China and Currency Manipulation

Does China manipulate its currency? This question has been the subject of some debate over the past decade. In his responses to Questions for the Record (.pdf), Treasury Secretary Timothy Geithner stated that:

President Obama - backed by the conclusions of a broad range of economists - believes that China is manipulating its currency. President Obama has pledged as President to use aggressively all the diplomatic avenues open to him to seek change in China's currency practices.

This unequivocal statement of fact hides a much more complex picture.

An Imbalanced Relationship

The International Monetary Fund has long set the rules which govern exchange rates. Specifically, members are obligated to:

avoid manipulating exchange rates or the international monetary system in order to prevent effective balance of payments adjustment or to gain an unfair competitive advantage over other members.

In 2007, for the first time in 30 years, the IMF released a new policy on "surveillance," a set of activities it conducts to monitor members' compliance with their obligations. This new policy laid out seven indicators of potential non-compliance with these commitments.

According to many observers both inside and outside government, measurements of these seven indicators strongly suggest that China is indeed manipulating its currency. The numbers cited most frequently in support of this are the current account (trade) balances run by the US and China: we run a massive deficit; they run a massive surplus.

In theory, if governments did not intervene, these balances would move towards zero. When the US imports goods, it has to sell dollars and buy the local currency of the exporter (like the Chinese renminbi, or RMB) to pay for these goods. Markets for currency, like all other markets, are driven by supply and demand. So, large amounts of imports imply that large quantities of dollars are being sold, which means that the dollar should lose value relative to other currencies.

The Other Side

However, the dollar hasn't lost as much value against the yuan as some think it ought to, and the current account balances remain far from zero. This is because China has been actively purchasing US dollars, mostly in the form of government bonds, at a rate of $15 billion to $20 billion a month. So, by selling the RMB and buying the dollar at such a pace, China could be construed as engaging in a "protracted large-scale intervention in one direction in the exchange market," one of the seven indicators of non-compliance with IMF Principles.

There are three important caveats to this. The first is that if the US government didn't run such massive budget deficits, it wouldn't have to issue large numbers of bonds, and China wouldn't be able to hold down the value of the RMB as easily. Second, the US has had a "strong dollar" policy since the Clinton administration, mostly to make it easier to finance deficits by selling government bonds. (A drop in the value of the dollar would make previous investments in US government debt less valuable for foreign investors, and so make future purchases of US debt less attractive). Because of the massive stimulus package which is likely to be enacted, President Obama will have to continue this policy. If it didn't run deficits the US could afford to let the dollar slide. Third, amassing large amounts of foreign currency is a wise policy, given the history of the Asian Financial Crisis of 1997-8. According to the Congressional Research Service, among the causes of this devastating crisis were currencies that are linked to the dollar via a fixed exchange rate, a weak banking sector, and insufficient currency reserves. Since both the first and the second of these could be used to describe the Chinese economy today, the government could make a strong case that ensuring that their country has adequate reserves to hedge against the possibility of capital flight is not wise financial planning.

Bleeding Jobs

The reason the President, Treasury Secretary, and a number of other politicians make a big deal about China and currency manipulation is because of concerns about US jobs. Obviously it's been a tough year for manufacturing - about 149,000 manufacturing jobs were lost just between November and December 2008 - so this is reasonable. Unfortunately, the anger toward exchange rates is misdirected.

Even some critics of Chinese policy acknowledge that exchange rates are not the primary cause of the US propensity to run up huge bills on imports, which are alleged to be undercutting domestic industry and employment. As Morris Goldstein of the Institute for International Economics noted in 2005 (.pdf):

...one should not exaggerate the likely impact of Asian currency appreciation on the US current-account imbalance. A 20 percent appreciation of all Asian currencies would likely reduce the US current -account deficit by about $80 billion.

The current account imbalance that year was some $660 billion. And recent estimates indicate that the RMB may be undervalued by as little as 10%.

The main reason China and other countries undercut US manufacturing is wages. The average income in China is $2,025 a year. The average figure for the US is more than 20 times higher. Chinese production costs are lower, so the goods it exports can be cheaper and still profitable.

What To Do

Going after China "aggressively" on its exchange rate policy, as Treasury Secretary Geithner has pledged to do, would not be wise. It won't help address the job losses which have made this a hot issue, and it will strain relations with a major world power. If Geithner and others truly want to deal with the trade imbalance with China, they will have to recognize that reducing our massive fiscal deficits is likely to be the both the most difficult and most effective way of doing so.