International Trade: Treasury Assessments Have Not Found Currency Manipulation, but Concerns about Exchange Rates Continue
Released: 2005-05-19T00:00:00

Letter

Background

Congress passed the Omnibus Trade and Competitiveness Act of 1988 (the 1988 Trade Act) to achieve macroeconomic and exchange rate policies consistent with a sustainable current account balance. The law increases the executive branch’s accountability for assessing the impact of international economic and exchange rate polices on the economy. Congressional concerns at the time included concern that the exchange rates of other countries placed competitive pressures on U.S. producers.

The 1988 Trade Act directs the Secretary of the Treasury to analyze the exchange rate policies of foreign countries for the purpose of considering whether any are manipulating their currencies to gain an unfair trade advantage and to report on international economic policies, including exchange rates. To find that a country is manipulating the rate of exchange between its currency and the U.S. dollar within the meaning of the Trade Act, Treasury must determine that the country is manipulating the exchange rate for the purpose of gaining an unfair trade advantage or preventing effective balance of payments adjustments, and has a material global current account surplus and a significant bilateral trade surplus with the United States.

If Treasury finds that a country is manipulating its currency as defined by the Trade Act, the act requires Treasury to initiate negotiations with that country to ensure a foreign currency exchange rate adjustment that eliminates the unfair trade advantage. Treasury’s international policy and exchange rate reports must meet eight reporting requirements, including an analysis of currency market developments, an assessment of the impact of the exchange rate of the dollar on three broad aspects of the U.S. economy, and an analysis of capital flows. (See app. II for the exact language of the law.)

China and Japan follow different policies for determining their currency values. China has, since 1994, when it unified its dual exchange rate system, pegged the value of its currency, the renminbi, to the U.S. dollar. Chinese authorities maintain this peg by standing ready to buy and sell renminbi in exchange for other currencies within a narrow band around the fixed rate. When there is an excess supply of foreign exchange at this rate, such as from surpluses in trade or net private capital flows, China’s purchases of that excess lead to an increase in its foreign reserves. China maintains controls on capital flows that to some extent limit the volume of transactions in the foreign exchange market, although these controls have not prevented substantial recent capital inflows. In contrast, the Japanese yen is on an independent float, which means that its value relative to other currencies is determined by demand and supply in the currency market. In the past, Japan has carried out significant interventions in the foreign exchange market through the sale of yen in exchange for U.S. dollars, which has put downward pressure on the value of the yen relative to the U.S. dollar. Nevertheless, from January 2002 through January 2005, the yen’s value relative to the dollar increased 22 percent, from 132 yen per U.S. dollar to 103 yen per U.S. dollar. Japan has not intervened in the foreign exchange market since March 2004.

Treasury Has Not Found Recent Instances of Currency Manipulation

Although the Chinese and Japanese governments have carried out certain economic policies and practices related to their currencies’ values that have raised concerns among observers, Treasury has found in recent reports that neither country meets all the legal criteria for currency manipulation. Treasury’s overall approach to determining the presence of currency manipulation under the terms of the Trade Act includes screening countries and economies using a range of indicators to identify some for closer examination, applying legally mandated criteria, and considering multiple aspects of economic conditions and activities. Although Treasury has cited Taiwan, Korea, and China for currency manipulation in the past, it has found no such instances since 1994.

Stages in Treasury’s Assessment of Currency Manipulation under the 1988 Trade Act

Treasury’s Office of International Affairs begins its analysis of currency manipulation by soliciting input from country desk officials responsible for monitoring economic activity. Treasury officials stated that they use analyses and information obtained throughout the year as the basis for determining whether a country is manipulating its currency. Treasury officials responsible for the currency manipulation analysis compile available information on exchange rates and other economic conditions. Treasury also collects information from external sources, such as private sector experts, and meets regularly with the IMF on broad international economic policy issues.

Treasury officials use the collected data to identify those economies deserving closer examination. In addition to including bilateral trade surplus and global current account surplus information in this initial consideration, they also take into account other factors, such as changes in currency value, capital flow conditions, and country size. (Fig. 1 presents the ranking of economies with the largest bilateral trade surpluses with the United States, and fig. 2 presents the ranking of those same economies according to their current account balance as a percentage of gross domestic product.)

Treasury does not usually scrutinize economies with large, obviously explainable, trade balances, such as major oil-exporting nations, for currency manipulation. On the other hand, Treasury reviews some economies regardless of economic indicators. For instance, Treasury consistently reviews the activities of major U.S. trading partners, such as Japan, the European Union, and Canada. It also monitors the three economies that it previously found to be manipulating their currencies— Taiwan, Korea, and China. Treasury selectively includes other nations in currency manipulation assessments when it determines that economic conditions merit.

Treasury officials stated that they make a positive determination on currency manipulation only when all the conditions specified in the Trade Act are satisfied. According to these officials, to reach a positive finding of currency manipulation under the Trade Act, Treasury must find that the economies have a material global current account surplus and a significant bilateral trade surplus with the United States, and they are manipulating their currency with the intent of gaining trade advantage. Treasury has significant flexibility in determining whether countries meet these criteria. Treasury officials told us they do not have operational definitions of a “material” global current account surplus or a “significant” bilateral trade surplus.

Treasury officials stated that they do not limit their analysis to the use of the material global current account surplus and significant bilateral trade surplus criteria listed in the Trade Act, but rather consider multiple aspects of the economy. Treasury officials also stated that they do not use a definitive checklist to make their determinations. Treasury officials told us that the country-specific economic and international trade factors they consider include restrictions and regulations governing the use and retention of foreign exchange and international financial flows; movement of exchange rates, authorities’ intervention in foreign exchange markets, and the effectiveness of that intervention; accumulation of foreign exchange reserves; institutional development related to banking and financial sectors; macroeconomic indicators, including gross domestic product (GDP) growth rates, inflation, and unemployment rates; savings/investment balances and underlying factors; foreign investment and international portfolio investment flow patterns; trade regime barriers; and external shock factors such as financial crises, oil price hikes, or natural disasters.

The 1988 Trade Act does not require Treasury to determine if a currency is undervalued while performing its currency manipulation assessments. Although Treasury has in the past included observations on whether currencies were undervalued, it no longer does so. While Treasury officials told us they do not make an official determination on undervaluation, in its March 2005 report to Congress (discussed below), Treasury included measures of undervaluation among the indicators it considers in its manipulation analysis.

Upon completion of the currency manipulation assessments, managers within the Office of International Affairs prepare recommendations for the approval of the Under Secretary for International Affairs. In the case of a positive finding of currency manipulation, Treasury initiates negotiations with officials of the economy in question, as called for by the Trade Act.

Treasury generally summarizes the results of the currency manipulation assessments in its semiannual report to Congress, but does not explain how it weighs the multiple economic factors it analyzes when making its currency manipulation determinations. Over time, Treasury reports have included varying lists of factors the department considers in conducting its currency manipulation analysis.

Congressional concern over Treasury’s currency manipulation assessments led to a mandate in the fiscal year 2005 Consolidated Appropriations Act requiring Treasury to report on how the statutory requirements of the 1988 Trade Act could be clarified administratively to enable currency manipulation to be better understood by the American people and by Congress. Treasury issued its report on March 11, 2005. In this report, Treasury provided a high-level discussion of factors it considers when conducting its currency manipulation assessments, including measures of undervaluation, capital controls, and trade balances, and also described difficulties related to rendering manipulation assessments. Treasury did not—and was not required to—provide information on a country-specific basis about recent currency manipulation assessments.

Treasury Has Not Found Recent Instances of Currency Manipulation under the Terms of the 1988 Trade Act

Since 1994, Treasury has not cited any economies for manipulating their currency as defined by the Trade Act. Treasury officials stated they have closely monitored recent economic behavior in China and Japan, due in part to the rapid accumulation of foreign currency reserves in those countries. Although Treasury has not cited China recently, it has engaged in discussions encouraging China to move to a more flexible exchange rate regime. Treasury did not find that Japan was manipulating its currency in 2003 and 2004. Treasury officials told us that they viewed Japan’s interventions as a part of macroeconomic policy aimed at combating deflation in Japan, and they expressed skepticism about the efficacy of intervention to affect the yen’s value.

Before 1994, Treasury Cited Taiwan, Korea, and China for Currency Manipulation

Since the enactment of the 1988 Trade Act, Treasury has identified three economies—Taiwan, Korea, and China—that manipulated their currencies under the Trade Act’s terms. Treasury first cited Taiwan and Korea in 1988 and China in 1992. Taiwan was cited again in 1992. Each citation lasted for at least two 6-month reporting periods for Taiwan and Korea, while China’s lasted for five reporting periods.

Treasury reported evidence that the criteria for currency manipulation under the Trade Act had been met in most of these cases. At the time of their citations, Taiwan, Korea, and, on three occasions, China had relatively large bilateral trade surpluses with the United States and relatively large global current account surpluses. However, China, on two later occasions in the mid 1990s, had either a substantially declining current account surplus or a current account deficit when cited by Treasury for currency manipulation.

The three economies also had other economic characteristics that Treasury considered when it determined they were manipulating their respective currencies. For instance, all three economies had also been rapidly accumulating foreign exchange reserves. In addition, for both Taiwan and Korea, Treasury found excessive restrictions on foreign exchange markets and capital controls and evidence of heavy direct intervention in foreign exchange markets by the authorities of Taiwan and Korea. In China’s case, Treasury was concerned by Chinese efforts in 1991 and 1992 to frustrate effective balance of payments adjustments through the use of a dual exchange rate system. Treasury cited continued devaluations of the official exchange rate and excessive controls on the market rates. (See app. III for more details on Treasury’s previous findings of manipulation for these three economies.)

As required by the Trade Act, Treasury entered into negotiations with Taiwan, Korea, and China, and all three made substantial reforms to their foreign exchange regimes. In addition, their currencies appreciated and external trade balances declined significantly until they reached the point at which the three were removed from the list of currency manipulators. Treasury continues to monitor the policies and practices of these economies for evidence of currency manipulation.

Treasury’s Recent Reporting on China and Japan

In recent reports Treasury has not found that either China or Japan meets the statutory criteria for currency manipulation. Since 2001 both countries have had periods of increasing current account surpluses and also periods of rapid accumulation of foreign exchange reserves.

With respect to China, while Treasury did not report data on China’s global current account surplus for the second half of 2003 or the first half of 2004, Treasury officials stated that the surplus had not reached a material level. In April 2004, Treasury reported that China’s overall trade surplus had been 2.6 percent of GDP in the second half of 2003. In December 2004, Treasury reported that for the first half of 2004 China had an overall trade deficit of 1 percent of its GDP. In the same report, Treasury stated that while Chinese foreign exchange reserves had risen sharply, the accumulation was due in large part to steady foreign direct investment inflows and a sharp increase in other capital inflows. (See app. IV for more details on China’s external account development in recent years.)

Treasury officials also stated that they do not think China’s current restrictions in foreign exchange markets and other administrative controls on trade are comparable to conditions in the early 1990s. At that time, important factors in Treasury’s determinations were China’s pervasive direct controls on external trade activities and a dual exchange rate regime with massive restrictions and controls. Since then, China has removed restrictions on the convertibility of the renminbi for trade transactions and substantially liberalized its trade regime, including implementing a variety of reforms related to its accession to the World Trade Organization in 2001.

Since 1994, China has followed a policy of maintaining its currency peg to the dollar regardless of economic conditions, according to Treasury officials. For example, during the Asian financial crisis of the late 1990s, China kept the renminbi’s value steady rather than depreciating it to stay competitive with the cheaper currencies of other Asian exporting economies. While this helped maintain the stability of its own economy and the region, it was not consistent with a policy of keeping a cheap currency for trade advantage, according to Treasury officials.

Despite the absence of a positive determination on currency manipulation, Treasury has stated that China should move from its long-term fixed exchange rate and has engaged in discussions with China to advocate a shift to market-based exchange rate flexibility. The Chinese government has indicated its willingness to move to a flexible exchange rate regime after undertaking a series of preparative steps but has established no specific timetable to complete them. To date, China has taken some steps to reduce barriers to capital outflows, liberalize interest rates, remove investment restrictions, and strengthen its financial infrastructure. Treasury has provided technical assistance to help China develop market mechanisms needed for the transition to a flexible regime, including central bank supervision of currency risk and regulation of foreign exchange derivative markets.

With respect to Japan, Treasury officials stated that the country’s ongoing current account surplus reflects a long-term imbalance between savings and investment. In the last three exchange rate reports covering 2003 and 2004, Treasury noted that Japan justified its currency market interventions as a response to market overshooting, or excess volatility, and that such activity did not target particular exchange rate values. Treasury officials stated that Japan’s interventions were part of a macroeconomic policy aimed at combating domestic deflationary pressures. In addition, Treasury officials expressed general skepticism about the efficacy of intervention. Japan has not intervened to prevent the appreciation of the yen since March 2004.

Treasury Has Generally Complied with Reporting Requirements, but Its Approach to Assessing the Impact of Exchange Rates on the U.S. Economy Has Changed

Treasury has generally complied with the reporting requirements mandated by the 1988 Trade Act (see table 1), although its discussion of U.S. economic impacts has become less specific over time. Treasury exchange rate reports have consistently included information responding to four requirements: (1) analysis of currency market developments, (2) evaluations of underlying conditions in the United States and other economies, (3) descriptions of currency market interventions, and (4) analysis of capital flows. Treasury can respond to a fifth reporting requirement, recommendations for changes necessary to attain a sustainable current account balance, at its discretion. A sixth requirement, reporting outcomes of negotiations, is only relevant when Treasury makes a finding for currency manipulation under section 3004 of the act, and Treasury has complied with this requirement when applicable. Treasury did not include updates for the seventh requirement—U.S.–IMF consultations—in six reports from 2001 to 2004. According to Treasury officials, by this time summaries and complete reports of IMF consultations with the United States had become publicly available on the Internet, and reporting on these consultations was unnecessary. The December 2004 report included an Internet link to IMF consultation information.

Treasury has over time changed its approach for complying with its remaining requirement—an assessment of the impact of the exchange rate on the U.S. economy. According to Treasury officials and our analysis of the exchange rate reports, Treasury’s view of the role of exchange rates on the U.S. balance of payments and the economy in general has changed since 1988. Treasury’s reports generally discussed at least some elements of the impact-reporting requirement from the late 1980s through the 1990s. From 1988 into the early 1990’s, Treasury’s reports generally discussed exchange rate effects on U.S. external balances and economic growth. From 1994 through 1999 and into 2000, Treasury reports generally advocated a “strong dollar” policy. Reports in 1994 through 1997 discussed specific U.S. benefits of such a policy, such as lower inflation and higher investment and economic growth.

Treasury’s impact-related analysis after the 1990’s cited the importance of broader macroeconomic and structural factors behind global trade imbalances. Treasury viewed exchange rates as one of several interacting economic variables needing attention to address global imbalances. For example, in the October 2003 and April 2004 reports, Treasury reported that the current account deficit represented the gap between savings and investment, and its sustainability depended on the attractiveness of U.S. capital markets to foreign investors. Its analysis also emphasized the importance for U.S economic interests of strong growth of U.S. trading partners. Treasury’s most recent report in December 2004 did identify exchange rate flexibility for certain Asian economies as an area of policy the administration is following to reduce global imbalances.

Given its broad approach to impact-related analysis, Treasury’s semiannual reports do not contain discrete examinations of the effect on the U.S. economy of changes in the dollar’s value. Thus, Treasury’s reports do not specifically address the impact of the dollar on aspects of economic activity listed in the 1988 Trade Act, including production, employment, and global industrial competition. Treasury states that it does consider the impact of the exchange rate on these variables and that their broader approach meets the intent of the impact reporting requirements set forth in the 1988 Trade Act.

Estimates of the Undervaluation of China’s Currency Vary Widely, and Views on Policy Steps Differ

Many experts maintain that China’s currency is significantly undervalued, while some believe that undervaluation is not substantial or that calculating reliable estimates is not possible. Even among experts who believe that China’s currency is undervalued, there is no consensus on how and when China should move to a more flexible exchange rate regime and whether or not capital account liberalization, including, for example, lifting restrictions on outward flows of Chinese capital, should be a part of that process.

Many Experts Conclude China’s Currency is Undervalued, but Methodological Challenges Cause Differences

Most of the estimates we reviewed indicated that China’s currency is undervalued to some extent, with some experts suggesting substantial undervaluation and others slight misalignment. While there is no consensus methodology for determining whether a country’s currency is undervalued, experts have applied a number of commonly used approaches to the case of China. (See app. V for details of the various methodologies and their limitations.) These approaches generally involve determining an equilibrium exchange rate, broadly defined as the exchange rate that is consistent with a country’s economic fundamentals, when the country is operating at full employment and in a free market. As table 2 illustrates, estimates of renminbi undervaluation range from none to over 50 percent. Some of these estimates are rough calculations based on “rule-of-thumb” assumptions while others are based on formal models. In addition, some of these estimates may be most appropriately categorized as measures of near-term undervaluation or short-term pressure indicators. Moreover, the margins of error for these estimates are generally unknown.

The significant variation in estimates of remninbi undervaluation can be attributed in part to different methodological approaches, but similar methodologies can also yield differences. The absolute version of the Purchasing Power Parity (PPP) methodology, which determines the exchange rate at which identical goods would trade at the same price in both countries, produces estimates that generally show the renminbi is considerably undervalued. The External Balance approach is based on calculating an exchange rate that would result in a country achieving a sustainable balance in its external accounts, such as its current account balance or its trade balance. In the studies we reviewed, this approach generally produced estimates of currency undervaluation for China from 4 to 25 percent, with one estimate of 40 percent. Moreover, there are often significant differences in estimates even when similar methodologies are used. For example, experts who use the Behavioral Equilibrium Exchange Rate (BEER) approach, which uses econometric relationships between exchange rates and other economic variables to estimate an equilibrium exchange rate, have found renminbi undervaluation ranging from 11 to 47 percent.

Some experts doubt that equilibrium exchange rates can be estimated and thus believe that whether a currency is under- or overvalued cannot be reliably determined. Treasury officials and some other experts we spoke with stated that estimating equilibrium exchange rates is especially challenging for developing economies with rapidly changing economic structures, such as China. According to Treasury, the determination of under- or overvaluation requires analysis of key economic variables, the measures for which are subject to considerable uncertainty in China. Moreover, determining an equilibrium exchange rate is especially difficult for China because China restricts the outflow of funds from the country. (See app. IV for a discussion of China’s capital controls.)

Some observers and analysts view China’s growing foreign exchange reserves as evidence that the renminbi is undervalued. China’s foreign exchange reserves increased by $399 billion dollars—185 percent—from the end of 2001 to the end of 2004. These observers maintain that the reserves, which partly reflect China’s surpluses in global trade and foreign direct investment (FDI), are evidence that the value of the renminbi is too low relative to the demand for renminbi-denominated goods, services, and other investments; as a result, China must purchase large amounts of dollars to keep the renminbi’s value from increasing beyond its U.S. dollar peg.

Using reserve accumulations as evidence of a mismatch between the current value of the renminbi and its long-run equilibrium value has limitations, however, according to several analysts. China’s foreign reserve accumulation has several components: the current account balance, FDI net inflows, non-FDI net inflows (which include portfolio investment such as stocks and other investments), and undocumented capital—referred to as errors and omissions. China’s current account surpluses and FDI inflows were the primary components of the $117 billion increase in its reserves in 2003, accounting together for about 80 percent. Net non-FDI inflows and errors and omissions accounted for about 20 percent of the reserve increase. (See further details in app. IV.)

Views on Policy Steps for China Differ

Treasury has urged China to move to a market-based flexible exchange rate and take steps to remove restrictions on capital flows. There is debate regarding steps and timing on both issues. With respect to whether and when China should change its exchange rate policy, there are varying views even among experts who believe the currency is undervalued. Some experts have recommended that China immediately revalue the renminbi, either relative to the U.S. dollar or to a broader group of currencies. Others have suggested that China should move to a more flexible system—with a freely floating exchange rate being the most flexible. Analysts have identified potential advantages of such policy changes for China and also for other countries. Analysts have also identified a number of challenges for China. For example, some experts have cautioned that there could be economic costs to China if the monetary authorities revalue the currency and guess wrong about how large the revaluation should be. They have stated that a small revaluation could encourage further speculative capital flows into the country in anticipation of a further revaluation, which would increase reserves. Some have also expressed concern that a large appreciation in the renminbi’s value could unnecessarily slow down the Chinese economy and worsen labor conditions in the country, which has high unemployment in certain regions.

There are also varying views on changes in China’s policies regarding restrictions on capital flows. China currently restricts outward flows of Chinese capital for foreign direct investment and purchases of securities abroad, although it eased some restrictions in 2004. (See app. IV for additional information on these restrictions.) A number of advocates of greater exchange rate flexibility maintain that China is not ready for significant capital account liberalization and that the government should maintain some capital controls after moving to a more flexible exchange rate. One reason cited is that liberalization would expose China’s financial sector to risk if, for example, banks in China that are not financially strong experienced erosion of their deposit base from investors switching funds offshore.

Several policy options advocated for China’s currency involve a gradual or multistep process, which proponents maintain could minimize the potential for adverse effects of revaluation. One expert, for example, has advocated a two-stage currency reform process for China. The first stage would entail pegging the renminbi to a group of currencies, including the dollar, rather than pegging to the dollar alone; a 15 to 25 percent revaluation; and setting a 5 to 7 percent band for renminbi fluctuation against the new currency basket. The second step would be a significant liberalization of capital outflows and adoption of a managed float. The second step would occur following adequate strengthening of China’s banking system.

The U.S. Impact of a Renminbi Revaluation Would Depend on Multiple Factors

A revaluation of the renminbi could have implications for various aspects of the U.S. economy—with both costs and benefits—although the impacts are hard to predict. First, a higher-valued renminbi would make Chinese exports to the United States more expensive and U.S. exports to China cheaper—with the extent depending on several factors—which could increase U.S. production and employment in certain sectors. Some groups could be negatively affected by a higher-valued renminbi, including U.S. producers who use imports from China in their own production and would face higher prices and costs of production. Consumers in the United States could also face higher prices. Finally, an upward revaluation of the renminbi could also affect flows of capital to the United States from China, which have in recent years accounted for a significant source of financing of the U.S. trade deficit.

Several Factors Could Significantly Influence the Impact of China’s Currency on the U.S. Economy

Although a revaluation of the renminbi relative to the dollar would tend to make U.S. exports to China cheaper and U.S. imports from China more expensive, just how much more expensive China’s imports would become—and the impact on the U.S. trade deficit, production, and employment—would ultimately depend on several factors. Some key factors include the following: How much of the exchange rate appreciation is “passed-through” to higher prices for U.S. purchasers. Experience with other nations generally shows that pass-through is less than complete, particularly in the short term, because contracts for exports to the United States may be written in dollars. Longer term, the extent of pass-through depends on factors such as the extent to which Chinese exports to the United States are made up of inputs from other countries (since these would become cheaper with a stronger renminbi), and the extent to which Chinese exporters reduce their costs or profit margins.

The extent of the U.S. market response to the higher prices. In some markets, U.S. purchasers may continue to buy nearly the same volume of Chinese imports at the higher prices, while in others U.S. purchasers may decide to sharply reduce their purchases. The less responsive the overall U.S. demand is to price changes of Chinese imports, the less changes in the renminbi-dollar exchange rate will affect the U.S. trade balance, production, or employment. The same is true on the other side of the market; if Chinese demand for U.S. exports is unresponsive to the lower prices of U.S. goods, Chinese buyers will not buy much more in the short run even if prices of U.S. exports have fallen.

The extent to which products now being manufactured in China would be produced in other countries rather than in the United States. It is probable that goods from other countries with low labor costs would replace a portion of Chinese exports to the United States if the renminbi were to increase in value, thus reducing the impact on the U.S. economy. Specifically, some experts believe that decreased imports from China would be largely replaced by slightly higher-priced imports from other low-income countries such as Sri Lanka, Vietnam, Bangladesh, and Pakistan, among others, instead of being manufactured in the United States.

Whether other countries follow China and adjust their policies. Some analysts contend that the renminbi’s peg to the dollar induces other East Asian countries to intervene in currency markets to keep their currencies weak against the dollar so that they can remain competitive with China. Some believe that a revaluation by China might encourage other countries to change their exchange rate policies as well. This would magnify the impact of a revaluation on the United States.

The time period necessary for these adjustments to take place. While a currency appreciation has some immediate effects, the impacts on the trade statistics, production decisions, and employment generally take a longer time. In the short term, the U.S. trade deficit may increase as it takes more dollars to buy the same amount of Chinese products. As the higher prices are factored into new purchasing decisions, the appreciation would lead to effects on U.S. production and employment that could occur over a period of months or years. (See app. VI for an additional discussion of these and other factors affecting the extent of revaluation impacts.)

A Renminbi Revaluation Could Have Both Costs and Benefits for the U.S. Economy

Changes in the value of a currency like the renminbi could affect the U.S. economy in a variety of ways, and assessing the effects is complex. For example, an increase in the renminbi’s value could affect the mix of jobs in certain sectors, benefiting those sectors that compete directly with foreign products. However, in terms of employment, many experts believe that a rise in the value of the renminbi relative to the dollar would be unlikely to have much, if any, effect on aggregate employment in the United States. This is because the overall level of U.S. jobs is generally viewed as being largely determined by factors such as the domestic labor supply and broader macroeconomic factors such as U.S. monetary policy. In addition, an increase in the value of the renminbi could have other types of impacts that affect the economy more broadly, such as influencing the prices of goods and interest rates.

Examples of groups that would be expected to benefit from an upward revaluation of the renminbi include: U.S. firms and workers exporting to China—U.S. exports would become cheaper for Chinese consumers.

U.S. firms and workers producing goods that compete with Chinese imports—Chinese imports would become more expensive for U.S. consumers.

Low-wage countries other than China—Their exports could displace Chinese exports to the United States.

U.S. investors in China—The value of assets in China would increase.

Examples of groups that would be expected to experience some losses from an upward revaluation of the renminbi include: U.S. consumers—Imports from China would cost more.

Certain U.S. producers—Firms that import Chinese components in the production of final goods would pay more for those components.

Borrowers in U.S. capital markets—A possible decrease in capital flows from China could increase pressure on U.S. interest rates.

Multinational firms in China—The cost of production in dollars would increase and possibly raise the prices of final goods shipped to the United States.

Analysis of Impacts of a Renminbi Revaluation on the U.S. Deficit and Manufacturing Sector Illustrates the Importance of Methodological Assumptions

Discussions of a revaluation of the renminbi have tended to focus on the outcome for workers in the U.S. manufacturing sector because U.S. employment in this sector has shrunk considerably in recent years and is believed to be sensitive to international trade. Predicting the manufacturing sector production and employment effects of a change in the renminbi’s value is complex and is related to changes in trade flows. Therefore, some analysts have used estimates of changes in the U.S. trade deficit to estimate potential manufacturing production and employment effects, at least over the short run, although such linkages involve further uncertainties.

The following exercise illustrates how possible impacts of a renminbi revaluation on the U.S. trade deficit could vary under different assumptions. The estimates use as a starting point an assumption for the relationship between the overall exchange rate of the dollar and the U.S. trade deficit from the IMF’s April 2004 World Economic Outlook and then illustrate the impact of additional assumptions regarding exchange rate pass-through, import displacement, and follow-on exchange rate adjustments (see table 3).

These assumptions are not analytically precise, and other researchers have used different assumptions.

As shown in the table, with a hypothetical upward revaluation of 20 percent, the estimates for trade deficit reduction due to a revaluation of the renminbi under these assumptions range from $3.3 billion to $13.3 billion, depending on pass-through, the displacement effect, and follow-on exchange rate adjustments. Estimates outside of the range of estimates provided here could be obtained using different assumptions. These estimates could change further by accounting directly for other factors such as the sensitivity of U.S. demand to price changes of Chinese imports.

Some analyses have drawn conclusions about the impact of exchange rate changes on U.S. manufacturing jobs by using additional assumptions to those employed above. For example, one analysis used the assumption that a $1 billion increase in the U.S. trade deficit would lead to a decline in U.S. manufacturing jobs of about 15,000. Applying such a value to estimates of a 20 percent renminbi revaluation, under the assumptions shown in scenario 3, would lead to estimates of manufacturing sector job impacts of about 49,800 jobs. Under scenario 4, with the additional assumption of follow-on exchange rate adjustments if the renminbi were revalued, the manufacturing sector job impact estimate would be 199,000. These analyses have limitations. Researchers have observed that trade affects the demand for manufacturing labor in complex ways, particularly with respect to imported goods and components. Moreover, as noted above, the long-run level of employment in the economy is generally viewed as being determined by demographic and broader macroeconomic factors such as monetary policy. Thus, to the extent there are manufacturing sector job impacts of a renminbi revaluation, they may be offset by job losses in other sectors of the economy.

An Upward Renminbi Revaluation Could Have Implications for U.S. Capital Flows

Capital flows must also be considered in an assessment of the implications of a renminbi revaluation. The U.S. bilateral trade deficit with China—and its maintenance of a fixed exchange rate to the dollar—has been accompanied by an inflow of funds into U.S. capital markets from China. This has occurred during a period of an overall rise in inflows of foreign capital accompanying increasing U.S. trade and current account deficits. To the extent that a revaluation of the renminbi would lead to a decrease in the U.S. global current account deficit, it would also be associated with lower capital inflows. Such capital inflows—U.S. borrowing from foreign sources—can benefit the United States by lowering interest rates and stimulating investment and consumption. However, U.S. interest payments on this foreign-held debt are sent abroad. In addition, some analysts believe that U.S. dependence on inflows of foreign capital carries risk because of the potential for foreign investors to decide to hold or purchase less U.S. debt. The potential for, and consequences of, a widespread withdrawal of investment funds from U.S. markets has recently been debated. While some analysts believe that the effects of a foreign withdrawal from U.S. financial markets—or a reduction in foreign purchases of U.S. debt—would have limited effects over the long run, some acknowledge that short-run disruptions, such as the loss of value of assets and higher interest rates, could be significant.

According to Treasury data, about 44 percent of the total value of outstanding U.S. Treasury securities held by the public is held by foreigners. At the end of 2004, China held 4.2 percent of the total holdings of outstanding U.S. Treasury securities, which is about 10 percent of these securities held by foreigners (see fig. 3). By far the largest holder of U.S. Treasury securities is Japan, which holds 16.6 percent. The United Kingdom, with 3.0 percent, is third behind China.

As figure 4 illustrates, China was one of the largest purchasers of U.S. Treasury securities from 2001 to 2004—$95.4 billion, compared to $367.4 and $168.1 billion for Japan and the United Kingdom, respectively. Like other foreign central banks, China’s central bank has chosen to purchase large quantities of U.S. Treasury securities with renminbi in part because it can buy and sell them quickly with minimal market impact. Figure 4 also shows that, in recent years, China has been a strong purchaser of other types of U.S. securities, especially agency bonds, according to data from the Treasury International Capital (TIC) reporting system. Between 2001 and 2004 China purchased on net about $243.5 billion in total U.S. securities, behind the United Kingdom and Japan. (See app. VII for more data on net purchases of U.S. Treasury securities by China and other countries).

Observations

While we make no recommendations in this report, we believe that our analysis provides important insights into the debate over exchange rates and U.S. government assessments of currency manipulation. The debate involves several issues that are related, but distinct. The first is currency manipulation. Assessing currency manipulation under the terms of U.S. law is complex and involves both country-specific and broader international economic factors. A second issue is undervaluation of currencies.

Countries with undervalued currencies are presumed to obtain trade benefits from the undervaluation and therefore are often assumed to be manipulating their currencies to maintain these benefits. Many experts tend to focus on undervaluation—which Treasury is not required to determine. A third issue is the policy response that is expected from nations that are the focus of the debate. For example, experts who believe that China’s currency is undervalued have varying views about what action China should take, including whether certain policy options entail risks to China’s economy. In this report, we have tried to keep these issues distinct, because we believe it aids in clarifying the debate.

The level of concern over exchange rate issues—especially with respect to China--is not surprising given the continuing growth of the U.S. trade deficit, the rapid growth of China’s exports to the United States, and the recent depreciation of the dollar against several major currencies. In addition, as trade agreements reduce many of the industry-specific barriers to world trade, there has been a shift in attention toward the macroeconomic aspects of trade, which include exchange rates as well as national savings and investment rates. News that China’s trade and current account surpluses were higher than expected in 2004 increases the need for good information on factors affecting international trade and financial flows, especially with respect to China, and the implications of these flows for the United States. Congress recently required Treasury to provide information on aspects of its reporting under the 1988 Trade Act, to facilitate better understanding by the American people and Congress. Treasury’s March 2005 report in response to this mandate provided a high- level discussion of key factors Treasury considers in its currency manipulation assessments and sheds light on the complexities of the assessments but did not provide—and was not required to provide-- country-specific information about Treasury’s recent assessments. Since then, Members of Congress have continued to propose legislation to address China currency issues. We believe that the analysis in this report provides a basis for further discussion of currency manipulation concerns.

Agency Comments and Our Evaluation

We provided a draft report to the Department of the Treasury. Treasury provided written comments, which are reprinted in appendix VIII. Treasury stated that the report is generally thoughtful and hopes that it will contribute to increased understanding of the complex issues covered in its exchange rate reports. Treasury also emphasized several aspects of its exchange rate assessments and its reports. For example, with respect to reporting on U.S. economic impacts, Treasury stated that when conducting its analysis it does consider how the exchange rate of the dollar affects areas such as the sustainability of the current account deficit, production, and employment. Treasury stated that it believes it is often more helpful to look at underlying developments that affect exchange rates and other macroeconomic conditions rather than to achieve a false sense of precision by isolating the exchange rate in the analysis. Treasury also provided technical comments, which we incorporated in the report as appropriate.

As agreed with your office, unless you publicly announce its contents earlier, we plan no further distribution of this report until 30 days from the date of its issuance. At that time, we will send copies of this report to interested congressional committees, the Secretary of the Treasury, and other interested parties. We will make copies available to others upon request. In addition, the report will be available at no charge on the GAO Web site at http://www.gao.gov.

If you or your staffs have any questions concerning this report, please contact me at (202) 512-4128 or at yagerl@gao.gov. Other GAO contacts and staff acknowledgments are listed in appendix IX.

Objectives, Scope, and Methodology

The Chairs of the Senate Committee on Small Business and Entrepreneurship and the House Committee on Small Business asked us to review the Department of the Treasury’s efforts to fulfill its legal obligations under the 1988 Trade Act and related issues. We examined (1) the process Treasury uses to conduct its assessments of currency manipulation and the results of recent assessments, particularly with respect to China and Japan; (2) the extent to which Treasury has met the 1988 Trade Act reporting requirements; (3) experts’ views on whether or by how much China’s currency is undervalued; and (4) the implications of a revalued Chinese currency for the United States.

To determine the process Treasury uses to conduct its currency manipulation assessments and the results of recent assessments, particularly with respect to China and Japan, we reviewed the legal provisions of the 1988 Trade Act requiring Treasury to analyze foreign currency manipulation, and the act’s legislative history. We also interviewed responsible Treasury officials to better understand the assessment process. In addition, we reviewed Treasury exchange rate report findings on whether other countries are manipulating their currencies. Specifically, we examined the conditions cited in the Treasury reports that led to determination of currency manipulations for Taiwan, Korea, and China from 1988 to 1994. We also examined the changes in the economies’ conditions that led to removals of citations or, in some cases, subsequent citations for these economies; and we interviewed Treasury officials to understand Treasury’s reasoning behind its findings for China and Japan. We interviewed IMF officials to obtain information on Treasury’s consultive process with IMF. To gain a broader perspective on the economic conditions of China and Japan, we examined recent domestic and international economic data and information on those two countries’ current exchange rate regimes and practices.

To determine the extent of Treasury’s compliance with reporting requirements, we reviewed all of Treasury’s exchange rate reports since 1988. We analyzed the reports and categorized our assessment of Treasury’s compliance for each of the eight reporting requirements. In addition, we interviewed Treasury officials to discuss Treasury’s recent efforts to address the requirement to assess the impact of the exchange rates on the U.S. economy. Finally, for verification, we compared statements of Treasury officials with the exchange rate reports.

To obtain experts’ views on whether or by how much China’s currency is undervalued and the value’s implications for the United States, we identified studies and views of economists with expertise in the area that had been cited in congressional testimony and in other prominent policy forums, reviewed those and related studies, and interviewed a selection of experts spanning the spectrum of opinions on Chinese currency valuation. GAO economists reviewed these research papers and testimonies solely to describe the analyses and differences among them. The inclusion of the results of these studies is to show that estimates of undervaluation for China vary widely and that the analysis of the impact on the U.S. economy is complex; their inclusion does not imply that we deem them definitive. To describe and analyze country economic data and indicators used by many of these experts, we used data from the International Monetary Fund’s (IMF) World Economic Outlook and other sources, including the Bureau of Labor Statistics and the Federal Reserve Board. We also obtained foreign exchange reserve data from Global Insight and data on Japanese interventions for the 2000 to 2004 period from Japan’s Ministry of Finance. We used U.S. trade statistics compiled by the Department of Commerce’s statistical agencies to analyze the composition and trends in the U.S. merchandise trade deficit. We note that there are significant differences between U.S.–China bilateral trade data reported by the United States and that reported by China. We did not conduct an evaluation of these differences, which others have attributed to general differences in how imports and exports are valued, how the United States and China record imports and exports shipped through Hong Kong, and the quality of Chinese statistics. The reliability of Chinese statistics may also impact IMF’s statistics because much of the data used by IMF is self-reported by member countries. We determined that these data are sufficiently reliable for our purposes of presenting and analyzing trends in trade patterns and basic economic trends for China.

In addition, to describe a range of views on how China might move to an alternative exchange rate value or regime, we identified several representative policy suggestions from the studies we reviewed and the experts we consulted regarding assessments of whether China’s currency is undervalued.

To describe the implications of a revalued Chinese currency for the United States, we identified and reviewed studies that had been cited in congressional testimony and other policy forums, and by research institutions including the IMF. We discussed these studies with several experts spanning a range of views. To illustrate how estimates of the effects of exchange rates on U.S. manufacturing jobs depend on key assumptions, we identified assumptions from studies we reviewed and made illustrative calculations using different assumptions. These assumptions are not analytically precise, and we did not present particular estimates as being superior to others. Alternative combinations of assumptions or alternative assumptions can yield impact estimates outside the ranges presented in our analysis. The hypothetical percentages of undervaluation and assumptions are for illustrative purposes; the illustration does not imply that GAO has taken a position on the value of China’s currency or its actual impact on the U.S. economy.

We also obtained data on hourly compensation costs from the Bureau of Labor Statistics to provide background for our discussion of the role of labor costs in international competitiveness. We determined that the data are sufficiently reliable for the purpose of illustrating substantial variations in labor costs across countries. However, the data are partially estimated and thus the statistics should not be considered precise measures of comparative costs and are subject to revision. For some foreign economies, the estimates are based on less than one year of data. There may also be variations in the definitions, scope, coverage, and methods used in compiling the data and in its presentation. These include the treatment of the financing of social security and the systems of taxes or subsidies.

In addition, we calculated the portion of U.S. Treasury bills and corporate equities held by the two countries using the U.S. Treasury International Capital Reporting System (TIC) and the Federal Reserve Board’s Flow of Funds data to present information on China and Japan’s weight in U.S. capital markets. We used these data because they constitute the only data available for these transactions, but we note in presenting the information that because of the way the data are collected there is a bias toward overcounting flows to countries that are major financial centers and toward undercounting flows to other countries. As a result, excessive foreign holdings may be attributed to some countries that are major custodial centers, such as the United Kingdom, Switzerland, Belgium, and Luxembourg. Moreover, because the Bureau of Economic Analysis adjusts the TIC data somewhat before it reaches the Federal Reserve Board and because of timing issues, the data on total foreign holdings from the two sources have slight but insignificant differences. We determined that the data are sufficiently reliable for our purpose of illustrating whether China and Japan are major holders or purchasers of U.S. securities. We note, however, that as a result of the limitations identified, GAO calculations of the percentage of U.S. securities held by Japan and China based on the primary TIC and Federal Reserve data should be viewed as approximations.

In addition to the bias detailed above, the raw transactions data (net purchases) documented in figure 5 and the associated tables in appendix VI may contain errors due to the manner in which repurchase and securities lending transactions are recorded within the TIC system. Because these transactions are known to be substantial, producers of the data note that this could produce significantly inaccurate data. Moreover, because these data include commissions and taxes associated with each transaction, the result is a slight overestimation of net purchases. These data are also revised periodically. The TIC system is the official source of this data, it is widely used by outside experts, and the limitations are not particular to any one country. Therefore we determined that they were sufficiently reliable for a comparison of net purchases of U.S. securities by China with other major purchasers and generally assessing the role of China in U.S. financial markets. However, the data must be interpreted with caution because recent transaction data may have overstated net foreign purchases of U.S. securities, especially debt instruments.

To verify the reliability of most data sources, we performed several checks to test the data’s accuracy or we reviewed limitations, wherever possible. We reviewed agency or company documents related to their quality control efforts and conferred with GAO’s statistical expert for relevant data. For several sources, we tracked secondary data to the source data and reviewed other experts’ uses and judgments of that data. For several sources, we compared the raw data, or the descriptive statistics computed using the data, with equivalent statistics from other sources. We determined that the data sources we used were sufficiently reliable for the purposes of this audit. Although in many cases there were limitations, they are generally minor in the context of this report. We were unable to conduct a review of the Japanese Ministry of Finance intervention data. However, given that the Ministry of Finance is the primary and official source of these data and they are widely used by outside experts and policymakers, including the Federal Reserve Bank of New York, we have included some of the data in this report for illustrative purposes.

We conducted our work from September 2003 through February 2005 in accordance with generally accepted government auditing standards.

Omnibus Trade and Competitiveness Act of 1988

Omnibus Trade and Competitiveness Act of 1988 (Pub. L. No. 100-418, §§ 3004(b) and 3005)

Sec. 3004. International Negotiations on Exchange Rate and Economic Policies. (b) Bilateral Negotiations—The Secretary of the Treasury shall analyze on an annual basis the exchange rate policies of foreign countries, in consultation with the International Monetary Fund, and consider whether countries manipulate the rate of exchange between their currency and the United States dollar for purposes of preventing effective balance of payments adjustments or gaining unfair competitive advantage in international trade. If the Secretary considers that such manipulation is occurring with respect to countries that (1) have material global current account surpluses; and (2) have significant bilateral trade surpluses with the United States, the Secretary of the Treasury shall take action to initiate negotiations with such foreign countries on an expedited basis, in the International Monetary Fund or bilaterally, for the purpose of ensuring that such countries regularly and promptly adjust the rate of exchange between their currencies and the United States dollar to permit effective balance of payments adjustments and to eliminate the unfair advantage. The Secretary shall not be required to initiate negotiations in cases where such negotiations would have a serious detrimental impact on vital national economic and security interests; in such cases, the Secretary shall inform the chairman and the ranking minority member of the Committee on Banking, Housing, and Urban Affairs of the Senate and of the Committee on Banking, Finance and Urban Affairs of the House of Representatives of his determination.

Sec. 3005. Reporting Requirements. (a) Reports Required—In furtherance of the purpose of this title, the Secretary, after consultation with the Chairman of the Board, shall submit to the Committee on Banking, Finance and Urban Affairs of the House of Representatives and the Committee on Banking, Housing, and Urban Affairs of the Senate, on or before October 15 each year, a written report on international economic policy, including exchange rate policy. The Secretary shall provide a written update of developments six months after the initial report. In addition, the Secretary shall appear, if requested, before both committees to provide testimony on these reports. (b) Contents of Report—Each report submitted under subsection (a) shall contain (1) an analysis of currency market developments and the relationship between the United States dollar and the currencies of our major trade competitors; (2) an evaluation of the factors in the United States and other economies that underline conditions in the currency markets, including developments in bilateral trade and capital flows; (3) a description of currency intervention or other actions undertaken to adjust the actual exchange rate of the dollar; (4) an assessment of the impact of the exchange rate of the United States dollar on (A) the ability of the United States to maintain a more appropriate and sustainable balance in its current account and merchandise trade account; (B) production, employment, and noninflationary growth in the United States; (C) the international competitive performance of United States industries and the external indebtedness of the United States; (5) recommendations for any changes necessary in United States economic policy to attain a more appropriate and sustainable balance in the current account; (6) the results of negotiations conducted pursuant to section 3004; (7) key issues in United States policies arising from the most recent consultation requested by the International Monetary Fund under article IV of the Fund’s Articles of Agreement; and (8) a report on the size and composition of international capital flows, and the factors contributing to such flows, including, where possible, an assessment of the impact of such flows on exchange rates and trade flows.

Conditions that Led to the Determination of Currency Manipulation and Removal

At different times during the period from 1988 to 1994, Treasury found that Taiwan, Korea, and China manipulated their currencies under the terms of the 1988 Trade Act. The conditions leading to their first citations and the changes in conditions that later led to their removal are listed below.

Overview of China and Japan’s Recent Economic Conditions

This appendix presents an overview of recent economic conditions for China and Japan that are relevant to exchange rate policies. These include economic growth, external account balances, foreign exchange reserves, exchange rate movements, currency exchange rate regimes, and direct interventions in foreign exchange markets by national authorities.

China

Economic Growth and Trade Balance

China has experienced high rates of economic growth in recent years. According to IMF- reported country data, the Chinese economy grew at annual rates of 7.1 percent to 9.6 percent during 1996 to 2004 (see fig. 5). Although economists have questioned the quality of Chinese national account statistics, there is a general consensus that the Chinese economy has grown rapidly during the past 2 years. In fact, the Chinese government has implemented policies since mid-2003 to slow economic growth because of concerns about overheating the economy.

China’s economic growth has been accompanied by a large total trade volume, which was 59 percent of gross domestic product (GDP) in 2003 and 73 percent of GDP according to preliminary 2004 data. The large trade volume has been accompanied by China’s consistently positive current account balance. While China’s current account surplus declined from around 3.3 percent of (GDP) in 1998 to less than 2 percent in 1999 to 2001, it rose to 2.8 percent in 2002 after accession to the World Trade Organization and then to 3.2 percent in 2003. Preliminary data for 2004 indicated a surplus of 4.2 percent. (See fig. 6.)

The Chinese government has rapidly accumulated foreign exchange reserves in recent years, which some observers have seen as evidence of currency undervaluation and manipulation. China’s total foreign exchange reserves (excluding gold and other assets at the IMF) reached $614.5 billion by the end of 2004. As figure 7 shows, this represents approximately three times the level of China’s reserves in 2001.

Changes in China’s foreign exchange reserves have several components: changes in the current account balance, changes in net flows of foreign direct investment (FDI), changes in net non-FDI flows, and undocumented capital—or errors and omissions. Both China’s current account surplus and net FDI inflows were major components of the reserve increases from 2001 through 2003. (See table 4.) In addition, changes in non-FDI net inflows (defined as portfolio investment and other investment) and errors and omissions have also been important to the reserve increases. These components had been strongly negative—meaning significantly greater outflows than inflows—in 1999 and 2000, which had worked to dampen China’s reserve accumulation. However, the balance changed and in 2003 non-FDI flows and errors and omissions were strongly positive. One reason for the increase in these inflows into China is large speculative inflows that may be driven by expectations of an upward revaluation of the renminbi.

The basic relationship between China’s current account balance and capital and financial account flows is also depicted in table 4. For 2003, the last year for which complete data is available, China had a current account surplus of $45.9 billion accompanied by a capital account surplus of $52.8 billion. Maintaining large surpluses in both current and capital accounts is relatively unusual compared to other countries. For example, the United States has had in recent years a current account deficit financed by a capital account surplus; that is, the United States borrows from foreigners to purchase goods. Japan, in contrast, has generally had in recent years a current account surplus and a deficit in its capital account, including a net outflow of FDI. China’s net capital inflow in 2003 was predominantly in the form of direct investment. This is in part because China has a relatively open door policy on FDI but restricts other forms of foreign investment.

China’s Exchange Rate

China has, since the fall of 1994, had a de facto fixed exchange rate regime, as classified by the IMF, with its exchange rate pegged to the dollar (see fig. 8). Prior to that point, China maintained a dual exchange rate regime with an official fixed rate and market-negotiated rates. The official fixed rate was devalued several times before it was unified with the prevailing market rate in early 1994, and the exchange rate regime was officially changed to a managed float. The renminbi began to appreciate slightly (to 8.3 renminbi per U.S. dollar) soon after the unification, mainly due to export growth caused by a wave of foreign direct investment. Chinese authorities decided to hold the rate within a small band of 0.25 percent. By 1998, the exchange rate had been allowed to appreciate slightly to 8.28 renminbi per U.S. dollar, with a narrow band, where it has stayed until the present.

Between 1986 and 1994, China had a dual exchange rate regime in which the official fixed exchange rate coexisted with the market-negotiated rates in Foreign Exchange Adjustment Centers (also called swap centers). The official rate applied to trade transactions and other activities that were controlled by state planning. Market rates, which were significantly lower than the official rate, suggesting overvaluation of the official rate, applied to all other activities. By 1993, the official rate was 5.7 renminbi per U.S. dollar and the market rate was 8.7 renminbi per U.S. dollar.

It is the real effective exchange rate that affects Chinese products’ trade competitiveness. Although the nominal exchange rate of Chinese currency has remained relatively stable since 1994, the real effective exchange rate of Chinese currency has shown variations since 1994 (see fig. 9). The variation is parallel to that of the U.S. dollar because the renminbi has been pegged to dollar.

Chinese authorities keep controls on foreign exchange earned from exports and other current account activities through “repatriation and surrender requirements” on foreign exchange proceeds. Under these controls, some exporters must sell a significant portion of their previous year’s foreign exchange earnings to authorized banks at a fixed rate for China’s currency. China also maintains controls on the use of foreign currencies related to imports and other outward flows for investment purposes. For instance, importers must provide proof of import needs and commercial bills to obtain foreign currencies. Overall, these measures are less restrictive than those in place in the early 1990s.

In addition to controls related to current account transactions, other restrictions continue to apply to most capital transactions. For instance, only certain qualified foreign institutional investors can bring in foreign capital to invest in the segment of Chinese domestic security markets denominated in renminbi. Foreign entities can purchase securities denominated in U.S. dollars more freely. China maintains an “open door” policy with respect to inbound FDI, but outward investment is limited and requires government approval. Chinese purchases of capital and money market instruments abroad are restricted to selected institutions and enterprises. In 2004, China eased some restrictions on outward capital flows, including allowing domestic insurance firms to invest a portion of their portfolios offshore and permitting multinational companies to transfer foreign exchange among subsidiaries.

Japan

Growth Rate and Trade Balance

Japan suffered from recession and deflation in the years immediately following the 1997 to 1998 Asian financial crisis (see fig. 10). Its economy recovered briefly with a 2.8 percent annual growth rate in 2000, declined in 2001, and stagnated in 2002 before picking up again in 2003. Despite inconsistent growth, Japan has maintained a consistent current account surplus, which fluctuated between 2.1 percent and 3.6 percent of GDP during 1998 to 2004 (see fig. 11). Nevertheless, Japan’s trade volume as a percentage of GDP was 18 percent in 2003 and 20 percent according to preliminary 2004 data, both of which were less than one-third that of China for the same years.

Japan’s total foreign exchange reserves increased from $215.5 billion in 1998 to $663.3 billion in 2003 and $833.9 billion in 2004 (see fig. 12). The rapid increase reflected a reversal of net capital flow direction—from a net outflow to a net inflow. The rapid accumulation of foreign exchange reserves in 2003 is attributable to an increase in non-FDI capital inflows. This increase was due to an equity market rally caused primarily by Japan’s economic recovery, an increase in the Japanese interest rate in the summer of 2003, and market anticipation of further yen appreciation. In contrast to China, Japan has had a steady FDI outflow over time. It ranged from $23 billion to $32 billion from 2000 to 2003.

The Japanese yen is on an independent float, with the exchange rate primarily determined by market forces. Japanese authorities have periodically carried out large interventions in the foreign exchange market through the sale of yen in exchange for U.S. dollars, resulting in slower yen appreciation. Japanese authorities intervened frequently in its foreign exchange markets in 2002, increased the frequency and magnitude of interventions in 2003, and continued interventions into early 2004 (see fig. 13). U.S. Treasury officials told us they did not think such interventions led to lasting effects on the yen exchange rate. Since 2003 Treasury has reported that it actively engages Japanese authorities to urge greater exchange rate flexibility.

The yen’s real effective exchange rate has fluctuated over the past decade (see fig. 14). Some market appreciation pressure on the nominal value of the yen during this period was due to larger capital inflows, particularly a large inflow from Europe in 1999 and another large inflow in 2003 due to prospects of higher stock market prices. Strong inflows continued into early 2004.

Commonly Used Methods to Determine Equilibrium Exchange Rates

Economists use various methods to analyze whether exchange rates are misaligned. In general, determining whether a country’s currency is under- or overvalued involves first determining the country’s equilibrium exchange rate as a reference or baseline. This is complex because estimating the equilibrium exchange rate requires information on what value the exchange rate would attain if it were consistent with a country’s economic fundamentals at a particular point in time. Different approaches to estimating equilibrium exchange rates and under- and overvaluation can yield widely varying results, especially for developing countries, and even similar approaches can result in different outcomes depending upon which assumptions and economic judgments are used. Thus, estimates of undervaluation for China vary substantially—from 0 to 56 percent. This appendix outlines some of the methodologies commonly used to estimate the extent of undervaluation of the renminbi.

Purchasing Power Parity (PPP) Approach

One methodology commonly used to define equilibrium exchange rates and determine if a currency is under- or overvalued is the Purchasing Power Parity (PPP) approach. The PPP approach is rooted in the law of one price, which states that identical goods in different countries should trade at the same price. Thus, the equilibrium exchange rate is defined as the exchange rate at which the general level of prices will be the same in every country and is calculated as the ratio of the domestic and foreign price levels. The goods and services analyzed are typically those that make up the GDP of each country. In some cases, narrower units have formed the basis of PPP comparisons, such as the “Big Mac” index which is a widely cited shortcut version that analyzes one standardized good across countries. Unfortunately, the law of one price has limitations; it does not hold across nations of sharply differing levels of development and is biased toward finding undervaluation for low-income countries compared to their higher- income counterparts. Additionally, the approach ignores other important factors that lead to inequality in prices, such as trade barriers and nontraded goods. Many experts maintain that PPP measures are more useful for analyzing cost-of-living differences than inferring the extent of currency misalignment.

A variation of the absolute PPP approach discussed above is the relative version of the PPP methodology, which is based on the hypothesis that changes in the exchange rate are determined by the difference between inflation rates in the two countries—or, equivalently, the real exchange rate between two currencies remains constant over time. The technique involves choosing a point in time that corresponds to equilibrium and then projecting the new equilibrium rate using the inflation differentials between countries. This analysis is based on trade-weighted exchange rate indexes because they are better indicators of overall competitiveness. One limitation of the approach is that it is very sensitive to the type of price index used for base calculations (e.g., the consumer price index vs. the producer price index), and the results depend on the time periods selected as the base year. The methodology also ignores structural changes in the economy that might cause the real exchange rate to change over time.

Fundamental Equilibrium Exchange Rate (FEER) Approach

The FEER approach to assessing currency valuation is based on the relationship between the current account and capital flows. The FEER is defined as the exchange rate that will bring the current account balance (consistent with domestic full employment) into equality with the “normal” or sustainable capital account balance. Thus, it is the value of the exchange rate that is consistent with both internal and external economic equilibrium. The FEER calculation requires macroeconomic or trade models to obtain the current account position that is consistent with internal balance, known as the “trend” current account. The second stage involves determining the real exchange rate changes necessary to ensure balance between medium-term capital flows and the trend current account. Within this framework, the equilibrium exchange rate is deemed “fundamental” in the sense that it is related to the fundamental economic determinants over the medium term.

Significant limitations of this approach are that it requires extensive modeling to capture the major trade relationships and economic judgments that are criticized by some as ad hoc (including a decision about “normal” or sustainable capital flow levels) and that it relies on estimates of the sensitivity of demand to prices that are difficult to make. In addition, changes in the structure of the economy that affect the current account and the equilibrium exchange rate may introduce further uncertainty in the estimates. This is important in China’s case because many economic conditions and institutions are rapidly changing in the move toward a market-based economy. Also, this approach is difficult to apply to China because of limitations in the quality of Chinese statistics.

Macroeconomic Balance Approach

This methodology is based on the premise that there is an appropriate current account position (external balance) associated with the equilibrium savings and investment balance within a country (internal balance). Once the full employment savings-investment position is established and its associated current account is determined, this approach uses estimated trade models to determine how much the real exchange rate would have to change to generate the required external balance. The approach is related to the FEER concept because the equilibrium exchange rate is associated with internal and external economic balances. Similar to the FEER, this methodology also requires considerable modeling and economic judgment, and the results are highly sensitive to variations in key parameters. The IMF notes that in its macroeconomic balance modeling approach assumptions are used to assess the current account positions and exchange rates that may not be entirely appropriate for developing countries. Moreover, the IMF industrial country methodology largely abstracts from the impact that structural policies and adjustments could have on the equilibrium savings investment position. Again, this is important in China’s case because of the many structural adjustments the country is currently undergoing.

External Balance Approach

Similar to the FEER and Macroeconomic Balance approaches, this method is based on the premise that there is an appropriate external account position. That is, there is a particular level of the current account that balances the “normal” capital flows so that there is no change in international reserves. It differs from these two approaches in that it does not consider internal equilibrium. This approach involves determining the sustainable external account balance—meaning one appropriate for a country’s economic situation. Once the relevant external balance is identified, estimated trade models or rule-of-thumb relationships are used to determine the exchange rate change needed to generate the target outcome. This method is highly dependent upon which portion of China’s external balances is considered. For example, the selection of China’s current account balance might lead to a finding that the renminbi is not significantly undervalued, while the broader basic balance might lead to a finding of substantial undervaluation. The approach also relies on elasticities that are difficult to estimate or rules of thumb that are not analytically precise. Moreover, the approach does not include an explicit consideration of a country’s internal economic equilibrium situation, such as whether the country is at full employment.

Behavioral Equilibrium Exchange Rate (BEER) Approach

Under this approach, equilibrium exchange rates are determined through observing long-run relationships between real exchange rates and the economic variables that determine them. That is, the BEER approach uses econometric relationships to model the equilibrium exchange rate, based on predicted economic relationships derived from an array of relevant theories. Misalignment of a currency is measured as the difference between the actual exchange rate and that predicted by the model variables. However, the determinants of exchange rates and their links to any underlying notion of economic fundamentals are neither well understood nor easily predicted. Thus, many complex BEER models do not predict exchange rates any better than simpler techniques. The BEER approach also uses a number of simplifying assumptions and precludes the identification of many other key parameters important to explaining the economic system. This makes it difficult to judge the plausibility of its estimates.

Qualitative Approaches Some analysts do not formally define an equilibrium exchange rate, but look at trends in certain data to determine whether or not a country’s currency is misaligned. One of the most widely cited trends used to infer currency misalignment is foreign exchange reserve growth. Some observers have noted that China has been accumulating reserves at a rapid pace and conclude that the renminbi must be undervalued. While it is true that China’s foreign exchange growth has outpaced all other countries, with the exception of Japan (see fig. 15), using China’s reserve accumulations as a measure of currency misalignment has limitations. For example, some analysts have noted that a significant portion of the capital inflow into China has been short-term speculative money, triggered by expectations of a renminbi appreciation. Given China’s commitment to a fixed exchange rate regime, the government must absorb this excess foreign exchange. Moreover, if China removes restrictions on capital account transactions, as many have been advocating, some analysts believe the currency may depreciate due to capital outflow. Thus, while rapid reserve growth indicates upward pressure on the currency, it does not necessarily suggest by itself that the current value of the renminbi is lower than its long-run equilibrium value.

Factors Influencing the Final Impact of Exchange Rate Changes

An undervalued currency relative to the dollar would tend to make U.S. exports more expensive and U.S. imports less expensive. However, just how much cheaper imports would be and the degree of impact on the U.S. trade deficit, production, and employment would ultimately depend on complex factors. This appendix discusses some of these important factors.

The impact of China’s currency on the U.S. economy would first depend on a number of factors that can weaken the exchange rate pass through—that is, the extent to which a change in the value of China’s currency changes the price of exports to the United States. These include: The import content of Chinese exports to the United States. A large portion of China’s export operations consists of the final assembly of products using components produced in other countries, especially Japan, Korea, and Taiwan. Some experts believe that the import content of Chinese exports to the United States may be 35 to 40 percent of the total value, and others have estimated as much as 80 percent. An appreciation of the renminbi could thus have limited impact on the prices of these exports to the United States because the currency change would leave the imported portions of the products (as much as 80 percent) unaffected, while a smaller portion (20 percent) would become more expensive.

The flexibility of the Chinese labor market. Some researchers believe that Chinese laborers might willingly take wage cuts to keep their jobs given the high unemployment rate in the country. Thus, the extent to which an increase in the value China’s currency increases the price of exports to the United States would depend on whether a revaluation of the renminbi leads to lower wages.

The response of foreign-invested enterprises (multinational companies operating in China). The response of import prices to the exchange rate would also be smaller if foreign producers absorb the exchange rate movements in their profit margins to sustain their U.S. market share. According to Chinese statistics, foreign firms, some of them U.S.-owned, produced more than 50 percent of all exports in 2002 and accounted for 65 percent of the total increase in Chinese exports from 1994 to mid-2003.

Once the impact on import prices is determined, the impact on trade flows, production, and the U.S. economy would still depend on additional factors.

Elasticity of demand. The sensitivity of U.S. demand for Chinese goods and of China’s demand for U.S. goods to price changes are also important factors. If U.S. consumers are sensitive to price changes of Chinese imports (i.e., elasticity of import demand is high), then an increase in import prices would significantly reduce the demand for Chinese goods and improve the bilateral trade deficit with China. Similarly, if the Chinese elasticity of demand for U.S. goods is low, an appreciation of the renminbi may not result in an increase in the demand for the cheaper U.S. products.

China’s weight in the U.S.’s overall trade. The trade-weighted dollar is a measure of the dollar’s value with respect to its major trading partners. Such indexes are useful for discussion of the relationship between exchange rates and the aggregate trade balance. According to the Federal Reserve Board, the renminbi carries a weight of approximately 10 percent in the trade-weighted real effective exchange rate (see fig. 16). Therefore, a 20 percent change in the value of the renminbi means the Federal Reserves’ trade-weighted dollar would change by roughly 2 percent. Thus, some maintain that a revaluation of the renminbi must be accompanied by an increase in the value of other currencies to have a significant impact on the United States’ global trade deficit.

How countries react to China’s exchange rate policies. Some analysts contend that China’s currency peg to the dollar induces other East Asian countries to intervene in currency markets to keep their currencies weak against the dollar so that they can remain competitive with China, thus magnifying the impact of China’s currency on the United States. Moreover, they conclude that a revaluation by China would encourage other countries to follow. As a result, there could be a large enough change in the trade-weighted dollar to impact the United States’ global trade deficit.

Labor-intensive tasks once performed in other countries are now being performed in China. As figure 17 shows, while the portion of the U.S. merchandise trade deficit accounted for by Japan and the rest of East Asia has fallen since 1999, China’s share has risen. This reflects the fact that exports from Japan and other East Asian countries to the United States are now increasingly finished and exported from China. For example, from 2000 to 2002, U.S. imports from China increased by $25.2 billion, while imports from Japan fell $24.5 billion. The extent to which Chinese exports to the United States are substituting for exports that would otherwise have entered the United States from alternative low-cost countries makes the impact on the U.S. economy difficult to quantify.

The role of cheap labor. Many believe that China competes primarily in terms of low labor costs. There are also a number of other countries whose manufacturing wages are only a fraction of those in the United States (see fig. 18). As a result, some believe a renminbi appreciation would not induce increased output in American factories. Instead, U.S. imports from other low-wage foreign suppliers would increase. If this is true, the bilateral trade deficit with China would decrease, but the trade deficits with other low-wage countries would increase, leaving the overall trade deficit unchanged (or slightly worse due to more expensive imports).

Degree of competition. The effects of the exchange rate are stronger when countries compete in similar markets. Some researchers maintain that the overlap between the production of China and the United States is small; that is, relatively few imports from China compete with domestic production in the United States. Others believe that the market competition is high enough that Chinese imports have displaced U.S. workers.

Lastly, potential income effects on China and economic interdependence between major trading partners are relevant to exchange rate impacts. For example, some experts have concluded that an appreciation of the renminbi would reduce employment, income, and growth in China, thereby affecting Chinese demand for U.S. exports. Similar forces must be considered for the United States, although it is unclear whether they would be significant given the distinct effects on the various sectors of the economy. Some believe that an appreciation of the renminbi (especially if accompanied by the elimination of capital restrictions) would lead to economic and financial instability in China and jeopardize other Asian countries that rely in part on exports to China to sustain their economies. Such instability in East Asia, if it were to occur, would likely have negative repercussions on the U.S. and global economies.

Net Foreign Purchases of U.S. Securities

China has in recent years purchased substantial amounts of U.S. securities, mostly agency bonds and U.S. Treasury securities (see table 5). However, China’s net purchases are not as large as those of the United Kingdom and Japan. Like other foreign central banks, China’s central bank has chosen to purchase large quantities of U.S. Treasury securities with renminbi in part because it can buy and sell them quickly with minimal market impact. According to monthly data compiled by the Treasury International Capital System, China’s investment in U.S securities climbed sharply during the 2000 to 2003 period, but was lower in 2004. This appendix presents detailed tables on foreign transactions in U.S. securities. While these transactions data are useful for showing China’s relative size in overall securities purchases, they have certain reliability limitations which are noted in the table and are further discussed in appendix 1.

Comments from the Department of the Treasury

GAO Contacts and Staff Acknowledgments

GAO Contacts

Acknowledgments

In addition to the persons named above, Lawrance Evans, Jr., Jane-yu Li, Jamie McDonald, Donald Morrison, and Richard Seldin made major contributions to this report.