In the just‐released report to Congress of the US‐China Economic and Security Review Commission, a key recommendation is that Congress “enact legislation to define currency manipulation as an illegal export subsidy and allow the subsidy to be taken into account when determining penalty tariffs”. If Congress enacted this recommendation next year, China would be the main target.
China’s soaring current account surplus, which will reach US$400 billion this year, and its treasure chest of nearly US$1.5 trillion in foreign exchange reserves, are taken as incontrovertible evidence that the yuan is substantially undervalued. Both the European Union and America want faster appreciation of the yuan against the US dollar. Treating “currency manipulation” as an actionable subsidy when deciding on anti‐dumping and countervailing duty cases, however, would run counter to World Trade Organisation practices.
Even if the less‐onerous term “currency misalignment” is used in the legislation, there are serious problems in calculating “fundamental” misalignment – because nobody knows what the equilibrium yuan‐ US dollar exchange rate is.
What we do know is that China’s current account surplus exceeds 12 per cent of gross domestic product, and is not sustainable. Either inflation or an appreciation of the nominal exchange rate would eventually help bring about a more normal balance‐of‐payments position. Beijing also needs to end financial repression and the forced savings it generates. It is not in China’s long‐term interests to divert domestic savings to accumulate low‐yielding US debt.
Of course, China is doing the US a favour by selling goods at artificially low prices and by keeping US interest rates lower than otherwise by accumulating billions of dollars of US government debt. The falling US dollar, however, makes it costly for China to continue to subsidise American goods and to hold so much US public debt. Beijing has created a sovereign wealth fund to begin diversifying and to earn a higher return on its foreign exchange holdings.
It is unlikely that Beijing will abandon the dollar as its key reserve currency. To do so would impose severe capital losses on China’s US dollar holdings. Yet, there is no question that China must slow the future inflow of dollars and allow greater capital freedom. In remarks at the Cato Institute’s 25th annual monetary conference on November 14, in Washington, Yi Gang , assistant governor of the People’s Bank of China, emphasised that diversification “should be proportional to real economic transactions”. He noted that the US dollar would remain “the main currency in our reserves, and that policy is very firm”.
Of course, if the dollar continues to fall and the US economy slows next year, Beijing would be foolish to place all its bets on the currency, and would diversify more rapidly. That expectation alone would have a negative impact on US asset markets and on the almighty US dollar.