"Chinese Currency Manipulation": Testimony of Ernest H. Preeg, Ph.D., before the U.S. Senate Committee on Banking, Housing, and Urban Affairs, May 1, 2002

Thank you, Mr. Chairman, for this opportunity to appear before your Committee to address the impact of the dollar on the U.S. balance of trade, economic growth, and long-term economic stability.  I will focus my presentation heavily on one particularly disturbing aspect of the trade deficit, namely currency manipulation to commercial advantage by some trading partners, and in particular by China, the nation with whom we have the largest and most lopsided trade deficit. To put this issue in broader context, however, I begin with brief comments on three basic concerns I have about the chronic and very large overall U.S. trade deficit.

Three Basic Concerns About the Trade Deficit

      The first, most immediate concern, is the impact of a larger trade deficit on U.S. economic recovery this year and next.  The U.S. trade deficit was $345 billion in 2001, and could rise sharply to $400 billion or more this year, as a result of a faster initial rate of economic recovery in the United States compared with our major trading partners and the time-lagged adverse trade impact of the strengthening of the dollar over the past two years.  More than 80 percent of the deficit—in the order of $350 billion this year—will fall on the manufacturing sector, which has been hardest hit by the economic slump of the past 18 months. U.S. manufacturing industry, through new product innovation and capital investment, is the engine for overall growth in the U.S. economy, and a major increase in the trade deficit for manufactures could be the Achilles' heel for the hoped-for strong rebound in such productivity-enhancing investment and sustained overall growth. 

      The second, somewhat longer term concern, is that the longer we maintain a trade deficit—or more precisely current account deficit—in the prospective order of 5-6 percent of GDP, the larger becomes the U.S. international debtor position, and the greater becomes the likelihood of a more disruptive "hard landing" for the dollar and the U.S. economy when the inevitable downward adjustment on trade account finally occurs.  The chronic trade deficit has transformed the United States from the largest net creditor nation in the mid-1980s to the unprecedented largest net debtor nation approaching $3 trillion of net foreign debt today, projected to $5 trillion by mid-decade.  There is near consensus that this foreign debt accumulation course is unsustainable and the question is rather how and when we will confront the point of unsustainability.  I believe an earlier downward adjustment in the trade deficit—which would entail a depreciation of the dollar exchange rate by perhaps 10-20 percent—would be less disruptive and better for longer term economic stability, in the United States and for the world economy, than a prolonged further debt buildup until financial markets finally react against the dollar under the cloud of a $5 trillion U.S. foreign debt. 

      My third and even longer term—but no less important—concern about the trade deficit and the consequent buildup of foreign debt is the social inequity we are imposing on our children and grandchildren.  A current account deficit of $500 billion per year means we are living beyond our means by roughly 5 percent of GDP, mostly for immediate personal consumption and to a lesser extent for investment.[1]  This consumer binge is being paid for through foreign borrowing comparable to the current account deficit, and the resulting $3-$5 trillion buildup of foreign debt is being left to our children and grandchildren to service indefinitely or to pay off fully in principal.  With a younger generation of Americans already concerned about paying rising Social Security and Medicare commitments to the current older generation, the foreign debt buildup is one more intergenerational income transfer being undertaken essentially by stealth.

      These are my three principal concerns about the trade deficit.  As to what we can or should do to reduce the deficit, there are two principal remedies.  The first is to increase domestic savings, thereby reducing the need to borrow abroad, about which more in the concluding section of this presentation.  The second and more immediate way to reduce the trade deficit is to restrain others from "manipulating" their exchange rates to commercial advantage. 

U.S. Benign Neglect of Currency Manipulation by Others

      We now have a predominantly floating exchange rate international financial system. The United States has a basically free float policy, with official market intervention rare and in only token amounts.  The EU, Canada, and Mexico have similarly followed a free float during the past several years.  Others, however, particularly in East Asia, implement a heavily managed float through large scale official purchases of foreign exchange, principally dollars, in order to keep their exchange rates lower than they would be subject to market forces alone, and consequently to push the dollar higher.  This managed approach is "mercantilist" in that the objective is to maintain a large trade surplus as a matter of national policy, and the result for the United States is a trade deficit larger than it would be based on market forces alone. 

      Article IV of the IMF Articles of Agreement states that members shall, "avoid manipulating exchange rates to gain an unfair competitive advantage," and, under IMF surveillance procedures, a principal indicator of such manipulation is "protracted large scale intervention in one direction in the exchange market." Protracted purchases of dollars by certain East Asian central banks would thus clearly qualify as currency manipulation, under the IMF definition, but the U.S. Treasury has rarely raised the issue, preferring a policy of benign neglect. 

      Japan, the largest trade surplus nation in the world, is an outstanding example of such currency manipulation, with $250 billion of official foreign exchange purchases (almost all dollars) since 1995, including $33 billion in September and October 2001 alone when market forces were putting upward pressure on the yen. The yen, meanwhile, declined by 15 percent vis-à-vis the dollar during 2001.  South Korea is another more recent example of such currency manipulation. The Korean central bank bought $9 billion of foreign exchange during 2001 while the nation recorded a $9 billion trade surplus.  In effect, the central bank purchases entirely offset any upward pressure on the won from the trade surplus, and the Korean currency, in fact, depreciated 5 percent against the dollar during the year.

      This form of currency manipulation does not, of course, explain all of the strengthening of the dollar vis-à-vis these currencies in recent years, but currency traders know that the central banks involved will not let their currencies strengthen significantly, and therefore they hold back speculative purchases even when market conditions would otherwise indicate a currency appreciation. It is also noteworthy that the relevant indicators involved are net figures, whether for central bank intervention, trade flows, or capital market transactions, and on this basis the net purchases of foreign exchange by the Bank of Japan in recent years have probably held the yen at a significantly lower level than would have prevailed based on market forces alone.  And consequently, Japan has likewise maintained a significantly larger trade surplus with the United States, especially in price-sensitive industries such as the automotive sector.

The Uniquely Powerful Chinese Currency Manipulation

      Chinese exchange rate policy is an important special case which spells currency manipulation in a different way.  The Chinese currency has a fixed rate to the dollar but is nonconvertible on capital account.  Over the past year, there has been a $25 billion trade surplus, a $45 billion net inflow of foreign direct investment—which also puts upward market pressures on the exchange rate—and over $50 billion of central bank purchases of foreign exchange.  In this case, the central bank purchases offset almost three-quarters of market-generated upward pressure on the yuan from the trade surplus and the FDI inflow combined.  Moreover, these official foreign exchange purchases may have been even larger except for an unfolding financial scandal involving billions of dollars of missing reserves.[2]

      Based on the IMF definition, China has clearly been manipulating its currency for mercantilist purposes.  The Bank of China has made protracted large scale purchases of foreign exchange—$150 billion since 1995—in order to maintain a large trade surplus as an offset to poor growth performance in the domestic economy.  A direct measure of the manipulation is not possible because of the nonconvertible fixed exchange rate.  There is no doubt, however, that if the central bank had not purchased $50 billion in 2001, there would have been strong upward pressures on the yuan in formal and informal markets.  The bottom line is that the Chinese yuan is substantially undervalued and should certainly not be devalued as the Chinese government occasionally threatens to do.

The Benefits and Costs of Chinese Currency Manipulation

      The unique form of Chinese currency manipulation provides a mix of benefits and costs for China and for the United States.  The most direct result is a larger trade surplus for China, which means more export-oriented jobs in the Chinese economy.  From the U.S. point of view, of course, it means a larger trade deficit with China and the loss of export-oriented and import-competing jobs. In 2001, U.S. imports from China were $102 billion, or more than five times larger than the $19 billion of U.S. exports to China.

      One problem for China in implementing currency manipulation through a fixed but nonconvertible exchange rate is that it creates breathtaking opportunities for official corruption, as noted above.  A floating rate, however heavily managed, would do the manipulation job more efficiently, as it does for Japan, and China will, for this and other reasons, likely move in this direction as its economy becomes progressively more open to international trade and investment.

      Additional benefits to China from its cumulative purchase of foreign exchange accrue in other areas of foreign policy.  With $220 billion of ready cash in the central bank—far greater than any measure of "adequate" reserves for commercial purposes[3]—Chinese purchases of weapons and other military equipment abroad, as regularly received from Russia, in particular, can be made without financial constraint. 

      A similar conclusion can and should be drawn about China as an economic aid "graduate."  There is no longer any justification for China to receive several billion dollars per year in long-term loans on favorable terms from the World Bank, the Asian Development Bank, and some bilateral donors, when there are $220 billion of unutilized funds stashed away in the central bank.  And yet the development banks continue to lend large sums to China!

      Another geo-economic advantage to China from its large reserves is the ability to offer concessionary trade and investment finance to other Asian nations, particularly in Southeast Asia, as a means of strengthening Chinese economic engagement in the region at the expense of the United States.  Some first steps along these lines have been taken together with Japan, to weaken "U.S. economic hegemony," and such trade-related incentives will likely be expanded in support of the recent Chinese initiative for a free trade arrangement with the Association of Southeast Asian Nations (ASEAN). 

      Finally, and more speculatively, China at some future point could use its official dollar holdings as foreign policy leverage against the United States by threatening to sell large quantities of dollars on the market, or merely shift its reserves away from dollars and into euros and yen.  This will not happen anytime soon because the result would be a decline in the dollar and an adverse impact on Chinese exports.  At some future point, however, if China were to become less dependent on exports to the United States for economic growth, such a threat could become credible.  For example, the threat of substantial Chinese sales of dollars, with its implications for a disruptive decline in the dollar and the U.S. stock market, especially during a downward phase in the U.S. economy and/or an election year, could influence the course of U.S. policy toward Taiwan.  Chinese military officers, in fact, in their studies of nonconventional defense strategies, include reference to George Soros and his attack on the British pound in 1992 as a template for disrupting a rival's (i.e., the United States) economic system.

      Thus Chinese currency manipulation is very real and substantial, with wide-ranging implications, and it deserves, as a policy response, something more than the total official neglect it has received up to this point.

A Long Overdue Policy Response

      The United States should adopt a clear and forceful strategy for reducing its chronically large external deficit.  Indeed, such an initiative is long overdue. 

      The first step in such a strategy would be to have frank discussions with major trading partners as to why it is a mutual interest to reduce current imbalances on current account.  These consultations could take place within the G-7 finance ministers' framework and with key trading partners, including China, Mexico, and South Korea. 

      The substance of the strategy should begin with a joint commitment to a free or very lightly managed floating exchange rate relationship, except for those nations engaged in full monetary union.  Within this international financial framework, the macroeconomic response would be for the United States to take steps to increase its domestic savings while other, large trade surplus countries would take corresponding steps to increase domestic consumption.  These domestic steps would force adjustment in the trade imbalances, in large part through downward movement of the dollar exchange rate. 

      The U.S. policy objective for the exchange rate would consequently change from current categoric support for a strong dollar to a neutral reliance on market forces to establish the rate, with the expectation of some downward adjustment of the dollar in parallel with a declining trade deficit.  Such a U.S. stated objective, in conjunction with complementary statements by major trading partners, would, in itself, likely lead to some decline in the dollar and the beginning of the trade adjustment process.

      Another immediate objective should be to restrain others from further currency manipulation to competitive advantage.  This could be done through G-7 and bilateral discussions and, in parallel, more formal consultations within the IMF.  The point of departure would be that nations with persistently large trade surpluses—and even more so if they have large FDI inflows as well—should cease official purchases of foreign exchange or any other actions that would maintain their currencies below market-determined levels.  A joint announcement to this effect should further influence financial market behavior, with upward pressures on floating currencies that have recently been subject to substantial manipulation, such as the yen and the Korean won, and corresponding downward movement of the dollar.

      China, once again, is an important special case in view of its nonconvertible fixed rate to the dollar, and should thus be given a very high priority for bilateral consultations.  The mutual interest in reducing the extremely lopsided bilateral trade account should be assessed in detail, starting with the question as to why China has such a large trade surplus with the United States and moderate trade deficits with most other trading partners.  A U.S. request to China to cease official foreign exchange purchases and to adjust its fixed rate upward would define the immediate U.S. objectives.  The longer term transition of China toward a fully convertible, floating rate relationship with the dollar should also be examined seriously, as a mutual interest, and as the best way to avoid trade conflict resulting from further unjustified Chinese currency manipulation.

[2] See the Financial Times, January 16, 2002, "Banker's fall throws spotlight on China's missing billions."

[3] The World Bank rule of thumb for adequate reserves is 25 percent of annual imports; China and Japan now have foreign exchange reserves of approximately 100 percent of annual imports.

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