International Trade
Treasury Assessments Have Not Found Currency Manipulation, but Concerns about Exchange Rates Continue Gao ID: GAO-05-351 April 19, 2005The 1988 Trade Act requires the Department of the Treasury to annually assess whether countries manipulate their currencies for trade advantage and to report semiannually on specific aspects of exchange rate policy. Some observers have been concerned that China and Japan may have maintained undervalued currencies, with adverse U.S. impacts, which has brought increased attention to Treasury's assessments. In 2004, Congress mandated that Treasury provide additional information about currency manipulation assessments, and Treasury issued its report in March 2005. Members of Congress have continued to propose legislation to address China currency issues. We examined (1) Treasury's process for conducting its assessments and recent results, particularly for China and Japan; (2) the extent to which Treasury has met legislative reporting requirements; (3) experts' views on whether or by how much China's currency is undervalued; and (4) the implications of a revaluation of China's currency for the United States. In commenting on a draft of this report, Treasury emphasized it does consider the impact of the exchange rate on the economy, and factors influencing exchange rates also affect U.S. production and competitiveness.
Treasury has not found currency manipulation under the terms of the 1988 Trade Act since it last cited China in 1994. Treasury officials make a positive finding of currency manipulation only when all the conditions in the Trade Act are satisfied--when an economy has a material global current account surplus and a significant bilateral trade surplus with the United States, and is manipulating its currency with the intent to gain an unfair trade advantage. Treasury said that in its 2003 and 2004 assessments, China did not meet the criteria for manipulation, in part because it did not have a material global current account surplus and had maintained a fixed exchange rate regime through different economic conditions. Japan did not meet the criteria in 2003 and 2004 in part because its exchange rate interventions were considered to be part of a macroeconomic policy to combat deflation. Treasury has generally complied with the reporting requirements for its exchange rate reports, although its discussion of U.S. economic impacts has become less specific over time. Recent reports stress the importance of broad macroeconomic and structural factors behind global trade imbalances, which Treasury officials contend meets the intent of economic impact requirements. Many experts have concluded that China's currency is undervalued, but by widely varying amounts, while some maintain that undervaluation cannot be determined. The significant variation in estimates can be attributed in part to different methodological approaches, but experts also believe that exchange rate assessments are especially challenging for rapidly developing economies such as China's. Among experts who believe China's currency is undervalued, views on policy steps to correct the imbalance differ. A revaluation of China's currency could have implications for various aspects of the U.S. economy, although the impacts are hard to predict. They depend on multiple factors, including how much appreciation is passed through to higher prices for U.S. purchasers and the extent to which reduced imports from China are replaced with imports from other countries. In addition to affecting trade-related sectors, a revaluation could have implications for U.S. capital flows.
GAO-05-351, International Trade: Treasury Assessments Have Not Found Currency Manipulation, but Concerns about Exchange Rates Continue
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Currency Manipulation, but Concerns about Exchange Rates Continue'
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Report to Congressional Committees:
April 2005:
International Trade:
Treasury Assessments Have Not Found Currency Manipulation, but Concerns
about Exchange Rates Continue:
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-05-351]:
GAO Highlights:
Highlights of GAO-05-351, a report to congressional committees:
Why GAO Did This Study:
The 1988 Trade Act requires the Department of the Treasury to annually
assess whether countries manipulate their currencies for trade
advantage and to report semiannually on specific aspects of exchange
rate policy. Some observers have been concerned that China and Japan
may have maintained undervalued currencies, with adverse U.S. impacts,
which has brought increased attention to Treasury's assessments. In
2004, Congress mandated that Treasury provide additional information
about currency manipulation assessments, and Treasury issued its report
in March 2005. Members of Congress have continued to propose
legislation to address China currency issues.
We examined (1) Treasury's process for conducting its assessments and
recent results, particularly for China and Japan; (2) the extent to
which Treasury has met legislative reporting requirements; (3) experts'
views on whether or by how much China's currency is undervalued; and
(4) the implications of a revaluation of China's currency for the
United States.
In commenting on a draft of this report, Treasury emphasized it does
consider the impact of the exchange rate on the economy, and factors
influencing exchange rates also affect U.S. production and
competitiveness.
What GAO Found:
Treasury has not found currency manipulation under the terms of the
1988 Trade Act since it last cited China in 1994. Treasury officials
make a positive finding of currency manipulation only when all the
conditions in the Trade Act are satisfied--when an economy has a
material global current account surplus and a significant bilateral
trade surplus with the United States, and is manipulating its currency
with the intent to gain an unfair trade advantage. Treasury said that
in its 2003 and 2004 assessments, China did not meet the criteria for
manipulation, in part because it did not have a material global current
account surplus and had maintained a fixed exchange rate regime through
different economic conditions. Japan did not meet the criteria in 2003
and 2004 in part because its exchange rate interventions were
considered to be part of a macroeconomic policy to combat deflation.
Chinese Renminbi and Japanese Yen Exchange Rates with U.S. Dollar
(nominal):
[See PDF for image]
[End of figure]
Treasury has generally complied with the reporting requirements for its
exchange rate reports, although its discussion of U.S. economic impacts
has become less specific over time. Recent reports stress the
importance of broad macroeconomic and structural factors behind global
trade imbalances, which Treasury officials contend meets the intent of
economic impact requirements.
Many experts have concluded that China's currency is undervalued, but
by widely varying amounts, while some maintain that undervaluation
cannot be determined. The significant variation in estimates can be
attributed in part to different methodological approaches, but experts
also believe that exchange rate assessments are especially challenging
for rapidly developing economies such as China's. Among experts who
believe China's currency is undervalued, views on policy steps to
correct the imbalance differ.
A revaluation of China's currency could have implications for various
aspects of the U.S. economy, although the impacts are hard to predict.
They depend on multiple factors, including how much appreciation is
passed through to higher prices for U.S. purchasers and the extent to
which reduced imports from China are replaced with imports from other
countries. In addition to affecting trade-related sectors, a
revaluation could have implications for U.S. capital flows.
www.gao.gov/cgi-bin/getrpt?GAO-05-351.
To view the full product, including the scope and methodology, click on
the link above. For more information, contact Loren Yager at (202) 512-
4128 or yagerl@gao.gov.
[End of section]
Contents:
Letter:
Results in Brief:
Background:
Treasury Has Not Found Recent Instances of Currency Manipulation:
Treasury Has Generally Complied with Reporting Requirements, but Its
Approach to Assessing the Impact of Exchange Rates on the U.S. Economy
Has Changed:
Estimates of the Undervaluation of China's Currency Vary Widely, and
Views on Policy Steps Differ:
The U.S. Impact of a Renminbi Revaluation Would Depend on Multiple
Factors:
Observations:
Agency Comments and Our Evaluation:
Appendixes:
Appendix I: Objectives, Scope, and Methodology:
Appendix II: Omnibus Trade and Competitiveness Act of 1988:
Appendix III: Conditions that Led to the Determination of Currency
Manipulation and Removal:
Appendix IV: Overview of China and Japan's Recent Economic Conditions:
China:
Japan:
Appendix V: Commonly Used Methods to Determine Equilibrium Exchange
Rates:
Purchasing Power Parity (PPP) Approach:
Fundamental Equilibrium Exchange Rate (FEER) Approach:
Macroeconomic Balance Approach:
External Balance Approach:
Behavioral Equilibrium Exchange Rate (BEER) Approach:
Qualitative Approaches:
Appendix VI: Factors Influencing the Final Impact of Exchange Rate
Changes:
Appendix VII: Net Foreign Purchases of U.S. Securities:
Appendix VIII: Comments from the Department of the Treasury:
Appendix IX: GAO Contacts and Staff Acknowledgments:
GAO Contacts:
Acknowledgments:
Tables:
Table 1: Treasury's Reporting on 1988 Trade Act Exchange Rate
Requirements:
Table 2: Estimates of Undervaluation of the Renminbi:
Table 3: Illustrative Scenarios of Upward Revaluation of the Renminbi
on the U.S. Trade Deficit:
Table 4: Conditions Treasury Cited in Earlier Determinations of
Currency
Manipulation:
Table 5: China's Balance of Payments:
Table 6: Real Net Purchases of U.S. Securities by China:
Table 7: Real Net Purchases of U.S. Securities by Foreigners, Selected
Countries:
Figures:
Figure 1: Economies with the Largest Bilateral Merchandise Trade
Surpluses with the United States, 2004:
Figure 2: Global Current Account Balance as Percent of GDP for Selected
Economies, 2004:
Figure 3: Percentage of U.S. Treasury Securities Held by Japan and
China, 2004:
Figure 4: Net Purchases of U.S. Securities by Select Economies, 2001-
2004:
Figure 5: China's Real GDP Growth Rate, 1996-2004:
Figure 6: China's Current Account Surplus in Billions of U.S. Dollars
and as a Percentage of GDP, 1996-2004:
Figure 7: China's Total Foreign Exchange Reserves, 1995-2004:
Figure 8: Chinese Renminbi/Dollar Exchange Rate, 1989-2004:
Figure 9: Real Effective Exchange Rate Indexes (China and the United
States), 1994-2004:
Figure 10: Japan's Real GDP growth rate, 1996-2004:
Figure 11: Japan's Current Account Surplus in Billions of U.S. Dollars
and as a Percentage of GDP, 1996-2004:
Figure 12: Japan's Total Foreign Exchange Reserves, 1995-2004:
Figure 13: Yen/Dollar Interventions, January 2000-December 2004:
Figure 14: Real Effective Exchange Rate Index for Japan, 1994-2004:
Figure 15: Total Reserves for Selected Economies, 2000-2004:
Figure 16: Total Trade Weights (broad index of the foreign exchange
value of the dollar):
Figure 17: Percentage of U.S. Merchandise Trade Deficit Accounted for
by Selected East Asian Economies, 1999-2004:
Figure 18: Hourly Compensation Costs for Production Workers in
Manufacturing in U.S. Dollars, 2002:
Abbreviations:
BEER: Behavioral Equilibrium Exchange Rate:
FDI: Foreign Direct Investment:
FEER: Fundamental Equilibrium Exchange Rate:
GDP: Gross Domestic Product:
GNP: Gross National Product:
IMF: International Monetary Fund:
PPP: Purchasing Power Parity:
TIC: U.S. Treasury International Capital:
Letter April 19, 2005:
The Honorable Olympia J. Snowe:
Chair:
Committee on Small Business and Entrepreneurship:
United States Senate:
The Honorable Donald A. Manzullo:
Chairman:
Committee on Small Business:
House of Representatives:
A significant portion of the recently growing U.S. merchandise trade
deficit[Footnote 1]--36.4 percent--is made up of large bilateral
deficits with China and Japan. In response to earlier concerns
regarding exchange rate policies of certain Asian countries and their
trade with the United States and the world, Congress passed the Omnibus
Trade and Competitiveness Act of 1988[Footnote 2] (the 1988 Trade Act),
which mandates that the Secretary of the Treasury annually analyze the
exchange rate policies of foreign countries and consider whether any
manipulate their currencies to gain an unfair trade advantage. A
separate provision of the 1988 Trade Act requires that Treasury report
to Congress on specific international economic policy and exchange rate
issues. Some observers are concerned that China and Japan have
intervened in currency markets to maintain an undervalued currency and
that these actions adversely affect U.S. output and employment,
particularly for small manufacturers. Because of these concerns,
Treasury's currency manipulation assessments have attracted increased
attention, and Congress recently mandated that Treasury report on how
statutory requirements about currency manipulation could be clarified
to result in a better understanding of currency manipulation.[Footnote
3]
You asked us to review Treasury's efforts to meet its requirements
under the 1988 Trade Act and related issues. Specifically, we examined
(1) the process Treasury uses to conduct its assessments of currency
manipulation and the results of recent assessments, particularly for
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
revaluation of China's currency for the United States.
To determine the process Treasury uses to conduct its assessments of
currency manipulation and recent results, particularly for China and
Japan, we reviewed the 1988 Trade Act, its legislative history, and
Treasury's analysis of foreign currency manipulation. In addition, we
interviewed responsible Treasury officials to better understand the
assessment process and Treasury's reasoning behind its analyses for
China and Japan. To determine the extent to which Treasury has met 1988
Trade Act reporting requirements, we analyzed the reports Treasury has
issued since 1988 that are required by the Trade Act. Finally, to
determine experts' views on whether or by how much China's currency is
undervalued and the implications of its revaluation for the United
States, we reviewed academic papers, other studies, and congressional
testimonies by economists with expertise in this area, and we
interviewed experts with a range of opinions on the matter. We also
analyzed relevant country economic data and macroeconomic indicators
used by many of these experts. For a complete description of our scope
and methodology, see appendix I. We conducted our work from September
2003 through February 2005 in accordance with generally accepted
government auditing standards.
Results in Brief:
Although China and Japan have engaged in economic activities that have
led to concerns about currency manipulation, the Department of the
Treasury has not in recent years found that either country meets all
the legal criteria for manipulation under the terms of the 1988 Trade
Act. More broadly, Treasury has not made a positive finding of currency
manipulation since it last cited China in 1994. Treasury officials
stated that they make a positive determination on currency manipulation
only when all the conditions specified in the Trade Act are
satisfied.[Footnote 4] Treasury has significant flexibility in making
its determinations, including determining the intent of any
manipulation. Treasury officials told us that they do not make an
official determination of undervaluation as a part of their
manipulation assessments although, according to their March 2005 report
to Congress, they do consider measures of undervaluation. With respect
to China, Treasury officials told us that China did not meet the Trade
Act's definition for currency manipulation for the purposes of
Treasury's 2003 and 2004 assessments, in part because it did not have a
material global current account surplus and had maintained a fixed
exchange rate regime since 1994 through different economic conditions.
However, Treasury has stated that China should move from its long-term
fixed exchange rate toward a more flexible exchange system and has
entered into discussions with China to this end. Treasury also did not
find that Japan met the Trade Act's definition for currency
manipulation in 2003 and 2004. Treasury officials told us that they
viewed Japan's exchange rate interventions as part of a macroeconomic
policy aimed at combating deflation in Japan, and they expressed
general skepticism about the efficacy of intervention to affect the
yen's value.
Treasury has generally complied with the requirements in the 1988 Trade
Act that it report to Congress on several specific issues related to
international economic and exchange rate policies, although its
discussion of U.S. economic impacts has become less specific over time.
Treasury has consistently met four of the reporting requirements, and
two others allow Treasury to report at its discretion.[Footnote 5]
Treasury's analysis and discussion in response to a remaining
requirement, that it assess the impact of the exchange rate on the U.S.
economy, have changed. From 1988 through the 1990s, Treasury generally
discussed at least some elements of the exchange rate impact reporting
requirement, which includes impacts of the exchange rate of the dollar
on the U.S. current account and production and employment. Treasury's
impact-related analyses after the 1990s have generally cited the
importance of broad macroeconomic and structural factors behind global
trade imbalances. These reports have not directly discussed the impact
of exchange rates on aspects of the U.S. economy set forth in the 1988
Trade Act, although Treasury's December 2004 report did identify
exchange rate flexibility for certain Asian economies as an area of
policy the administration is following to reduce global imbalances.
Treasury officials stated that they consider the impact of the exchange
rate on areas such as U.S. production and employment while conducting
their analysis and that their current approach meets the intent of the
exchange rate impact reporting requirements.
Many experts have concluded that China's currency is undervalued, by
amounts ranging from a few percentage points to almost 50 percent,
while some maintain that undervaluation cannot be determined. The
significant variation in estimates can be attributed in part to
different methodological approaches, but similar methodologies can also
yield differences. Treasury officials, and some other experts we spoke
with, stated that exchange rates assessments are especially challenging
for developing economies with rapidly changing economic structures,
such as China. 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 loosening
controls on capital flows--such as restrictions on Chinese citizens
investing abroad--should be a part of that process.
A revaluation of the Chinese currency, 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. A higher-valued
renminbi would make China's exports to the United States more expensive
and U.S. exports to China cheaper (in terms of renminbi), which could
increase U.S. production and employment in certain sectors, but the
extent of these impacts depends on many factors. One key factor, for
example, is the degree to which Chinese exports to the United States
would be replaced by imports from other countries. 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 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. current account deficit.
While we have no recommendations in this report, we observe that the
level of concern over exchange rate issues--especially with respect to
China--is not surprising in light of the rising 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. 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, such as savings and investment rates and exchange
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 trade and financial flows--including exchange rates-
-and the implications of those flows for the United States. Treasury's
March 2005 report, in response to Congress's mandate for more
information on its assessments, provided a high-level discussion of key
factors Treasury considers and shed additional light on the
complexities of the assessments; but it 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 directed at China's currency issues. We believe
that the analysis in our report enhances the basis for further
discussion of exchange rate policy concerns.
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 Treasury's reporting on U.S. economic impacts of
exchange rates, it 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 have an impact on 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.
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.[Footnote 6] 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.[Footnote 7] 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[Footnote 8] 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,[Footnote 9] pegged the value of its currency, the
renminbi, to the U.S. dollar.[Footnote 10] 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.[Footnote 11] 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[Footnote 12] 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.)
Figure 1: Economies with the Largest Bilateral Merchandise Trade
Surpluses with the United States, 2004:
[See PDF for image]
[End of figure]
Figure 2: Global Current Account Balance as Percent of GDP for Selected
Economies, 2004:
[See PDF for image]
Note: Estimates for Asia-Pacific, Africa and Middle East, and Latin
America updated using Global Insight Quarterly Review and Outlook,
March 2005. The economies shown are those with the largest bilateral
merchandise trade surpluses with the United States in 2004.
[End of figure]
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.[Footnote 13]
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,[Footnote 14] 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.[Footnote
15] 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,[Footnote 16] 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.[Footnote
17]
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.[Footnote 18]
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.[Footnote 19] 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.[Footnote 20] 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.[Footnote 21] (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.[Footnote 22] 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.[Footnote 23] 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.
Table 1: Treasury's Reporting on 1988 Trade Act Exchange Rate
Requirements:
Trade Act reporting requirements: Analysis of currency market;
Reporting status: Reported since 1988.
Trade Act reporting requirements: Evaluation of underlying conditions;
Reporting status: Reported since 1988.
Trade Act reporting requirements: Description of currency market
intervention;
Reporting status: Reported since 1988.
Trade Act reporting requirements: Report on capital flows[A];
Reporting status: Reported since 1988.
Trade Act reporting requirements: Recommendations for sustainable
current account balance; Reporting status:
Reported at Treasury discretion.
Trade Act reporting requirements: Report on negotiation results per
section 3004(b);
Reporting status: Reported as needed.
Trade Act reporting requirements: Update on U.S.-IMF Article IV
consultation;
Reporting status: Deemed unnecessary by Treasury from 2001 through
2003[B].
Trade Act reporting requirements: Assessment of impact of the exchange
rate on: (a) Ability of the United States to maintain sustainable
current and merchandise trade accounts; (b) Production, employment, and
non-inflationary growth; (c) U.S. global industrial competition and
external indebtedness;
Reporting status: Reports generally discussed at least some impact
elements through 1999; Reports generally did not directly discuss
impact elements in 2000-2004.[C].
Source: GAO analysis of Treasury exchange rate reports.
[A] Treasury did not include explicit capital flow analysis in reports
issued from 1995 to 1997.
[B] Treasury's December 2004 report included an Internet link to IMF
consultation information.
[C] Treasury's December 2004 report identified exchange rate
flexibility for certain Asian countries as one area of policy the
administration is following to reduce global imbalances.
[End of table]
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.[Footnote 24]
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.[Footnote 25] (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,[Footnote 26] 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.
Table 2: Estimates of Undervaluation of the Renminbi[A]:
Source: Lawrence Lau (Stanford)[C];
Estimate (percentage): Indeterminate;
Methodology[B]: Qualitative assessment, with consideration of factors
such as capital account restrictions.
Source: IMF;
Estimate (percentage): No clear evidence of substantial undervaluation;
Methodology[B]: Macroeconomic Balance approach[D].
Source: Stephen Roach (Morgan Stanley);
Estimate (percentage): Not undervalued;
Methodology[B]: PPP (relative version) and Qualitative approaches.
Source: Barry Bosworth (Brookings Institute)[E];
Estimate (percentage): Not fundamentally undervalued;
Methodology[B]: Macroeconomic Balance approach;
Source: Barry Bosworth (Brookings Institute)[E];
Estimate (percentage): 40;
Methodology[B]: PPP (absolute version) approach.
Source: Pieter Bottelier (Johns Hopkins)[F];
Estimate (percentage): 4- 5;
Methodology[B]: External Balance approach.
Source: Barry Eichengreen (University of California, Berkeley);
Estimate (percentage): 5-10;
Methodology[B]: Qualitative approach.
Source: Jim O'Neill (Goldman Sachs);
Estimate (percentage): 9.5-15;
Methodology[B]: FEER/BEER approach (lower);
External Balance approach (upper) (Trade-Weighted Renminbi).
Source: Funke/Rahn (Hamburg University);
Estimate (percentage): 11;
Methodology[B]: BEER approach.
Source: Goldstein/Lardy (Institute for International Economics);
Estimate (percentage): 15-25;
Methodology[B]: External Balance approach.
Source: Gene Hsin Chang (University of Toledo);
Estimate (percentage): 22;
Methodology[B]: PPP (absolute version) approach.
Source: Jon Anderson (UBS)[G];
Estimate (percentage): 15-25;
Methodology[B]: External Balance approach.
Source: Jeffrey Frankel (Harvard);
Estimate (percentage): 35;
Methodology[B]: PPP (absolute version) approach.
Source: Ernest Preeg (Hudson Institute, Manufacturers Alliance/MAPI);
Estimate (percentage): 40;
Methodology[B]: External Balance approach.
Source: Benassy-Quere et al. (University of Paris);
Estimate (percentage): 47.3;
Methodology[B]: BEER approach.
Source: Big Mac Index (Economist)[H];
Estimate (percentage): 56;
Methodology[B]: PPP (absolute version) approach.
Source: GAO synthesis of published studies and selected communication
with authors.
[A] Estimates using certain methodologies are particularly sensitive to
changes in China's balance of payments data, and thus can change as new
information becomes available.
[B] PPP is Purchasing Power Parity, FEER is Fundamental Equilibrium
Exchange Rate, and BEER is Behavioral Equilibrium Exchange Rate.
Appendix V describes these methodologies in detail.
[C] Lau stated that no methodology can determine the true equilibrium
rate given capital account restrictions in China.
[D] The IMF uses at least in part the Macroeconomic Balance Approach,
which is closely related to FEER. Its view on the renminbi is based on
the perceptions of "most directors."
[E] Bosworth's two methodological approaches resulted in significantly
different results. He stated that his overall conclusion is that this
type of analysis implies a degree of precision that does not really
exist.
[F] Bottelier reported this estimate, using a Basic Balance approach,
in January 2005. He stressed that there is no standard methodology for
estimating undervaluation and such estimates are valuable primarily as
indicators of direction of potential change.
[G] Anderson stated that he does not have an estimate for "fundamental"
over or undervaluation of the renminbi.
[H] The Economist has also calculated a PPP (absolute version) index
based on the "Tall Latte," which showed the renminbi to be undervalued
by 1 percent.
[End of table]
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.[Footnote
27] 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[Footnote 28] 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.[Footnote 29] 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.[Footnote 30] (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.[Footnote 31]
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.[Footnote 32]
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.[Footnote 33] 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),[Footnote 34] 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.[Footnote 35] 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.[Footnote 36] 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.[Footnote 37]
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.[Footnote 38] 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[Footnote 39] 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.[Footnote 40]
Table 3: Illustrative Scenarios of Upward Revaluation of the Renminbi
on the U.S. Trade Deficit:
Scenario: Scenario 1:
Baseline assumption,[A] with no additional assumptions about exchange
rate pass-through, shift to other foreign sources, or follow-on
exchange rate adjustments;
Decrease in U.S. trade deficit (dollars in billions): 5 percent upward
revaluation: $2.8;
Decrease in U.S. trade deficit (dollars in billions): 20 percent upward
revaluation: $11.1.
Scenario: Scenario 2:
50 percent exchange rate pass-through and no shift to other foreign
sources[B];
Decrease in U.S. trade deficit (dollars in billions): 5 percent upward
revaluation: $1.4;
Decrease in U.S. trade deficit (dollars in billions): 20 percent upward
revaluation: $5.5.
Scenario: Scenario 3:
50 percent exchange rate pass-through and 40 percent shift to other
foreign sources;
Decrease in U.S. trade deficit (dollars in billions): 5 percent upward
revaluation: $0.8;
Decrease in U.S. trade deficit (dollars in billions): 20 percent upward
revaluation: $3.3.
Scenario: Scenario 4:
Follow-on exchange rate adjustments (Korea, Taiwan, and Japan)[C] plus
50 percent exchange rate pass-through and 40 percent shift to other
foreign sources;
Decrease in U.S. trade deficit (dollars in billions): 5 percent upward
revaluation: $3.3;
Decrease in U.S. trade deficit (dollars in billions): 20 percent upward
revaluation: $13.3.
Source: GAO analysis based on assumptions specified.
[A] These estimates employ a rough assumption discussed in the IMF's
April 2004 World Economic Outlook that a 10 percent depreciation in the
dollar would lead to an improvement in the U.S. trade balance
equivalent to 0.5 percent of GDP.
[B] Specifically, this scenario assumes that the exchange-rate pass-
through is 50 percent less than any pass-through level represented in
scenario 1.
[C] The follow-on exchange rate adjustments are assumed to be half as
large, in percentage terms, as the renminbi revaluation.
[End of table]
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.[Footnote 41]
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.[Footnote 42] 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.[Footnote 43] 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.[Footnote 44] 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).[Footnote
45] 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.[Footnote 46]
Figure 3: Percentage of U.S. Treasury Securities Held by Japan and
China, 2004:
[See PDF for image]
Note: These percentages are approximate because of data limitations
detailed in appendix I. Estimates are as of the end of the third
quarter, 2004.
[End of figure]
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,[Footnote 47] 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).
Figure 4: Net Purchases of U.S. Securities by Select Economies, 2001-
2004:
[See PDF for image]
Notes: Figures are adjusted for inflation using the GDP deflator. Data
includes commissions and taxes associated with each transaction.
Reporting procedures for the collection of these data lead to a bias
toward overcounting flows from economies that are major financial
centers and undercounting flows from other economies. Errors may also
occur due to the manner in which repurchases and securities lending
transactions are recorded within the TIC system. See appendix I for
data limitations.
[End of figure]
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 [Hyperlink,
http://www.gao.gov].
If you or your staffs have any questions concerning this report, please
contact me at (202) 512-4128 or at [Hyperlink, yagerl@gao.gov]. Other
GAO contacts and staff acknowledgments are listed in appendix IX.
Signed by:
Loren Yager:
Director, International Affairs and Trade:
[End of section]
Appendixes:
Appendix I: 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.[Footnote 48] 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.
[End of section]
Appendix II: Omnibus Trade and Competitiveness Act of 1988:
Omnibus Trade and Competitiveness Act of 1988[Footnote 49] (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.
[End of section]
Appendix III: 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.
Table 4: Conditions Treasury Cited in Earlier Determinations of
Currency Manipulation:
Conditions: Bilateral trade surplus with U.S;
Taiwan: (first half of 1988): $17.4 billion (18% of GNP) in 1987;
Korea: (first half of 1988): $9.4 billion in 1987 (8.3% of GNP);
China: (second half of 1991): $12.7 billion in 1991, second only to
Japan, grew rapidly.
Conditions: Current account surplus (% of GNP);
Taiwan: (first half of 1988): $18.1 billion (18.5% of GNP) in 1987);
Korea: (first half of 1988): Near $10 billion (8.3% of GNP) in 1987;
China: (second half of 1991): $12.2 billion (3.3% of GNP) in 1990.
Conditions: Other indicators highlighted;
Taiwan: (first half of 1988): Strong economic fundamentals and rapidly
rising foreign exchange reserves; Insufficient currency appreciation
(40% since 1985 Plaza Accord, less than 92% appreciation by Japanese
yen, and 60% by German mark); Undervaluation, resulting from
interventions, capital controls, and administrative mechanisms
preventing further appreciation;
Korea: (first half of 1988): Strong economic fundamentals, prepayment
of external debt, and rising foreign exchange reserves; Insufficient
currency appreciation (26% since 1985 Plaza Accord, less than 92%
appreciation by Japanese yen and 60% by German mark); Undervaluation,
resulting from interventions, capital controls, and administrative
mechanisms preventing further appreciation;
China: (second half of 1991): Rising foreign exchange reserves, $44
billion in 1991, enough to cover 10 months of imports; Dual exchange
rate regime--continued devaluations of the fixed official exchange rate
and excessive controls on the dual market determined rates. (China
claimed these actions were aimed at eliminating costly export subsidies
and unifying dual rates.)
Conditions: Activities considered as potential manipulation or
conditions considered as constraining market forces in foreign exchange
market;
Taiwan: (first half of 1988): Substantial capital and exchange
restrictions under the managed float system; Heavy direct interventions
(buy or sell) by the central bank in foreign exchange markets;
Korea: (first half of 1988): Substantial capital and exchange
restrictions under the managed float system; Established currency value
administratively based on undisclosed basket (combination) of
currencies;
China: (second half of 1991): Pervasive administrative controls over
external trade; Treasury interpreted Chinese repeated devaluations and
controls on dual market rates as efforts to frustrate effective balance
of payment adjustments.
Conditions: Number of 6-month periods continuously cited for
manipulating currency;
Taiwan: (first half of 1988): 2;
Korea: (first half of 1988): 3;
China: (second half of 1991): 5.
Conditions: Changes in conditions that led to removal of citation;
Taiwan: (first half of 1988): 12% more appreciation of currency since
first citation; Reduction of global current account surplus by 43%
(8.5% of GNP); Implemented a new exchange rate system (5 months before
the Treasury report was issued) that liberalized the system and reduced
capital controls; No evidence of substantial interventions, but concern
remained on potential interventions by government controlled banks;
Korea: (first half of 1988): Global current account surplus reduced to
$5.1 billion (2.5% of GNP); Bilateral surplus reduced to $6.3 billion
in 1989; Introduction of new "market average rate" system of exchange
rate determination in March (1 month before Treasury report was
issued); Initiation of the bilateral Financial Policy Talks during the
period;
China: (second half of 1991): Current account turned from negative in
1993 to small surplus in 1994; Bilateral surplus projected to be $28.7
billion for 1994; Foreign exchange reserves $39.8 billion, can cover 5
months of imports; Unified the dual exchange rate regime and
liberalized domestic firms' access to foreign exchanges in; 1994;
Government approval of foreign exchange purchases by foreign-funded
enterprises remained; Treasury determined that China was not
manipulating exchange rate but maintained capacity to do so in the
future.
Conditions: Changes in conditions that led to additional citation and
its removal;
Taiwan: (first half of 1988):
Additional Citation;
(Second half of 1991 and first half of 1992);
* Current account surplus rose to $12 billion (6.7% of GNP) in 1991;
* Bilateral surplus $9.8 billion;
* Official foreign exchange reserves rose significantly to $83.2
billion in Feb 1992, the world's largest, and enough to cover 17 months
of imports;
* Continued intervention to moderate upward pressure;
* Remaining restrictions prevent full market forces in foreign exchange
market;
* Strong economic fundamentals;
Removal;
* Current account surplus fell to $7.9 billion (3.8% of GNP) in 1992;
* Bilateral surplus declined slightly to $9.4 billion in 1992;
* Foreign exchange reserves declined slightly to $82.3 billion, second
to Germany;
* Remaining foreign exchange restrictions and capital controls no
longer constrained currency appreciation;
* It appears that Chinese authorities engaged in direct interventions
in foreign exchange markets to prevent currency depreciation;
Korea: (first half of 1988): N/A;
China: (second half of 1991): N/A.
Source: GAO analysis of Treasury exchange rate reports.
[End of table]
[End of section]
Appendix IV: 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.
Figure 5: China's Real GDP Growth Rate, 1996-2004:
[See PDF for image]
Note: The 2004 value is an estimate from Global Insight.
[End of figure]
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.[Footnote 50] 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.[Footnote 51] (See fig. 6.)
Figure 6: China's Current Account Surplus in Billions of U.S. Dollars
and as a Percentage of GDP, 1996-2004:
[See PDF for image]
Note: The 2004 value is an estimate from Global Insight.
[End of figure]
Foreign Exchange Reserves:
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.
Figure 7: China's Total Foreign Exchange Reserves, 1995-2004:
[See PDF for image]
Note: Values represent total foreign exchange reserves, minus gold.
[End of figure]
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.
Table 5: China's Balance of Payments:
Balance of payments concepts: Current account balance;
1999: $21.1;
2000: $20.5;
2001: $17.4;
2002: $35.4;
2003[A]: $45.9.
Balance of payments concepts: Capital and financial account balance;
1999: $7.6;
2000: $2.0;
2001: $34.8;
2002: $32.3;
2003[A]: $52.8.
Balance of payments concepts: Net foreign direct investment;
1999: $37.0;
2000: $37.5;
2001: $37.4;
2002: $46.8;
2003[A]: $47.2.
Balance of payments concepts: Net portfolio investment;
1999: - $11.2;
2000: - $4.0;
2001: - $19.4;
2002: - $10.3;
2003[A]: $11.4.
Balance of payments concepts: Net other investment[B];
1999: - $20.5;
2000: - $31.5;
2001: $16.9;
2002: - $4.1;
2003[A]: - $5.9.
Balance of payments concepts: Errors and omissions[C];
1999: - $17.6;
2000: - $11.7;
2001: - $4.7;
2002: $7.5;
2003[A]: $18.0.
Balance of payments concepts: Overall balance (increase in foreign
exchange reserves);
1999: $8.7;
2000: $10.7;
2001: $47.5;
2002: $75.3;
2003[A]: $116.6.
Balance of payments concepts: Basic balance (Current account + FDI);
1999: $58.1;
2000: $58.0;
2001: $54.8;
2002: $82.2;
2003[A]: $93.1.
Source: IMF.
[A] 2003 is the most recent year for which complete data on the balance
of payments component are available.
[B] Other investment includes trade credits, loans, and currency and
deposits.
[C] Errors and omissions often reflect undocumented capital flight.
[End of table]
Balance of Payments:
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.[Footnote 52] 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.
Figure 8: Chinese Renminbi/Dollar Exchange Rate, 1989-2004:
[See PDF for image]
[End of figure]
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).[Footnote 53] 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.[Footnote 54] 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.
Figure 9: Real Effective Exchange Rate Indexes (China and the United
States), 1994-2004:
[See PDF for image]
Note: JP Morgan indexes, 2000=100:
[End of table]
Foreign Exchange and Capital Controls:
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.[Footnote 55] 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.[Footnote 56]
Figure 10: Japan's Real GDP growth rate, 1996-2004:
[See PDF for image]
Note: The 2004 value is an estimate from Global Insight.
[End of figure]
Figure 11: Japan's Current Account Surplus in Billions of U.S. Dollars
and as a Percentage of GDP, 1996-2004:
[See PDF for image]
Note: The 2004 value is an estimate from Global Insight.
[End of figure]
Foreign Exchange Reserves:
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,[Footnote 57] 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.
Figure 12: Japan's Total Foreign Exchange Reserves, 1995-2004:
[See PDF for image]
Note: Values represent total foreign exchange reserves, minus gold.
[End of figure]
Japan's Exchange Rate:
The Japanese yen is on an independent float, with the exchange rate
primarily determined by market forces.[Footnote 58] 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.[Footnote 59] Japanese
authorities intervened frequently in its foreign exchange markets in
2002,[Footnote 60] 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.
Figure 13: Yen/Dollar Interventions, January 2000-December 2004:
[See PDF for image]
Note: GAO did not assess the reliability of the Ministry of Finance
data. This is quarterly data.
[End of figure]
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.
Figure 14: Real Effective Exchange Rate Index for Japan, 1994-2004:
[See PDF for image]
Note: JP Morgan indexes, 2000=100.
[End of figure]
[End of section]
Appendix V: 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.[Footnote 61] 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.[Footnote 62] 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.[Footnote
63] 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.[Footnote 64] 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.[Footnote 65] 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.[Footnote 66] 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.[Footnote 67] Once the
relevant external balance is identified, estimated trade models or rule-
of-thumb relationships[Footnote 68] 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.[Footnote 69] 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.[Footnote
70] 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.[Footnote 71]
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.
Figure 15: Total Reserves for Selected Economies, 2000-2004:
[See PDF for image]
Note: Values represent total foreign exchange reserves, minus gold.
[End of figure]
[End of section]
Appendix VI: 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.[Footnote 72]
* 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.[Footnote 73]
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).[Footnote 74] 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.
Figure 16: Total Trade Weights (broad index of the foreign exchange
value of the dollar):
[See PDF for image]
Note: These weights are those in use between December 16, 2003, and
February 2, 2005. The index weights, which change over time, are
derived from U.S. export shares and from U.S. and foreign import
shares.
[End of figure]
* 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.[Footnote 75] 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.
Figure 17: Percentage of U.S. Merchandise Trade Deficit Accounted for
by Selected East Asian Economies, 1999-2004:
[See PDF for image]
Note: Other East Asia is Korea and Taiwan.
[End of figure]
* 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).
Figure 18: Hourly Compensation Costs for Production Workers in
Manufacturing in U.S. Dollars, 2002:
[See PDF for image]
Note: Europe denotes the EU-15. These statistics should not be
considered as precise measures of comparative compensation costs given
the data limitations including the fact that compensation is partially
estimated for some countries. See appendix I for details.
[End of figure]
* 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.
[End of section]
Appendix VII: 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.
Table 6: Real Net Purchases of U.S. Securities by China:
Dollars in millions.
1989;
U.S. Treasuries: -$274;
U.S. agencies: -$18;
U.S. corporate bond: $26;
U.S. corporate stocks: $12;
Foreign bonds: -$138;
Foreign equity: $0;
Total: -$392.
1990;
U.S. Treasuries: $457;
U.S. agencies: -$4;
U.S. corporate bond: -$15;
U.S. corporate stocks: $1;
Foreign bonds: $224;
Foreign equity: -$1;
Total: $662.
1991;
U.S. Treasuries: $142;
U.S. agencies: $59;
U.S. corporate bond: $19;
U.S. corporate stocks: $8;
Foreign bonds: $554;
Foreign equity: $0;
Total: $782.
1992;
U.S. Treasuries: $4,254;
U.S. agencies: $608;
U.S. corporate bond: $870;
U.S. corporate stocks: $14;
Foreign bonds: $507;
Foreign equity: $5;
Total: $6,258.
1993;
U.S. Treasuries: $553;
U.S. agencies: $678;
U.S. corporate bond: $188;
U.S. corporate stocks: -$54;
Foreign bonds: -$270;
Foreign equity: -$131;
Total: $963.
1994;
U.S. Treasuries: $14,649;
U.S. agencies: $598;
U.S. corporate bond: $125;
U.S. corporate stocks: -$25;
Foreign bonds: $247;
Foreign equity: -$706;
Total: $14,888.
1995;
U.S. Treasuries: $827;
U.S. agencies: $1,006;
U.S. corporate bond: $16;
U.S. corporate stocks: -$13;
Foreign bonds: -$323;
Foreign equity: -$188;
Total: $1,324.
1996;
U.S. Treasuries: $16,683;
U.S. agencies: $3,181;
U.S. corporate bond: $297;
U.S. corporate stocks: -$2;
Foreign bonds: $39;
Foreign equity: -$73;
Total: $20,125.
1997;
U.S. Treasuries: $9,263;
U.S. agencies: $1,939;
U.S. corporate bond: $79;
U.S. corporate stocks: $70;
Foreign bonds: $60;
Foreign equity: -$548;
Total: $10,864.
1998;
U.S. Treasuries: $2,919;
U.S. agencies: $980;
U.S. corporate bond: $53;
U.S. corporate stocks: $1;
Foreign bonds: $1,927;
Foreign equity: -$9;
Total: $5,871.
1999;
U.S. Treasuries: $9,066;
U.S. agencies: $9,236;
U.S. corporate bond: $576;
U.S. corporate stocks: $226;
Foreign bonds: $372;
Foreign equity: -$246;
Total: $19,230.
2000;
U.S. Treasuries: -$4,302;
U.S. agencies: $20,389;
U.S. corporate bond: $875;
U.S. corporate stocks: -$112;
Foreign bonds: $1,959;
Foreign equity: -$272;
Total: $18,537.
2001;
U.S. Treasuries: $20,226;
U.S. agencies: $27,485;
U.S. corporate bond: $7,076;
U.S. corporate stocks: $3;
Foreign bonds: $4,267;
Foreign equity: $42;
Total: $59,099.
2002;
U.S. Treasuries: $25,058;
U.S. agencies: $30,457;
U.S. corporate bond: $6,205;
U.S. corporate stocks: $168;
Foreign bonds: $3,642;
Foreign equity: -$39;
Total: $65,491.
2003;
U.S. Treasuries: $31,176;
U.S. agencies: $30,282;
U.S. corporate bond: $4,728;
U.S. corporate stocks: -$79;
Foreign bonds: $2,524;
Foreign equity: -$10;
Total: $68,622.
2004;
U.S. Treasuries: $18,895;
U.S. agencies: $16,387;
U.S. corporate bond: $12,341;
U.S. corporate stocks: -$290;
Foreign bonds: $3,603;
Foreign equity: $-614;
Total: $50,322.
Source: GAO calculations based on the U.S. Treasury's International
Capital (TIC) reporting system.
Notes: Figures are adjusted for inflation using the U.S. GDP deflator.
Data includes commissions and taxes associated with each transaction.
[End of table]
Reporting procedures for the collection of these data lead to a bias
toward over-counting flows to countries that are major financial
centers and undercounting flows to other countries. Errors may also
occur due to the manner in which repurchases and securities lending
transactions are recorded within the TIC system.
U.S. agencies include bonds issued by government-sponsored agencies
such as Freddie Mac and Fannie Mae.
China's net purchases slowed during a portion of 2004, giving rise to
speculation that China's willingness to invest in U.S. Treasury
securities or other assets had decreased. However, China's purchases
were relatively strong during the last quarter of 2004.
Table 7: Real Net Purchases of U.S. Securities by Foreigners, Selected
Countries:
Dollars in millions.
1993;
UK: -$46,773;
Japan: $35,646;
China: $963;
Canada: -$8,457;
Hong Kong: $3,738;
Germany: -$14,767;
Korea: -$2,519;
Mexico: -$14,842.
1994;
UK: $81,198;
Japan: $22,822;
China: $14,888;
Canada: -$2,624;
Hong Kong: $3,934;
Germany: $8,683;
Korea: -$1,649;
Mexico: -$7,565.
1995;
UK: $84,361;
Japan: -$10,077;
China: $1,324;
Canada: -$7,654;
Hong Kong: $5,260;
Germany: $10,982;
Korea: $2,599;
Mexico: $2,171.
1996;
UK: $106,748;
Japan: $56,883;
China: $20,125;
Canada: $1,568;
Hong Kong: $1,361;
Germany: $18,114;
Korea: -$1,179;
Mexico: -$3,330.
1997;
UK: $166,494;
Japan: $27,822;
China: $10,864;
Canada: $1,092;
Hong Kong: $21,921;
Germany: $41,485;
Korea: -$15,349;
Mexico: -$409.
1998;
UK: $159,179;
Japan: $20,797;
China: $5,871;
Canada: $134;
Hong Kong: $9,059;
Germany: $16,646;
Korea: $11,971;
Mexico: $1,332.
1999;
UK: $186,843;
Japan: -$300;
China: $19,230;
Canada: $13,347;
Hong Kong: $12,092;
Germany: $23,446;
Korea: $11,014;
Mexico: $1,740.
2000;
UK: $147,455;
Japan: $79,062;
China: $18,537;
Canada: $16,040;
Hong Kong: $8,804;
Germany: $31,642;
Korea: $5,403;
Mexico: $10,085.
2001;
UK: $164,452;
Japan: $38,588;
China: $59,099;
Canada: $17,867;
Hong Kong: $30,073;
Germany: $22,322;
Korea: $325;
Mexico: $8,831.
2002;
UK: $199,715;
Japan: $84,668;
China: $65,491;
Canada: $7,105;
Hong Kong: $15,149;
Germany: $24;
Korea: $13,524;
Mexico: $10,607.
2003;
UK: $165,864;
Japan: $152,387;
China: $68,622;
Canada: $36,399;
Hong Kong: $19,844;
Germany: $14,528;
Korea: $12,745;
Mexico: $11,025.
2004;
UK: $165,528;
Japan: $218,623;
China: $50,322;
Canada: $26,761;
Hong Kong: $22,154;
Germany: $18,877;
Korea: $12,758;
Mexico: $31,229.
Source: GAO calculations based on the U.S. Treasury's International
Capital (TIC) reporting system and data from the Congressional Research
Service.
Notes: Figures are adjusted for inflation using the GDP deflator. Data
includes commissions and taxes associated with each transaction.
Reporting procedures for the collection of these data lead to a bias
toward over-counting flows to countries that are major financial
centers and the undercounting flows to other countries. Errors may also
occur due to the manner in which repurchases and securities lending
transactions are recorded within the TIC system. See appendix I for
data limitations.
[End of table]
[End of section]
Appendix VIII: Comments from the Department of the Treasury:
DEPARTMENT OF THE TREASURY:
WASHINGTON, D.C. 20220:
April 1, 2005:
Loren Yager:
Director:
International Affairs and Trade:
Government Accountability Office:
Dear Mr. Yager:
Thank you very much for the opportunity to review the draft report
entitled "International Trade: Treasury Assessments Have Not Found
Currency Manipulation but Concerns about Exchange Rates Continue." The
draft report is generally thoughtful, and we hope it will contribute to
increased understanding of the complex issues covered in the Treasury
reports.
It is important to underscore that Treasury does not view the exchange
rate as a policy instrument. Exchange rates are determined through the
complex interplay of macroeconomic and microeconomic forces throughout
the world. As you know, it is not Treasury's policy to target a
specific value for the dollar or a current account objective.
The focus of Treasury's policy efforts is to promote good macroeconomic
management, to maintain a healthy environment for Americans to produce
goods and services, to strengthen the openness of our economy and to
reinforce the depth and liquidity of the U.S. financial system. By
keeping its own affairs in order, the United States can both enhance
growth and employment at home and contribute to the health of the
global economy and financial system. Strong and persisting foreign
demand for U.S. financial assets is emblematic of the strength of the
U.S. economy.
Treasury does indeed consider the impact of the exchange rate on such
areas as the sustainability of the current account deficit, production,
employment, and industrial competitiveness in the United States. Allow
me to make two specific comments in this regard:
The sustainability of any country's current account deficit depends
directly on the strength of the country's economy and the
attractiveness of its investment environment. A strong economy,
particularly one like that of the United States with persistently high
productivity growth, creates jobs, fosters profitable investment
opportunities and attracts capital from the rest of the world.
* Regarding the interplay between the exchange rate and real economy,
some of the most important basic influences on exchange rates - such as
the flexibility of labor markets, the inflation rate, and productivity
growth - also affect production, employment and competitiveness.
Instead of trying to achieve a false precision by isolating the
exchange rate in the analysis, it is often more helpful to look at
underlying developments that have an impact on both exchange rates and
other macroeconomic conditions. The U.S. experience of the late 1990s,
when the dollar appreciated even as production and employment rose,
illustrates the utility of this approach.
The draft report's description of the complex issues that must be
examined in assessing China's exchange rate regime is valuable, as is
the discussion of the wide range of modeling results produced by a
large number of analysts. Treasury's analysis takes into account, among
other things, the maintenance of China's peg through widely varying
international economic conditions and recent developments in China's
current account, international reserve growth, capital flows and
controls on capital flows. However, Treasury's policy analysis also
concludes that, while China's peg may have been useful in the past,
given the changes that have taken place in the Chinese economy and its
greatly increased role in the international trade and financial
systems, China should now move to a market-based flexible exchange
rate. This would benefit both the Chinese and international economies.
Finally, I would note that Treasury has provided in past reports under
Section 5304 considerable detail about the reasoning behind its
currency manipulation conclusions. Treasury will continue to do so in
its future reports, supported by the draft report's helpful
suggestions.
Thank you once again for the effort that went into this draft report
and the opportunity to comment on it.
Sincerely,
Signed by:
Mark Sobel:
Deputy Assistant Secretary:
International Monetary and Financial Policy:
[End of section]
Appendix IX: GAO Contacts and Staff Acknowledgments:
GAO Contacts:
Celia Thomas, (202) 512-8987;
Anthony Moran, (202) 512-8645:
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.
(320226):
FOOTNOTES
[1] The U.S. merchandise trade deficit for 2004 was $650.8 billion,
compared to $532.3 billion for 2003, according to the U.S. Census
Bureau.
[2] Pub. L. No. 100-418, §§ 3001-06, 102 Stat. 1372 and following.
[3] Pub. L. No. 108-447, Div. H, title II, § 221, 118 Stat. 3242,
required 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
Congress. Treasury issued its report on March 11, 2005.
[4] The conditions are (1) manipulating the exchange rate for the
purposes of gaining an unfair trade advantage or preventing effective
balance of payments adjustments and (2) having a material global
current account surplus and a significant bilateral trade surplus with
the United States. The global current account surplus is the current
account surplus of merchandise, services, and transfers with all other
countries, while the bilateral trade surplus is the surplus in goods
and services trade with one trading partner country only.
[5] One requirement pertained to reporting on certain U.S.-
International Monetary Fund consultations, information about which was
not publicly available in 1988. Treasury officials noted that the
International Monetary Fund now makes information on these
consultations available through the Internet.
[6] The current account balance is a summary measure of a country's net
balance over a period of time with all other countries in trade of
goods and services, income, and unrequited transfers (such as foreign
aid payments and workers' remittances). The balance of trade in goods
and services is a subset of the current account balance.
[7] The language pertaining to Treasury's manipulation assessment and
exchange rate reporting obligations is in sections 3004(b) and 3005,
respectively. 22 U.S.C. § 5304(b).
[8] The balance of payments is a summary measure of a country's total
trade, other economic transactions, and financial flows. It is made up
of the current account (current transactions), the capital and
financial account (capital and financial transactions), and a balancing
item to even out difficulties in recording international transactions.
[9] The dual exchange rate system consisted of an official rate that
applied to state-controlled transactions including trade, and a lower
market rate that applied to all other activities. See appendix IV for
more details.
[10] The pegged rate has not varied from 8.28 per U.S. dollar since
1998.
[11] Treasury does not have formal departmental guidance for performing
its assessment of manipulation under the 1988 Trade Act. According to
Treasury, it provides guidance to desk officers for country analysis,
specifying a set of indicators to be examined. Senior staff coordinate
desk officer submissions to ensure that countries are analyzed in a
consistent manner.
[12] Technically, not all the economies monitored by Treasury (e.g.,
Hong Kong) are countries.
[13] In its March 2005 report to Congress, Treasury defined these
concepts generally. It defined "material global current account
surplus" as a large current account surplus, measured as a percent of
an economy's GDP. It defined "significant bilateral trade surplus" as a
large bilateral trade surplus with the United States, relative to the
size of U.S. trade.
With respect to data for China, Treasury stated it uses official
Chinese statistics when determining China's global current account and
trade balances, but it has also examined trade statistics reported by
China's trading partners. China's global current account and trade
balance statistics differ markedly from the aggregate statistics of its
trading partners. One reason is that much trade to and from China
travels via Hong Kong, and while both China and its trade partners
usually report the actual source of their imports, they often record
the destination of their exports as Hong Kong, even though the goods
may go on to other markets. Treasury is analyzing these data
discrepancies, according to Treasury officials.
[14] In October 1988, Treasury reported that the Taiwanese and Korean
currencies were undervalued.
[15] According to Treasury officials, approval ultimately rests with
the Secretary of the Treasury.
[16] While Treasury is only required to make a manipulation assessment
on an annual basis, it includes an assessment in each of the semiannual
exchange rate reports that will be discussed in the next section.
[17] For example, the October 2001 report listed two economic factors
that Treasury considered to determine currency manipulation, the
October 2003 report listed none, and the April and December 2004
reports listed seven.
[18] For the fourth and fifth findings of manipulation against China,
covering 1993 and 1994, Treasury reported that China's current account
had, in the first instance, declined substantially, and, in the second
instance, gone into deficit. Treasury officials observed that in those
cases, mandated negotiations that had begun earlier were still being
carried out and institutional changes deemed necessary to remedy
conditions were incomplete.
[19] Taiwan's global current account surplus declined from 18.5 percent
(1987) of gross national product (GNP) to 8.5 percent (1988) during the
first period it was on the list of manipulators, and from 6.7 (1991) to
3.8 (1992) during the second period. Korea's current account surplus
declined from 8.3 percent GNP (1987) to 2.5 percent (1989), and China's
declined from 3.3 (1990) percent to a small surplus (1994).
[20] China reports its current account balance on an annual basis, with
a lag of several months after the end of the year. In July 2004, the
IMF reported that based on preliminary data China had a global current
account surplus of 3.3 percent of GDP for 2003. Also in July 2004,
Global Insight's estimate for China's 2004 current account surplus was
1.0 percent of GDP. Recent estimates from Global Insight for China's
global current account surplus for 2004 are higher.
[21] The IMF defines foreign direct investment as the acquisition of a
lasting interest in an enterprise operating in an economy other than
that of the investor and characterized by an effective voice in
management of the enterprise. The Organization for Economic Cooperation
and Development states that a 10 percent or greater ownership stake
would satisfy this requirement.
[22] Treasury officials noted that between late February 2002, when the
Federal Reserve's trade-weighted index of the dollar reached its most
recent maximum, and the end of June 2004, the dollar depreciated by
18.7 percent against the yen, broadly similar to its 22.6 percent
depreciation against the major currency component of the index over the
same period.
[23] Explicit capital flow analysis was not included in reports issued
from 1995 to 1997.
[24] The other policies cited were increasing U.S. public and private
sector savings and improving global economic growth.
[25] Some of these include the Purchasing Power Parity (PPP),
Fundamental Equilibrium Exchange Rate (FEER), Behavioral Equilibrium
Exchange Rate (BEER), Macroeconomic Balance, and External Balance
approaches.
[26] These analyses can focus on different sets of economic
fundamentals to determine the equilibrium rate.
[27] The economic profession has no consensus on the model to be used
in determining what the appropriate or sustainable external balance
should be for a given country. Some experts have pointed out that
certain external account balance standards, such as an overall balance
of zero in a country's balance of payments accounts, would require that
China run a trade deficit to meet that standard in order to offset the
net investment flows into the country.
[28] China's current account surpluses were 1.5 percent, 2.8 percent,
and 3.2 percent of GDP in 2001, 2002, and 2003, respectively. Its 2004
current account balance, not yet officially reported, is 4.2 percent of
GDP, according to a March 2005 Global Insight estimate.
[29] These non-FDI inflows and undocumented capital are believed to
include speculative inflows in anticipation of a renminbi revaluation.
[30] Also in 2003, China used $45 billion of its foreign exchange
reserves to support, or recapitalize, its banks.
[31] A related concern that has been expressed is that if China's
restrictions on capital outflows were lifted, bad news about the
banking system or the economy more generally could cause large-scale
capital flight from China and sharp currency depreciation.
[32] This two-stage approach has been proposed by Morris Goldstein.
(See Morris Goldstein, "China and the Renminbi Exchange Rate," in C.
Fred Bergsten and John Williamson, ed., Dollar Adjustment: How Far?
Against What? Institute for International Development, Washington, D.C:
2004.) Goldstein also summarizes other proposed approaches, including
(1) a "go-slow" approach, combining a series of trade, capital account,
and tax measures with a very small revaluation; (2) floating the
currency but maintaining controls on capital outflows, and (3) open
capital markets with a floating exchange rate.
[33] The discussion in this section presumes that if China did change
its nominal exchange rate, it would result in a change in its inflation-
adjusted, or real, exchange rate. That is, it assumes that the real
exchange rate is an instrument over which Chinese authorities have some
control. This is in contrast to an assumption in traditional economic
theory that under free market conditions countries' real exchange rates
are determined by broader economic relationships, and governments
cannot control them in the long run. Many analyses of developing
economies with significant economic controls still in place, such as
China, presume that governments in these economies do have some ability
to affect real exchange rates over some period of time.
[34] It also depends on other factors, such as the flexibility of the
Chinese labor market and the strategic pricing decisions of
multinational enterprises.
[35] In fact, the total import bill and thus the trade deficit could
rise in the short run rather than fall, in response to a revaluation of
the renminbi, if prices of Chinese imports go up faster than demand for
Chinese goods falls. Economists have found empirical evidence of this
short-term effect of exchange rate changes, which is sometimes called
the J-curve.
[36] There are differing views about how a revaluation of the renminbi
might affect the exchange rates of other Asian countries. One view is
that if China revalued its currency against the dollar, other Asian
economies, including Korea, Taiwan, and perhaps Japan, would also let
their currencies appreciate relative to the dollar. In contrast, some
experts, citing modeling exercises, maintain that these currencies are
unlikely to strengthen relative to the dollar if the renminbi
appreciates and, in fact, might weaken, which would have opposite
implications for the U.S. balance of payments.
[37] The number of jobs in the U.S. manufacturing sector declined by
about 2.8 million, or 15.9 percent, between 2000 and 2003, according to
the Bureau of Labor Statistics. One recent study estimated that about
314,000 of those jobs were lost due to U.S. trade with all countries.
(See Martin Bailey and Robert Lawrence, "What Happened to the Great
U.S. Job Machine? The Role of Trade and Electronic Offshoring"
Brookings Papers on Economic Activity; 2004; 2: Washington, D.C. One
study that looked directly at the relationship between U.S.
manufacturing employment and exchange rates estimated that for each 1
percent increase in the real trade-weighted value of the dollar, the
number of workers employed in U.S. manufacturing falls by 0.12 percent
(or by about 17,400 jobs in 2003). (See Robert Blecker, "The Benefits
of a Lower Dollar," EPI Briefing Paper, 2003.)
[38] We use these percentages of revaluation for illustrative purposes
only.
[39] This assumption is that a 10 percent depreciation in the real
(inflation-adjusted) trade-weighted value of the dollar leads to an
improvement in the U.S. trade balance equal to 0.5 percent of GDP.
[40] For example, prominent analysts have used an estimate for changes
in the value of the dollar relative to changes in the trade deficit
that is about double the rule employed in this illustration--that a 1
percent decline in the trade-weighted value of the dollar would lead to
a $10 billion reduction in the U.S. trade deficit (implying a 10
percent decline leads to a $100 billion reduction in the trade deficit-
-roughly 1 percentage point of GDP). See Morris Goldstein (2004),
"China and the Renminbi Exchange Rate" in C. Fred Bergsten and John
Williamson, ed., Dollar Adjustment: How Far? Against What?, Institute
for International Economics, Washington, D.C.: 2004. See also Ernst H.
Preeg, "Exchange Rate Manipulation to Gain an Unfair Competitive
Advantage: The Case of Japan and China" in C. Bergsten and J.
Williamson (eds.) Dollar Overvaluation and the World Economy, Institute
for International Economics, Washington, D.C.: 2003.
[41] That value is similar in magnitude to job-multiplier analyses used
in other studies, including a 1997 government analysis of NAFTA job
impacts that assumed that about 13,000 jobs are supported for every $1
billion in increased U.S. exports.
[42] According to the U.S. Bureau of Labor Statistics, total employment
in the U.S. manufacturing sector was about 14.3 million at the end of
2004.
[43] When the United States runs a current account deficit, it
necessarily borrows from the rest of the world by having a net inflow
of foreign capital.
[44] Some analysts have focused on the broader issue of the overall
level of the U.S. debt owed to both citizens and foreigners and the
implications of future interest obligations more generally for the U.S.
government and the U.S. economy. They note that inflows of foreign
capital accompanying the U.S. current account deficit are one
manifestation of a relatively low U.S. savings rate.
[45] These values are based on data from the U.S. Treasury and the
Board of Governors of the Federal Reserve System.
[46] China and Japan collectively held roughly 1 percent of outstanding
U.S. corporate equity at the end of 2003.
[47] Agency bonds are bonds issued by government and government-
sponsored agencies, including Fannie Mae and Freddie Mac.
[48] This is because the sale or purchase of a financial asset is
attributed to the country in which the transaction was conducted rather
than the residence of the buyer. As a result, a Chinese resident's
purchase of a U.S. security using an intermediary in Hong Kong would be
reported as a Hong Kong purchase of a U.S. security. For a discussion
of the system used to estimate foreign holdings, including
methodological limitations, see William L. Griever, Gary A. Lee, and
Francis E. Warnock, "U.S. System for Measuring Cross-Border Investment
in Securities: A Primer with a Discussion of Recent Developments,"
Federal Reserve Bulletin (Washington, D.C.: October 2001).
[49] This appendix only includes language relevant to Treasury's
manipulation assessment criteria and exchange rate reporting
requirements.
[50] The current account balance is a summary measure of a country's
net balance over a period of time with all other countries in trade of
goods and services, income, and unrequited transfers (such as foreign
aid payments and workers' remittances).
[51] These preliminary data are Chinese statistics reported by Global
Insight, Monthly Outlook Asia-Pacific, issued in March 2005.
[52] According to the IMF, under a pure managed float regime, the
monetary authority can influence the movement of the exchange rate
through active intervention in the foreign exchange market without
specifying, or precommitting to, a pre-announced path for the exchange
rate.
[53] Multiple market-negotiated rates existed because the arbitrage
among swap centers was imperfect.
[54] The real effective exchange rate is the real, or inflation-
adjusted, exchange rate between a country and its trade partners,
computed as a weighted average of bilateral real exchange rates.
[55] Since May 2004, this portion has been 50 percent to 70 percent.
Before that, it was 80 percent. Some special-purpose transactions, such
as donations, are exempted from this requirement.
[56] These trade volume data are from Global Insight.
[57] The recovery was driven by stronger Chinese market demand for
Japanese goods, among other factors. China, not including Hong Kong,
has become the second largest market for Japanese exports.
[58] As classified by the IMF.
[59] According to the IMF, countries with independent floating exchange
rates can intervene in foreign exchange markets if the goal is to
moderate the rate of change and prevent undue fluctuations in the
exchange rate.
[60] Japanese authorities intervened eight times in the first half of
2002.
[61] This is mainly due to the fact that low productivity, wages, and
income in developing nations are often not accounted for properly.
[62] For example, if U.S. inflation is 5 percent a year, while
inflation in China is 2 percent a year, relative PPP dictates that the
dollar should depreciate against the renminbi by 3 percent a year.
[63] The balance of payments identity states: Current Account = -
Capital and Financial Account. This means that any change in a
country's current account (trade in goods and services plus
miscellaneous items) must be balanced by an offsetting change in the
capital and financial account, with the exception of changes in foreign
exchange reserves.
[64] The capital and financial account tracks the movement of funds for
investments and loans into and out of a country. The capital and
financial account makes up part of the balance of payments. The current
account, which makes up the other part, records the flow of current
transactions, including goods, services, investment and other income,
and current transfers between countries.
[65] However, this approach is rooted in the national income accounting
identity: (Domestic Savings - Domestic Investment) = Current Account.
This identity holds true because any excess of investment above
national savings must be made with foreign savings (capital inflows).
Changes in capital flows must be balanced by changes in the current
account.
[66] See IMF (2001), Methodology for Current Account and Exchange Rate
Assessments, Occasional Paper 209.
[67] Different analysts consider different portions of a country's
external accounts. For example some use the current account while
others use the basic balance (current account plus foreign direct
investment flows) or broader balance of payment measures.
[68] One such rule of thumb analysts have used is that a 1 percent
depreciation of the dollar leads to a $10 billion improvement in the
U.S. trade balance. Another such rule of thumb is that a 10 percent
depreciation in the real effective exchange rate of the dollar leads to
an improvement in the U.S. trade balance equal to .5 percent of GDP
over a period of 2 to 3 years.
[69] Analysts typically identify a small number of key relationships
describing some behavioral relationships between major economic
variables and then combine these to derive a single equation to explain
the determination of the observed exchange rates over time.
[70] Federal Reserve Board Chairman Alan Greenspan before the Economic
Club of New York stated that despite extensive efforts, "No model
predicting directional movements in exchange rates is significantly
superior to tossing a coin" (New York, N.Y.: Mar. 2, 2004).
[71] Some believe that the capital inflow is unsustainable and that
further inflow may induce excessive investment and asset price bubbles.
[72] An increase in the value of the renminbi also implies that China
would be able to purchase inputs from other Asian countries and other
foreign territories more cheaply.
[73] However, such indexes omit industry-specific distinctions and thus
ignore the distributional effects of bilateral exchange rate movements.
As we discussed earlier, bilateral exchange rate changes impact
different producers differently.
[74] According to a recent Chicago Federal Reserve Board study, China's
manufactured goods accounted for 2.7 percent of the U.S. domestic
market (domestic production plus imports) in 2001, up from .4 percent
in 1989. See W. Testa, J. Liao, and A. Zelenev, "Midwest Manufacturing
and Trade with China," Chicago Fed Letter, No. 196 (2003).
[75] According to the Congressional Budget Office, its analysis based
on data from 1997 through 2002 showed that over 80 percent of the
increased U.S. imports from China displaced imports from other
countries rather than U.S. production. See D. Holtz-Eakin, "The Chinese
Exchange Rate and U.S. Manufacturing Employment," CBO Testimony before
the Committee on Ways and Means, October (2003), 19.
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