By Evan Abrams
Bashing China for currency manipulation has become a popular refrain among American politicians. Republicans and Democrats alike, find it politically expedient to point the finger at China for the decline in American manufacturing and stagnant wage and job growth in the middle class. Their arguments tend to focus on export-led employment because that issue is most salient to the voting public. However, the most pernicious long-term problem caused by an undervalued Yuan is the yawning payments imbalance that has emerged between the two nations.
China’s current account surplus creates a capital account deficit, leading to an outflow of foreign portfolio investments. This can help lead to asset bubbles and has been blamed, by Ben Bernanke and others, as contributing to the subprime mortgage crisis of 2007-2008. It also creates a strong market for United States treasury bills, helping America to continue to live beyond its means. Conversely, the U.S. current account deficit means that much of the growth in the American economy over the past decade and a half has been financed by debt, both public and private. This arrangement of debt financed American consumption of Chinese goods is clearly unsustainable.
Of course, the artificially low Chinese currency is not the only factor leading to the present imbalance. Persistent U.S. budget deficits have led to a national debt of roughly 18 trillion USD. The question is: who will adjust to whom? In other words, will the current situation unwind principally due to a decline in U.S. spending or an increase in Chinese consumption? For U.S. policy makers, the latter is clearly preferable and an adjustment in the value of the Chinese currency is a critical ingredient in making that a reality.
Yet, while there is ample evidence that China’s currency is undervalued, there are few if any effective mechanisms through which American policy makers could force an adjustment. The two most obvious choices, in a multilateral context, would be the IMF and WTO. Article IV, Section 1(iii) of the IMF Agreement gives the IMF jurisdiction to review currency manipulation as it relates to preventing a balance of payments adjustment or creating an unfair competitive advantage. However, the power of the IMF to force a country to change their policy is quite limited. This is particularly true of a country like China who has no need for financial assistance from the IMF (China holds nearly 4 trillion USD in foreign reserves).
The WTO has a well functioning dispute resolution system that can authorize retaliatory trade sanctions in order to induce compliance. Thus, at first glance, the WTO seems like it could be an ideal body to litigate this dispute. However, the WTO lacks jurisdiction over currency issues, which have traditionally been ceded to the IMF. It may be possible to argue that China’s undervalued currency amounts to an illegal trade subsidy in violation of WTO rules. However, this would rub against the traditional definition of trade subsidies and would be unlikely to succeed before a WTO judge.
The domestic options available to lawmakers are quite limited as well. Many politicians have hammered home the necessity of labeling China as a currency manipulator. However, such a designation is unlikely to produce any significant changes. The 1988 law that governs the labeling process empowers the Treasury Department to initiate negotiations with the country in question, but does not authorize the use of retaliatory trade sanctions. The U.S. has already been in prolonged discussions with China regarding their exchange rate and it is unclear that labeling China as a currency manipulator would do anything but ruffle feathers.
Finally, it is important to understand that a sharp and sudden rise in the value of the Yuan would be devastating to business and employment in China. This could have serious ramifications on the Chinese economy, which would almost certainly reverberate to the U.S. economy, and it could lead to widespread discontent with the ruling communist party and a challenge to the Chinese regime. Chinese leaders would not contemplate anything with the potential for such dramatic domestic consequences and would fiercely resist U.S. efforts for a dramatic short-term change in currency valuation.
A long-term, gradual increase is more plausible but even this carries significant risks, because any announced schedule for appreciation would likely place strong demand on Yuan from speculators and investors, causing the currency to rise more rapidly than intended or China to take strong corrective actions to hold the rate steady.
So while the current scenario is clearly unsustainable there is no obvious legal or political mechanism to unwind the large imbalances that have developed. How American and China navigate this thorny issue will help determine the economic fortunes of their respective countries in the years and decades to come.