The Case Against China

The most important and immediate U.S. policy conflict with China is in the area of international finance.

At the core of the conflict lies the issue of “currency manipulation,” whereby China is maintaining its exchange rate to the dollar far below the market-determined level — and is thus gaining an unfair trade advantage.

The great anomaly, up to this point, of the Chinese economic strategy for market-based industrialization through open trade and foreign investment has been the maintenance of a non-convertible currency on the capital account, which is rigidly linked to the dollar.

After all, almost all less-developed — and even the least-developed countries — have some form of currency convertibility and exchange rate flexibility. That helps them avoid the economic distortions and corruption that result from a non-convertible currency that is fixed well above or below its market-based level.

A change by China to a flexible, market-oriented exchange rate is thus long overdue — all-the-more so since it would resolve the conflict with trading partners over currency manipulation.

More exchange rate flexibility would also provide a more productive financial sector within the Chinese economy — and pave the way for China to assume its proper role as an international financial power.

Currency manipulation can be described as a deliberate policy to keep the exchange rate below its “equilibrium” rate so as to gain an unfair competitive advantage in trade through lower export and higher import prices.

For currency manipulation to provide an unfair competitive advantage, a country’s central bank has to purchase foreign exchange on a sustained basis, so that it can hold the currency below its market-oriented level.

These basic points about currency manipulation were well understood by the framers of the international financial and trading systems — the International Monetary Fund (IMF) and the General Agreement on Tariffs and Trade (GATT), now incorporated in the World Trade Organization.

In fact, the term “currency manipulation” derives from IMF Article IV and is appropriately defined in terms of measurable policy actions through central bank intervention, in particular.

Article IV, Section 1, states that members should “avoid manipulating exchange rates . . . in order. . . to gain an unfair competitive advantage over other members.” Section 3 then elaborates “the right of members to have exchange arrangements of their choice consistent with the purposes of the Fund and the obligations under Section I of this Article.”

In other words, member exchange-rate policies — whether a floating rate, as now exists for the Japanese yen, or a fixed rate, as for the Chinese yuan — must all be implemented in a way that does not entail currency manipulation, as proscribed under Section 1.

This leads to the official definition of currency manipulation, which is contained in the IMF surveillance provision related to Article IV, referring to it as “protracted large-scale intervention in one direction in the exchange market.”

“In one direction,” again, means central bank purchases of foreign currencies, since this is the way to maintain an undervalued currency in order to gain an unfair competitive advantage.

Thus, the question of whether China has been manipulating its currency in violation of its IMF Article IV obligations is determined by these three adjectives: “protracted,” “large-scale” and “one directional.”

Before examining this in terms of recent performance, however, it is useful to relate the IMF currency manipulation obligation to counterpart obligations under Article XV of the GATT, now incorporated within the WTO.

This article deals with “Exchange Arrangements” and stipulates that members should not take exchange rate actions that “frustrate the intent of the provisions of this Agreement.”

The intent of the agreement, as stated in broadest terms in the Preamble, is the objective of “entering into reciprocal and mutually advantageous arrangements directed to the substantial reduction of tariffs and other barriers to trade.”

Clearly, “exchange rate manipulation to gain an unfair competitive advantage,” as defined by IMF Article IV, meets the “frustrate the intent” test.

Moreover, GATT Article XV also provides for full consultation with the IMF, including the stipulation that members “should accept all findings of statistical fact presented by the Fund relating to foreign exchange.” Thus, there is a direct link between IMF proscribed currency manipulation and WTO obligations under GATT Article XV.

This IMF-WTO linkage is important in terms of policy recourse for countries suffering the adverse trade effects of currency manipulation.

Even if China were to be found in violation of its IMF Article IV obligations not to manipulate its currency, no significant IMF penalties are available if China were to continue currency manipulation.

The most the IMF could do would be to make China ineligible for IMF stand-by loans, which is pointless in view of Chinese foreign exchange holdings of $660 billion, as of March 2005.

A counterpart finding of violation of GATT Article XV, however, opens the way to WTO dispute settlement procedures — with ultimate recourse to trade sanctions.

Turning to the three adjectives that define currency manipulation, an assessment of whether the Chinese central bank purchases of foreign exchange were “protracted” and “large-scale” can best be viewed in relation to the Chinese external basic balance.

If this basic balance is in substantial surplus, there will likely be a net inflow of foreign currencies, which will put upward pressure on the exchange rate. Central bank purchases under these circumstances, however, take this foreign currency inflow off the market, thereby keeping the exchange rate below a fair or market-determined level.

In the current context of a fixed and non-convertible yuan, the Chinese government does this by requiring almost all incoming foreign exchange, which is not used to purchase imports or for other current account expenditures, to be sold to the central bank at the fixed rate.

Within this analytic context, Chinese central bank purchases from 2001 through 2004 and the inflow of foreign direct investment together are an approximation of the basic balance.

Central bank purchases were $57 billion in 2001, rising steadily to $118 billion in 2003, and then skyrocketing to $207 billion in 2004. The basic balance, in parallel, rose steadily from $61 billion in 2001 to $130 billion in 2004.

For the three-year period 2001-2003, central bank purchases totaled $249 billion, compared with a cumulative basic balance surplus of $222 billion. In other words, Chinese central bank purchases during these three years more than offset the entire net inflow of foreign exchange from the current account surplus plus the inflow of FDI.

As for 2004, the surge in central bank purchases to $207 billion greatly exceeded the $130 billion basic balance surplus.

However, many of these purchases were made to offset the inflow of short-term capital in anticipation of a yuan revaluation which, incidentally, would have put further upward pressure on a market-based or floating yuan.

The enormity of these central bank purchases over four years, related to what were also extraordinarily large basic balance surpluses, surely qualifies as “protracted” and “large-scale.”

Nothing comes remotely close during the 60-year history of the IMF, except recent Japanese central bank purchases, which also clearly qualify as currency manipulation.

There could be mitigating circumstances for occasional large-scale purchases, such as to replenish an inadequate level of foreign exchange holdings or to mitigate a large trade deficit that is having a negative impact on economic growth.

The opposite circumstances currently prevail in China, however, with $660 billion in foreign exchange holdings, roughly equal to annual imports, while the trade account has consistently been in surplus.

Thus, there should be no question that China has been manipulating its currency in gross violation of its obligations under IMF Article IV and — by extension — GATT Article XV of the WTO.