The Chinese Currency Peg and its Effect on the US and the Chinese Economies

1. The Chinese Currency Peg and its Effect on the US and the Chinese Economies Presented by: Nathan Johnson Dimitar Minchev

2. Historical Overview • Prior to 1994 China maintained a dual rate exchange system • An official exchange rate of 5.8 yuan per dollar • Market swap rate (used mainly for trade transactions) of about 8.7 yuan per dollar • In 1994 the two rates were unified • China pegt its currency to the US dollar form 1994 to 2005 at a rate of 8.28 yuans to the dollar

3. Overview - Explanation • What is a fixed exchange rate? • Pegged, or fixed exchange rate is a rate the government (central bank) sets and maintains as the official exchange rate. A set price will be determined against a major world currency (usually the U.S. dollar, or a basket of currencies). In order to maintain the local exchange rate, the central bank buys and sells its own currency on the foreign exchange market in return for the currency to which it is pegged.

4. Overview - Explanation • China’s reasons for establishing fixed exchange rate: • Economic stability, respectively political stability • Increased FDI flows • Lower inflation • Increased Exports • Increased Demand

5. Economic Consequences of the Currency Peg • Economic Consequences for China • Annual GDP growth of 8.79% for the 94-05 period (more than 10% for the 03-07 period) • Foreign reserves of $1.8 trillion in July of 2008 • Strong export industry • Increased employment • Troubled import industry

6. Economic Consequences of the Currency Peg • Economic Consequences for the US • Increased exports to China from $14,2 billion in 98 to $65,2 billion in 2007 • Increased trade deficit from $56,9 billion in 98 to $256,2 in 2007 • Increased level of foreign debt $10,6 trillion • Loss of manufacturing jobs that compete directly with goods and services produced in China

7. Legislation • U.S. Position: • Many in Congress have argued for more punitive legislation against China for their currency manipulation. • The argument against China is that they are keeping their currency artificially low to gain a competitive advantage over the U.S. • This represents a protectionist measure by China. • China is hurting the U.S. manufacturing industry which can’t compete with China’s lower prices and is resulting in a loss of U.S. manufacturing jobs.

8. Legislation • China’s position: • They argue that the issue of China’s trade surplus with the U.S. is unrelated to their exchange rate. • Wages in China are so much lower in the U.S. that a revaluation of the yuan would have little impact on China’s competitive advantage over the U.S. • China’s exports also have a large import component and so any revaluation of the yuan would also lower the input prices of its exports thus diminishing the impact of revaluation. • China argues that the stability of its currency plays an important role in global financial stability.

9. Attempted Legislation • The Fair Currency Enforcement Act of 2003 sponsored by Joe Lieberman would: • Direct the President to begin immediately a 90-day period of bilateral negotiations with those nations that are most egregiously engaged in currency manipulation to bring an end to it. • Direct the International Trade Commission during those 90 days to gather facts and prepare the legal basis for action under existing provisions of the International Monetary Fund, the World Trade Organization, and various U.S. trade laws (including sections 301 and 406 of the Trade Act of 1974). • Direct the President, in the event that bilateral negotiations fail, to institute formal proceedings in the appropriate national and international agencies as detailed by the ITC report or give the Congress detailed reasons why he declines to do this. • Require the preparation of additional reports and recommendations from the Administration on the impact on our national security due to the loss of keys industries (such as semiconductor manufacture) due to currency manipulation; more effective enforcement of existing trade laws and agreements; and better utilization of government resources for trade promotion. • *This bill never became law

10. Other Legislation • April of 2005 a bill was introduced in the Senate by Charles Schumer and Lindsey Graham that would impose a 27.5% on all imports from China unless they floated their currency or came close to it. • The President could suspend the tariff during bilateral talks. • China responded to this bill by allowing the yuan to appreciate 2.1% as well as committing to letting market forces play a stronger role in determining the value of the yuan. • U.S. officials have stated that this bill has strengthened their position in bilateral talks • However, since the initial appreciation of the yuan there has been little to no change in it’s value. • Bilateral talks have failed to effect any change.

11. Other Legislation • Trade Act of 1988: • Mandates a biannual report to Congress on foreign trade and currency manipulation. • The U.S. Treasury must identify in this report countries that are purposefully manipulating their currency to gain a competitive advantage. • Once a country has been labeled a currency manipulator by the Treasury, the U.S. initiates bilateral talks to end the offending practice. • China was last tagged as a currency manipulator in 1994. • In their most recent report in April of 2005 the Treasury stated that they have not found currency manipulation in China but concerns about exchange rates continue. • The reason they did not label China a currency manipulator is because they did not meet all of the legal criteria as stated in the Trade Act of 1988. • The Treasury report stated that China was exempt 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. • The report still recommended the U.S. to engage in bilateral talks to move from its fixed exchange rate to a more flexible one.

12. Key Legislation • The Trade Act of 1974: • Section 301 - The principal statutory authority under which the United States may impose trade sanctions against foreign countries that maintain acts, policies and practices that violate, or deny U.S. rights or benefits under, trade agreements, or are unjustifiable, unreasonable or discriminatory and burden or restrict U.S. commerce. • Mandatory Retaliatory Action -  Where USTR determines that a foreign government is violating or denying U.S. rights or benefits under a trade agreement, or its acts, policies or practices are unjustifiable and burden or restrict U.S. commerce, Section 301 requires retaliation unless an exception applies. • Discretionary Retaliatory Action - Where USTR determines that a particular act, policy or practice of a foreign country is unreasonable or discriminatory and burdens or restricts U.S. commerce, it has discretion as to whether to take retaliatory action. • Scope of Authorized Retaliatory Action -   Where USTR makes an affirmative determination that an act, policy or practice is actionable under Section 301, it may suspend or withdraw trade concessions, impose duties or other import restrictions.

13. Key Legislation • The Trade Act of 1974: • Section 406 – Concerning trade with Communist countries. • A Commission determines whether imports from a Communist country are causing market disruption in the United States. • If the Commission finds market disruption, it then makes a remedy recommendation to the President. • The President makes the final decision with respect to remedy.

14. Major Problems • US export producers competing directly with Chinese producers are at a loss due to the cheaper labor cost in China. However, over the long run, the fixed exchange rate encourages trade (and investment) between the two countries by eliminating exchange rate risk. The reduced risk could make both imports and exports higher than under a floating system.

15. Major Problems • US Consumers will also benefit in the long term. The undervalued yuan will increase their purchasing power. Since imports from China are not limited to the consumption goods, US producers will also import capital equipment and final products from China. An undervalued yuan lowers the price of these US products, while increasing their output.

16. Major Problems • The effect on US borrowers can be seen in the US balance of payments accounts. China’s central bank, citizens and corporations are heavily investing in US debt. This resulted in China becoming the biggest US debtor with 20,45% of the US foreign debt. At the same time, the increased capital investment lowers the US interest rates, and companies were able to make investments that were previously unprofitable.

17. Major Problems • The net effect on the US Economy in the short-run is that output in the trade sector falls more quickly than the output of US recipients of Chinese capital rises, aggregate spending and employment will temporarily fall. • However, free trade should be pursued because the gains from trade are large enough that the losers from trade can be compensated by the winners, and the winners will still be better off.

18. Major Problems • The US government has experienced sustained pressure for years from the export manufacturing lobby to press China to let the yuan to appreciate. This was due to the loss of manufacturing jobs to China and was combined with the unprecedented levels of ever increasing trade deficit. The unresponsiveness and the aggressive stance of the Chinese government further increased tensions between countries until in July 2005 China began controlled appreciation of its currency.

19. Policy Issues • The Yuan has appreciated more than 20% since Beijing removed the peg to the dollar in July of 2005 under the threat of the Schumer/Graham legislation. • Even so, Obama has indicated that he will challenge China on the issue of currency manipulation. • He has called for China to rely less on exports and more in encouraging its domestic demand for growth. • China wants the U.S. to lift its restrictions on high-tech exports saying this would help to level out the trade imbalance.

20. Policy Proposals • Allow China to enact a gradual appreciation of its currency to reduce dollar-related inflation. • Floating the yuan may further worsen global economic stability. • Avoid falling into the trap of rising protectionism through sanctions under section 301. Global trade is decreasing as a result of the financial crisis and it is important to maintain trading relationships.

21. Conclusion • Questions?

22. References • http://www.freetrade.org/node/83 • http://www.census.gov/foreign-trade/balance/c5700.html#2007 • http://afp.google.com/article/ALeqM5jV-Vqd3eFprUamekQ_ctIU89Txyw • http://www.chinability.com/GDP.htm • http://www.treasurydirect.gov/NP/BPDLogin?application=np • http://en.wikipedia.org/wiki/United_States_public_debt#cite_note-1

23. References-cont. • http://digital.library.unt.edu/govdocs/crs/permalink/meta-crs-8739:1 • http://www.treas.gov/press/releases/js774.htm • http://blog.mises.org/archives/008221.asp • http://www.pbs.org/newshour/bb/asia/china/pntr/ • http://cbapp.csudh.edu/newsletter/052006/on_point.htm • Asia Times Online :: China News, China Business News, Taiwan and Hong Kong News and Business.

24. References-cont. • China Ends Fixed-Rate Currency • China's currency peg is a gift to Europe | The Japan Times Online • Floating And Fixed Exchange Rates • FTD - Congressional Highlights