China's Currency: Economic Issues and Options for U.S. Trade Policy

Publication Date: May 2008

Publisher: Library of Congress. Congressional Research Service

Author(s):

Research Area: Economics; Trade

Type:

Coverage: China

Abstract:

The continued rise in the U.S.-China trade imbalance and complaints from U.S. manufacturing firms and workers over the competitive challenges posed by Chinese imports have led several Members to call for a more aggressive U.S. stance against certain Chinese trade policies they deem to be unfair. Among these is China's refusal to adopt a floating exchange rate system. From 1994-July 2005, China pegged its currency (renminbi or yuan) to the U.S. dollar at about 8.28 yuan to the dollar. On July 21, 2005, China announced it would immediately appreciate its currency to the dollar by 2.1% (to 8.11 yuan per dollar) and link its currency to a basket of currencies (rather than just to the dollar). Many Members contend that the yuan has only appreciated slightly since these reforms were implemented and that it continues to "manipulate" its currency in order to give its firms an unfair trade advantage, which has led to U.S. job losses. Several bills have been introduced in Congress to address China's currency policy, including S. 295, which would impose 27.5% in additional tariffs on imported Chinese goods unless it appreciated its currency to market levels.

If the yuan is undervalued against the dollar, there are likely to be both benefits and costs to the U.S. economy. It would mean that imported Chinese goods are cheaper than they would be if the yuan were market determined. This lowers prices for U.S. consumers and dampens inflationary pressures. It also lowers prices for U.S. firms that use imported inputs (such as parts) in their production, making such firms more competitive. When the U.S. runs a trade deficit with the Chinese, this requires a capital inflow from China to the United States. This, in turn, lowers U.S. interest rates and increases U.S. investment spending. On the negative side, lower priced goods from China may hurt U.S. industries that compete with those products, reducing their production and employment. In addition, an undervalued yuan makes U.S. exports to China more expensive, thus reducing the level of U.S. exports to China and job opportunities for U.S. workers in those sectors. However, in the long run, trade can affect only the composition of employment, not its overall level. Thus, inducing China to appreciate its currency would likely benefit some U.S. economic sectors, but would harm others, including U.S. consumers.

Critics of China's currency policy point to the large and growing U.S. trade deficit ($202 billion in 2005) with China as evidence that the yuan is undervalued and harmful to the U.S. economy. The relationship is more complex, for a number of reasons. First, while China runs a large trade surplus with the United States, it runs a large trade deficit with the rest of the world. Second, an increasing level of Chinese exports are from foreign-invested companies in China that have shifted production there to take advantage of China's abundant low cost labor. Third, the deficit masks the fact that China has become one of the fastest growing markets for U.S. exports. Finally, the trade deficit with China accounted for 24% of the sum of total U.S. bilateral trade deficits in 2005, indicating that the overall trade deficit is not caused by the exchange rate policy of one country, but rather the shortfall between U.S. saving and investment. That being said, there are a number of valid economic arguments for China to adopt a more flexible currency policy. This report will be updated as events warrant.