Commentary

China and the Truth about the Senate’s Exchange Rate Oversight Act

In moving toward passage of the Currency Exchange Rate Oversight Reform Act, the U.S. Senate has sent the wrong signal to China, our fastest-growing export market. We have told Beijing that we alone know the true value of the dollar-yuan exchange rate and have the authority to unilaterally penalize Chinese companies for pricing their products using the official exchange rate, which is deemed to undervalue the yuan by anywhere from 12% to 50%.

One of the co-sponsors of the Reform Act, Sen. Olympia Snowe (R-Maine), asserts that “China’s currency manipulation has been among the greatest impediments to our manufacturing sector.” Yet the Treasury Department has never labeled China a “currency manipulator,” and the term never appears in the Act. In fact, in real terms (after adjusting for inflation), the yuan has been appreciating by about 10% against the dollar this year. And there is little evidence that a stronger yuan would reduce the U.S. trade deficit with China or improve the jobs picture.

In promoting the Act, Sen. Snowe argued, “If there were ever a moment to empower our work force when it comes to competing in the global economy, that time is now.” Similar rhetoric has come from other key sponsors such as Sens. Sherrod Brown (D-Ohio), Charles E. Schumer (D-N.Y.), and Lindsey Graham (R-S.C.).

[T]here is little evidence that a stronger yuan would reduce the U.S. trade deficit with China or improve the jobs picture.”

None of those protectionist senators mention that the dismal U.S. job picture is due primarily to our own policy mistakes, including excessive regulations, high taxes on capital, uncertainty due to the lack of transparent fiscal and monetary policy rules, labor laws that favor unions and substantially increase labor costs, and runaway government spending that slows economic growth and job creation.

Blaming China for our woes is politically attractive but dangerous. Since 1978, China has greatly liberalized its economy and is now the second largest trading nation in the world. U.S. consumers have benefited from lower prices and more choices than if China had followed the path of state monopoly.

In the process of globalization some U.S. manufacturers have been harmed and jobs have been lost. However, other factors such as high union labor costs, technological changes and shifts in consumer preferences have been important determinants of what jobs were created and destroyed. Treating currency “manipulation” as an actionable subsidy under U.S. trade law opens a Pandora’s Box to further politicize U.S.-China trade.

Under the Reform Act, the U.S. Secretary of the Treasury must report to Congress biannually and identify for “priority action” any country that has a “fundamentally misaligned currency” as indicated by a sustained accumulation of foreign exchange reserves, among other factors. China, with more than $3 trillion in foreign exchange reserves, is the prime target of the legislation.

The real intent of the Act is to penalize China for its large bilateral trade surplus with the U.S., which is assumed to be the result of an undervalued yuan. The truth is that the trade surplus is due to many factors. A trade surplus merely reflects an excess of saving over investment in China. The purpose of trade is to increase wealth, not to increase jobs.

If China wants to peg its currency to the dollar at an artificially low rate and accumulate reserves in the form of U.S. public debt, we should thank China for providing us with more consumption opportunities and keeping U.S. interest rates lower than they would otherwise be.

One of the unforeseen consequences of China’s willingness to accumulate reserves, stemming from undervaluing the yuan, is that the Chinese people have been forced to forego current consumption and a higher standard of living by diverting savings to finance U.S. deficit spending — allowing the federal government to expand.

Narrowly focusing on the trade balance and the exchange rate diverts attention from a far more important issue — China’s capital controls. Although the yuan is convertible on the trade account, it is not freely convertible for financial transactions. The Reform Act does not address that issue. Implying that China is cheating by manipulating its exchange rate, the Act will injure U.S.-China relations.

The good news is that the Act will almost certainly not be passed by the U.S. House of Representatives, although a similar bill passed the House last year when the Democrats had the majority. Moreover, making undervalued currencies an actionable subsidy is unlikely to be compliant with World Trade Organization rules.

China is currently designated a “nonmarket economy.” Until 2007, countervailing duties could not be used against China. Rather, anti-dumping methodology was used to determine if China was selling in the U.S. market at “unfair” prices. That methodology is highly flawed and needs reform. Introducing yet another complicating factor — “fundamentally misaligned currencies” — to the formula would enrich trade lawyers and keep bureaucrats employed, but only at the expense of wealth creation and free trade.

The U.S. should use the Strategic and Economic Dialogue to promote trade and investment liberalization, and recognize that it is in China’s own interest to allow greater exchange-rate flexibility. It does not make sense for a capital-poor country like China to be a net exporter of capital and hold billions of dollars of U.S. government debt.

Washington should welcome Chinese direct investment that does not affect national security and welcome the opportunity to trade with China. Engagement, not destructive protectionism (under the guise of saving American jobs), is the only path to peaceful development.

James A. Dorn is a China specialist at the Cato Institute and editor of the Cato Journal.