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Since 1994, the Chinese government has maintained a policy of intervening in currency markets to limit or halt the appreciation of its currency, the renminbi (RMB), against the U.S. dollar and other currencies. Critics charge that this policy has made Chinese exports to the United States significantly cheaper, and U.S. exports to China much more expensive, than would occur under free market conditions. Some policymakers argue that China's currency policy is a major factor behind the large annual U.S. trade deficits with China and has lead to the widespread loss of U.S. manufacturing jobs. Some economists have argued that China's currency policy is disruptive to global economic recovery because it induces many countries to intervene in currency markets in an effort to hold down the value of their currencies against the dollar in order to enable their firms to remain competitive vis-a-vis Chinese firms. Some economists have expressed concern that these actions may worsen economic imbalances and could undermine the world trading system.
From July 2005 to July 2008, the central bank of China allowed the RMB to appreciate against the dollar by about 21%. However, once the effects of the global economic crisis began to become apparent, China halted appreciation of the RMB in an effort to limit job losses in industries dependent on trade. From July 2008 to late June 2010, China kept the exchange rate of the RMB at roughly 6.83 yuan (the base unit of the RMB) to the dollar. On June 19, 2010, the China's central bank stated that, based on current economic conditions, it had decided to "proceed further with reform of the RMB exchange rate regime and to enhance the RMB exchange rate flexibility." From June 18 to December 24, 2010, China allowed the RMB/dollar exchange rate to rise by about 2.9%% overall. U.S. officials have criticized the slow pace of RMB's appreciation, especially given the rapid growth in Chinese exports and trade surplus over the past year, and have urged China to quicken the pace of currency reform and flexibility.
Many members of Congress have urged the Obama Administration take a more aggressive stand against China over its currency policy, including designating it as a "currency manipulator" under U.S. trade law. Several currency-related bills were introduced in the 111th Congress. In September 2010, the House approved an amendment in the nature of a substitute to H.R. 2378, which would have attempted to treat certain fundamentally undervalued currencies as an actionable subsidy under U.S. countervailing duty (which could have resulted in higher tariffs on certain imported Chinese products). The Senate did not consider the bill. In addition to bilateral talks, the Obama Administration has sought to put more pressure on China by attempting to boost multilateral cooperation on addressing exchange rate policies and global trade imbalances.
Many economists contend that a sharp appreciation of the RMB would help to rebalance the global economy, but note that this must be accompanied by lower saving and greater consumption in China. An immediate and sharp appreciation of China's currency could disrupt its export industries and lead to widespread lay-offs, which in turn could slow its economic growth and reduce import demand. However, if RMB appreciation occurred along with measures to boost domestic consumption, laid off Chinese workers in the export sector would be able to find jobs in other (non-export) sectors, which could help maintain healthy economic growth and boost Chinese demand for imports. While an appreciation of the against the dollar could help boost U.S. exports to China, it could also entail costs to the U.S. economy in the near term. China would not need to buy as many U.S. Treasury securities, which could cause real U.S. interest rates to rise. A more expensive RMB could also mean higher costs for U.S. consumers as well as firms that use Chinese-made inputs for their products. To reduce U.S. external imbalances (including with China), the United States would need to boost national saving.
Contents Introduction Background on China's Currency Policy 2005: China Reforms the Peg RMB Developments and Policy Debate Concerns in the United States Over China's Currency Policy: Trade Deficits and Jobs Past Legislative Proposals to Address Undervalued Currencies The Obama Administration's Position and Policies An Economic Analysis of the Effects of China's Currency on the U.S. Economy Is the RMB Undervalued, and if so, by How Much? Why do Estimates of the RMB's Undervaluation Differ so Much? The Debate over the Effects of Exchange Rate Appreciation on Trade Flows and the Deficit The Bilateral Trade Deficit Continued to Grow during the Previous Period of RMB Appreciation The J Curve Effect The Role of Exchange Rate Pass-Through China's Role in the Global Supply Chain Underlying Macroeconomic Imbalances Are Unlikely to Disappear Differing Opinions on Making RMB Appreciation a Top U.S. Trade Priority Winners and Losers of RMB Appreciation from an Economic Perspective Effect on U.S Exporters and Import-Competitors Effect on U.S. Consumers and Certain Producers Effect on U.S. Borrowers Net Effect on the U.S. Economy China's Perspective and Concerns: Economic Growth and Stability The Effects of an Undervalued RMB on China's Economy Policy Options for the RMB and Potential Outcomes Current Account Balances, Savings, and Investment Sources of Economic Growth Investment and Consumption Relative to GDP
January 12, 2011
China's policy of intervention to limit the appreciation of its currency, the renminbi (RMB), or yuan, against the dollar and other currencies has become a major source of tension with many of its trading partners, especially the United States. (1) Some analysts contend that China deliberately "manipulates" its currency in order to gain unfair trade advantages over its trading partners. They further argue that China's undervalued currency has been a major factor in the large annual U.S. trade deficits with China and the loss of millions of U.S. manufacturing jobs, and, because of the current high rate of U.S. unemployment, can no longer be tolerated. President Obama stated in February 2010 that China's undervalued currency puts U.S. firms at a "huge competitive disadvantage," and he pledged to make addressing China's currency policy a top priority.
Chinese officials have maintained that China's currency policies are intended to promote economic stability and do not negatively impact other countries. From July 2005 to July 2008, China allowed the RMB to gradually appreciate against the dollar. However, once the effects of the global economic crisis became apparent, the appreciation of the RMB was halted and the exchange rate with the dollar was held constant at 6.83 yuan. This move was criticized by many of China's major trading partners, including the United States and the European Union. China responded by calling the growing international pressure on China to appreciate its currency "protectionism." However, on June 19, 2010, the People's Bank of China stated that, based on current economic conditions, it had decided to "proceed further with reform of the RMB exchange rate regime and to enhance the RMB exchange rate flexibility."
The pace of the RMB's appreciation since that announcement has been criticized as being too slow. On September 29, 2010, the House passed an amended version of H.R. 2378, which would attempted to treat a fundamentally undervalued currency as an actionable subsidy under U.S. countervailing laws (which could have raised U.S. tariffs on certain imported Chinese products). The Senate did not consider the bill.
Although economists differ as to the extent of the RMB's undervaluation against the dollar and the economic effects that undervaluation has on China's major trading partners, including the United States (many cite both positive and negative effects), most agree that currency flexibility would be an important factor in helping to reduce global imbalances, which are believed to have been a major factor that sparked the global financial crisis and economic slowdown. They further contend that currency reform is in China's own long-term economic interest. However, many economists argue that a Chinese currency appreciation will do little to reduce trade imbalances in the United States and China unless such action is accompanied by changes to U.S. and Chinese macroeconomic practices (i.e., the United States would need to save more and consume less and China would need to save less and consume more), which could lower overall U.S. imports (including from China) and boost China's overall imports (including from the United States). In addition, some analysts contend that Chinese industrial policies pose a much greater challenge to U.S. economic interests than an undervalued currency.
This report provides an overview of the economic issues surrounding the current debate over China's currency policy. It identifies the economic costs and benefits of China's currency policy for both China and the United States, and possible implications if China were to allow its currency to significantly appreciate or to float freely. It also examines proposed legislation in the 111th Congress that seek to address China's currency policy.
Background on China's Currency Policy
Prior to 1994, China maintained a dual exchange rate system. This consisted of an official fixed exchange rate system (which was used by the government), and a relatively market-based exchange rate system that was used by importers and exporters in "swap markets," although access to foreign exchange was highly restricted in order to limit imports, resulting in a large black market for foreign exchange. The two exchange rates differed significantly. The official exchange rate with the dollar in 1993 was 5.77 yuan versus 8.70 yuan in the swap markets. China's dual exchange rate system was criticized by the United States because of the restrictions it (and other policies) placed on foreign imports.
In 1994, the Chinese government unified the two exchange rate systems at an initial rate of 8.70 yuan to the dollar, which eventually was allowed to rise to 8.28 by 1997 and was then kept relatively constant until July 2005. The RMB became largely convertible on a current account (trade) basis, but not on a capital account basis, meaning that yuan are not regularly obtainable for investment purposes. From 1994 until July 2005, China maintained a policy of pegging the RMB to the U.S. dollar at an exchange rate of roughly 8.28 yuan to the dollar. The peg appears to have been largely intended to promote a relatively stable environment for foreign trade and investment in China (since such a policy prevents large swings in exchange rates)--a policy utilized by many developing countries in their early development stages. The Chinese central bank maintained this peg by buying (or selling) as many dollar-denominated assets in exchange for newly printed yuan as needed to eliminate excess demand (supply) for the yuan. As a result, the exchange rate between the RMB and the dollar basically stayed the same, despite changing economic factors which could have otherwise caused the yuan to appreciate (or depreciate) relative to the dollar. Under a floating exchange rate system, the relative demand for the two countries' goods and assets would determine the exchange rate of the RMB to the dollar.
2005: China Reforms the Peg
The Chinese government modified its currency policy on July 21, 2005. It announced that the RMB's exchange rate would become "adjustable, based on market supply and demand with reference to exchange rate movements of currencies in a basket," (2) and that the exchange rate of the U.S. dollar against the RMB was adjusted from 8.28 yuan to 8.11, an appreciation of 2.1%. Unlike a true floating exchange rate, the RMB would be allowed to fluctuate by up to 0.3% (later changed to 0.5%) on a daily basis against the basket.
After July 2005, China allowed the RMB to appreciate steadily, but very slowly. From July 21, 2005 to July 21, 2008, the dollar-RMB exchange rate went from 8.11 to 6.83, an appreciation of 18.7% (or 20.8% if the initial 2.1% appreciation of the RMB to the dollar is included). The situation at this time might be best described as a "managed float"--market forces determined the general direction of the RMB's movement, but the government retarded its rate of appreciation through market intervention. China halted its currency appreciation policy around mid-July 2008 (see Figure 1) mainly because of declining global demand for Chinese products that resulted from the effects of the global financial crisis. The RMB depreciated against the dollar slightly in July-August 2008 and in December 2008, but generally was kept constant at 6.83 yuan through around mid-June 2010.
[FIGURE 1 OMITTED]
China's relative peg to the dollar after July 2008 has meant that as the dollar depreciated or appreciated against a number of major currencies, China's currency depreciated or appreciated as well (even though the RMB's exchange rate with the dollar remained constant). From July 2008 to May 2010, the real (inflation adjusted) trade-weighted exchange rate of China's currency based on its trade with 57 economies appreciated by 8.9%. Although China's real trade-weighted exchange rate depreciated through much of 2009, it began to rise in 2010, due in part to the effects of the debt crisis in the Eurozone countries and the depreciation of the euro against the dollar (see Figure 2). From January to September 2010, the trade-weighted exchange rate of China's currency against the currencies of these economies increased by 5.2%
[FIGURE 2 OMITTED]
RMB Developments and Policy Debate
China has expressed strong opposition to outside pressure on its currency policy, calling it a form of protectionism and interference in China's domestic economic policy. However, on June 19, 2010, China's central bank, the People's Bank of China (PBC), stated that, based on current economic conditions, it had decided to "proceed further with reform of the RMB exchange rate regime and to enhance the RMB exchange rate flexibility." It ruled out any large one-time revaluations, stating "it is important to avoid any sharp and massive fluctuations of the RMB exchange rate," in part so that Chinese corporations could more easily adjust (such as through upgrading) to an appreciation of the currency. Many observers contend the timing of the RMB announcement was intended in part to prevent China's currency policy from being a central focus of the G-20 summit in Toronto …