Currency Misalignments and the US Economy
Testimony before the Subcommittees on Trade, Ways and Means Committee; Commerce, Trade and Consumer Protection, Energy, and Commerce Committee; and Domestic and International Monetary Policy, Trade and Technology, Financial Services Committee of the House of Representatives
The Global Imbalances and the US Economy
The US global merchandise trade and current account deficits rose to $857 billion in 2006. This amounted to 6.5 percent of US GDP, twice the previous record of the middle 1980s.1 The deficits have risen by an annual average of $100 billion over the past four years.
These global imbalances are unsustainable for both international financial and US domestic political reasons. On the international side, the United States must now attract about $8 billion of capital from the rest of the world every working day to finance the US current account deficit and foreign investment outflows. Even a modest reduction of this inflow, let alone its cessation or a sell-off from the $14 trillion of dollar claims on the United States now held around the world, could initiate a precipitous decline in the dollar. Especially under the present circumstances of nearly full employment and full capacity utilization in the United States, this could, in turn, sharply increase US inflation and interest rates, severely affecting the equity and housing markets and potentially triggering a recession. The global imbalances probably represent the single largest current threat to the continued growth and stability of the US and world economies.
The domestic political unsustainability derives from the historical reality that substantial dollar overvaluation, and the large and rising trade deficits that it produces, are the most accurate leading indicators of resistance to open trade policies in the United States. Such overvaluation and deficits alter the domestic politics of US trade policy, adding to the number of industries seeking relief from imports and dampening the ability of exporters to mount effective countervailing pressures. Acute pressures of this type, threatening the basic thrust of US trade policy and thus the openness of the global trading system, prompted drastic policy reversals by the Reagan Administration, to drive the dollar down by more than 30 percent via the Plaza Agreement in the middle 1980s, and by the Nixon Administration, to impose an import surcharge and take the dollar off gold to achieve a cumulative devaluation of more than 20 percent in the early 1970s.
The escalation of trade pressures against China at present, despite the strength of the US economy and the low level of unemployment, is the latest evidence of this relationship between currency values and trade policies. With deep-seated anxieties over globalization already prevalent in our body politic and the failure of the Doha Round to maintain the momentum of trade liberalization around the world, continued failure to correct the currency misalignments could have a devastating impact on the global trading system.
The Role of China
China's global current account surplus soared to about $250 billion in 2006, about 9 percent of its GDP. Its trade surplus has doubled again in the first quarter of 2007.2 China has become by far the largest surplus country in the world, recently passing Japan and far ahead of all other countries. Its foreign exchange reserves have also passed Japan's to become the largest in the world and now substantially exceed $1 trillion, an enormous waste of resources for a country where most of the huge population remains very poor.
A substantial increase in the value of the Chinese currency is an essential component of reducing the imbalances. A recent joint study of the imbalances by leading think tanks in Asia and Europe, along with the US-based Peterson Institute for International Economics, concludes that the renminbi (RMB) needs to appreciate by at least 35 percent against the dollar.3
However, China has blocked any significant rise in the RMB by intervening massively in the foreign exchange markets, buying $15-20 billion per month for several years to hold its currency down. The level of Chinese intervention has almost doubled in the first quarter of this year, to about $45 billion per month. China has recently let the RMB rise marginally against the dollar, but since it continues to link its exchange rate to the dollar and the dollar has fallen against virtually all other currencies, the average exchange rate of the RMB is weaker now than in 2001 when China's current account surplus accounted for a modest 1.3 percent of its GDP. The world's most competitive economy has become even more competitive through a deliberate policy of currency undervaluation.
About one-quarter of all of China's economic growth in the past two years has stemmed from the continued sharp increase in its trade surplus. China is thus overtly exporting unemployment to other countries and apparently sees its currency undervaluation as an off-budget export and job subsidy that, at least to date, has avoided effective international sanction.
By keeping its own currency undervalued, China has also deterred a number of other Asian countries from letting their currencies rise very much against the dollar for fear of losing competitive position against China. Hence China's currency policy has taken much of Asia out of the international adjustment process. This point is critical, because Asia accounts for about half the global surpluses that are the counterparts of the US current account deficit, has accumulated the great bulk of the increase in global reserves in recent years, and is essential to the needed correction of the exchange rate of the dollar because it makes up about 40 percent of the dollar's trade-weighted index. The most obvious Asian candidates for sizable currency appreciation in addition to China are Japan, Taiwan, Singapore, and Malaysia.
The Role of Japan
Japan is the world's second largest surplus country, with a current account imbalance of $167 billion in 2006, and a holder of foreign exchange reserves. Japan must play an important role in correction of the global imbalances.
There are two important differences between Japan and China on these issues. On the one hand, Japan is by far the world's largest creditor country as a result of the cumulation of huge surpluses that it has run for most of the past 30 years. Its surpluses have been much more persistent than those of China, which have mushroomed to substantial magnitude only over the past decade.
On the other hand, Japan has not intervened in the currency markets for over three years. It too intervened heavily back in 2003 to early 2004, even more than China during some periods, to keep the yen from rising. However, it has not done so since that time. The yen remains weak, primarily because of Japan's very low interest rates, which have approximated zero for over five years, which induces investors from around to the world to borrow yen and invest them in higher-yielding assets in other countries (the "carry trade"). Hence Japan cannot be accused of "manipulation" at this time.
The same new international study referenced above, however, concluded that the yen was also substantially undervalued. The group's judgment was that it needed to rise by about 25 percent against the dollar, to around 90:1 from its current level of close to 120:1, as part of a new global equilibrium.4
The Policy Implications
It is essential to reduce the US external deficit and the counterpart surpluses, especially in China and Japan, by substantial amounts in as orderly a manner as possible. The goal of US adjustment should be to cut US global current account deficit to 3-3.5 percent of GDP, about half its present level, at which point the ratio of US foreign debt to GDP would eventually stabilize and should be sustainable. China's goal, already accepted in principle by its political leadership but without much policy follow-up, should be to totally eliminate its global current account surplus and stop the buildup of foreign exchange reserves. Japan should pare its surplus to perhaps 1 percent of its GDP.
The United States should take the lead in addressing the imbalances by developing a credible program to convert its present, and especially foreseeable, budget deficits into modest surpluses like those that were achieved in 1998-2001. Such a shift, of perhaps 3-4 percent of US GDP, would reduce the excess of US domestic spending relative to domestic output and thus cut demand for imports. It would pare the shortfall of US domestic savings relative to domestic investment and thus reduce the country's need for foreign capital inflows, which push the dollar to levels that are overvalued in trade terms. Fiscal tightening is the only available policy instrument that will produce such adjustments. Hence I strongly recommend that the new Congress take effective and immediate steps in that direction.5
China needs to adopt policies to promote an opposite adjustment, reducing its uniquely high national saving rate by increasing domestic consumption. China can do so most easily through higher government spending on health care, pensions, and education. Such new government programs are needed for purely internal reasons anyway because of the political unrest in China that has resulted from the demise of state-owned enterprises that provided these benefits in previous times. They would reduce the precautionary motive for household saving in China and boost private, as well as government demand, contributing importantly to the needed international adjustment. A number of important Chinese domestic goals, such as increasing employment and reducing energy consumption, also call for such shifts in the composition of China's growth strategy.6
Large changes in exchange rates will also have to be a major component of this adjustment process. The dollar will need to fall, hopefully in a gradual and orderly manner over the next two or three years, by a trade-weighted average of about 20 percent. A change in China's currency policy, in both the short and longer runs, must be a major component of this adjustment and is in fact by far the single most important issue in US-China economic relations. The short-term success of the new Strategic Economic Dialogue must be judged largely by whether it achieves effective resolution of this problem.7
An increase of at least 15 percent in the average value of the RMB against all other currencies, which would imply an appreciation of about 35 percent against the dollar and sizable appreciations against the dollar of other key Asian currencies, will be required to achieve an orderly correction of the global imbalances.8 Such a change could be phased in over several years to ease the transitional impact on China. It could be accomplished either by a series of step-level revaluations, like the 2.1 percent change of July 2005 against the dollar but of much larger magnitudes and with a substantial initial "down payment" of at least 10-15 percent, or by a much more rapid upward managed float of the RMB than is underway at present. Such an increase in the RMB and other Asian currencies against the dollar would reduce the US global current account deficit by about $150 billion per year, more than one third of the total adjustment that is required.9
Over the longer run, China should adopt a more flexible exchange rate that will respond primarily to market forces. These forces would clearly have pushed the RMB to much higher levels by now in the absence of China's official intervention. There is some justification, however, for China's fears that an abrupt move to a freely floating exchange rate now, particularly if accompanied by abolition of its controls on financial outflows, could trigger capital flight and jeopardize its economy in view of the fragility of its banking system. Full-scale reform of China's exchange rate system will have to await completion of the reform of its banking system, which will take at least several more years. Hence the adoption of a flexible exchange rate regime in China, which is essential to avoid recreation of the present imbalances in the future, can be only a second stage in the resolution of the currency problem and the immediate need is for a substantial increase in the price of the RMB (especially against the dollar).10
A New US Currency Strategy
It is obvious that China is extremely reluctant to make the needed changes in its currency policy. It is equally obvious that US efforts on the issue over the past four years, whether the earlier "quiet diplomacy" of the presidential administration, the threats of congressional action, or the new Strategic Economic Dialogue, have borne little fruit to date. A new US policy is clearly needed.
One cardinal requirement is for the administration and Congress to adopt a unified, or at least consistent, position. To date, there has been something of "good cop (administration)-"bad cop" (Congress; e.g., the threat of the Schumer-Graham import surcharge legislation) bifurcation between the two branches. China has exploited these differences, essentially counting on the administration to protect it from Congress-a bet that, to date, has paid off.
I would therefore suggest a new five-part strategy for US policy on the currency issue.
First, it is clear that China has aggressively blocked appreciation of the RMB through its massive intervention in the currency markets and that the US Treasury Department has severely jeopardized its credibility on the issue by failing to carry out the requirements of current law to label China a "currency manipulator." The US Treasury report of May 2005 indicated that "…if current trends continue without substantial alteration [emphasis added], China's policies will likely meet the statute's technical requirements for designation." The report of May 2006 sharply criticized China for its currency policies, clearly suggesting that there has been no "substantial alternation" in those practices, but inexplicably failed to draw the obvious conclusion of its own analysis.11 The latest report, submitted in December 2006, was much milder. The US Treasury Department has thus been reducing its criticism of China's currency practices even as the RMB has become increasingly undervalued and China's external surpluses have soared.
The US Treasury Department policy needs to be changed sharply and quickly. The administration should notify the Chinese that, if China fails to make a significant "down payment" appreciation of at least 10 percent prior to the release of the US Treasury's next semi-annual report, it will be labeled a "manipulator." This action would trigger an explicit US negotiation with China on the currency issue.
Second, the administration should notify its G-7 partners and the International Monetary Fund (IMF) that it plans to make such a designation, in the absence of major preventive action by China, with the goal of galvanizing a multilateral effort on the issue and reducing its confrontational bilateral character. The objective of that international effort, hopefully spearheaded by the IMF, could be a "Plaza II" or "Asian Plaza" agreement that would work out the needed appreciation of the major Asian currencies through which the impact on the individual countries involved (including China) would be tempered because they would not be moving very much vis-à-vis each other.12 The Europeans have an especially large incentive to join the United States in such an initiative, because their own currencies will rise much more sharply when the dollar experiences its next large decline if China and the other Asians continue to block their own adjustment (and perhaps to head off the incipient United States-China "G-2" implied by the Strategic Economic Dialogue).
Third, the administration (with as many other countries as it can mobilize) should also take a new multilateral initiative on the trade side by filing a World Trade Organization(WTO) case against China's currency intervention as a "frustration of trade commitments" or as an export subsidy. As Fed Chairman Ben Bernanke indicated in his highly publicized speech in Beijing last December, in connection with the first Strategic Economic Dialogue, China's exchange rate intervention clearly represents an effective subsidy (to exports, as well as an import barrier) in economic terms. It should be addressed as such.13
Fourth, if the multilateral efforts fail, the United States will have to address the China currency issue unilaterally. The US Treasury Department can pursue the most effective unilateral approach by entering the currency markets itself. It is impossible to buy RMB directly, because of its continued inconvertibility, so the Treasury would have to select the best available proxies in the financial markets. The message of US policy intent would be clear, however, and at a minimum there would be a further sharp increase in speculative inflows into the RMB that would make it even more difficult for the Chinese authorities to resist their inflationary consequences and thus the resultant pressures to let the exchange rate appreciate.
Direct intervention could be much more effective in promoting the needed appreciation of the yen, since that currency is traded freely in global markets. Japan could, of course, undertake such intervention itself by selling (probably modest amounts of) dollars from its huge foreign exchange reserves.14
The United States has conducted such currency intervention on many occasions in the past, most dramatically via the Plaza Agreement in 1985 and most recently when it bought yen to counter the excessive weakness of that currency in 1998 (when it approached 150:1)-a similar step to what could be undertaken now, with the yen as weak (adjusted for inflation differentials since 1998) as it was then. All those actions have been taken with the agreement of the counterpart currency country, however, and usually in cooperation with that country. This would be the essence of the proposed "Plaza II" or " Asian Plaza" agreement, as suggested above, and the multilateral approach would be preferable now as always and should be pursued vigorously by the administration. Failing such agreement, however, the unilateral option is available and might have to be adopted.
Fifth, the administration should quietly notify the Chinese that it will be unable to continue opposing responsible congressional initiatives to address the issue if they fail to act responsibly on their own. Congress should then proceed, hopefully in cooperation with the administration, to craft legislation that would effectively sanction the Chinese (and perhaps some other Asians) for their failure to observe their international currency obligations-making sure that any proposed trade policy remedies are compatible with the multilateral rules of the WTO.
Such unilateral steps by the United States, although decidedly inferior to the multilateral alternatives proposed above, could hardly be labeled as "protectionist," since they are designed to counter a massive distortion in the market ( China's intervention) and indeed promote a market-oriented outcome. Nor could they be viewed as excessively intrusive in China's internal affairs, since they would be no more aggressive than current US efforts on intellectual property rights and other trade policy issues (including the filing of subsidy and other cases on such issues with the WTO). Such steps should therefore be considered seriously if China continues to refuse to contribute constructively to the needed global adjustments.
1. I note with immodesty but pride that, based on the work of my colleague Catherine L. Mann, I predicted precisely such an outcome for 2006 in the third paragraph of my testimony before the Senate Committee on Banking, Housing, and Urban Affairs on May 1, 2002.
2. A superb and comprehensive analysis of this issue can be found in Morris Goldstein, A (Lack of) Progress Report on China's Exchange Rate Policies. Paper presented at The China Balance Sheet in 2007 and Beyond, sponsored by the Center for Strategic and International Studies and the Peterson Institute for International Economics, Washington, May 2, 2007.
3. Alan Ahearne, William R. Cline, Kyung Tae Lee, Yung Chul Park, Jean Pisani-Ferry, and John Williamson. 2007. Global Imbalances: Time for Action. Policy Brief in International Economics 07-4. Washington: Peterson Institute for International Economics.
4. It should be noted that the suggested increases in the value of the RMB and yen against the dollar would represent much smaller rises in the trade-weighted average exchange rates of those currencies, which should make them much more acceptable to the countries involved. If all major currencies rise against the dollar, as they must to achieve a substantial reduction in the US external deficit and as the rest of the truly floating currencies (euro, pound, Swiss franc, Canadian dollar, etc.) have already done, then the average rise for each of them is, of course, much less. The real increase in the RMB and yen, for example, would be only about half their rise against the dollar.
5. See my testimonies on that topic to the US House Budget Committee on January 23, 2007 and the US Senate Budget Committee on February 1, 2007. I suggest in those testimonies that the external imbalances are in fact the most likely source of a crisis that could force the United States at some point into precipitous, and thus unpalatable, budget adjustments if preemptive action is not taken.
6. See Chapter 2 of China: The Balance Sheet: What the World Needs to Know Now About the Emerging Superpower (Public Affairs 2006), and Nicholas Lardy. 2006. China: Toward a Consumption-Driven Growth Path. Policy Brief in International Economics 06-6. Washington: Institute for International Economics.
7. The Strategic Economic Dialogue also has the long-term potential to foster a more constructive relationship between the two countries that will inevitably lead the world economy over the coming years and perhaps decades. It thus begins to implement the "G-2" concept proposed in my chapter, "A New Foreign Economic Policy for the United States" (In The United States and the World Economy: Foreign Economic Policy for the Next Decade. 2005. C. Fred Bergsten and the Institute for International Economics. Washington: Institute for International Economics, 53-4.
9. I have studiously refrained from mentioning the very large Chinese bilateral trade surplus with the United States, which should not be a primary focus of policy because of the multilateral nature of international trade and payments. At present, however, the bilateral imbalance is a fairly accurate reflection of the global imbalances and thus is more relevant than usual.
11. The US Treasury and the IMF have justified their inaction on the grounds that there is insufficient evidence that China is manipulating its exchange rate with the "intent" of frustrating effective current account adjustment. This rationale is, of course, ludicrous because it is highly unlikely that China (or any country) would admit such a motive, and it is impossible to discern any other purpose for the policy.
13. These ideas are analyzed in Gary Clyde Hufbauer, Yee Wong, and Ketki Sheth. 2006. US-China Trade Disputes: Rising Tide, Rising Stakes. Washington: Institute for International Economics, p. 16-26.
14. Another option is for China to pursue the desired diversification of its dollar reserves by selling some of them for yen. See my article, "The Yen Beckons China's Dollars," Financial Times, March 12, 2007.