China's exchange rate manipulation: what should the United States do?

• Author: Schield, Bradley

1. INTRODUCTION II. U.S. RELATIONS WITH CHINA A. Background B. Economic Impact of Currency Manipulation III. U.S.-CHINALAWAND CURRENCY MANIPULATION A. Congress B. General Agreement on Tariffs and Trade Article XV IV. WHAT SHOULD THE UNITED STATES DO? A. Create a Long-Term Plan for China B. Label China as a Currency Manipulator C. Place Duties on Chinese Imports V. CONCLUSION I. INTRODUCTION

   If China and U.S. trade continue on their present course, a trade war seems likely. (1) Chinese exporters have benefited tremendously at the expense of American goods. (2) In August 2011 alone, the U.S. imported $37 billion in goods from China, while only exporting $8 billion. (3) Treasury Secretary Timothy Geithner accused China of currency manipulation and was unhappy with progress on the yuan. (4) Any problems with China trade relations could hurt an already struggling global economy. (5) One of the most important aspects of free trade agreements is that they hinge on a level playing field, and American workers are not currently playing on one. (6) According to President Obama, the United States needs to make sure our prices "are not artificially inflated." (7)

   China's power in the global economy is significant: it accounts for a quarter of the world's population, it is armed with nuclear weapons, (8) and it is rapidly expanding in terms of gross domestic product (GDP). (9) Isolating or ignoring China realistically is not an option, but Americans are at a large disadvantage in important industries. (10)

   This Comment is broken into four parts. The first part describes the history of U.S. trade relations with China, the current state of the law between the countries, and the economic impact from currency manipulation. The second part describes what international laws China may have broken by manipulating currency and the most recent proposed U.S. laws. The third part describes what the United States should do to fix the trade situation with China. The fourth part concludes this Comment.

2. U.S. RELATIONS WITH CHINA

   1. Background

      Since 1979 China has introduced major economic and trade reforms which have transformed the nation into the world's fastest growing economy. (11) Once the U.S. and China reestablished diplomatic relations in early 1979, trade between the two nations increased tremendously. (12) The United States provided China with most-favored-nation (MFN) status in 1980. (13) That MFN status created heavy controversy following the Tiananmen Square protests of 1989. (14) However, generally MFN status is aligned more with American trade and tariff restrictions than with human rights. (15) President Clinton explicitly rejected determining MFN status based on human rights. (16) Many, including the AFL-CIO, viewed President Clinton's renewal of MFN status critically, stating "profits, not people, matter most." (17) Nevertheless, China's MFN status continued and became permanent in 2000. (18)

      In 1993, China amended its constitution and declared that the promotion of a "socialist market economy" was the ultimate goal for China's foreign trade. (19) In November 2001, China officially joined the World Trade Organization (WTO). (20) China's admission to the WTO was carefully negotiated, with the full protocol covering thousands of lines of tariffs and specific agreements covering approximately 1500 pages. (21) Conditions for China to enter the WTO included sharp decreases in tariffs; tariffs of industrial products, for instance, were lowered from 35% to 17% in a period of five years. (22)

      China differs from most advanced economies because it does not have a market-based floating exchange rate. (23) Between 1994 and July 2005, China pegged its currency at about 8.28 yuan to the dollar. (24) Originally, the international trade arena viewed this exchange rate policy favorably. (25) "In July 2005, China appreciated the [yuan] to the dollar by 2.1% and moved to a 'managed float' based on major foreign currencies." (26) From July 2005 to July 2009, the dollar-yuan exchange rate went from 8.27 to 6.93 yuan per dollar, while the Chinese government made large-scale purchases of U.S. dollars. (27) However, once the global financial crisis became apparent, the Chinese government halted its gradual appreciation of the yuan and has kept the yuan-dollar exchange rate relatively constant since July 2009 at 6.83. (28)

      Aside from currency manipulation, U.S. disputes with China include intellectual property rights, (29) payment processing, (30) steel duties, (31) U.S. poultry, (32) and toys. (33) Many times the U.S. has brought, and won, cases against China for violating its WTO commitments. (34) However, while these cases are important, they do not address the fundamental causes that create the U.S.-China trade deficit. (35)

   2. Economic Impact of Currency Manipulation

      The U.S. economy has fallen into a depression during a global recession, contrasted with the booming Chinese economy. As of October 2010, the unemployment rate in the United States was 9.6%. (36) Meanwhile, China's unemployment rate was last reported at 4.2%. (37) The United States' GDP growth was 3.1% in 2005, 2.7% in 2006, 2.1% in 2007, 0.4% in 2008, and -2.4% in 2009. (38) Meanwhile, China's GDP growth was 11.3% in 2005, 12.7% in 2006, 14.2% in 2007, 9.6% in 2008, and 9.1% in 2009. (39) China recently surpassed Japan as the world's second-largest economy, (40) and it is projected that China will pass the U.S. as the world's biggest economy as early as 2030. (41) Many economists are critical of the excessive growth of China's GDP in recent years, and view worldwide inflation as a strong possibility in coming years. (42)

      One of the factors in measuring GDP is net exports. When a country is exporting more goods than it is importing, the GDP increases as the country is producing more goods than it is importing. (43) The U.S. imports significantly more goods from China than it exports. (44) In 2005 alone, the U.S. ran a trade deficit with China at $201 billion. (45)

      Most experts believe that China's currency is undervalued relative to the dollar; however, there exists a major dispute on the exact amount of the undervaluation. (46) Some legislators have suggested that China has undervalued its currency by as much as 40%. (47) The Alliance for American Manufacturing reports that the currency manipulation "destroyed some 68,000 jobs in Michigan" alone. (48) Other reports suggest that the United States could have lost as many as 2.4 million jobs from currency manipulation. (49) Some researchers also view currency manipulation as detrimental to China. (50) Thus, while its economy is currently booming, the excessive growth is viewed by many as dangerous. (51)

      It is unclear that if China actually were to allow its currency to shift with exchange rates whether the effect would be to lower the gross imbalance of trade. Elasticity of U.S. exports and elasticity of U.S. imports appear to be different. (52) This is known as the Houthakker-Maggee effect. (53) Consistently, the elasticity of foreign imports is far less than in the case of American imports. (54) Thus, a direct 40% increase in the value of the yuan might not create the impact that many congressmen believe it would create.

      Economists are not settled on whether a trade imbalance is a bad thing for a country. Nobel Prize-winning Milton Friedman argued that trade deficits are not necessarily important because high exports raise the value of currency and vice versa for imports. (55) Friedman has pointed out in the past that a large trade deficit signaled that the country's currency was strong and desirable. (56) This view has been quite accurate when comparing the weakening U.S. dollar to the euro and other currencies, (57) and as the U.S. dollar has weakened, the trade gap decreased as exports have increased. (58) But a Friedman analysis falls apart when a country deliberately tries to control its currency price. (59)

      When China joined the WTO, member countries viewed China as a developing nation. (60) China, as a developing nation, has relied heavily on exports. (61) Perhaps doubts still remain as to whether China's economy can handle a fully free-floating currency system, causing these actions.

      Chinese officials are also concerned with China's banking system. Chinese banks are predominantly state-owned and are called upon to make low-interest loans without risk assessments. (62) The Chinese have effectively been saying that they want to go to a flexible system, but their banking system cannot withstand it. (63) Congress has acknowledged that on some level this is true. (64) America loses credibility when Americans tell the Chinese that they just need to privatize their banks and open up their whole exchange rate system. This loss of credibility comes from the current financial troubles of U.S. banks, as well as the Asian financial crisis, which was caused by the privatization and opening up of many Asian nations' exchange rate systems. (65) For example, "South Korea and Thailand opened their short term capital accounts prematurely, and eventually ... when they started going south [there was no] regulatory capacity to keep people from making those bad decisions [and then there was] trouble." (66) This is a misstep China wishes to avoid. (67)

      China benefits from buying U.S. treasuries for several reasons. Only the U.S. dollar bond market possesses the size and liquidity to absorb China's dollar holdings. (68) Most developing economies lack broad bond markets in their domestic currency, (69) a problem often referred to as "original sin." (70) A 10% drop in the value of China's dollar holdings would result in a loss of about 3% of China's GDP. (71) Secretary Clinton acknowledged that

      in order to start exporting again to its biggest market, namely the United States, the United States has to take some very drastic measures with this stimulus package, which means we have to incur more debt.... It would not be in China's...