers replied, in their public statements, that they hoped it would not take too long (24) but they agreed that Chinashould not be pressured and it had the right to determine when and how it would reform itscurrency. (25)

Since July 2005, observers have been waiting for an announcement by China that it wouldfurther liberalize its exchange rate policy. The IMF executive board urged this at its discussion ofChina's policies in August 2005. The governing boards of the IMF and World Bank urged it at theirjoint annual meetings in late September 2005. Treasury Secretary Snow urged it during his October2005 trip to China. President Bush reiterated the point during a state visit to China in November2005.

In September 2005, the finance ministers of the G-7 countries said, in the communiquefollowing a meeting in Washington, D.C., that "we welcome the recent decision by the Chineseauthorities to pursue greater flexibility in their exchange rate regime." (26) This was the first time aG-7 communique had called on China by name to take action. "We expect the development of thismore market-oriented system to improve the functioning and stability of the global economy and theinternational monetary system," they added. China's President told the G-8 leaders that China wantedto base the yuan's value on market forces but it would do this on its own time and not as a result offoreign pressure. (27)

The G-7 finance ministers were even more specific in their communique following theirmeeting in London on December 3, 2005. They said that "further implementation of China'scurrency system would improve the functioning and stability of the global economy and theinternational monetary system." They said, in language not directly mentioning China, that suchdisparities, along with high oil prices, were a threat to a "solid" world economy. (28) They also said that"exchange rates should reflect economic fundamentals" and that they would monitor exchangemarkets closely. This was much stronger language than the "welcome" the ministers had expressedthree months earlier.

Individual leaders were even more specific in their remarks. European Central Bankpresident Jean-Claude Trichet said at the time that the G-7's public comments were "in continuitywith the message that we have been giving." He also said, referring to Asia, that "this part of theworld has to contribute to the solution of global imbalances." (29) Japan's finance minister,Sadakazu Tanigaki, said, at the same time, that "we believe China needs some time to getaccustomed to their new currency regime, but a considerable time has already passed. I expect Chinato make its currency a bit more flexible." (30) Treasury Secretary Snow said, on this occasion, that "this rigidityconstrains exchange rate flexibility in the region and thus poses risks to China's economy and theglobal economy." Jin Renqing, China's finance minister, did not comment directly but did say thatChina would over time allow market forces to play a greater role in determining the value of therenminbi.

U.S. Views. In the United States, both theAdministration and Congress have spoken to the issue of China's currency.

Action by the Executive Branch. In January 2004,President George W. Bush told a crowd in Toledo, Ohio that "we expect countries like China tounderstand that trade imbalances mean that trade is not balanced and fair. They have got to deal withtheir currency." (31) OnJuly 21, 2005, responding to China's announcement that it was adopting a new exchange rate system,Treasury Secretary John Snow said that he welcomed the announcement but "we will monitorChina's managed float as their exchange rate moves to alignment with underlying marketconditions." (32) Heagreed that the initial 2% change was small, but he said the important thing was China's willingnessto change. "This is the start of a process," he said, "and the Chinese have indicated they want to gettheir currency based on markets rather than a peg." (33)

The United States has urged the IMF to press China to introduce market forces in its foreignexchange process more quickly. (This is discussed further, below.) In January 2006, at the WorldEconomic Forum in Davos, Switzerland, Under Secretary Tim Adams told Bloomberg Televisionthat China was not doing enough. "China needs to undertake serious reforms. They're on the roadto reform but they need to move faster." (34) He also told a panel at the Forum that the United States hadnever asked China to float its currency as it does not think the Chinese financial system couldwithstand it. Rather, he said, the United States had urged China to allow more flexibility in theirexchange rate. "All we've asked them to do is what they've agreed to do and what they know is intheir best interest to do," he said. (35)

The Omnibus Trade and Competitiveness Act of 1988 (sec. 3004) requires the Secretary ofthe Treasury to determine, in consultation with the International Monetary Fund, whether countriesare manipulating their currency in order to gain unfair trade advantage. In May 2005, Treasury reported that China was not manipulating its currency. (36) Some observers said the Treasury Department was more criticalof China in this report than earlier in part due to congressional pressure. "If current trends continuewithout substantial alteration [i.e., revaluation]," the report said, "China's policies will likely meetthe statute's technical requirements" for designating China as a country which unfairly manipulatesits currency value. Nevertheless, the report said that Chinese authorities had assured TreasurySecretary Snow that they were laying the groundwork for a future revaluation of the yuan. It was onthis basis that the Department found that China was not manipulating its currency. Snow reportedlygave China six months to rectify the situation and he called for an immediate 10% revaluation. (37) No such change occurred.

In November 2005, Treasury reported that China's actions "are not sufficient and do notrepresent fulfillment of the Chinese authorities' [earlier] commitment." (38) It said, though, thatChinese authorities had pledged in October 2005 "that they would enhance the flexibility andstrengthen the role of market forces in their managed floating exchange rate regime." It also said that"President Hu told President Bush that China would unswervingly press ahead with reform in itsexchange rate mechanism." Therefore, by implication, they were not manipulating the yuan. TheChinese authorities should act, the report concluded, "by the time this report is next issued" (i.e., insix months).

In May 2006, in its most recent six-month report, the Treasury Department reported that "toolittle progress has been made in introducing exchange rate flexibility for the renminbi." (39) The Departmentdetermined once again, however, that China's foreign exchange policies did not violate the terms ofthe Omnibus Trade and Competitiveness Act of 1988. Whatever the effects of China's policiesmight be, the Department said it was unable to determine, from the evidence at hand "that China'sforeign exchange system was operated during the last half of 2005 for the purpose (i.e., with theintent) of preventing adjustments in China's balance of payments or gaining China an unfaircompetitive advantage in international trade." Therefore, without a demonstration of intent, "thetechnical requirements for China to be designated under the terms of the Act have not been met."The report cited the various initiatives China had introduced in the past six months. It also reportedthat China's President Hu told President Bush in April 2005 that China would reduce its tradebalance in the future by boosting demand and stimulating domestic growth.

Action by Congress. In late 2005, Congress passedlegislation which urged the President to create a comprehensive plan to address diplomatic, militaryand economic issues relating to China. (40) In particular, it said the Administration should encourage Chinato revalue its currency further against the U.S. dollar by allowing the yuan to float against atrade-weighted basket of currencies. Congress is currently considering several bills which wouldrequire the United States to limit trade with China if it does not revalue the yuan or direct thePresident to take the yuan-dollar exchange rate issue to the IMF or WTO for action.

Three bills are prominent among this legislation. In July 2005, the House of Representativespassed legislation ( H.R. 3283 ) introduced by Representative Phil English which wouldmake imports from non-market economies (such as China) subject to U.S. countervailing duty. (41) Exports from China whichwere found to be subsidized on account of exchange rate manipulation might be subject to thesetrade rules and monetary penalties could be assessed which would raise the price of those goods inU.S. markets. The bill also required the Treasury Department to define the term "currencymanipulation" for the purpose of U.S. law and to report periodically on China's implementation ofits new exchange rate regime. (42)

The House is also considering another bill ( H.R. 1498 ), introduced byRepresentatives Tim Ryan and Duncan Hunter, that would make it clear under U.S. law thatexchange rate manipulation by China would make goods imported from that country actionable toU.S. countervailing duties. (43) Proponents argue that the language of H.R. 3283 ,though seemingly aimed at China, would actually make it more difficult for firms to levycountervailing duty claims against China. No action has been taken on H.R. 1498, thoughit currently has 169 co-sponsors.

The Senate is also considering legislation that would limit China's access to the U.S. marketif it does not stop manipulating the value of its currency. Senators Charles Schumer and LindseyGraham proposed on April 6, 2005, for example, that Congress enact a 27.5% tariff on all Chineseproducts entering the United States if China does not raise the value of its currency. (44) This is deemed to be theaverage degree of undervaluation identified by several studies. The Senate voted 67-33 for thisproposal, as a rider on another bill, but it was later introduced as a separate bill ( S. 295 ).Originally scheduled for consideration in mid-2005, action was postponed. The bill is expected tocome up again for consideration sometime in 2006.

Five Key Questions

Is the Yuan Undervalued? By How Much?

The IMF said in its 2004 evaluation of the Chinese economy that it was "difficult to findpersuasive evidence that the renminbi [yuan] is substantially undervalued." (45) Since then, manyeconomic studies have been published seeking to determine the yuan's "equilibrium" exchange rate.(This is the exchange rate that would prevail if the value of the yuan was not controlled and if theU.S. and Chinese economies were both at macroeconomic equilibrium.) The results of these studiesdiffer widely. Consequently, there is sufficient research available to support any position about thevalue of the yuan that one might wish to take.

The IMF's China experts found in their 2005 evaluation that the yuan is undervalued and therate of undervaluation is increasing. More flexibility is needed, they said, to avoid disruption of thedomestic economy. (46) The difficulty, however, one expert told CRS, is the lack of any reliable way of knowing how largethe distortion may be or how its effects can be separated from the other factors (such as labor costsand productivity) which affect the international price of Chinese goods.

In a market economy, the exchange rate of a currency (vis-a-vis another currency) can beaffected by many things. These including interest rates, trade relationships, institutional arrangementsthe international flow of money between currency markets, and interventions (purchases or sales ofcurrency) by the central bank. Market forces will balance these factors and establish an exchangerate which is supposed to reflect the actual value of goods and services in one country compared tothose in another country but sometimes -- depending on other considerations affecting the economyof either country -- it does not.

The task of assessing exchange rates is more difficult when market forces are constrained andcurrency values are set by official action. A simple method would have one look at the price of asingle product in world markets, on the theory that properly functioning currency markets shouldadjust to equalize product costs. One example is the Economist 's well known "Big Mac Index," alight-hearted procedure which compares the cost of McDonald's hamburgers around the world. (47) By its calculation, basedon the price of hamburgers sold in both markets, the yuan is 59% undervalued compared to the U.S.dollar. Most economists agree that this index provides only a general suggestion of the relativevaluation of currencies. (48) The disparity in hamburger prices around the world can also beread as a comment on the valuation of the U.S. dollar. The Economist says that the index shows thatthe U.S. dollar is more overvalued now, compared to most other currencies, than at any time sincemeasure was introduced 16 years ago. (49)

A more substantive effort to calculate the equilibrium value requires construction of aneconometric model for the countries whose currencies are being compared. Much statisticalinformation is required as well as a clear concept of the way the institutions and sectors relate to eachother. Often, information is not available and analysts have to substitute data based on theirunderstanding as to how each economy works and what the correct number would be if it wereavailable. (50)

In 2005, the Chinese Currency Coalition published a report citing eight reports or statements(in addition to the Big Mac Index) which said that, to varying degrees, the yuan was substantiallyundervalued. (51) Twoof the sources dated from 1998 or 2000. The others dated from 2002 or 2003. These included (inaddition to the hamburger index) a reference saying that the World Bank thought the yuan was 75%undervalued and other studies, statements or testimony to Congress saying the yuan was priced 10%to 40% below its "real" value. (52)

The IMF published a paper in late 2005 which compared eight major studies released in 2004and 2005 that sought to calculate China's "real" exchange rate on the basis of macroeconomic andeconometric analysis. (53) One scholar found, in two studies using 2003 data, that the yuan was either slightly undervalued orslightly overvalued that year. He found in a later study (using the next year's data) that the yuan was5% overvalued in 2004. Another analyst found, using the same data, that the yuan was only slightlyundervalued in 2004. By contrast, other scholars have found, using essentially the same statistics,that the yuan has been substantially undervalued in recent years. One team concluded, for example,that the yuan was pegged (in a study using 2002 data) at a rate that 18%-49% and (in another studyusing 2003 data) 23% below its "real" value. Another researcher found, in a study using 2000 data,that the yuan was undervalued by 35% that year. Yet another scholar concluded, on the basis of2004 data, that the official rate that year was 15%-30% below its "real" market equilibrium value.

Meanwhile, Funke and Rahn, two scholars from Hamburg University in Germany, found"compelling evidence that the renminbi is not substantially undervalued." (54) They seem to haveemployed the same econometric equilibrium modeling techniques used by scholars cited in the recentIMF paper. The claims by some that China's currency is grossly undervalued are incorrect, theyargue. Rather, they say, it seems in some circles to be "politically expedient to scapegoat the Chinesecurrency for economic difficulties elsewhere." Higgins and Humpage, two economists with theFederal Reserve Bank of Cleveland, report that it "is next to impossible"to determine the equilibriumexchange rate for developing countries through econometric modeling. (55) China is particularlydifficult, they say, because institutions and patterns of economic activity are changing very rapidly.

Data on the Chinese economy are incomplete, uncertain or unreliable. In late December2005, China announced that -- when services previously omitted from official statistics were takeninto account -- its gross domestic product (GDP) was 17% larger than expected. This was likediscovering a province the size of Turkey or Indonesia that was previously not counted in nationalstatistics. The new data make the Chinese economy the sixth largest in the world in dollar terms. If it grows by 10% in 2006 and its currency appreciates by a like amount, China could surpassGermany, Britain and France to become the world's third largest economy. (56) All the previousmacroeconomic ratios -- investment to GDP, exports as a share of GDP, rate of growth, etc. --changed with the advent of the new data. None of the studies cited above used the new data. Thus,even if they are correct in their use of the old data, their calculations do not reflect this more recentdata on the Chinese economy.

The variations in the conclusions of the 17 studies mentioned above may be due in large partto the way scholars define the relationships among the different segments of the Chinese economyand the different assumptions they use to fill in gaps when they lack adequate information. Withoutcareful analysis of the methodology and assumptions used in each study, there is no way of knowingwhether the results of any of these studies are more accurate than others. (57)

It appears that few of the participants in the debate about the value of China's currency havestudied the methodologies or the assumptions of the various studies. Rather, it seems that advocatesselect the studies they quote more because they like their conclusions than because they believe theyare the best research available. Few of the participants in the debate cite findings which supportconclusions other than those they support or provide reasons why their preferred studies are superioron substantive grounds to others which disagree.

Is China Manipulating Its Currency?

The IMF and Exchange Rate Policy. In the pastthirty years, the role of the IMF in the international financial system has changed. Until the early1970s, the IMF had a central role in determining world exchange rates. All currencies had a fixedvalue ("par value") compared to the U.S. dollar and the U.S. dollar was worth a specified amountof gold. If countries wanted to change their par value compared to the U.S. dollar, the IMF had tofirst approve. Since 1976, however, with passage of the Second Amendment to the IMF Articles ofAgreement, each country is free to determine the exchange rate system it will use. Some countrieshave floated the value of their currency in world money markets, others have fixed the value of theircurrency to that of another major country, and others have pursued a mixed strategy.

IMF Surveillance. The IMF is no longer thearbiter of world exchange rates. Rather, in the modern world, it exercises surveillance over exchangerates in order to encourage and to help countries comply with the basic rules. Article IV of the IMFcharter prohibits countries from manipulating their exchange rates in order to gain unfair tradeadvantage. It also says that "the Fund shall exercise firm surveillance over the exchange rate policiesof members, and shall adopt specific principles for the guidance of all members with respect to thosepolicies." Its current principles for surveillance were adopted by the IMF executive board in 1979and have been revised periodically since. (58) The principles say that countries may peg the value of theircurrency to another currency but they cannot do this in ways which violate the requirements ofArticle IV. Basically, the pegged rate needs to reflect a country's underlying economic realities.These include, for example, changes in the volume and composition of its domestic output, in thesize, composition and direction of its foreign trade, in its domestic rates of growth and nationalincome, in the size of its reserves and in shifts in its domestic fiscal and monetary policies, relativerates of productivity and of change and technological advance.

Countries are allowed, under the guidelines, to use their exchange rates to promote growthand development. The IMF rules for surveillance say the Fund's appraisal of country policies "shalltake into account the extent to which the policies of a member, including its exchange rate policies,serve the objectives of the continuing development of orderly underlying conditions that arenecessary for financial stability, the promotion of sustainable economic growth, and reasonablelevels of employment." However, countries are also required to "take into account in theirintervention policies the interests of other members, including those of the countries in whosecurrencies they intervene." In other words, countries can use exchange rate policy to help sustaingrowth and employment in their domestic economy but they cannot use an unrealistic exchange rateto prevent balance of payments (BOP) adjustment or to gain unfair trade advantages. Adjustmentincludes such things as increased imports, capital inflows to fund BOP deficits or outflows to offsetBOP surpluses, increased domestic interest rates or price levels, and the accumulation of excessreserves. If one country does not adjust its BOP imbalance, the burden of adjustment will be thrownupon its trading partners through monetary contraction, unemployment and the like.

China and Manipulation. The IMF has six criteriawhich might be used to identify situations where countries are manipulating their currencies in orderto gain unfair trade advantage. Any one of the criteria would be sufficient to note the likelypresence of manipulation. It appears that China's foreign exchange practices are congruent with atleast four of the IMF criteria. (59)

Persistent Intervention. The IMF says (its criterionnumber 1) that "protracted large-scale intervention in one direction in the exchange market" is oneindication that a country may be manipulating the value of its currency. Countries may intervenein foreign exchange markets to counter short-term disorderly conditions that cause disruptiveshort-term movements in the exchange value of their currencies. However, the IMF guidelines saythat persistent one-way intervention"might indicate the need for discussion with a member." (60)

If China's currency were properly priced and the goal were exchange rate stability, the centralbank would intervene in the market in both directions, buying and selling yuan in order to dampenthe effect of temporary shocks and to spread the effects of change over a longer period of time. Instead, China routinely sells yuan in order to keep the market price from rising. It rarely buys yuanto keep the market price from sinking too low. This would seem to be the kind of "protractedlarge-scale intervention in one direction" which the IMF specified in its first operational definitionof manipulation.

An Unchanging Peg. The IMF's second criterionwhich indicates that a country might be manipulating its currency is "behavior of the exchange ratethat appears to be unrelated to underlying economic and financial conditions including factorsaffecting competitiveness and long-term capital movements." Countries may peg the value of theircurrency to another currency but the pegged rate needs to reflect the country's economic realities.These include, for example, changes in the volume and composition of its domestic output, in thesize, composition and direction of its foreign trade, in its domestic rates of growth and nationalincome, in the size of its reserves and in shifts in its domestic fiscal and monetary policies, relativerates of productivity and of change and technological advance.

The yuan-dollar exchange rate was largely unchanged from1994 to 2005. Since reformswere announced in mid-2005 it has changed very little. Some might argue that the fact that Chinaheld its exchange rate constant during this period is evidence that China was not manipulating theyuan through fine-tuning of its valuation. However, manipulation can be as much a lack of changeas an act of change. (61)

Whether an unchanging exchange rated is a violation of Article IV depends on the way thecountry holds the rate constant. China did not have to micro-manage the daily rate for its currencyin order to maximize its export opportunities. They merely sold yuan whenever the yuan-dollarexchange rate increased beyond the level the central bank desired. Chinese authorities used domesticmonetary policy and other domestic economic practices to offset the effects of the fixed yuan-dollarrate.

Economic conditions have changed markedly in China since 1994. Production andconsumption patterns changed. Import and export patterns changed. The relative value of goods andservices and the relative value of labor, capital and other factors of production changed. Theinternational value of China's currency should have changed as well to reflect these changes. Amongother things, this would have produced price signals that could have changed consumption andproduction patterns, promoted efficient and effective utilization of resources, and improved theChinese people's standard of living and level of real income. The behavior of the yuan-dollarexchange rate after 1994 "appears to be unrelated to underlying economic and financial conditions"and is therefore consistent with the IMF's second criterion for identifying currency manipulation.

Prolonged Foreign Lending. The IMF's fourthcriterion says that "excessive and prolonged short-term official or quasi-official lending for balanceof payments purposes" can be evidence that currency manipulation is taking place. Prolongedborrowing for the same purpose is also evidence of manipulation.

Since 1994, China's foreign exchange reserves have grown sixteen-fold, from $53 billionto $819 billion. Some of the funds in China's foreign exchange reserves are equity investments. Most, however, are loans to foreign governments or private borrowers. For example, China'sinvestment in U.S. Government debt has more than tripled in the past five years, from $71 billionin 2000 to $242 billion in 2005. By definition, these are loans to the U.S. Government and they areshort-term, in the sense that they can be liquidated at any time through sales in security markets.They help the United States cover its balance of payments (current account) deficit and they helpChina adjust its balance of payments in a way which does not require it to spend its internationalincome on purchases of goods and services from abroad. At least on the part of China, this appearsto be the kind of behavior "to prevent effective balance of payments adjustment" (in the words ofArticle IV) that meets the IMF's fourth test for currency manipulation.

Influence on Capital Movements. The IMF's fifthcriterion says that a conversation with a country might be in order if it evidences "the pursuit, forbalance of payments purposes, of monetary and other domestic policies that provide abnormalencouragement or discouragement to capital flows." Many observers say that the growing size ofChina's reserves shows that its government is promoting an abnormal outflow of capital for BOPpurposes.

The Chinese government purchases large amounts of foreign exchange in order to maintainthe price of its currency. Thus, foreign money is less available to Chinese citizens and firms thanit might be otherwise. Consequently, instead of being cleared on the current account through importsand other current activity, China's balance of payments is cleared through the capital account by largeadditions to China's foreign exchange reserves.

Many analysts agree that China's reserves are larger than its normal trade or financial needswould require. They are larger, for example, than any need China is likely to face if its internationalincome suddenly declined -- as a result, for instance, of an economic shock originating elsewherein the world economy -- and it needed money for a while to pay for imports or to service debt. Inthis light, many would argue with reference to the IMF criterion noted above, that continuedexpansion of China's foreign exchange reserves is not just an encouragement for the outward flowof capital but an encouragement for "abnormal" flows as well.

Some would argue in addition that the continued growth of China's reserves is inconsistentwith provisions of the IMF charter. Article IV also stipulates that all members shall "seek topromote stability by fostering orderly underlying economic and financial conditions and a monetarysystem that does not tend to produce erratic disruptions." Every dollar that China adds to its reservesis a dollar that some other country adds to its foreign debt. Arguably, the accumulation of largereserves and large debts does not enhance the stability of the world financial and trading system. Countries with large foreign exchange reserves do not import as much as they could and debtorcountries have difficulty retiring their foreign obligations by trade. In that sense, high reserves arenot a formal trade barrier but they have the same effect. They hamper "the expansion and balancedgrowth of international trade" (one of the purposes, stated in its Articles of Agreement, for whichthe IMF was created.) China is not the only country accumulating large reserves but many wouldargue that its practices are a source of concern.

China's View. Chinese officials say they are notseeking unfair trade advantage. They only want exchange rate stability to protect their economyfrom destabilizing change. The result, however, is the same. Chinese officials say that, whateverthe technicalities might be, the economic benefits of stability are important and are shared by manycountries. Moreover, they could argue, their efforts to influence exchange rates through interventionin currency markets differ little in their effect from similar action which countries with floatingexchange rates take to influence their currencies' exchange rates -- changes in interest rates and otherpolicies, for example. Furthermore, they might say, Japan and other Asian countries also buy dollarsin order to keep down the value of their currencies and to stimulate their exports. Arguably, theywould argue, it is unfair to single out China in this regard when others do the same thing and theirtrade impact on the U.S. economy is at least as great as that of China. (62)

How Fast Should China Revalue?

If China can continue to contain the inflationary pressures caused by rapid growth in itseconomy and its foreign exchange reserves, it can probably delay for some time any need for a majorchange in the dollar value of its currency. Unlike countries with overvalued currencies, it will notrun out of foreign exchange if it postpones the decision. Rather, its foreign exchange reserves willgrow.

China could increase the value of the yuan overnight to a much higher level if it wished todo so. However, Chinese officials are concerned that too-fast and too-steep an increase could hurtthe growth rate, employment rate, and reform prospects of the Chinese economy. Chinese officialssay they want to shift away from export led growth towards an economic program focused more ongrowth in the internal economy. However, they do not want to slow down the export sector untiltheir internal economy is able to provide the growth they need to continue the transformation processnow underway. These considerations seem to suggest that revaluation should take place gradually. However, if speculative capital flows are a problem, as discussed below, they may want to delay theprocess considerably.

Most experts agree that China's current situation is not sustainable and they cannot postponerevaluation of the yuan indefinitely. If nothing is done to slow the growth of China's foreignexchange reserves, for instance, inflation may eventually push up domestic prices in China and raiseits export prices. Experts differ, though, as to how quickly China should move towards amarket-based exchange system. The IMF says a gradual approach is needed. In July 2005, the IMFstaff proposed that China adopt a phased approach in moving towards full exchange rateflexibility. (63) Morerecently, the director of the IMF's research department urged a deliberate pace. (64) Experience has shown,he said, that emerging markets do not handle large, rapid exchange rate movements well. In China,he suggested, rapid change might disrupt or bankrupt major segments of the economy -- particularlythe banking system -- and make reform a long, drawn-out and painful process.

Other experts believe that policy reform must occur more quickly. Some say that China'sundervalued currency is hurting other countries and fairness requires rapid action to remedy thesituation. Some suggest that China risks a financial crisis if it does not revalue soon. (65) One says that rapidrevaluation is needed because China's emphasis on export-led growth makes it vulnerable to anyslowdown in global demand. (66) Otherwise, they say, China risks being another "Asian miracle"country, like those that went bust during the Asian financial crisis in the 1990s.

Many also believe quick action is needed because the current economic relationship betweenthe United States and China is unstable and harbors serious risk. Roubini and Setser argue, forinstance, that change is inevitable and the only question is how it will take place. (67) A smooth landing ispossible, they say, if Chinese officials lessen China's emphasis on exports and the accumulation ofreserves and U.S. policy makers reduce their country's dependence on foreign loans and capital.Otherwise, they believe, some unforseen event may trigger a crisis which could have serious negativeconsequences for both countries.

Is China Hiding its Real Trade Surplus?

Some people argue that China's trade surplus is many times larger than the amount whichChina publishes in its official statistics. The China Currency Coalition says, for instance, that China'strade balance was nearly six times larger in 2003 than its official statistics suggest. (68) IMF data show that in2004 the 156 countries it categorized as "world" had a combined trade deficit with China of $267billion, roughly six and one-half times more than trade surplus of $41 billion that China reported that year. (69) If China'strade income were the larger of these figures, this would be strong evidence the yuan is undervalued.

In theory, the net trade figures reported by exporter and importer countries should match. In practice, the data are often inconsistent. There is strong reason to believe that methodologicalreasons account for much of the discrepancy in data. Perhaps countries keep better count of theirimports than their exports. Perhaps the figures are confused and intermingled when products areimported and re-exported or when inputs from several sources are channeled through a final exportercountries.

The IMF's Direction of Trade Statistics (DOTS) shows, in any case, that -- when the exportsof all countries to every country are subtracted from the imports every country receives from allcountries, the world had a $269 billion trade deficit with itself in 2004. (70) Other countries showsimilar disparities between the trade balances they report and those reported by their tradepartners. (71) In 2005,the IMF executive board noted weaknesses in China's BOP statistics in its annual Article IV reviewin 2005 and it urged the Chinese authorities to take advantage of Fund's technical assistance to helpimprove them. (72)

The China Currency Coalition says, however, that China is "hiding the ball" by deliberatelyreporting incorrect trade statistics. It believes the figure reported by importer countries moreaccurately reflects China's net income from trade. This is further evidence, the Coalition says, thatthe yuan is seriously overvalued.

If this is correct, China must be receiving over $200 billion more each year from tradeincome than it reports. In that case, the money must be somewhere. China could not have spent thismoney on imports, as it would have then shown up in the trade statistics of the exporter countries. It seems unlikely that Chinese exporters would have brought this additional foreign currency backinto China. If they had, the People's Bank of China would have had to spend three times more yuanthan the amount officially announced to keep the yuan at the pegged rate. The inflationary impactof these additional yuan would be substantial and would have manifested itself through rapidlyincreasing domestic price levels.

Alternatively, the presumed $200 billion in extra annual revenue might have been heldabroad. This would require the cooperation of Chinese officials, since it would mean that roughly80% of China's trade income each year does not come back to China. It seems unlikely that Chinahas been giving the money away, since this would make it the world's largest foreign aid donor (tentimes the size of the United States) and international effects of its generosity would be evident. Possibly, if the money exists and is not the product of a methodological flaw, the government ofChina might have accumulated it annually into secret foreign exchange reserves. This would mean,again if the money exists, that China has perhaps $1 trillion in clandestine funds invested in othercountries (over and above its announced official reserves.) Even if China were only using thismoney to acquire revenue, not influence, it would be difficult to hide. If the assets were registeredas Chinese at the time of purchase, for instance, they would likely show up in host country statistics.

As another possibility, if the government of China does not control the money, then it mightbe held by Chinese citizens and companies. In any other country, the fact that people prefer to holdforeign currencies rather than their own currency might be taken as evidence of capital flight. Itmight suggest that people "in the know" believe the yuan is overpriced and likely to crash. Keepingtheir assets in foreign currencies would be a way of protecting themselves against that eventuality. For China, however, the general view is one suggesting that the yuan will be going up in value andforeign currencies will go down in value compared to it. It seems unlikely that Chinese insiderswould see the situation so differently from the common view or that they would have been able tohold a secret this big for so long.

The above scenarios are not be impossible, but they seem unlikely. It seems more likely thatthe $200 billion difference in the trade data reported by China and its trade partners is not realmoney. Rather, it is probably the result of methodological and procedural error. China's real exportfigures may be higher or its trading partners' import figures may be lower than the reported amounts. We do not know. Caution in the use of published data would seem appropriate. It is probably nota good idea, though, to ignore or discard the existing body of world trade and finance statistics justbecause some of the data do not match. The IMF and its member countries might scrutinize theirprocedures to see whether errors and inaccuracies of this sort can be reduced or eliminated overtime.

Would Revaluation Help the U.S. Economy?

A Symbiotic Relationship. The dollar-yuanexchange rate is not determined in a vacuum. Rather, the relationship between the two currenciesreflects the broader relationship between the countries which issue them. The rates are theconsequence of each country's economic priorities and the way those priorities interact. The UnitedStates needs to import capital from abroad to finance its present level of economic activity withoutincurring higher interest rates. Consequently, the international value of the dollar must be relativelyhigh in order to encourage the inflow of capital. China needs to encourage exports in order tostimulate economic growth and facilitate economic reform. Therefore, for China's purpose, the valueof the yuan must be low enough to encourage export growth. So long as these are the main issueson each country's economic agenda, major changes in yuan-dollar exchange rate or the U.S. tradedeficit are unlikely.

The U.S. Imports Capital. The United States doesnot save enough domestically to finance simultaneously its preferred levels of consumption andinvestment and to cover the Federal budget deficit. By contrast, other countries (including severalin Asia) save more than their economies can effectively absorb. The United States needs morecapital than it can generate on its own to sustain the U.S. economy and foreigners need safe andprofitable ways to invest their surplus funds. This generates a continual inflow of foreign funds intothe United States. The inflow of funds, in turn, helps generate more demand for imported goods. TheU.S. current account deficit equals about 6% of GDP and requires the United States to import morethan $2 billion daily from abroad. (73)

This capital inflow pushes up the exchange value of the dollar, which lowers the relativeprice of imports and generates a corresponding inflow of foreign goods. It is a basic principle ofeconomics that countries which are net borrowers of money from the world must be net importersof goods and services as well. (74) If the value of the yuan increased, the volume of Chineseexports and Chinese capital flows to the United States would likely decrease. (75) In the short run, U.S.producers would probably take over a share of the market previously supplied by Chinese goods,though consumers would likely have to pay more for those goods than they did for Chinese imports. Profits and employments in those firms would likely increase. If China's trade balance declined,under this scenario, its rate of investment in the United States would also likely decline. In that case,many economists believe, U.S. interest rates would probably increase. This would likely have anegative impact, they expect, on the housing market and (with interest taking a larger share ofhousehold income) on consumer purchases.

Over the longer run, foreign production is likely to shift from China to other low-costcountries. As their exports to the United States increase, producers in these other countries wouldlikely recover much of the market previously supplied by the Chinese. On the other hand, higherinterest rates in the United States might stimulate an inflow of capital from other foreign sources. One can only speculate whether interest rates would eventually decline to their former level and whatthe impact these changes would have on the U.S. economy.

China Wants Growth. China, for its part, alsohas priorities other than an accurate valuation of the yuan. Chinese officials believe they need topursue a policy of export-led growth. They believe their domestic economy is too inefficient togenerate the levels of employment and resources needed for economic reform and conversion of theeconomy from a state-directed to a market-based system. They worry that the domestic economycannot otherwise absorb the unemployment being generated by reform in the rural sector andstate-owned enterprises. They also worry that their banking system would be unable to allocatecapital effectively or to cope with the speculative pressure that might follow the introduction of amore flexible exchange rate system and more open capital markets.

China's economy has been growing at a rate of about 9% annually for the past decade. Mostexperts believe this rate cannot be sustained indefinitely, given both the present levels of productivityand the strain and inflationary pressure such growth places on the economy. Many believe Chinaneeds to slow down its growth rate in order to consolidate recent gains and to correct imbalances. Increasing the value of the yuan would help, they say, by slowing the growth in reserves, loweringinflationary pressures, reducing the cost of imports, raising per capita income, reducing distortionsand encouraging the flow of resources from the export sectors to the domestic economy. However,Chinese officials are reluctant to shift from a policy of export-led growth to one based more oninternal growth until they believe their domestic economy is more efficient and productive andeconomic reform has further progressed.

According to the IMF, most Chinese officials believe they eventually need to liberalize theyuan and shift more to a policy of domestic led growth. (76) Senior Chinese officials told the press in December 2005 that thevalue of the yuan would be increasingly influenced by the market and the trend is for China'scurrency to appreciate over time. (77) Yu Yongding, a member of the central bank's policy committee, said at the time that there is a risk that inflation could be ignited if the exchange rate is not allowedto appreciate. He also said that China's foreign exchange reserves had been growing too fast.

Many in the Chinese leadership believe their country is not yet ready for substantial changesin the value of the yuan. In any case, they say, efforts to resolve the imbalances in the worldeconomy will require concerted action by many nations and China should not be expected to solvethem alone. (78)

Three Dilemmas For China

Intervention and Reserves

The People's Bank of China intervenes in the market to buy foreign exchange and sell yuanin order to hold the value of its currency at a relatively constant level. As a result, China hasaccumulated foreign exchange reserves which now total more than $819 billion. At the present rateof growth, its reserves will surpass those of Japan and total $1 trillion by the end of 2006. (79) If the bank did not sellyuan, the value of China's currency would rise and its volume of exports would fall. Many ofChina's export industries reportedly operate on very slim profit margins and many might go bankruptif the yuan rose substantially in price. (80)

Much attention has been paid to the size of China foreign exchange reserves. Many see themas a potential financial threat to other countries. Many believe the growth in China's reserves provesthat its currency is undervalued and manipulated.

However, the growth in China's reserves causes problems as well. For one thing, it putsgreat pressure on China's monetary system. China cannot have an independent monetary policy,since its domestic money supply grows at the size of its foreign reserves expands. For every dollarbought by the central bank to maintain the peg, the People's Bank of China creates 8 yuan which itgives to the seller. The PBC has reportedly intervened in the currency market at a rate equal to about12% of China's GDP. (81) The IMF says that only about half the liquidity caused by the increase in reserves has been sterilized(that is, removed from circulation through sales of government bonds.) (82) Thus, the central bank hashad to hold down the growth of credit and lending by state banks in order to keep this excessliquidity from causing inflation. The June 2005 IMF Article IV staff report urged China to wringmore excess liquidity from the system and to tighten monetary policy still further.

The growth in China's reserves also creates another problem. Roughly 70% of its reservesare held in dollars or dollar-denominated securities. If the yuan should go up in value compared tothe dollar, the value of China's reserves will go down and China would lose a great deal ofmoney. (83) If a changein the value of the yuan vis-a-vis the dollar is inevitable, then Chinese officials might want to actquickly to revalue the yuan because the problem will only get worse the longer they wait. On theother hand, if they raise the value of the yuan too much, they will lose large amounts of moneyunnecessarily. Further, if the change in the value of the yuan is a gradual process, China mightreduce the size of its exposure if it gradually shifted some of its present dollar-denominated assetsinto other currencies.

The State Agency for Foreign Exchange announced in mid-January 2006 that it would be"actively exploring more efficient use of our FX [foreign exchange] reserve assets" and "wideningthe foreign exchange reserves scope." It said it wanted to "optimize the currency and asset structure"of China's reserves and to "actively boost investment returns." (84) Some market analyststhought this meant that China intended to sell some of its dollar-denominated assets. (85) Their alarm abated,however, when it became clear that China simply planned to invest a smaller portion of its newreserves in dollars and more in the currencies of other trading partners.

Where's the Money Coming From?

Hot Money or Trade? China's foreign exchangereserves are growing because the country's central bank is buying dollars and other foreign currenciesin order to stabilize the market price of the yuan. The question is where the foreign currency iscoming from. Many argue that the growth in China's reserves is the result of its trade policies as wellas the inflow of foreign investment. Recent research suggests, however, that speculative inflows("hot money") may be responsible for over three-quarters of the net increase in China's foreignexchange reserves since 1998.

Table 1. Composition of China's Buildup in Foreign ExchangeReserves

(billions of U.S. dollars)

Source: Prasad and Wei.

a. Foreign reserve increase is the sum of the current account and capital account balances plus errorsand omissions.

b. FDI is Foreign Direct Investment.

c. Includes errors and omissions.

Accounting the BOP. Table 1 shows (based onIMF data) the size and amount of change which took place in China's foreign exchange reserves andbalance of payments (BOP) during the period 1998 to 2004. Foreign exchange reserves andalternative BOP figures have been discussed above. The balance of payments is a comprehensivepicture of a country's international financial and commercial transactions. It has three parts: thecurrent account balance, the capital account balance and the total for errors and omissions. Thecurrent account balance is the net sum of a country's exports and imports of goods and services plusits net income from foreign investment. The capital account balance is the net sum of all themonetary flows to or from a country -- net foreign investments, loans made or received, transfers byindividuals (remittances from migrant workers, for example) and other transactions needed tofinance activity in the current account.

Conceptually, the current account and capital account balances should cancel each other out,one being positive and the other negative. Imports which are not paid for with current revenue, forexample, would have to be financed directly or indirectly by capital from abroad. In fact, however,some financial and commercial transactions are not recorded and the current account or capitalaccount is often larger than the other. To make the two parts of the BOP match, economists add athird figure, called "errors and omissions" (E&O), which acknowledges that for unexplained reasonsmore money is in one account or the other. This may reflect income from illegal trade,mis-measurement, or undisclosed movement of money by individuals ("capital flight") seeking toprotect their assets from an expected change in the exchange rates or by speculators hoping to profitfrom that change.

Analyzing China's BOP

Table 1 breaks China's balance of payments figures into these three components. It alsoprovides separate figures, in the capital account, for foreign direct investment. Prasad and Wei, theauthors of the table, identified the annual changes in China's foreign exchange reserves and theamounts recorded for each element of China's balance of payments and they present the averageannual amounts for each item for the first three and the last four years of the 1998 to 2004period. (86) From thatdata, they derive the amount of change which occurred in each instance between the first and the lasthalves of that seven-year period.

On first inspection, looking only at the middle column, it seems that most of the growth inChina's reserves was due to trade and investment. Between 2001 and 2004, Prasad and Wei note,China's net annual current account balance was $42.2 billion while the net inflow from FDI was$46.6 billion. (87) Itappears, therefore, that the $88.8 billion from these two sources accounted for most of the $128billion average annual increase in China's foreign exchange reserves during that period.

Prasad and Wei find, however, that other factors -- particularly the inflow of "hot money"were more important. As Table 1 also shows, comparing the first and second columns, that theaverage annual level of China's foreign exchange reserves grew by $8.5 billion from 1998 to 2000and by $122.8 billion from 2001 to 2004. In column 3, Prasad and Wei found that the annualchange in China's trade receipts ($18.5 billion) and FDI ($8.1 billion), shown in column three, werenot sufficient to account for the average $114.3 billion in China's reserves. On the other hand, theswing in flows from non-FDI investment and E&O were substantial.

Between 1998 and 2000, they observe, capital flowed out of China openly (non-FDI) orcovertly (E&O.) They speculate that initially Chinese firms and families moved money abroad totake advantage of favorable investment and exchange rate opportunities. After 2001, however, theysuggest, Chinese firms and families and foreign speculators began moving money back into Chinain hopes of profiting from the expected increase in the value of the yuan. They observe that, as Table 1 indicates, the net flow of funds from non-FDI investment and E&O between the two periodsamounted to an average $87.7 billion a year, nearly 77% of total change in China's foreign exchangereserves during the 1998-2004 period.

Policy Implications. The policy prescriptions aredifferent, depending on the source, if one wants to reduce the inflow of foreign currencies and tolessen the central bank's incentive to sell yuan in foreign exchange markets. If trade-related factorsare the major reason why foreign exchange is flowing to China, then changes in the country's tradepolicies and exchange rate would help diminish the flow. China's government would need to takesteps, in this scenario, to shift resources and employment from the export sector to the domesticeconomy.

On the other hand, if "hot money" is responsible for the buildup in reserves, then a gradualappreciation in the value of the yuan might encourage further inflows of speculative funds. In thatcase, the central bank might cool the inflow of "hot money" by holding the value of the yuan constantfor a sustained period of time.

The Economist reported in late January 2006 that the delay and uncertainty of the newChinese exchange rate system may have had this effect. (88) The flow of portfolio capital investment, one form of "hotmoney," declined to about $1 billion a month in late 2005, it reported, from the average level of $8billion a month seen from late 2003 through mid-2005. It appears, the Economist suggests, that "thespeculators who have been furiously pumping money into China for the past three years have at lastgiven up and gone home." The magazine predicts that China's trade surplus may also start to falland import growth may revive.

If the data for the last part of 2005 are correct and if the Economist 's predictions are right --and it is much too soon to know whether these are so -- then the People's Bank of China may havean easier time managing monetary policy in the future. There would be less need, for example, forit to print yuan in order to keep down the value of the yuan by buying up the inflow of dollars. Thiswould make it easier, if the PBC wishes to do so, for the central bank to relax its control and to allowmarket forces more influence on the yuan-dollar exchange rate.

Would Revaluation Hurt China's Banks?

Many believe China needs to reform its financial system before the yuan can rise appreciablyin value. If revaluation occurs first, they say, the banking system may not be able to cope and thismight have negative effects on economic growth. Others believe, however, that -- while more reformis needed -- China's banking system should be able to accommodate more flexibility in the value ofthe yuan. Nevertheless, there is serious worry on the part of many that a floating exchange ratesystem could lead to destabilizing capital outflows. (89)

The IMF says that major steps have been taken to restructure the banking system (eventhough further action is required) and the condition of the banking system is no longer an obstacleto exchange rate reform. As a result of recapitalization, sales of nonperforming loans, and otherreform efforts, the IMF staff reported, the capital strength, asset quality and operating results forChina's banks have significantly improved. In the old days, state banks made loans to state industrywith little expectation those loans would be repaid. Thus the savings of Chinese individuals weresunk into subsidizing these money-losing firms.

Most of these "legacy" loans have been transferred to four government-owned assetmanagement corporations (AMCs), so the government budget rather than the banking system willbear the cost of those bad loans. Consequently, the IMF reports, bad loan ratios for the majorcommercial banks (the four largest state banks and 14 joint stock commercial banks) have fallenfrom about 24% of loans in 2002 to about 13% in September 2005. (90) These institutions accountfor about three-quarters of total bank assets. They say that efforts to tighten the banks' balance sheetsand to strengthen their internal controls and risk management procedures are still needed.

The IMF does not report figures for the ratio of bad loans (non-performing loans) in thebanking system as a whole because the procedures for reporting bad loans by small banks aredifferent from those for large banks. Two IMF economists, Prasad and Wei, reported in their 2005article that non-performing loans in the banking system amounted to 30% of GDP in 2003. (91) IMF staff indicates thatthis larger figure calculates the bad loan ratio for smaller banks in the same way that bad loans arecalculated for the larger banks. Prasad and Wei suggest that a major share of China's foreignexchange reserves may need to clear up the accumulated bad debt.

Setser asserts that conditions in the Chinese banking system are grim and the costs of reformwill be great. (92) Hesays the banking system is not ready yet for a more flexible currency. Bad debt in the bankingsystem is equivalent to 20% or 30% of GDP, he says. Officials estimates reported that 40% of allloans in 2002 were non-performing, he indicates, and "legacy" bad loans (debt owed by state firms)totaled $400 billion. Other estimates put the figure at $650 billion, he says, or about 50% of China's2002 GDP. The recent boom in bank lending may have reduced the level to 25% or so, he says.However, he suggests, the total volume of bad debt may be higher once the bad loans made since2002 are included in the total.

Setser says that many analysts believe that the government will need to buy out the bad"legacy"debt if it wants to improve the soundness of the banking system. The IMF's statement (seeabove) that some bad loans were transferred out of the banking system seems to confirm this view. Setser says the government will also need to provide large amounts of money to stabilize itsundercapitalized state banks. Some estimates report, he says, that the cost of cleaning up thefinancial system could equal 20% of national GDP (about $340 billion of China's 2004 GDP) andnearly all of it will be borne by the national government. This could push the national debt-to-GDPratio, he says, from 33% in 2004 to perhaps 50% overall.

IMF experts say that China does not need to resolve the problem of bad debt in its bankingsystem before its currency can be liberalized. They argue that -- so long as capital controls continue-- the yuan-dollar exchange rate could be more flexible without harming the Chinese banks. TheChinese banks know how to trade currencies and manage their foreign exchange exposure, the IMFstaff reports. They already do this in their worldwide operations. Some economists believe that Chinacannot have a flexible currency until it ends capital controls. (93) IMF experts argue,however, that China's banks cannot handle full liberalization of the capital account at this juncture. If capital controls were removed, they assert, a substantial outflow of capital from the banks wouldlikely occur and this would be very destabilizing. (94)

Options for the United States

There are several ways the United States might encourage China to move more quicklytowards increasing the value of the yuan. These options or policy tools are not mutually exclusive,but it might be difficult or awkward for the United States to pursue some of them simultaneously. (95)

First, the U.S. government might continue pressing China publicly for additional changes inits foreign exchange system in order to make the international value of the yuan better reflect marketconditions and economic realities. This assumes either that China is reluctant to change or thatreformers in China will be helped by external stimulus. Second, the U.S. Government might stoppressing China publicly for change. This option is predicated on the expectation that reformers willbe able to move China more rapidly towards currency liberalization if China is not pressured fromabroad. Third, the United States could enact legislation restricting Chinese exports to the UnitedStates if the value of the yuan is not increased. This assumes that China will change its exchangerate policies only if forced to do so. Fourth, the U.S. government might refer the question to theIMF, asking the international agency to determine whether China has been manipulating its currencyin violation of IMF rules. This assumes that technical findings and persuasion by the IMF and itsmajor member countries may have effect. Fifth, the U.S. government might refer the issue to theWorld Trade Organization (WTO), alleging that the United States has been injured by unfair tradepractices linked to the undervaluation of China's currency. If the WTO found that the U.S. petitionhad merit, it could authorize trade remedies to correct the allege abuse. This assumes that exchangerate issues and questions of general system-wide subsidy will fall within the purview of the WTOrules.

Continue Public Pressure

Continued public pressure is one method the United States might use to encourage China toadopt further reforms in its foreign exchange procedures. This might include official findings by theTreasury Department that China is a manipulator or strong exhortations by high-level U.S. officials. Among other things, U.S. officials might press Chinese officials to provide them more informationas to the ways they intend to link reform of their domestic economy to reform in their exchange rateregime and the criteria they might use for discerning progress.

In evaluating this option, it would be helpful to know whether Chinese officials really intendto move towards a market-based valuation of the yuan or whether they intend to drag the process outas long as possible. If China adopted the reforms announced to date mainly in response to foreignpressure, then it is possible that further pressure might persuade them to go faster. However, ifChinese officials adopted these reforms because they believe that market-based reform is in China'sbest interests, foreign pressure may complicate this process. China has a long tradition of not givingin to foreign pressure. Foreign pressure might strengthen the hand of the reformers, but it might alsostiffen resistence by the opponents of reform and make it harder for the reformers to achieve theirends.

It also might be helpful if U.S. officials and legislators had more information about China'sinternal decision making process. How strong are the reformers? What key choices do Chineseofficials believe they face as regards the economy and value of the yuan? How do they think Chinaand other countries can best determine what the true international value of the yuan might be? Whatcriteria do they believe are relevant for determining currency value and their timetable for change?

Given their most recent statements, other G-7 countries will likely support the United Statesif it continues to press China for more rapid action. However, they may also back away and leavethe United States on its own if they believe U.S. efforts are potentially counterproductive.

Pursue a Policy of Restraint

Instead of pressing China publicly for reform, the United States might decide on a policy ofrestraint. This is not an option in favor of the status quo. Rather, it accepts the premise that Chineseofficials want to proceed with their reform program as rapidly as economic conditions and the policyconsensus in China permits. This option assumes that overt foreign pressure may becounterproductive if it slows the process and strengthens the hand of those in China who opposereform. Arguably, the Treasury Department has shown restraint of this sort when it said, in itsrecent reports, that China was not manipulating the value of its currency.

Some might argue that the United States should view the trade and currency dispute withinthe context of its overall relationship with China. While economic issues are important, this viewwould suggest, it is also important not to raise tensions to the point where China becomes reluctantto cooperate with the United States on other issues, such as North Korea's policies on nuclearweapons. Pressing the yuan-dollar exchange rate issue to the exclusion of other important U.S.interests might be seen, from this perspective, as counterproductive. Others might respond,however, that China will cooperate with the United States in other areas when it believes that thisserves its interests.

China may have strong reasons for wanting change in its foreign exchange system. As notedbefore, China faces the prospect of serious inflation if it does not slow or stop the growth in itsforeign exchange reserves. An increase in the value of its currency would be a key way ofaccomplishing that goal.

Ironically, some kind of external encouragement may still be needed to help Chinaaccomplish its plans. Even if Chinese authorities want to move forward with their reform program,they may need some external pressure -- if only in the form of agreed deadlines and benchmarks --to help them overcome inertia when they encounter difficult choices as they put their currency reformpolicies into effect.

Restrict Exports to the United States

Instead of exerting public and mostly verbal pressure, the United States could adoptlegislation restricting China's access to the U.S. market until it raises the value of its currency. Thereare several ways this could be done. The English bill ( H.R. 3282 ), Ryan-Hunter bill( H.R. 1498 ) and Schumer/Graham bill ( S. 295 ), all mentioned above, would have this effect. By raising the U.S. price of Chinese imports, they would presumably reducethe flow of Chinese exports to the United States, raise the prices paid by U.S. consumers (perhapshelping some U.S. producers) and stimulate the growth of export industries in other countries thatwould take China's place.

Similar effects would likely occur if the U.S. government invoked the provisions of Section301, authorizing the U.S. Trade Representative to respond to unreasonable or discriminatorypractices that burden or restrict U.S. commerce. (96) Likewise, if the Treasury Department found in its semi-annualreport that China was manipulating the value of its currency to the detriment of the United States,consultations with China and trade actions would also be required. Under the Section 301mechanism, the United States could impose trade sanctions against Chinese goods if China does notchange its trade or foreign exchange policies. The United States could also use other U.S. trade lawsto impose special "safeguard" restrictions on Chinese goods if the growth in Chinese imports isfound to have caused (or threatens to cause) market disruption to U.S. domestic produce. (97) Measures of this sort areallowable under WTO rules on a temporary or limited basis but it is less clear that they may be usedacross the board or for longer periods.

It is not clear how much the price of Chinese goods would need to increase, or the volumeof Chinese exports to the United States would decrease, though, if the value of the yuan increased. Components purchased from other countries account for a major share of the value of exportsbearing the label "Made in China." The cost of Malaysian or Thai inputs would not change for theproducer in China if the value of the yuan increased. The price of the final product would only needto increase by an amount sufficient to recover the higher cost of the producer's that weredenominated in yuan. Depending on the products and methods of production, it is possible that theoverall increase in product costs would be modest and the volume of Chinese exports to the UnitedStates would be large even after the value of the yuan increased.

It is uncertain what the Chinese authorities and Chinese firms would do if faced withrestrictive import legislation of this sort. They might cut prices and trim profits in order to keepunchanged their share of U.S. markets. They might retaliate against U.S. exports, setting off a tradewar between the United States and China. They might also ask the WTO for authority to levy tradesanctions, on grounds that the United States was not complying with the WTO rules on internationaltrade. Alternatively, they might raise the value of the yuan in hopes that this will eliminate the newU.S. tariffs on their goods.

The WTO trade rules allow countries to levy countervailing duties to offset any subsidiesforeign exporters might receive from their home governments. WTO rules do not allow countriesto impose tariffs or restrictions merely for the purpose of excluding foreign goods. If the UnitedStates hopes to persuade other countries that its special levies on Chinese imports are fair andcompensatory, it will likely need to show that the size of the levies match the degree of subsidywhich Chinese producers receive through the undervalued yuan. It might be helpful in this regardif there were more agreement among scholars and the affected countries as to whether and by howmuch China's currency is undervalued.

If the United States put special levies on Chinese goods, China might ask the WTO to rulethat the United States acted in a manner inconsistent with its obligations. (98) The countervailing dutiesand anti-dumping penalties allowed under WTO rules are usually applied to specific goods ratherthan to all exports coming from a particular country. Exchange rate manipulation might be seen asa type of general across-the-board subsidy for a country's exports. Nevertheless, there is littleprecedent (but see below) at the WTO for considering exchange rates from this perspective. TheWTO may be concerned that the rules governing world trade would be harder to enforce if countrieswere free to impose countervailing duties whenever they decided unilaterally that the currencies ofother countries were undervalued.

If the WTO agreed with China's petition, it could authorize China to retaliate by withdrawingtariff concessions on U.S. goods. The WTO dispute settlement process is adjudicated with referenceto the WTO rules and there seems little room for political pressure by the United States and othercountries. Other countries could, however, submit briefs in support of the U.S. or the Chineseposition. Countries likely will give some thought to the potential impact that a trade dispute betweenthe United States and China might have more broadly on world trade negotiations.

If the volume of Chinese exports to the United States declines because of new tradelegislation, the profits of foreign firms located in China which produce those goods will likely godown as well. Exporters could shift their production facilities further to the west in China, wherelabor costs are lower than on the coast. This might reduce costs enough for Chinese exporters to paythe new tariff and leave their prices unchanged. Alternatively, Chinese companies and internationalfirms might shift production to other countries where the costs of production have become lowerthan those in China because of yuan revaluation. In that case, these countries might replace Chinaas major suppliers of manufactured products to the United States.

If the United States wants to keep out foreign products (not just Chinese products) whichundersell U.S. manufactures, then new legislation would be needed to penalize other countries asthey ramp up to take China's place. This would violate WTO rules and the terms of internationaltrade agreements to which the United States is a party. Because the U.S. economy needs to importforeign goods of similar value to the foreign capital it imports each year, it may be hard for the U.S.government to stop countries from expanding their exports to the United States. role. If the volumeof imports declines, however, prices for manufactured products in the United States may increase,giving U.S. producers some relief. U.S. consumers would likely need to spend a larger portion oftheir income in this case to purchase the goods which were previously produced abroad.

Take It to the IMF

The United States could also pursue the issue of China's exchange rate policy at theInternational Monetary Fund. The key issue is whether China is complying with the requirementsof Article IV of the IMF Articles of Agreement and, if not, what steps it should take to comply. Though other countries seem to have preferred that the United States take the lead and break the icefor them, they are also affected by China's trade policies. Arguably, international meetings whererepresentatives of the major countries may speak with Chinese officials at the same time will bemore persuasive than scattered bilateral talks where the only strong public statements come from theUnited States.

There continues to be debate as to what, if anything, the outside world can do to acceleratethe reform process in China. In late September 2005, Treasury Under Secretary Adams demandedthat the IMF crack down on countries that violate the prohibition in Article IV against currencymanipulation, though it is not clear what tools he thought the IMF should use. (99) The IMF was, he said,"asleep at the wheel" and it should confront China concerning the deficiencies in its exchange ratepolicies. IMF Managing Director Rodrigo de Rato rejected that charge. (100) The IMF wasaddressing all aspects of the issue, he replied. The IMF had already investigated and rejectedsuggestions that China's currency policies warrant the use of "special consultations." Rather, hesuggested, the United States should act more vigorously to straighten out its own budget andeconomic policies rather than blaming other countries for its problems.

According to IMF sources, special consultations between IMF management and a countryhave occurred twice previously in response to formal complaints by another country that it wasmanipulating its currency. In the 1990s, the United States made a complaint about Korea andGermany filed a complaint about Sweden. The two countries eventually adjusted their currencyvalues, though they may have done this for their own reasons rather than in response to IMFconsultations.

In January 2006, Adams maintained that the IMF should play a stronger role enforcingexchange rates and preventing currency manipulation. (101) The IMF should demonstrate strong leadership on multilateralexchange rate surveillance, he said. "A strong IMF role in exchange rate issues is central to thestability and health of the international economy," he remarked. The IMF's leaders "should endorsesuch an enhanced role for the IMF, restoring its central role on exchange rates." While Adams didnot mention China by name, he said the IMF should identify countries "whose exchange rate policiesmight not be in accord with Fund principles" and it should "seek to identify problematic orinappropriate exchange rate behavior."

However, IMF Managing Director Rato told a session at the World Economic Forum inDavos, Switzerland that he does not consider China to be a currency manipulator. He rejectedproposals that the Fund should put greater pressure on China. He said "there is a trade-off betweenour role as confidential adviser in our surveillance work and our role as a transparent judge." (102) He noted that the IMFhad been the first international body to urge China to move from its fixed peg to a more flexibleexchange rate process. Rato also said the IMF should not take a proactive role on exchange rates,in response to Adam's question what the IMF should do about countries "that are attempting tothwart balance of payments adjustments."

On February 9, 2006, Rato outlined his future plans for the IMF. He said the IMF should putmore emphasis on surveillance but he raised several reservations about the Fund's taking the centralpolicing role Adams had proposed. (103)

The IMF is a place where the views of affected countries can be presented to China andefforts can be made to press China to revalue its currency. The IMF cannot force countries to haveexchange rate policies which mirror underlying economic conditions, even if they might benon-compliant with IMF rules. However, continuing discussion at the IMF and at other internationalmeetings serves to focus attention on the issue. At the least, it puts Chinese officials in a situationwhere they need to explain or justify their policies and to respond in some way to internationalpressure. Arguably, it has caused them to take steps towards liberalization that they otherwise mightbe reluctant to take -- or they might have taken more slowly -- if these conversations had not takenplace.

If the IMF were given the broader authority contemplated by Adams and others, thefundamental structure of the world exchange rate system would change and many countries, inaddition to China, would have to seriously revise their domestic and international economic policies. China might not be willing to make fundamental changes in its foreign exchange and economicpolicies unless other major countries make fundamental changes in their policies as well.

Refer It to the WTO

Another option might be for the United States to refer the issue of China's undervaluedcurrency to the World Trade Organization (WTO). In 2004, the China Currency Coalition and 30Members of Congress petitioned the U.S. Trade Representative separately asking the Administrationto take action of this sort. The undervalued exchange rate for the yuan is a kind of subsidy forChinese exports, they argue. It lowers the cost of production in China and enables Chinese exportersto sell products abroad at prices lower than their real costs of production should allow. They believethis is an unfair practice which is inconsistent with the rules of the world trading system and theyappear to believe that a WTO dispute settlement panel would support that view if the issue were putbefore it. The Administration rejected the two petitions, however. (104) Officials expresseddoubt that the United States could win a case of this sort in the WTO, though they did not detail thereasons for their doubt. They also said that action to challenge China's exchange rate and tradepolicies in the WTO might be "more damaging than helpful at this time." (105)

The WTO and IMF have a formal agreement between them which specifies that certain kindsof international finance issues shall be referred to the IMF for judgment, if they come up in thecontext of WTO deliberations, and the IMF's findings will be considered conclusive. (106) The scope of theagreement is discussed below. China's critics acknowledge that the WTO has no authority toadjudicate exchange rate issues. Some believe, however, that if the United States complained to theWTO that China was manipulating its currency in order to gain unfair trade advantage and the IMFagreed, the WTO could authorize the United States and other countries to put special tariffs onChinese goods. These would stay in effect until China raised the value of its currency.

This section discusses whether appealing this issue to the WTO is a feasible alternative. First, this section examines the question whether export subsidies arranged through exchange ratemanipulation are a "subsidy" as the WTO defines the term. The WTO's list of prohibited practicesis specific and limited in scope. Complaints that China is subsidizing its exports through currencymanipulation are actionable in the WTO dispute settlement process if currency manipulation is notconsidered to be covered by the agreement. Second, this section discusses two ways the UnitedStates might seek to change the rules of the world trading system so as to make currencymanipulation actionable in the WTO context. There are several contexts within the WTO where theUnited States could raise the issue and seek international agreement to revise the rules andobligations of members of the organization. In some cases, consensus or unanimity is required. Inone instance, however, a very large majority can change the requirements of the WTO in way thatapplies the changes so that new requirements apply to all member countries, even those which didnot approve its adoption.

The WTO's dispute settlement process is a quasi-judicial procedure that is intended to resolvetrade disputes between countries which cannot be resolved through conciliation or negotiation. Ifa complaining country so requests, a three member panel is appointed. The panel reviews the factsand arguments in the case and renders judgment based on the facts and WTO rules. (107) The WTO AppellateBody may review the initial panel's findings and, unless the panel and Appellate Body's findings areset aside by the WTO membership by consensus, the disputing parties are expected to implementthe panel decision, together with any modifications made by the Appellate Body. If a country doesnot comply within a reasonable period of time, the WTO may authorize the complaining country toimpose retaliatory duties on the non-compliant country's goods or take other retaliatory action thecomplainant proposes. Those duties or barriers remain in force until the country complies or untilthe disputing parties otherwise resolve the issue. (108)

There are several issues with the China scenario discussed above. First, some critics maymisconstrue the nature and extent of the agreement between the IMF and the WTO. The agreementhas to do with temporary trade restrictions, not with exchange rate policies or currency manipulation. The General Agreement on Tariffs and Trade (GATT) and the General Agreement on Trade inServices (GATS) include provisions which allow countries to impose temporary trade barriers inorder to safeguard their external financial situation. Certain financial and balance of paymentsconditions must be present, however, in order for countries to be justified in taking these steps. TheIMF has the final word as to whether those conditions prevail. (109) Currency manipulationfor the purpose of gaining unfair trade advantage and exchange rate policy are not mentioned in theinteragency agreement between the WTO and IMF or in the text of the GATT itself. (110)

Second, the key issue is not so much whether China's exchange policy gives it unfairadvantages in international trade but whether this is a kind of subsidy which is prohibited by WTOrules. When Chinese officials say they need to keep their currency at roughly its present rate becausean increase might bankrupt large sectors of China's export economy, they are admitting that theirexchange rate subsidizes exports. However, the WTO has a specific definition as to the types ofthings which are subsidies and therefore prohibited under its rules. Currency manipulation is notincluded among them.

When the core rules and obligations of the world trading system were laid down in 1947,with the adoption of the GATT, the world was on a fixed-parity exchange rate system managed bythe IMF. It was difficult, during this period, for countries to manipulate their exchange rates in orderto gain unfair trade advantage. During the 1970s, the fixed rate system broke down and the rulesof the IMF were changed to allow countries to have floating, fixed or whatever other types ofexchange rate systems they desire. (111) The IMF was given the task of monitoring ("surveillance")exchange rates but, as discussed above, it was given no effective means of enforcing its rule (ArticleIV) against currency manipulation. For its part, the GATT did not amend its rules when the IMFprocedures changed to take into account the possibility that countries might use exchange ratemanipulation as a trade policy tool. The WTO likewise took no steps when it was formed to fill thisapparent lacuna in the rules and obligations of the world trading regime.

The WTO defines the concept "subsidy" in very specific terms. If a government's actions donot meet the terms of the definition, even if they benefit exporters or cause trade injury, they are notactionable (subject to challenge) for purposes of the WTO dispute adjudication process. Further,to be actionable, subsidies must be specific to an industry ("specificity.") The WTO Agreement onSubsidies and Countervailing Measures (ASCM) expressly prohibits (112) export subsidies, whichare defined as "subsidies contingent...upon export performance." The ASCM deems export subsidiesto be per se specific. Domestic subsidies are not prohibited but may be challenged if they cause tradeinjury, as specified in the ASCM.

Subsidies that are not directly export contingent are also not allowed if (1) the governmentmakes a financial contribution and (2) it benefits the recipients. Government financial support cantake a variety of forms, such as direct payments to the exporter, the waiver of tax payments or otherrevenue that would otherwise be collected from the exporter, or special government purchases or theprovision of low-cost goods and services (other than general infrastructure) which lowers the costof production. Tax subsidies to broad categories of exporters, through mechanisms such as foreignsales corporations, also meet the test for specificity.

The WTO agreement makes no mention of subsidies provided through exchange ratepractices or monetary policy. All of the subsidies mentioned in the agreement occur on the fiscalside of the government's ledger and involve a direct cost to the government. Some legal analystsbelieve that, though doing so would be difficult, it might be possible to challenge China's actions inthe WTO. (113) Benitah suggests, for instance, that if the United States were able to show that China's fixedexchange rate is a de facto export subsidy it could take advantage of the per se specificity language. He also suggests that China's fixed rate might be viewed as a form of "in kind" subsidy similar tothat prohibited by the ASCM. Other legal commentators believe, however, that the likelihood thatthe WTO would view China's exchange rate practices as a prohibited subsidy are at best veryslim. (114)

Some critics of China's exchange rate policies have sought to circumvent this difficulty byarguing that China pays a direct subsidy to Chinese exporters through its exchange rate policy. Thedirect financial support occurs, they say, because Chinese exporters receive more yuan in exchangefor the dollars they earn from trade than they would if the yuan were valued correctly. An exportermight receive 8 yuan from the central bank today when it exchanges its dollars for yuan, whereas itmight receive 7 yuan instead if the yuan were valued appropriately. That extra yuan is a subsidy toexporters, the theory holds, and it is therefore a direct violation of WTO trade agreements. (115)

The idea that exports can be subsidized in this fashion seems to contradict the normallyaccepted concepts about international monetary transactions. Moreover, the effects on the worldtrading system would be considerable if the idea were accepted and applied to all countries. TheChinese are perhaps more blatant in the way their official actions effect currency values, but mostgovernments do things from time to time which influence the value of their national currency. If acentral bank lowers interests rates and the exchange value of its currency declines, one could arguethat the central bank is making its national exports more competitive and increasing the amount (inlocal currency) that its national exporters earn from trade. Likewise, an increase in exchange ratesmight be seen as an effort to purchase goods from other countries for less than their true value or toreduce the price that a country's foreign investors would need to pay in real terms for foreignacquisitions. If every change in the exchange rate for a currency is deemed to provide a subsidy orraise a barrier to trade, then the current rules of the world trading system would be unworkable ina world of floating (or inaccurately fixed) exchange rates.

Some would also argue that the concept that exchange rate differences can provide a subsidyto exporters is fundamentally flawed. Regardless of the exchange rate, the exporter receives a dollar'sworth of its local currency whatever the current rate might be. When the local currency goes up invalue, the exporter receives less local currency but each unit is more valuable than before. Importedgoods would also be cheaper and a dollar's worth of local currency would buy more foreign goodsthan before. Firms that use imports as part of their commercial process would see their costs declineproportionally.

In any case, the presumed subsidy implicit in the yuan exchange rate is not paid solely toexporters, as likely would be necessary for it to be found in violation of the direct payment andexport contingency provisions of the ASCM. Anybody -- exporters, tourists, banks, or personswishing to buy yuan in order to make foreign investments in China -- receives the same exchangerate for their money.

It is also not clear that the exchange rate "subsidy" is paid by the government or at thegovernment's behest. Many organizations in China buy and sell currency and -- while the centralbank continues to have a substantial effect on currency prices -- market forces determine the contextin which the central bank exerts its influence. If an exporter sells dollars to a commercial bank, theimplicit subsidy in the transaction would be paid by the bank and not the government. If Chineseexports were priced in yuan, the purchaser would have to sell dollars and buy yuan in order to settleits bill. In that case, the purchaser would pay any subsidy that is implicit in the transaction.

It appears that a strict interpretation of the WTO's current rules would provide little latitudefor a finding that China's exchange rate practices constitute a "subsidy" for exports insofar as thatterm is used within the WTO. The United States has taken a "strict construction" view of the WTOrules. Special Trade Representative Susan Schwab told Congress in May 2006, for example, that"the United States has emphasized the necessity for strict adherence to the Rules negotiating mandate... which requires that the effectiveness and basic principles of the WTO Antidumping and SubsidiesAgreements must be preserved." (116) Efforts by other countries to interpret the rules more broadlyor flexibly have been met, she said, by vigorous U.S. attacks.

Schwab also said that "initiating a WTO case on this matter [currency manipulation] wouldplace China in the position of defending, rather than reforming, its currency regime." (117) This would be the firstoccasion where the WTO was asked to resolve a currency dispute, she said, and it "would thereforehave an unpredictable outcome and take a relatively long time to reach completion." Some suggestthat a WTO decision against the U.S. position could have the effect of making currency manipulationan implicitly acceptable practice under the WTO, a result quite contrary to U.S. goals. Schwab saidthat continued dialog with China about its currency regime would likely be a more constructivemeans for resolving this concern.

Article IV of the IMF charter prohibits countries from manipulating their exchange rates forthe purpose of gaining an unfair trade advantage. Giving the IMF the authority to enforce thatprovision of its charter would be one way of addressing the currency manipulation problem. However, as noted above, this could require major changes in the structure of the world financialsystem and it could give the IMF new authority over the economic policies of its member countries. Many countries might be reluctant to adopt far-reaching changes of this sort merely to address theexchange rate aspects of a controversy about international trade.

It might be possible to address this issue through adjustments in the rules governing worldtrade. It could be argued, for example, that restrictions on currency manipulation should be includedin the rules of the WTO in order to make its procedures consistent with the requirements of theArticles of Agreement of the IMF. The IMF may not have the effective authority to enforce theprohibition in its Articles of Agreement against currency manipulation for the purpose of unfair tradeadvantage. This does not mean, however, that the world must live with the problem of currencymanipulation and contrary effects it may have on the relative efficiency of international productionand the patterns of international trade. The WTO could choose instead to incorporate this sameprohibition against currency manipulation into its own text in order to take deleterious trade effectsinto account.

There are two ways the United States might seek to make exchange rate manipulationactionable within the WTO dispute settlement framework if it wished to pursue the issue. First, itcould raise the issue during the Doha Round trade negotiations. Second, it could raise the issueseparately at the WTO Governing Council or the WTO Ministerial Conference in hopes of garneringa sufficient majority to reinterpret the WTO rules or to amend the trade agreements. In both cases,the goal would be adoption of changes in the WTO language in order to make exchange ratemanipulation a prohibited trade practice.

First, the United States might broach the issue in the current world trade negotiations. TheDoha Round of trade negotiations is currently discussing major changes in the basic ground rulesfor world trade as well as possible adjustments in tariff rates. The United States could ask that thecurrency manipulation issue should be added to the agenda. There are already many difficultsubjects on the agenda, however, and the WTO members have not yet agreed on a framework fornegotiating the most contentious issues before them. Adding another controversial issue to theagenda may not make the task of the negotiators any easier. On the other hand, nobody knows atthis point how many countries might want to make currency manipulation actionable under WTOrules.

Alternatively, the United States could raise the issue of currency manipulation in the WTO'sGoverning Council and in the biannual meeting of its Ministerial Conference. The Doha roundnegotiations seem to be in trouble and it may be too late, as a practical matter, to add anothercontroversial issue to the agenda. The Ministerial Conference consists of the trade ministers of allthe WTO member countries. These are the top policy making bodies of the WTO. Positive actionby them could lead to a change in WTO treatment of the exchange rate issue, either throughreinterpretation of the existing WTO rules or through amendment to the international agreementsthemselves. (118)

Article IX of the Agreement Establishing the World Trade Organization (WTO Agreement)says that decisions shall be made by consensus. However, it says, when consensus cannot beachieved, decisions shall be made on the basis of a majority of the votes cast, each country havingone vote. Interpretation of the charter and of international trade agreements and amendments tothose documents require a higher majority, however, to be effective. Article IX of the WTO chartersays that the General Council and Ministerial Conference have exclusive authority to adoptinterpretations of the WTO Agreement and the multilateral trade agreements such as the GATT,GATS, TRIPS, ASCM, etc. Interpretations are to be based on recommendations of the Council andrequire an affirmative vote of three-quarters of the entire WTO membership.

In theory, a three-quarters vote of the General Council and Ministerial Conference couldinterpret the existing trade rules in such a way as to make exchange rate manipulation for the purposeof gaining unfair trade advantage actionable under WTO rules. However, Article IX says that theinterpretation clause should not be used to undermine the amendment clause (Article X) of the WTOcharter. The procedural difficulties of using Article IX are daunting. A three-quarters vote of theentire membership is required, yet at most meetings of the WTO less than that share of themembership is in attendance at any one time. Nevertheless, there are sections of the GATT whichmight be considered anew in terms of their contemporary relevance. Article XV says, for instance,that the contracting parties "shall not, by exchange action, frustrate the intent of the provisions of thisAgreement, nor, by trade action, the intent of the Articles of Agreement of the InternationalMonetary Fund." Whether this could be interpreted as meaning that members of the WTO shouldnot violate Article IV of the IMF charter by manipulating their currency might be a matter for debate.

The United States could also propose that the WTO Agreement should be amended. ArticleX of the WTO Agreement says that any country may propose to the Ministerial Conference that theWTO charter or the multilateral trade agreements should be amended. Amendments can also beproposed by the WTO General Council or its subsidiary bodies. The Ministerial Conference mayadopt amendments to these documents by consensus. If consensus is not reached, then theConference may recommend by a two-thirds vote of the entire membership to submit a proposedamendment to the WTO's member countries for their consideration. Generally, amendments becomeeffective if they are ratified by two-thirds of the WTO's member countries. Amendments to a fewarticles of the WTO charter and the multilateral trade agreements require a unanimous vote. However, none of these seem to involve exchange rate issues or questions of export subsidy. Theimpact of any amendment to the WTO Agreement or the multilateral trade agreements may belimited, however. Article X says that any amendment which affects member rights and obligationsshall apply only to the countries which ratified it. One prominent WTO legal scholar, John H.Jackson, says that, in practice, this means that any changes of a substantive nature would apply onlyto the countries which endorsed them. (119) It would seem likely, then, that an amendment which said thatcurrency manipulation for the purpose of achieving unfair trade advantage was not an acceptabletrade practice would apply only to the countries which endorsed it.

The Ministerial Conference can also decide by a three-quarters vote of the entiremembership, however, that an amendment shall apply to all countries even if all countries have notratified its adoption. Article X says that the Ministerial Conference may decide that a country whichdoes not accept an amendment within a time period specified by the Conference "shall be free towithdraw from the WTO or to remain a Member with the consent of the Ministerial Conference." Presumably, serious negotiations would predate any decision that a country would be allowed toremain a WTO Member without accepting the application of a new amendment to itself.

It cannot be known in advance whether the United States and other countries that areconcerned about the trade effects of currency manipulation would succeed in gaining the votesnecessary to reinterpret or amend the trade rules. This is a very steep requirement. While theUnited States and its associates were lobbying the membership to consider the change, China andother countries which employ that practice would presumably be lobbying the membership to votethe other way. The result would likely depend on the strength of the arguments brought forth insupport of the initiative and the number of countries that believe that currency manipulation for thepurpose of gaining unfair trade advantage is injuring their interests or is otherwise undesirable.

It may not be possible to achieve the three-quarters positive vote needed to reinterpret theWTO agreement or to adopt amendments which are mandatory for all member countries. Nonetheless, discussion of this issue within the WTO may have salutary effects. It would requirethe countries which favor use of this trade practice to defend their policies and to explain why theybelieve currency manipulation is an appropriate tool of trade policy. The countries which might beamenable to changes in the WTO rules might also be identified. This information may be usefulif the United States decides to seek a negotiated arrangement during a later phase of the Doha tradenegotiations or in some future round of talks.

A strategy of taking the Chinese currency issue to the WTO is not likely to lead to a promptresolution of the controversy. It seems doubtful that adequate grounds can be found, given thecurrent language of the WTO agreement and the accompanying multilateral trade agreements, tosuccessfully address the question in the WTO dispute settlement process. Addressing the questionin the WTO policy process may offer opportunities for building support for changing the rules andguidelines used by organization, however. Discussion in the General Council and MinisterialConference would offer the United States an opportunity to discuss why, as a general principle,currency manipulation should not be a legitimate tool of national trade policy. It need not bediscussed, in this context, as an issue affecting only China. Obtaining the three-quarters vote tochange the language or prevailing interpretation of the WTO agreements would be difficult. Discussion in this context may help identify potential supporters and lay the groundwork for possiblyincluding currency manipulation as an additional agenda item in future trade negotiations.