Order Code RL32165
CRS Report for Congress
Received through the CRS Web
China’s Exchange Rate Peg: Economic Issues
and Options for U.S. Trade Policy
Updated May 10, 2005
Wayne Morrison
Specialist in International Trade and Finance
Foreign Affairs, Defense, and Trade Division
Marc Labonte
Analyst in Macroeconomics
Government and Finance Division
Congressional Research Service ˜ The Library of Congress

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China’s Exchange Rate Peg:
Economic Issues and Options for U.S. Trade Policy
Summary
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 cheap
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, such as China’s policy
of pegging its currency (the yuan) to the U.S. dollar. Some Members assert this
policy constitutes a form of “currency manipulation” intended to give China an unfair
trade advantage and is contributing to the loss of U.S. manufacturing jobs.
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 diminishes 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,
diminishing their production and employment. In addition, an undervalued yuan
makes U.S. exports to China more expensive, thus diminishing 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 peg point to the large and growing U.S. trade deficit 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 significant 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 23% of the sum of total U.S. bilateral trade deficits in
2004, 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.

Several bills have been introduced in the 109th Congress to address China’s
currency policy, including H.R. 1216, H.R. 1498, H.R. 1575, S. 14, S. 295, S. 377,
and S. 593; some would impose trade sanctions against China unless it accepted a
market-based currency system. While the Bush Administration has pressed China to
make the yuan fully convertible, it has sought to avoid confrontation with China on
the issue. Instead, it has offered technical assistance to China to help it make the type
of reforms to its financial system that, if implemented, will induce China to move
more quickly toward adopting a more flexible currency regime. This report will be
updated as events warrant.

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Contents
U.S. Concerns About China’s Currency Peg . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
China’s Concerns About Abandoning Its Currency Peg . . . . . . . . . . . . . . . . . . . . 2
The Economics of Fixed Exchange Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
How the Peg Operates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Pros and Cons of a Peg . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
A Critique of Various Estimates of the Yuan’s Undervaluation . . . . . . . . . . 8
Trends and Factors in the U.S.-China Trade Deficit . . . . . . . . . . . . . . . . . . . . . . 13
Economic Consequences of China’s Currency Peg . . . . . . . . . . . . . . . . . . . . . . . 18
Implications of the Peg for China’s Economy . . . . . . . . . . . . . . . . . . . . . . . 18
Implications of the Peg for the U.S. Economy . . . . . . . . . . . . . . . . . . . . . . . 19
Effect on Exporters and Import-Competitors . . . . . . . . . . . . . . . . . . . . 19
Effect on U.S. Borrowers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
Effect on U.S. Consumers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
U.S.-China Trade and Manufacturing Jobs . . . . . . . . . . . . . . . . . . . . . 21
Net Effect on the U.S. Economy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
The U.S.-China Trade Deficit in the Context of the Overall
U.S. Trade Deficit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
Policy Options for the Peg and U.S. Trade Policy with China . . . . . . . . . . . . . . 25
Changes to the Peg and Potential Outcomes . . . . . . . . . . . . . . . . . . . . . . . . 26
Policy Options to Induce China to Reform the Peg . . . . . . . . . . . . . . . . . . . 28
Diplomatic Efforts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
Utilize Section 301 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
Utilize the Dispute Resolution Mechanism in the WTO . . . . . . . . . . . 29
Utilize Special Safeguard Measures . . . . . . . . . . . . . . . . . . . . . . . . . . 29
Other Bilateral Commercial Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
Legislation in the 109th Congress . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
List of Figures
Figure 1. Real and Nominal China-U.S. Exchange Rate . . . . . . . . . . . . . . . . . . . 5

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List of Tables
Table 1. China’s Foreign Exchange Reserves and Overall Current Account
Surplus: 1990-2004 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Table 2. Foreign Exchange Reserves and Current Account Balance in
Selected Asian Countries, 2004 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Table 3. Exports and Imports by Foreign-Invested Enterprises in China:
1986-2004 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Table 4. Major Foreign Suppliers of U.S. Computer Equipment Imports:
2000-2004 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Table 5. Percentage Annual Change in U.S. Exports to Top Ten U.S.
Export Markets: 2000-2003 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
Table 6. Manufacturing Employment in Selected Countries: 1995 and 2002 . . 22

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China’s Exchange Rate Peg: Economic
Issues and Options for U.S. Trade Policy
China pegs its currency, the yuan (or renminbi), to the U.S. dollar.1 Under this
system, China’s central bank issues a reference dollar/yuan exchange rate along with
a limited band (about 0.3%) in which the reference rate is allowed to fluctuate. This
system has been in place with a peg of about 8.3 yuan to the dollar since 1994. Many
economists contend that for the first several years of the peg, the fixed value was
likely close to the market value. But in the past few years, economic conditions have
changed such that the yuan would likely have appreciated if it had been floating.
This situation has raised concerns in the United States, but the Chinese, with
concerns about their own economy, have been reluctant to alter the peg.
U.S. Concerns About China’s Currency Peg
Many U.S. policymakers and business and labor representatives have charged
that China’s currency is significantly undervalued vis-a-vis the U.S. dollar by as
much as 40%, making Chinese exports to the United States cheaper, and U.S. exports
to China more expensive, than they would be if exchange rates were determined by
market forces. They further argue that the undervalued currency has contributed to
the burgeoning U.S. trade deficit with China (which has risen from $30 billion in
1994 to $162 billion in 2004) and has hurt U.S. production and employment in
several U.S. manufacturing sectors (such as textiles and apparel and furniture) that
are forced to compete domestically and internationally against “artificially” low-cost
goods from China.
Furthermore, some analysts contend that China’s currency peg induces other
East Asian countries to intervene in currency markets in order to keep their
currencies weak against the dollar to remain competitive with Chinese goods.2
Several groups are pressing the Bush Administration to pressure China either to
revalue its currency (by increasing the band in which it is allowed to be traded in
China) or to allow it to float freely in international markets. During an interview with
CNBC’s Ron Insana on September 5, 2003, President Bush criticized China’s
currency peg and stated that exchange rates should be determined by market forces.
1 A brief summary of this report can be found in CRS Report RS21625, China’s Currency
Peg: Implications for the U.S. and Chinese Economies, by Marc Labonte and Wayne
Morrison.
2 See Prepared Remarks of Dr. C. Fred Bergsten, President, Institute for International
Economics, before the House Small Business Committee, June 25, 2003.

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CRS-2
China’s Concerns About Abandoning
Its Currency Peg
Chinese officials argue that its currency peg policy is not meant to favor exports
over imports, but instead to foster economic stability by tying its currency to the U.S.
dollar at a constant level, as many other countries do. They have expressed concern
that abandoning the peg could spark an economic crisis in China and would
especially be damaging to its export industries at a time when painful economic
reforms (such as closing down inefficient state-owned enterprises) are being
implemented. They further contend that the Chinese banking system is too
underdeveloped and burdened with heavy debt to be able to deal effectively with
possible speculative pressures that could occur with a fully convertible currency. The
combination of a convertible currency and poorly regulated financial system is seen
to be one of the causes of the 1997-1998 Asian financial crisis.
Chinese officials view economic stability as critical to sustaining political
stability; they fear an appreciating currency could reduce foreign investment, cause
deflation, reduce employment, and lower wages in several sectors, and thus could
cause worker unrest. Chinese officials also point out that during the Asian crisis,
when several other nations sharply devalued their currencies, China “held the line”
by not devaluing its currency (which might have prompted a new round of destructive
devaluations across Asia). This policy was highly praised by U.S. officials, including
President Clinton. During a visit to China in September 2003 by U.S. Treasury
Secretary John Snow, Chinese officials stated that, while making the exchange rate
regime more flexible was a long-term goal, China had no immediate plans to
eliminate the peg, but was considering certain financial reforms. In October 2003,
Chinese officials agreed to a U.S. proposal to set up a joint technical cooperation
program with the United States to facilitate cooperation and communication between
financial experts in both countries to promote the development of China’s financial
markets and to examine ways China can move more quickly towards a floating
exchange rate.3
The Economics of Fixed Exchange Rates
How the Peg Operates. China maintains a fixed exchange rate with the
United States, where the Chinese central bank buys or sells as much currency as is
needed to keep the yuan-dollar exchange rate constant at 8.3 yuan per dollar.4 The
primary alternative to this arrangement would be a floating exchange rate, as the U.S.
3 The White House, Office of the Press Secretary, Background Briefing by a Senior
Administration Official on the President’s Meeting with the President of China, Oct. 19,
2003.
4 Prior to this time, China maintained a dual exchange rate system: an official exchange rate
of about 5.8 yuan to the dollar and a market swap rate (used mainly for trade transactions)
of about 8.7 yuan to the dollar (at the end of 1993). The reforms in 1994 unified the two
rates. Since Hong Kong also fixes its exchange rate to the dollar, China in effect also
maintains a fixed exchange rate with Hong Kong.

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CRS-3
maintains with the Euro area, in which supply and demand in the marketplace causes
the euro-dollar exchange rate to continually fluctuate. Under a floating exchange rate
system, the relative demand for the two countries’ goods and assets would determine
the exchange rate of the yuan to the dollar. If the demand for Chinese goods or assets
increased, more yuan would be demanded to purchase those goods and assets, and
the yuan would rise in value (if the central bank kept the supply of yuan constant) to
restore equilibrium.
When a fixed exchange rate is equal in value to the rate that would prevail in the
market if it were floating, the central bank does not need to take any action to
maintain the peg. However, over time economic circumstances change, and with
them change the relative demand for a country’s currency. If the Chinese had
maintained a floating exchange rate, appreciation would likely have occurred in the
past few years for a number of reasons. For instance, productivity and quality
improvements in China may have increased the relative demand for Chinese goods
and foreign direct investment in China. For the exchange rate peg to be maintained
when economic circumstances have changed requires the central bank to supply or
remove as much currency as is needed to bring supply back in line with market
demand, which it does by increasing or decreasing foreign exchange reserves. This
is shown in the following accounting identity, used to record the international balance
of payments:
Net Current Account = Net Capital Account
[(Exports-Imports) + Net Unilateral = [(Private Capital Outflow-Inflow) +
Transfers]
Change in Foreign Exchange Reserves]
Thus, anytime net exports (exports less imports) or net private capital inflows
(private capital inflows less outflows) increase, foreign exchange reserves must
increase by an equivalent amount to maintain the exchange rate peg. This is the
current situation for the Chinese central bank. At the prevailing exchange rate peg,
there is excess demand for yuan (equivalently, excess supply of dollars). For the
central bank to maintain the peg, it must increase its foreign reserves by buying
dollars from the public in exchange for newly printed yuan. As seen in Table 1,
foreign reserves grew from $22 billion in 1993, to $168 billion in 2000, to $610
billion at year-end 2004. About half of these reserves, at a minimum, are non-U.S.
assets.5 China’s foreign exchange holdings rose by 39% in 2003 (over the previous
5 Only data on overall Chinese foreign reserves are publicly available. Data are not
available to determine how much of the increase in foreign reserves comes from the
accumulation of assets of other countries (e.g., Japan or the Euro area). If the increase in
foreign reserves came from the purchase of non-U.S. assets, the increase would play no role
in the defense of the exchange rate peg. By comparing Chinese foreign reserve data to data
reported by the U.S. Treasury on total U.S. assets purchased by China (from private and
official sources), an upper bound of China’s reserves held in U.S. securities is $194.5 billion
of U.S. Treasury securities at the end of 2004 and $88 billion of U.S. agency debt in June
2003. Therefore, at least half of the central bank’s holdings were not U.S. assets. The upper
bound is probably too high since it assumes all U.S. assets were bought by the central bank.
Source: U.S. Treasury “Report on Foreign Portfolio Holdings of U.S. Securities,” June
(continued...)

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CRS-4
year) and by 51.2% in 2004. As long as the Chinese are willing to accumulate dollar
reserves, they can continue to maintain the peg.6 Rather than hold U.S. dollars,
which earn no interest, the Chinese central bank mostly holds U.S. financial
securities — primarily U.S. Treasury securities, but also likely U.S. Agency securities
(e.g., the obligations of Fannie Mae and Freddie Mac).
Table 1. China’s Foreign Exchange Reserves
and Overall Current Account Surplus: 1990-2004
Current Account
Cumulative Foreign Exchange Reserves
Balance
Year
billions of $
% of GDP
% of imports
billions of $
1990
29.6
7.6
54.9
11.9
1991
43.7
10.8
68.4
13.1
1992
20.6
4.3
25.2
6.2
1993
22.4
3.7
21.6
-11.7
1994
52.9
9.8
45.8
6.5
1995
75.4
10.8
57.1
1.3
1996
107.0
13.1
77.1
5.6
1997
142.8
15.9
100.4
32.5
1998
149.2
15.8
106.4
31.2
1999
157.7
15.9
95.1
21.1
2000
168.3
15.6
74.8
20.5
2001
215.6
18.1
88.5
17.5
2002
291.1
23.5
98.6
35.4
2003
403.3
28.1
97.7
31.4
2004
609.9
38.5
108.6
58.7
Source: Economist Intelligence Unit and International Monetary Fund.
Note: Data for 2004 are estimates.
But maintaining a peg is not the only reason the Chinese government could be
accumulating foreign exchange reserves. Foreign exchange reserves are necessary
to finance international trade (in the presence of capital controls) and to fend off
5 (...continued)
2003; U.S. Treasury International Capital System.
6 If the demand for yuan relative to dollars were to decline, the central bank would face the
opposite situation. It would need to buy yuan from the public in exchange for U.S. dollars
to maintain the peg. This strategy could only be continued until the central bank’s dollar
reserves were exhausted, at which point the peg would have to be abandoned.

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CRS-5
speculation against one’s currency. One would expect a country to increase its
foreign reserves for these purposes as its economy and trade grew. However, Table
1 illustrates that the increase in foreign exchange reserves in China has significantly
outpaced the growth of GDP or imports in the last couple of years.
Economic activity, including the level of imports and exports, is not determined
by the nominal exchange rate, but by the real (inflation-adjusted) exchange rate.
Because the United States and China have had roughly similar increases in the
overall price levels in the past 10 years (29% in China vs. 24% in the United States),
the difference between the real and nominal rate has been small between 1994 and
2003. However, China had much higher inflation than the United States from 1994-
1997, so the real and nominal exchange rates diverged considerably during that time.
The real exchange rate appreciated from China’s perspective, making their exports
more expensive and U.S. imports cheaper. Since then, the real and nominal
exchange rates have converged because China’s inflation rate has been lower than
U.S. inflation in the past few years. This can be seen in Figure 1. In 2003, the
Chinese exchange rate reached its lowest level since 1994 in real terms, from the
Chinese perspective, making their exports progressively less expensive since 1997.7
However, inflation was higher in China than the U.S. in 2004, so their real exchange
rate slightly appreciated from its 2003 value.
Figure 1. Real and Nominal China-U.S. Exchange Rate
11
10
Real Exchange
9
Rate
/$
n
8
a
Nom inal
yu
7
Exchange Rate
6
4
5
6
8
0
1
3
199 199 199 1997199 1999200 200 2002200 2004

Source: CRS calculations based on IMF data.
Note: Real exchange adjusted for inflation using the consumer price index, based on 2000 prices.
7 Some commentators have suggested that the extent of yuan undervaluation can be
estimated from inflation differentials. In other words, although the nominal exchange rate
has been constant, adjusting for inflation can determine how much the real rate has
depreciated, and proves that the yuan is undervalued. The problem with this approach is
that the estimate will be highly sensitive to the selection of the base year. For example, if
the base year was 1996, the yuan would have been undervalued by 14% in 2002, but if the
base year was 1994, the yuan would have been overvalued by 5% in 2002. The current
account balance was close to zero (one definition of equilibrium) in both years.

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CRS-6
In the long run, real (inflation-adjusted) exchange rates return to their market
value whether they are (nominally) fixed or floating. Imagine that the demand for
Chinese goods and services were to increase. If the yuan were floating, it would
appreciate, as more yuan were acquired to purchase Chinese goods. It would
continue to appreciate until the excess demand for Chinese goods was exhausted
(since they are now more expensive in terms of foreign currency), at which point the
trade balance would return to its equilibrium level. With a fixed exchange rate, the
real exchange rate returns to its market value through price adjustment instead, which
takes time. If the exchange rate were fixed below the level that would prevail in the
market, Chinese exports would be relatively inexpensive and U.S. imports would be
relatively expensive. As long as this situation prevailed, the trade surplus with the
United States would persist. The trade surplus (plus net remittances) is equal to the
capital flowing from China to the United States. Part of this capital consists of the
purchase of U.S. assets by private Chinese citizens. The other portion consists of the
accumulation of dollar reserves by the Chinese central bank. By increasing its dollar
reserves, the central bank is also increasing the supply of yuan. This causes the
inflation rate in China to rise, all else equal.8 Over time, as prices rise, exports will
become more costly abroad and imports less costly. At that point, the trade surplus
will return to its equilibrium value. Although the nominal exchange rate never
changed, because of the rise in prices, the real exchange rate would now equal the
market rate that would prevail if the exchange rate had been floating. Thus,
undervaluing a fixed exchange rate does not confer any permanent competitive
advantage for a country’s exporters and import-competing industries. However,
because price adjustment takes time, floating exchange rates return to the real market
value much more quickly than fixed exchange rates.
Pros and Cons of a Peg. Fixed exchange rates have a long history of use,
including the Bretton Woods system linking the major currencies of the world from
the 1940s to the 1960s and the international gold standard before then. There is little
consensus among economists and policymakers whether floating or fixed exchange
rates are preferable. Both systems, and the many hybrid systems in between, have
their advantages and disadvantages. Furthermore, since countries differ so
significantly in their economic and demographic conditions, an exchange rate regime
8 The Chinese can try to offset the upward pressure on prices by selling Chinese government
securities to take the additional yuan out of circulation (called “sterilized intervention”).
But this will push interest rates back up, attracting more foreign capital to China, causing
the central bank’s dollar reserves and the supply of yuan to expand again. It is difficult to
tell whether the Chinese have sterilized their foreign reserve accumulation in recent years.
All else equal, if China sterilized its intervention, the growth rate of the money supply and
the inflation rate would not rise. The growth rate of one measure of the Chinese money
supply, M2, accelerated in both 2001 and 2002. The growth rate of another measure, M1,
decelerated in 2001 but accelerated in 2002. Inflation was very low through 2003, but rose
to 3.9% in 2004. However, inflation and money growth could have been affected by factors
other than reserve accumulation in recent years. It has been argued that sterilization is an
“unfair” practice to use with a peg, since it is meant to prevent the price adjustment that
brings trade between the two countries back into equilibrium.

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CRS-7
that suits one country may be unsuitable for another. Economists identify two main
advantages, one economic and one political, to a fixed exchange rate.9
Economically, a fixed exchange rate provides stability between the country and
the partner to which it is linked. This reduces risk and uncertainty in the price of
goods, services, and capital between the two countries, thereby fostering greater trade
and capital integration between the two. China’s focus on attracting foreign direct
investment makes stability particularly appealing. The drawback to greater stability
is less policy flexibility for the country maintaining the peg, in this case China, to use
monetary and fiscal policy to offset changes in the business cycle (the U.S. loses no
policy flexibility from China’s peg). For example, a peg would prevent a country
from lowering its interest rates to offset an economic downturn. If it did, capital
would flow out of the country to assets with higher interest rates in the rest of the
world, and the country would find its currency peg under pressure (since investors
would sell the country’s currency and buy foreign currency to transfer their capital
abroad) until it raised its interest rates.
This loss of flexibility is relatively unimportant for small countries that fix their
exchange rate to large neighbors that share the same business cycle, since the large
neighbor would also likely be affected by the downturn and lower its interest rates.
But the loss in flexibility is costly when a country is tied to a partner to whom it is
not closely linked and does not experience similar business cycles, as is arguably the
case between the United States and China.
However, China mitigates the loss of flexibility that a country with a fixed
exchange rate would normally experience through its use of capital controls (legal
barriers restricting access to foreign currency). The currency is convertible on a
current account basis (such as for trade transactions), but not on a capital account
basis (for various types of financial flows, such as portfolio investment). In addition,
nearly all Chinese enterprises are required to turn over their foreign currency holdings
to China’s state bank in exchange for yuan, and purchases of foreign exchange by
individuals and firms in China are closely regulated. Because capital cannot easily
leave China when interest rates are lowered, China retains some flexibility over its
monetary and fiscal policy despite the fixed exchange rate. Another drawback to
fixed exchange rates is the possibility of speculative attacks if investors believe that
the central bank is unable to defend the peg. Capital controls also decrease the
likelihood of speculative attacks, which have been a major proximate cause of
economic crisis in developing countries in recent years, including Southeast Asia,
Argentina, and Turkey.10
Politically, a fixed exchange rate is seen as a way to enhance the credibility of
a country’s monetary authorities by “tying its hands.” Since a fixed exchange rate
limits a country’s use of discretionary monetary policy, the country is no longer as
9 For more information, see CRS Report RL31204, Fixed Exchange Rates, Floating
Exchange Rates, and Currency Boards: What Have We Learned? by Marc Labonte.
10 For detailed information and a time line on Chinese capital controls, see Eswar Prasad and
Shang-Jin Wei, “The Chinese Approach to Capital Inflows: Patterns and Possible
Explanations,” IMF working paper 05/79, April 2005.

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CRS-8
free to abuse its monetary discretion. Notably, the country is less able to use
inflationary monetary policies to stimulate the economy for short-term gain or to
finance government spending that has not been financed through tax revenues. Many
developing countries with a history of high inflation adopt fixed exchange rates as
a way to “break with the past.” Once credibility has been established through many
years of price stability, the credibility rationale for a fixed exchange rate becomes less
important. China’s inflation rate never rose higher than 2.8% between 1997 and
2003 (and in some years was negative), and has never exceeded 24.1% (1994) since
its transition to a market economy beginning in the late 1970s. Inflation rose to 3.9%
in 2004, fueled in part by speculation in real estate, over-investment in certain
industries, and rising costs for energy and raw materials. In response, the Chinese
Central Bank in October 2004 raised its one year lending rate by a 0.27 percentage
point, the first rate hike by the bank in more than nine years.
Fixed exchange rates do not have to be kept constant when economic conditions
change; they can be revalued and then fixed at a new rate. Frequent revaluation,
however, diminishes the economic benefit of stability and the political benefit of
credibility (particularly when the exchange rate is devalued, or revalued downward),
which could increase the likelihood of future speculation against the currency.
A Critique of Various Estimates of the Yuan’s Undervaluation
Although it is certain that the yuan would appreciate if the central bank were not
increasing its foreign reserves, there is no direct way to determine how much it would
appreciate. Estimates of the extent of the yuan’s undervaluation have been cited in
many articles and interviews. This report attempts to evaluate only those estimates
in which the author explains how the estimate was derived. It should be noted that
many of the estimates were made some time ago, so the yuan may be more or less
undervalued at this point than when the estimates were made.
Ernest Preeg, senior fellow at the Manufacturers’ Alliance, estimates that the
yuan is undervalued by 40%.11 While this claim is not based on any formal analysis,
he uses several rule-of-thumb estimates to reach this conclusion. His first
observation is that the increase in Chinese foreign exchange reserves equaled 100%
of the Chinese trade surplus less net foreign direct investment (FDI) flows in the first
six months of 2002. He concludes that the entire trade surplus less net foreign direct
investment would be zero in the absence of the increase in foreign exchange reserves.
His second observation is a rule-of-thumb estimate that a 1% decline in the dollar
leads to a $10 billion decline in the trade deficit in the United States He then
observes that the dollar would need to decline by 40% according to that rule of thumb
to eliminate the trade deficit since the U.S. trade deficit equaled about $400 billion
in 2002. Since the Chinese trade surplus plus net FDI flows equaled 100% of the
increase in foreign exchange reserves, he concludes that if the central bank no longer
11 Ernest H. Preeg, “Exchange Rate Manipulation to Gain an Unfair Competitive Advantage:
The Case against Japan and China,” in C. Fred Bergsten and John Williamson, eds., Dollar
Overvaluation and the World Economy (Washington, DC: Institute for International
Economics, 2003).

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CRS-9
increased its foreign exchange reserves by letting the yuan float, the surplus less FDI
would be zero and the yuan would appreciate by 40%, based on the U.S. ratio.
The Institute for International Economics (IIE) estimates that the yuan is 15-
25% undervalued. It argues that the “underlying” current account surplus was 2.5-
3% of GDP, larger than the actual surplus (1.5%) (it does not explain why).12 They
then argue that the surplus should be reduced by $50 billion (or 4% of GDP) to return
to equilibrium, which would leave China with a deficit of 1-1.5% of GDP in
equilibrium. They believe that the revaluation required to achieve this reduction in
the current account surplus is unusually large because of the extensive use of imports
in the production of Chinese exports. IIE Fellow Morris Goldstein testified that
These estimates of [yuan] misalignment can be obtained either by solving a trade
model for the appreciation of the RMB that would produce equilibrium in
China’s overall balance of payments, or by gauging the appreciation of the RMB
that make a fair contribution to the reduction in global payment imbalances,
especially the reduction of the U.S. current-account deficit to a more sustainable
level.13
Goldman Sachs Economic Research Group has estimated that the yuan is 9.5-
15% undervalued.14 They argue that the current account less FDI should be zero in
equilibrium (which means that China would have a current account deficit equal to
FDI), which could be accomplished with a 9.5-15% revaluation. This is based on
their elasticity estimates that exports would fall 0.2% and imports would rise 0.5%
when the exchange rate rose 1%.
All three of these estimates are based on a similar logic, so a few general
observations can be made about all of them. A shortcoming of all of the estimates
is that they are not the product of theoretically grounded, econometrically estimated
economic models. Rather, they are “back of the envelope” estimates based on a few
simple “rule of thumb” assumptions. “Rules of thumb” such as the Preeg 10%-$1
billion estimate or the Goldman Sachs import and export elasticities may not be
accurate over time or over large changes in the exchange rate.
The main source of contention in all of the estimates of the yuan’s
undervaluation is the definition of an “equilibrium” current account balance. All
three estimates are defined as the appreciation that would be required for China to
attain “equilibrium” in the current account balance. But there is no consensus based
on theory or evidence to determine what equilibrium would be; rather, the authors
12 According to the data cited elsewhere in this report, the actual surplus in 2002 was 2.9%
of GDP and 2.2% in 2003.
13 Morris Goldstein, testimony before the Subcommittee on Domestic and International
Monetary Policy, Committee on Financial Services, U.S. House of Representatives, Oct. 1,
2003.
14 Jim O’Neill and Dominic Wilson, How China Can Help the World, Goldman Sachs
Global Economics Paper 97, Sept. 17, 2003.

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CRS-10
base equilibrium on their own personal opinion.15 Some economists argue that
current account balance would always be close to zero in equilibrium, but this
neglects the fact that countries with different saving and investment rates may
willingly lend to and borrow from one another for long periods of time.
In fact, all three estimates use an assumption of equilibrium less favorable to
China than current account balance. These studies actually call for balance only in
official and portfolio borrowing. They still allow for foreign direct investment (FDI)
inflows, which means their estimate of China’s overall “equilibrium” current account
position is actually a deficit. If they had chosen balance (the traditional
“equilibrium” measure with a fixed exchange rate) instead of a deficit as their
equilibrium benchmark, their estimates of the yuan’s undervaluation would have
been smaller. Even if portfolio flows are essentially limited by capital controls at
present, it is not clear why requiring the Chinese to borrow from the rest of the world
is any less unsustainable than the current arrangement where China is lending to the
rest of the world. With capital controls and net FDI inflows, increasing foreign
reserves is the only way that China can keep its net foreign indebtedness from
increasing. And all three measures rule out any accumulation of foreign official
reserves for reasons other than to influence the exchange rate.
It is particularly difficult to determine the equilibrium current account balance
in China because of the current presence of capital controls. If China were to
maintain capital controls after currency reform (if, for example, they revalued the peg
rather than let the yuan float), current account balance may be a reasonable
assumption. But if capital controls were eliminated, as is typically the case with a
floating exchange rate, the economic situation would change entirely —
“equilibrium” could now involve persistent borrowing from or lending to the rest of
the world by private Chinese citizens, which would result in a corresponding
persistent trade deficit or surplus, respectively. If private citizens lent as much to the
United States in equilibrium as the Chinese central bank is currently lending (and
U.S. lending to China remained unchanged), then the equilibrium market exchange
rate would be equal to the current fixed rate, and the trade deficit would remain
unchanged. If private capital outflows exceeded the current increase in foreign
reserves, the yuan would depreciate. Since China is a country with both a high
national saving rate and a high investment rate, it is not clear whether China would
be a net borrower (in which case it would run a current account deficit) or lender
(current account surplus) if their currency floated and capital controls were abolished.
This issue is particularly relevant when the equilibrium exchange rate is defined as
“market determined,” since capital controls currently prevent portfolio investment
flows from being market determined. Bosworth argues that China’s high internal
saving rate is more than sufficient to finance its investment, so it makes sense for
China to offset FDI inflows with official outflows in the form of foreign reserve
15 A thorough attempt to estimate exchange rates according to this method can be found in
John Williamson, ed., Estimating Equilibrium Exchange Rates (Washington, DC: Institute
for International Economics, 1994).

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CRS-11
accumulation rather than run a current account deficit. Therefore, he argues, foreign
reserve accumulation should not be considered proof of undervaluation.16
IIE and Preeg also base their analysis on their belief that the U.S. trade deficit
is unsustainable, and revaluing the yuan would reduce it. If trade and financial
markets are rational over the medium run, then the value of the dollar and the size of
the trade deficit are never unsustainable — if they were, investors would be unwilling
to hold U.S. assets and would sell the dollar, and the trade deficit would decline.
There is no widely accepted theoretical approach to determining trade deficit
sustainability, and prima facie evidence does not suggest the U.S. trade deficit is
unsustainable — it has lasted several years, it did not prevent the U.S. economy from
achieving record growth and low unemployment in the late 1990s, U.S. investment
income paid to foreigners is not large, and there have not been any unusually large
or sudden declines in the dollar since the trade deficit emerged.17
Furthermore, if the Chinese central bank stopped buying U.S. assets, and hence
reduced its bilateral trade deficit with the United States, it is not clear that the overall
U.S. trade deficit would fall by a corresponding amount. Other foreigners would still
be free to lend to the United States, which could cause its other bilateral trade deficits
to widen. Thus, it is not clear that a “fair share” of a reduction in the U.S. trade
deficit can be apportioned to the Chinese. On the other hand, if China’s overall trade
surplus were eliminated, it might still run a bilateral trade surplus with the United
States. Even countries with overall trade deficits, including the United States, have
some trading partners with whom they run surpluses and some with whom they run
deficits.
There are additional criticisms of the Preeg estimate. First, Preeg’s conversion
of the rule of thumb from dollar terms to percentage of the total trade deficit is
without justification. His conversion implies that if the U.S. trade deficit were $1,
a 40% decline in the dollar would lower the deficit by $1. By that logic, if the trade
deficit were $1 trillion, a 40% decline in the dollar would lower the deficit by $1
trillion. Clearly, a 40% decline in the dollar cannot have such different effects on the
trade deficit simply because the dollar value of the trade deficit has changed. Second,
Preeg applies his estimate based on U.S. data to the Chinese trade surplus without
any supporting evidence. Since the United States and China have different
economies, trading patterns, trade balances, and exchange rate regimes, there is no
reason to think the estimate would be the same for both countries. He also uses
overall and bilateral trade balances interchangeably. There is no reason to think that
a 40% decline in the dollar would have the same effect on a $400 billion U.S. overall
16 Barry Bosworth, “Valuing the Renminbi,” paper presented at Tokyo Club Research
Meeting, February 9-10, 2004.
17 Sensible rules of thumb for long-term sustainability, such as estimating the current
account deficit that would keep U.S. assets a constant share of foreign investment portfolios,
need not hold in the short run. For instance, after a change in fundamentals, current account
deficits may persist for several years as the United States transitions to a new steady state.

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CRS-12
trade deficit (from which he does not subtract FDI) as a 40% decline in the yuan
would have on a $60 billion bilateral Chinese trade surplus less FDI.18
Does international experience suggest what the Chinese current account balance
would be in equilibrium? The closest comparison is probably to other East Asian
countries, which also grew rapidly and maintained high saving rates in recent
decades. The experience of these countries is mixed. From 1980 to 1997, Korea,
Malaysia, Philippines, Indonesia, and Thailand typically ran current account
deficits, while Hong Kong, Singapore, Taiwan, and Japan (which had already
industrialized) typically ran current account surpluses. Since the Asian financial
crisis in 1997, all of these countries have run large current account surpluses. This
may suggest that the current economic environment is not conducive to developing
world borrowing. As seen in Table 2, the same combination of large foreign
exchange reserves and a large current account surplus can be seen in several other
countries in the region, even though these countries range in their exchange rate
regimes from a float (Japan and South Korea) to a currency board (Hong Kong).
Table 2. Foreign Exchange Reserves and Current Account
Balance in Selected Asian Countries, 2004
($ billions and as percent of GDP)
Foreign Exchange Reserves
Current Account Surplus
billions of $
% of GDP
billions of $
% of GDP
Japan
833.9
17.9%
172.1
3.7%
China
609.9
38.6%
58.7
3.7%
Taiwan
241.7
79.2%
18.9
6.2%
South Korea
199.0
30.4%
27.6
4.1%
Hong Kong
123.5
77.4%
13.0
8.1%
Source: Economist Intelligence Unit estimates and official Chinese data.
There are two other estimates of the yuan’s undervaluation based on the theory
of purchasing power parity (PPP), the theory that the same good should have the
same price in two different countries. If it did not, then arbitrageurs could buy it in
the cheaper country and sell it in the more expensive country until the price disparity
disappeared. While this simple idea is powerful in theory, it has been proven to be
unreliable in reality: prices are consistently lower in developing countries than
industrialized countries. Economist Jeffrey Frankel argues that income level can be
regressed on the exchange rate using a cross-sample of countries to find a predictable
18 On the basis of the data used in this report, the bilateral trade surplus less FDI equaled
about $50 billion, rather than $60 billion, in 2002, and China’s overall trade balance less
FDI equaled a deficit of about $15 billion.

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CRS-13
relationship between a country’s income level and its equilibrium exchange rate
based on PPP. By this measure, he estimates that China’s exchange rate was
undervalued by 36% in 2000.19 Newer data is not available, but he speculates that,
if anything, the undervaluation has increased since then. He acknowledges a number
of caveats to this analysis. First, PPP only holds over the long run, at best, and
financial flows can cause even market-determined exchange rates to significantly
diverge from PPP for several years. Second, the regression does not control for other
factors and only explains 57% of the variation in the data. Third, Frankel argues that
any adjustment in the exchange rate should be gradual so as not to be economically
disruptive. He also warns that “It is not even true that an appreciation of the
renminbi against the dollar would have an immediately noticeable effect on the
overall U.S. trade deficit or employment...”20
Another frequently cited estimate of the yuan’s undervaluation is based on the
Economist magazine’s Big Mac Index, which estimated that China’s currency was
undervalued by 58% in December 2004.21 The Economist portrays the Big Mac
Index as a “light hearted guide” to exchange rates, and there are important drawbacks
to relying too heavily on it. Based on the theory of purchasing power parity, the Big
Mac Index compares the price of a McDonald’s Big Mac in China to the United
States. Since a Big Mac in China was 56% cheaper than in the United States, the
index concludes that the yuan is undervalued by that much. But purchasing power
parity only applies to tradeable goods, and a Big Mac is not tradeable. In fact, Ong
estimates that 94% of the value of a Big Mac comes not from the hamburger itself,
but the services associated with the hamburger.22 These include the wages of
employees serving the Big Mac and the rent of the restaurant in which it is eaten,
both of which are determined by local factors. Since the hamburger itself is the only
tradeable portion of the Big Mac, only a small fraction of the Big Mac’s value should
be determined by purchasing power parity. As a result, a Big Mac in New York City
is more expensive than a Big Mac purchased in the U.S. rural south. Taken literally,
the Big Mac Index would imply that a dollar in the rural south is undervalued
compared to a dollar in New York City.
Trends and Factors in the U.S.-China Trade Deficit
Critics of China’s currency peg often point to the large and growing U.S.-China
trade imbalance as proof that the yuan is significantly undervalued and constitutes an
attempt to gain an unfair competitive advantage over the United States in trade.
However, bilateral trade balances reflect structural causes as well as exchange rate
19 Bosworth points out that, by this measure, the Indian rupee is even more undervalued, yet
few people make that argument. Bosworth, Op Cit.
20 Jeffrey Frankel, “On the Renminbi: The Choice Between Adjustment Under a Fixed
Exchange Rate and Adjustment Under a Flexible Exchange Rate,” National Bureau of
Economic Research, working paper 11274, April 2005, p. 3.
21 Economist, “Economic and Financial Indicators,” December 18, 2004, p. 194.
22 Li Ong, “Burgernomics: The Economics of the Big Mac Standard,” Journal of
International Money and Finance, vol. 16, no. 6 (December 1997), p. 865.

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CRS-14
effects. There are a number of other factors at work that are also important to
consider when analyzing the bilateral trade deficit.
First, although China had (according to U.S. statistics) a $162 billion
merchandise trade surplus with the United States in 2004, its overall trade surplus
was much smaller, only $32 billion (Chinese data), indicating that China had a trade
deficit of $130 billion in its trade with the world excluding the United States.23 In
comparison, Japan in 2004 had a $75.2 billion trade surplus with the United States
(U.S. data) and $110.5 billion overall trade surplus (Japanese data), indicating that
Japan had a trade surplus of $35.3 billion with the world excluding the United States.
Second, there is strong evidence to suggest that a significant share of the
growing level of imports (and hence U.S. trade deficit) from China is coming from
export-oriented multinational companies (including U.S. firms24) that have moved
their production facilities to China to take advantage of China’s abundant low-cost
labor (among other factors). Chinese data indicate that the share of China’s exports
produced by foreign-invested enterprises (FIEs) in China has risen dramatically over
the past several years. As indicated in Table 3, in 1986, only 1.9% of China’s
exports were from FIEs, but by 1996, this share had risen to 40.7% and by 2004 it
had risen to 57%. A similar pattern can be seen with imports: FIEs accounted for
only 5.6% of China’s imports in 1986, rose to 47.9% by 2000, and to 58.0% in 2004.
The sharp rise in the share of China’s trade by FIEs appears to be strongly linked
to the rapid growth in foreign direct investment (FDI) in China, which grew from
$1.9 billion in 1986 to $64.0 billion in 2004, much of which went to export-oriented
manufacturing, a large share of which was exported to the United States.25 Data in
Table 3 indicate that the U.S. trade deficit with China began to increase rapidly
beginning in the early 1990s, roughly the same time that saw a significant rise in FDI
in China and a sharp rise in exports by FIEs. By comparing exports and imports in
Table 3, one can see that FIEs have little effect on China’s overall trade balance,
since the FIEs import roughly as much as they export.
23 U.S. and Chinese data on their bilateral trade differ substantially, due mainly to how each
side counts Chinese exports and imports that are transshipped through Hong Kong. China
counts most of its exports that go to Hong Kong but are later re-exported to the United
States as Chinese exports to Hong Kong. As a result, China statistics state that it had a
$80.3 billion trade surplus with the United States in 2004. The United States counts imports
from Hong Kong that originated from China as imports from China, but it often fails to
attribute exports to China that pass through Hong Kong as exports to China. As a result, the
United States and China cannot agree on the actual size of the U.S.-China trade imbalance.
See Robert Feenstra et al., “The U.S.-China Bilateral Trade Balance: Its Size and
Determinants,” NBER Working Paper 6598 (June 1998).
24 The returns to capital of U.S. owned firms in China flow to Americans.
25 About 43% of FDI in China (based on data for 1979 to 2004) has come from Hong Kong.
The United States is the second largest investor in China (at 8.5% of total FDI) followed by
Japan (8.3) and Taiwan (7.0%). See CRS Issue Brief IB91121, China’s Economic
Conditions, by Wayne M. Morrison.

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CRS-15
Table 3. Exports and Imports by Foreign-Invested Enterprises
in China: 1986-2004
FDI in
Exports by FIE
Imports by FIEs
China
U.S. Trade
Deficit
As a % of
As a % of
With
Total
Total
China
$ billions
$ billions
$ billions
Chinese
Chinese
($ billions)
Exports
Imports
1986
1.9
$0.6
1.9%
$2.4
5.6%
-$1.7
1987
2.3
1.2
3.1
3.4
7.8
-2.8
1988
3.2
2.5
5.2
5.9
10.6
-3.5
1989
3.4
4.9
9.4
8.8
19.9
-6.2
1990
3.5
7.8
12.6
12.3
23.1
-10.4
1991
4.4
12.0
16.8
16.9
36.5
-12.7
1992
11.0
17.4
20.4
26.4
32.7
-18.2
1993
27.5
25.2
27.5
41.8
40.2
-22.8
1994
33.8
34.7
28.7
52.9
45.8
-29.5
1995
37.5
46.9
31.5
62.9
47.7
-33.8
1996
41.7
61.5
40.7
75.6
54.5
-39.5
1997
45.3
74.9
41.0
77.7
54.6
-49.7
1998
45.4
81.0
44.1
76.7
54.7
-56.9
1999
40.3
88.6
45.5
85.9
51.8
-68.7
2000
40.7
119.4
47.9
117.2
52.1
-83.8
2001
46.9
133.2
50.0
125.8
51.6
-83.1
2002
52.7
169.9
52.2
160.3
54.3
-103.1
2003
53.5
240.3
54.8
231.9
56.0
-124.0
2004
64.0
338.2
57.0
305.6
58.0
-162.0
Source: China’s Customs Statistics and U.S. International Trade Commission Dataweb.
FIEs import raw materials and components (much of which come from East
Asia) for assembly in China. As a result, China tends to run trade deficits with East
Asian countries and trade surpluses with countries with high consumer demand, such
as the United States.26 These factors have led many analysts to conclude that much
of the increase in U.S. imports (and hence, the rising U.S. trade deficit with China)
26 According to Chinese data, China’s largest trading deficits in 2003 were with Taiwan
($31.5 billion), South Korea ($13.1 billion), and Japan ($5.0 billion).

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CRS-16
is a result of China becoming a production platform for many foreign companies,
(who are the largest benefactors from this arrangement) rather than unfair Chinese
trade policies.27 This suggests a fundamental change in trade between China and the
United States that could affect the bilateral trade deficit independently of the
exchange rate regime.
U.S. trade data strongly suggest that the sharp increase in U.S. imports from
China is largely the result of movement in production facilities from other Asian
countries to China.28 That is, various products that used to be made in Japan,
Taiwan, Hong Kong, etc., and then exported to the United States are now being made
in China (in many cases, by foreign firms in China) and exported to the United
States. An illustration of this phenomenon can be seen in Table 4 on U.S. imports
of computer equipment and parts from 2000-2004. In 2000, Japan was the largest
foreign supplier of U.S. computer equipment (with a 19.6% share of total shipments),
while China ranked 4th (at 12.1%). In just five years, Japan’s ranking fell to 5th, the
value of its shipments dropped by over half, and its share of shipments declined to
8.5% (2004); Singapore and Taiwan also experienced significant declines in their
computer equipment shipments to the United States over this period. In 2004, China
was by far the largest foreign supplier of computer equipment with a 39.9% share of
total shipments. However, while U.S. imports of computer equipment from China
rose by 255% over the past five years, the total value of U.S. imports of these
commodities rose by only 7.9%, indicating in part that several foreign firms have
shifted their production facilities to China.
27 One analyst has estimated that the domestic value-added content of Chinese exports to the
United States by foreign-invested firms in China to be about 20%, while 80% comes from
the value of imported parts that come into China for assembly. As a result, an appreciation
of China’s currency would likely have only a minor effect on China’s exports to the United
States (since the cost of imported inputs would fall as a result). See Testimony of Professor
Lawrence J. Lau before the Congressional-Executive Commission on China, Is China
Playing by the Rules? Free Trade, Fair Trade, and WTO Compliance, hearing, September
24, 2003.
28 Chinese data indicate that the share of China’s exports produced by foreign-invested
enterprises (FIEs) in China rose from 1.9% in 1986 to 54.8% in 2003.

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CRS-17
Table 4. Major Foreign Suppliers of U.S. Computer Equipment
Imports: 2000-2004
(billions of $ and % change)
2000-2004 %
2000
2001
2002
2003
2004
Change
Total
68.5
59.0
62.3
64.0
73.9
7.9
China
8.3
8.2
12.0
18.7
29.5
255.4
Malaysia
4.9
5/0
7.1
8.0
8.7
77.6
Mexico
6.9
8.5
7.9
7.0
7.4
7.2
Singapore
8.7
7.1
7.1
6.9
6.6
-24.1
Japan
13.4
9.5
8.1
6.3
6.3
-53.0
Taiwan
8.3
7.0
7.1
5.4
4.1
-50.6
Source: U.S. International Trade Commission Trade Data Web.
Note: Ranked according to top 6 suppliers in 2004.
Third, productivity gains in Chinese exporting firms have increased rapidly in
the past few years, a boost to exports that is unrelated to the fixed exchange rate. For
example, Chinese export prices have fallen by a cumulative 27% since 1995 in
Chinese prices.
Fourth, the sharp rise in the U.S. trade deficit with China diverts attention from
the fact that, while U.S. imports from China have been rising rapidly, U.S. exports
to China have been increasing sharply as well. Table 5 lists annual percentage
change in U.S. exports to its top 10 trading partners and to the world for the period
2000-2004. These data indicate that U.S. exports to China have risen more sharply
than total U.S. exports to the world and more than any other top 10 U.S. trading
partners. China was one of the only significant export markets that has grown during
the world wide economic downturn in 2001 and 2002. During this period, total U.S.
exports declined by 6.3% and 5.2%, while U.S. exports to China rose by 18.4% and
14.6%, respectively. In 2004, total U.S. exports rose by 12.8%, while those to China
rose by 22.2%. From 2000-2004, total U.S. exports rose by 4.6%, while those to
China grew by 112.9%. China also went from being the 11th largest U.S. export
market in 2000 to its 5th largest market in 2004.29 China’s rapid economic growth
and implementation of its WTO commitments is likely to result in continued rapid
growth in U.S. exports to China.30
29 In 2000, 2.1% of total U.S. exports went to China; this share increased to 4.2% in 2004.
30 However, obtaining full compliance with China’s WTO commitments to date has been a
problem for the United States. See CRS Issue Brief IB91121, China-U.S. Trade Issues, by
Wayne M. Morrison.

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CRS-18
Table 5. Percentage Annual Change in U.S. Exports
to Top Ten U.S. Export Markets: 2000-2003
2000-2004
Year
2000
2001
2002
2003
2004
Overall
Change
Canada
7.6
-7.2
-1.8
5.4
10.8
6.4
Mexico
28.3
-9.1
-3.9
-0.1
13.7
-0.8
Japan
13.5
-11.7
-10.8
1.2
4.5
-16.7
United Kingdom
8.5
-1.9
-18.5
1.9
6.1
-13.1
China
23.9
18.4
14.6
28.9
22.2
112.9
Germany 9.2
3.0
-11.6

8.3
8.8
7.5
South Korea
21.6
-20.4
1.8
6.7
9.3
-5.7
Netherlands
13.2
-11.1
-6.1
12.9
17.3
10.5
Taiwan
27.5
-25.5
1.3
-11.7
24.3
-11.1
France 7.5
-1.8
-4.4
-10.3
24.4
4.4
The World
12.6
-6.3
-5.2
4.4
12.8
4.6
Source: United States International Trade Commission Dataweb.
Note: Listed according to the top 10 U.S. export markets in 2004.
Economic Consequences of China’s Currency Peg
If the yuan is undervalued against the dollar, as many critics charge, then there
are benefits and costs of this policy for the economies of both China and the United
States.
Implications of the Peg for China’s Economy
If the yuan is undervalued, then Chinese exports to the United States are likely
cheaper than they would be if the currency were freely traded, providing a boost to
China’s export industries (which employ millions of workers and are a major source
of China’s productivity gains). Eliminating exchange rate risk through a peg also
increases the attractiveness of China as a destination for foreign investment in export-
oriented production facilities, much of which comes from U.S. firms. However, an
undervalued currency makes imports more expensive, hurting Chinese consumers
and Chinese firms that import parts, machinery, and raw materials. Such a policy,
in effect, benefits Chinese exporting firms (many of which are owned by foreign
multinational corporations) at the expense of non-exporting Chinese firms, especially
those that rely on imported goods. This may impede the most efficient allocation of
resources in the Chinese economy.

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CRS-19
The accumulation of large foreign exchange reserves by China may make it
easier for Chinese officials to move more quickly toward adopting a fully convertible
currency (if the government feels it could defend the currency against speculative
pressures). However, the accumulation of large foreign exchange reserves (which
reached $610 billion in December 2004) also entails opportunity costs for China:
such funds (instead of sitting in the central bank) could be used to fund China’s
massive development needs, such as infrastructure improvements, that may have a
higher rate of return than U.S. Treasuries.
Implications of the Peg for the U.S. Economy
Effect on Exporters and Import-Competitors. When a fixed exchange
rate causes the yuan to be less expensive than it would be if it were floating, it causes
Chinese exports to the United States to be relatively inexpensive and U.S. exports to
China to be relatively expensive. As a result, U.S. exports and the production of U.S.
goods and services that compete with Chinese imports fall, in the short run.31 Many
of the affected firms are in the manufacturing sector, as will be discussed below.
This causes the U.S. trade deficit to rise and reduces aggregate demand in the short
run, all else equal.32
China has become the United States’s second largest supplier of imports (2004
data). A large share of China’s exports to the United States are labor-intensive
consumer goods, such as toys and games, textiles and apparel, shoes, and consumer
electronics. Many of these products do not compete directly with U.S. domestic
producers — the manufacture of many such products shifted overseas several years
ago. However, there are a number of U.S. industries (many of which are small and
medium-sized firms), including makers of machine tools, hardware, plastics,
furniture, and tool and die that are expressing concern over the growing competitive
31 Putting exchange rate issues aside, most economists maintain that trade is a win-win
situation for the economy as a whole, but produces losers within the economy. This view
derives from the principle of comparative advantage, which states that trade shifts
production to the goods a country is relatively talented at producing from goods it is
relatively less talented at producing. As trade expands, production of goods with a
comparative disadvantage will decline in the United States, to the detriment of workers and
investors in those sectors (offset by higher employment and profits in sectors with a
comparative advantage). Economists generally argue that free trade should be pursued
because the gains from trade are large enough that the losers from trade can be compensated
by the winners, and the winners will still be better off. Critics argue that the losses from
free trade are not acceptable as long as the political system fails to compensate the losers
fairly. See CRS Report RL32059, Trade, Trade Barriers, and Trade Deficits: Implications
for U.S. Welfare, by Craig Elwell.
32 On the other hand, over the long run, the fixed exchange rate encourages trade (and
investment) between the two countries by eliminating exchange rate risk. In the long run,
the reduced risk could make both imports and exports higher than under a floating system.

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CRS-20
challenge posed by China.33 An undervalued Chinese currency may contribute to a
reduction in the output of such industries.
On the other hand, U.S. producers also import capital equipment and inputs to
final products from China. For example, U.S. computer firms use a significant level
of imported computer parts in their production, and China was the largest foreign
supplier of computer equipment to the United States in 2004. An undervalued yuan
lowers the price of these U.S. products, increasing their output and competitiveness
in world markets. And many imports from China are produced by U.S.-invested
enterprises (as discussed above), which benefit from an undervalued peg.
Effect on U.S. Borrowers. An undervalued yuan also has an effect on U.S.
borrowers. When the United States runs a current account deficit with China, an
equivalent amount of capital flows from China to the United States, as can be seen
in the U.S. balance of payments accounts. This occurs because the Chinese central
bank or private Chinese citizens are investing in U.S. assets, which allows more U.S.
capital investment in plant and equipment to take place than would otherwise occur.
Capital investment increases because the greater demand for U.S. assets puts
downward pressure on U.S. interest rates, and firms are now willing to make
investments that were previously unprofitable. This increases aggregate spending in
the short run, all else equal, and also increases the size of the economy in the long run
by increasing the capital stock.
Private firms are not the only beneficiaries of the lower interest rates caused by
the capital inflow (trade deficit) from China. Interest-sensitive household spending,
on goods such as consumer durables and housing, is also higher than it would be if
capital from China did not flow into the United States. In addition, a large proportion
of the U.S. assets bought by the Chinese, particularly by the central bank, are U.S.
Treasury securities, which fund U.S. federal budget deficits. According to the U.S.
Treasury Department, China (as of January 2005) held $194.5 billion in U.S.
Treasury securities, making China the second largest foreign holder of such securities
(after Japan). If the U.S. trade deficit with China were eliminated, Chinese capital
would no longer flow into this country on net, and the government would have to
find other buyers of its U.S. Treasuries. This would increase the government’s
interest payments, increasing the budget deficit, all else equal.
Effect on U.S. Consumers. A society’s economic well-being is usually
measured not by how much it can produce, but how much it can consume. An
undervalued yuan that lowers the price of imports from China allows the United
States to increase its consumption of both imported and domestically produced goods
through an improvement in the terms-of-trade. The terms-of-trade measures the
terms on which U.S. labor and capital can be exchanged for foreign labor and capital.
Since changes in aggregate spending are only temporary, from a long-term
33 Testimony of Franklin J. Vargo, National Association of Manufacturers, before the House
Committee on Financial Services, Subcommittee on Domestic and International Monetary,
Trade, and Technology Policy hearing, China’s Exchange Rate Regime and Its Effects on
the U.S. Economy, Oct. 1, 2003.

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CRS-21
perspective the lasting effect of an undervalued yuan is to increase the purchasing
power of U.S. consumers.34
U.S.-China Trade and Manufacturing Jobs. Critics of China’s currency
peg argue that the low value of the yuan has had a significant effect on the U.S.
manufacturing sector, where 2.7 million factory jobs have been lost since July 2000.
While job losses in the U.S. manufacturing sector have been significant in recent
years, there is no clear link between job losses and imports from China. First, only
some manufacturers export to China or compete with Chinese imports. Second, the
economic recession and subsequent “jobless recovery” that ended in August 2003
reduced employment across the entire economy. Third, the “strong dollar” and
growing trade deficit have not been limited to China; the trade-weighted dollar index
was appreciating until early 2002 and the overall trade deficit is still increasing.
Finally, there is a long-run trend that is moving U.S. production away from
manufacturing and toward the service sector.35 U.S. employment in manufacturing
as a share of total nonagricultural employment has fallen from 31.8% in 1960 to
22.4% in 1980 to 12.8% in 2002.36 This trend is much larger than the Chinese
currency issue, and is caused by changing technology (which requires fewer workers
to produce the same number of goods)37 and comparative advantage. With enhanced
globalization, comparative advantage predicts the United States will produce
knowledge- and technology-intensive goods that it is best at producing for trade with
countries, such as China, who are better at producing labor-intensive goods. Since
the production of some manufactured goods is labor-intensive and some services
cannot be traded, trade leads to more manufacturing abroad, and less in the United
States.38 Over time, it is likely that the trend shifting manufacturing abroad will
continue regardless of China’s currency peg.
34 Some commentators have compared the undervalued exchange rate to a Chinese tariff on
U.S. imports. One major difference between a tariff and the peg is that a tariff does not
result in any benefit to U.S. consumers, as the peg does. A more appropriate comparison
might be an export subsidy, which benefits consumers who purchase the subsidized product
at a lower cost, but may harm some domestic firms that must compete against the
subsidized product.
35 See CRS Report RL32350, Deindustrialization of the U.S. Economy, by Craig Elwell. A
thorough analysis of the trend can also be found in Robert Rowthorn and Ramana
Rasmaswamy, Deindustrialization: Its Causes and Implications, Economic Issues 10
(Washington, DC: International Monetary Fund, 1997).
36 Council of Economic Advisers, 2003 Economic Report of the President.
37 Since June 2000, manufacturing output has fallen by 6% (according to the Industrial
Production Index) while manufacturing employment has fallen by 15.7%. Thus,
productivity has increased such that fewer workers are needed to produce a given amount
of output.
38 Lower wages alone do not give China a price advantage relative to the United States. U.S.
workers are much more productive than Chinese workers, and this primarily accounts for
their higher wages. Lower unit labor costs (wages divided by productivity) determine which
country has a price advantage. In labor-intensive industries, China is likely to have lower
unit labor costs; in knowledge-intensive industries, the United States is likely to have lower
unit labor costs.

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CRS-22
The decline in manufacturing employment is not unique to the United States.
According to a study by Alliance Capital Management, employment in
manufacturing among the world’s 20 largest economies declined by 22 million jobs
between 1995 and 2002. At the same time, the study estimated that total
manufacturing production among these economies increased by more than 30% (due
largely to increases in productivity). As indicated in Table 6, while the number of
manufacturing jobs in the United States declined by 1.9 million (or 11.3%) during
this period, they declined in many other industrial countries as well, including Japan
(2.3 million or 16.1%), Germany (476,000 or 10.1%), the United Kingdom (446,000
or 10.3%), and South Korea (555,000 or 11.6%). The study further estimated
employment in manufacturing in China during this period declined by 15 million
workers (from 96 million workers in 1995 to 83 million in 2002), a 15.3%
reduction.39 In the United States and United Kingdom, the employment decline
began in 1999; in the other countries in Table 6, the decline began earlier. In 2004,
the industrialized countries experienced a loss of 865,000 more manufacturing jobs,
and a cumulative 6.3 million manufacturing job losses over the previous five years.40
Table 6. Manufacturing Employment in Selected Countries:
1995 and 2002
(in thousands and percent change)
Manufacturing Employment
Change in Manufacturing
(000)
Employment: 1995/2002
Total Change
Percent
1995
2002
(000)
Change (%)
United States
17,251
15,304
-1,947
-11.3
Japan
14,570
12,230
-2,340
-16.1
Germany
8,439
7,963
-476
-10.1
United Kingdom
4,402
3,956
-446
-10.3
South Korea
4,796
4,241
-555
-11.6
China
98,030
83,080
-14,950
-15.3
Source: Alliance Capital Management L.P., Alliance Bernstein, Manufacturing Payrolls Declining
Globally: The Untold Story, U.S. Weekly Economic Update, October 10, 2003.
39 Alliance Capital, Management L.P., Alliance Bernstein, U.S. Weekly Economic Update,
Manufacturing Payrolls Declining Globally: The Untold Story, by Joseph Carson, October
10, 2003. Note that the study attributes most of the job reductions in China in the
manufacturing sector to increased productivity in China. However, it is likely that the
Chinese government’s restructuring of inefficient state-owned enterprises, and consequent
large-scale layoffs by such firms, was also a major factor.
40 Alliance Capital, Management L.P., Alliance Bernstein, U.S. Weekly Economic Update,
Manufacturing Jobs Still Declining in Industrialized Economies, by Joseph Carson,
February 18, 2005.

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CRS-23
The sharp increases in U.S. imports of manufactured products from China over
the past several years do not necessarily correlate with subsequent production and job
losses in the manufacturing sector. A study by the Federal Reserve Bank of Chicago
estimated that the import penetration by Chinese manufactured products (i.e., the
ratio of imported manufactured Chinese goods to total manufactured goods
consumed domestically) was only 2.7% in 2001.41 The study acknowledged that,
while China on average is a small-to-moderate player in most manufacturing sector
markets in the United States, it has shown a high growth in import penetration over
the past few years, growing by nearly 60% between 1997-2001 (from 1.7% to 2.7%).
However, the study concluded that “the bulk of the current U.S. manufacturing
weakness cannot be attributed to rising imports and outsourcing,” but rather is largely
the result of the economic slowdown in the United States and among several major
U.S. export markets.42
Determining how much of the loss in manufacturing employment is due to
Chinese imports would require sophisticated economic modeling, and is beyond the
scope of this report. But by making a simple calculation, an upper-bound estimate
can be placed on how much manufacturing job loss can be attributable to Chinese
imports to put the issue in perspective. If imports have a one-time effect on U.S.
employment, then the relevant figure is the increase in (not the level of) Chinese
imports over the past couple of years. Between 2000 and 2002, manufacturing
imports from Chinese increased by about $25 billion. At the same time, U.S.
manufacturing exports to China increased by $5 billion. If we assumed that every
additional dollar of Chinese manufacturing imports reduced US manufacturing
output by one dollar - a highly unrealistic assumption - and every additional dollar
of manufacturing exports increased manufacturing output, then trade with China can
account for about a 1.5%, or 0.25 million, decline in manufacturing employment
from 2000 to 2002. Manufacturing employment fell by 11.3%, or 2 million, from
2000-2002, so that trade with China can only explain at most about one eighth of the
total decline in those years. The Chicago Fed study cites two reasons why the actual
figure would be smaller:
! the positive economic effects of low-priced Chinese goods on real
incomes in the United States (which enables consumers to purchase
more goods and services, including those from domestic sources);
and
! the fact that many such products, if they were not made in China,
would be imported from other foreign countries.
In addition, the actual job loss would be smaller because of the expansion in output
of interest-sensitive industries, which include some manufacturing industries, since
the capital inflow from China lowers U.S. interest rates.
41 Federal Reserve Bank of Chicago, Chicago Fed Letter, November 2003.
42 According to the study, U.S. manufactured domestic exports declined by 7.5% in 2001
and by 5.6% in 2002.

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CRS-24
Net Effect on the U.S. Economy. In the medium run, an undervalued yuan
neither increases nor decreases aggregate demand in the United States. Rather, it
leads to a compositional shift in U.S. production, away from U.S. exporters and
import-competing firms toward the firms that benefit from the lower interest rates
caused by Chinese capital inflows. In particular, capital-intensive firms and firms
that produce consumer durables would be expected to benefit from lower interest
rates. Thus, it is expected to have no medium- or long-run effect on aggregate U.S.
employment or unemployment. As evidence, one can consider that the United States
had a historically large and growing trade deficit throughout the 1990s at a time when
unemployment reached a three-decade low and there was no decline in manufacturing
employment. However, the gains and losses in employment and production caused
by the trade deficit will not be dispersed evenly across regions and sectors of the
economy: on balance, some areas will gain while others will lose.
Although the compositional shift in output has no negative effect on aggregate
U.S. output and employment in the long-run, there may be adverse short-run
consequences. If output in the trade sector falls more quickly than the output of U.S.
recipients of Chinese capital rises, aggregate spending and employment could
temporarily fall. If this occurs, then there is likely to be a decline in the inflation rate
as well (which could be beneficial or harmful, depending if inflation is high or low
at the time). A fall in aggregate spending is more likely to be a concern if the
economy is already sluggish than if it is at full employment. Otherwise, it is likely
that government macroeconomic policy adjustment and market forces can quickly
compensate for any decline of output in the trade sector by expanding other elements
of aggregate demand.
By shifting the composition of U.S. output to a higher capital base, the size of
the economy would be larger in the long run as a result of the capital inflow/trade
deficit. U.S. citizens would not enjoy the returns to Chinese-owned capital in the
United States. U.S. workers employing that Chinese-owned capital would enjoy
higher productivity, however, and correspondingly higher wages.
The U.S.-China Trade Deficit in the Context of the Overall U.S.
Trade Deficit. While China is a large trading partner, it accounted for only about
13.4% of U.S. imports in 2004 and 23.0% of the sum of the bilateral trade deficits.
Over a span of several years, a country with a floating exchange rate can run an
ongoing overall trade deficit for only one reason: a domestic imbalance between
saving and investment. This has been the case for the United States over the past two
decades, where saving as a share of gross domestic product (GDP) has been in
gradual decline.43 On the one hand, the United States has high rates of productivity
growth and strong economic fundamentals that are conducive to high rates of capital
investment. On the other hand, it has a chronically low household saving rate, and
recently a negative government saving rate as a result of the budget deficit. As long
as Americans save little, foreigners will use their saving to finance profitable
43 See Congressional Budget Office, Causes and Consequences of the Trade Deficit, March
2000.

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CRS-25
investment opportunities in the United States; the trade deficit is the result.44 The
returns to foreign-owned capital will flow to foreigners instead of Americans, but the
returns to U.S. labor utilizing foreign-owned capital will flow to U.S. labor.
For this reason, economists generally are more concerned with the overall trade
deficit than bilateral trade balances. Because of comparative advantage, it is natural
that a country will have some trading partners from which it imports more, and some
trading partners to which it exports more. For example, the United States has a trade
deficit with Austria and a trade surplus with the Netherlands even though both
countries use the euro, which floats against the dollar. Of concern to the United
States from an economic perspective is that its low saving rate makes it so reliant on
foreigners to finance its investment opportunities, and not the fact that much of the
capital comes from China.45 If the United States did not borrow from China as a
result of the exchange rate peg, it would still have to borrow from other countries.46
Policy Options for the Peg and
U.S. Trade Policy with China

The United States could utilize a number of options to try to induce China to
change its exchange rate policy if U.S. policymakers deemed that such a policy
would promote overall U.S. economic interests.47 Options for currency reform range
from making the yuan fully convertible to keeping the peg but revaluing the yuan
against the dollar by a certain amount to switching to a peg against a basket of
international currencies.48 Options to induce China to reform its exchange rate
regime might include (1) diplomatic efforts to convince China to change the peg; (2)
44 Nations that fail to save enough to meet their investment needs must obtain savings from
other countries with high savings rates. By obtaining resources from foreign investors for
its investment needs, the United States is able to enjoy a higher rate of consumption than it
would if investment were funded by domestic savings alone (although many analysts warn
that America’s low savings rate could be risky to the U.S. economy in the long run). The
inflow of foreign capital to the United States is equivalent to the United States borrowing
from the rest of the world. The only way the United States can borrow from the rest of the
world is by importing more than it exports (running a trade deficit).
45 From a political perspective, some U.S. policymakers have expressed concern over the
high level of U.S. government debt owed to the Chinese government.
46 For more information, see CRS Report RL30534, America’s Growing Current Account
Deficit: Its Cause and What It Means for the Economy, by Marc Labonte and Gail Makinen.
47 As the above discussion implies, appreciating the yuan would likely entail costs and
benefits for the U.S. economy.
48 A middle-of- the road proposal has been made by Morris Goldstein and Nicholas Lardy,
(Institute for International Economics) which would reform China’s peg in two stages.
During the first stage, the yuan would be appreciated by 15-25%, the currency band
expanded to between five and seven percent, and the yuan would be pegged to a basket of
major foreign currencies (the dollar, the yen, and the euro). In the second stage, China
would, once it reformed its financial sector, adopt a managed floating exchange system. See
“Two-Stage Currency Reform for China,” Wall Street Journal, Sept. 12, 2003.

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CRS-26
utilization of U.S. trade laws (such as Section 301 of the 1974 Trade Act, as
amended, used to respond to unfair foreign trade barriers), which might involve the
threat of imposing unilateral trade sanctions against China; and (3) trying to make a
case before the World Trade Organization (WTO) that China’s currency peg violates
multilateral trade rules.
Changes to the Peg and Potential Outcomes
If the Chinese were to allow their currency to float, its value would be
determined by private actors in the market based on the supply and demand for
Chinese goods and assets relative to U.S. goods and assets. If the relative demand
for the Chinese currency has increased since the exchange rate was fixed in 1994,
then the floating currency would appreciate. This would boost U.S. exports and the
output of U.S. producers who compete with the Chinese. The U.S. bilateral trade
deficit would likely decline (but not necessarily disappear). At the same time, the
Chinese central bank would no longer purchase U.S. assets to maintain the peg. U.S.
borrowers, including the federal government, would now need to find new lenders
to finance their borrowing, and interest rates in the United States would rise. This
would reduce spending on interest-sensitive purchases, such as capital investment,
housing (residential investment), and consumer durables. The reduction in
investment spending would reduce the long-run size of the U.S. economy. If the
relative demand for Chinese goods and assets were to fall at some point in the future,
the floating exchange rate would depreciate, and the effects would be reversed.
Floating exchange rates fluctuate in value frequently and significantly.49 Over time,
the volatility of the floating rate could reduce the levels of bilateral trade and
investment between the United States and China.
A move to a floating exchange rate is typically accompanied by the elimination
of capital controls that limit a country’s private citizens from freely purchasing and
selling foreign currency. Capital controls exist in China today, and one of the major
reasons China arguably opposes a floating exchange rate is because it fears that the
removal of capital controls would lead to a large private capital outflow from China.
This might occur because Chinese citizens fear that their deposits in the potentially
insolvent state banking system are unsafe. If the capital outflow were large enough,
it could cause the floating exchange rate to depreciate rather than appreciate.50 If this
49 Some economists argue that short-term movements in floating exchange rates cannot
always be explained by economic fundamentals. If this were the case, then the floating
exchange rate could become inexplicably overvalued (undervalued) at times, reducing
(increasing) the output of U.S. exporters and U.S. firms that compete with Chinese imports.
These economists often favor fixed or managed exchange rates to prevent these
unexplainable fluctuations, which they argue are detrimental to U.S. economic well-being.
Other economists argue that movements in floating exchange rates are rational, and
therefore lead to economically efficient outcomes.
50 This argument is made in Morris Goldstein and Nicholas Lardy, “A Modest Proposal for
China’s Renminbi,”Financial Times, Aug. 26, 2003. Alternatively, if Chinese citizens
proved unconcerned about keeping their wealth in Chinese assets, the removal of capital
controls could lead to a greater inflow of foreign capital since foreigners would be less
(continued...)

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CRS-27
occurred, the output of U.S. exporters and import-competing firms would be reduced
below the level prevailing under the fixed exchange rate regime, and the U.S.
bilateral trade deficit would expand. In other words, the United States would still
borrow heavily from China, but it would now be private citizens buying U.S. assets
instead of the Chinese central bank. China could attempt to float its exchange rate
while maintaining its capital controls, at least temporarily. This solution would
eliminate the possibility that the currency would depreciate because of a private
capital outflow. While this would be unusual, it might be possible. It would likely
make it more difficult to impose effective capital controls, however, since the
fluctuating currency would offer a much greater profit incentive for evasion.
If the Chinese were to revalue their currency (adjusting the peg) to the rate that
would prevail in the market, the immediate effects on the U.S. economy would be the
same as if the yuan were allowed to float: it would increase the output of exporters
and import-competing firms and reduce interest-sensitive U.S. spending. The
difference between revaluation and floating would occur over time. With future
changes in the relative demand for goods and assets, the yuan could again become
overvalued or undervalued. If it were to become overvalued, it could come under
speculative attack, as happened to Southeast Asian currencies during the Asian
Crisis, since investors would view the government as more willing to alter the
exchange rate. Revaluing would have the advantage of maintaining exchange rate
stability, which would lead to closer bilateral trade and investment ties than if the
yuan were allowed to float. (Revaluing would lead to lower bilateral trade and
investment flows compared to maintaining a constant peg, however, since the peg
would now be viewed as less permanent.) China would also be able to maintain its
capital controls, preventing the possibility of a destabilizing capital outflow by its
private citizens.51
Another option is to maintain the status quo. Although the nominal exchange
rate would stay constant in this case, over time the real rate would adjust as inflation
rates in the two countries diverged. As the central bank exchanged newly printed
yuan for U.S. assets, prices in China would rise along with the money supply until
the real exchange rate was brought back into line with the market rate. This would
cause the U.S. bilateral trade deficit to decline and expand the output of U.S.
exporters and import-competing firms. This real exchange rate adjustment would
only occur over time, however, and pressures on the U.S. trade sector would persist
in the meantime.
50 (...continued)
concerned about being unable to access their Chinese investments. This would cause the
exchange rate to appreciate.
51 Another problem for China if the yuan appreciated, whether through floating or a
revaluation, is that it would reduce the value of their U.S. assets. Since China held $194.5
billion of U.S. Treasury securities at the end of 2004 and $88 billion of U.S. agency debt in
June 2003 — much of it in the central bank — these capital losses could potentially be very
large. Unlike a private bank, a central bank does not have to worry about insolvency as a
result of capital losses since they control their liabilities, but it could potentially have
negative fiscal or inflationary ramifications. See “A License to Lose Money,” The
Economist, April 30, 2005, p. 74.

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CRS-28
None of the solutions guarantee that the bilateral trade deficit will be eliminated.
China is a country with a high saving rate, and the United States is a country with a
low saving rate; it is natural that their overall trade balance would be in surplus and
deficit, respectively. At the bilateral level, it is not unusual for two countries to run
persistently imbalanced trade, even with a floating exchange rate. If China can
continue its combination of low-cost labor and rapid productivity gains, which have
been reducing export prices in yuan terms, its exports to the United States are likely
to continue to grow regardless of the exchange rate regime.
Policy Options to Induce China to Reform the Peg
Diplomatic Efforts. The U.S. government could attempt to persuade China
through direct negotiations to change or reform its exchange rate policy. President
Bush on a number of occasions has criticized China’s currency peg, stating that
exchange rates should be determined by market forces, and he raised the issue in a
meeting with Chinese President Hu Jintao in October 2003. Shortly before that
meeting, the United States was able to convince China to agree to the establishment
of a joint technical cooperation program to promote the development of China’s
financial markets and to examine ways China can move more quickly toward a
floating exchange rate.52 Alternatively, the United States could attempt to persuade
China to participate in talks with other East Asian economies (that are viewed as
intervening in currency markets) in order to reach a consensus on exchange rate
policy.53 A key factor in any negotiations would be to convince China that
liberalization of its exchange rate system would serve China’s long term economic
interests.
Utilize Section 301. The U.S. government could attempt to pressure China
by threatening to impose unilateral trade sanctions. For example, it could threaten
to initiate a Section 301 case, a provision in U.S. trade law that gives the U.S. Trade
Representative authority to respond to foreign trade barriers, including violations of
U.S. rights under a trade agreement, and unreasonable or discriminatory practices that
burden or restrict U.S. commerce.54 If the United States contended that China’s
currency peg violated WTO rules (see below), it would then have to bring a dispute
settlement proceeding before the WTO. If the United States contended that China’s
52 On October 30, 2003, the Treasury Department released its semi-annual report on foreign
exchange rate policies. Although Treasury was under pressure from several Members of
Congress to state that China “manipulated” its currency (which, by U.S. law, would have
required Treasury to negotiate with China to end such practices), it did not make such a
designation. Thus, it is unclear how hard the Bush Administration is willing to push China
on this issue.
53 Some analysts argue that China’s currency peg has induced other East Asian economies,
particularly Japan, Taiwan, and South Korea to intervene in currency markets to keep their
currencies weak (in order to compete with Chinese exports). Thus, the United States could
seek to reach a broad consensus with all the major economies in East Asia to halt or limit
currency interventions.
54 Section 301 to 309 of the 1974 Trade Act, as amended. For additional information, see
CRS Report 98-454, Section 301 of the Trade Act of 1974, as Amended: Its Operation and
Issues Involving Its Use by the United States, by Wayne Morrison.

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CRS-29
currency policy was not covered under WTO agreements and burdened or restricted
U.S. trade, it could then proceed under the Section 301 mechanism. This would
involve negotiations with China to remove the trade barrier within a specified time
period, and potentially, the imposition of trade sanctions against China (such as
higher tariffs on Chinese goods imported into the United States) if the issue could not
be resolved. However, China might respond with sanctions against U.S. products,
or it could bring a case against the United States in the WTO, arguing that U.S.
sanctions against China violated WTO trade rules.
Utilize the Dispute Resolution Mechanism in the WTO. Some critics
have charged that China’s currency policy violates WTO rules.55 The United States
could file a case before the WTO’s Dispute Settlement Body (DSB) against China’s
currency peg.56 If the DSB ruled in favor of the United States, it would direct China
to modify its currency policy so that it complies with WTO rules. If China refused
to comply, the DSB would likely authorize the United States to impose trade
sanctions against China. The advantage of using the WTO to resolve the issue is that
it involves a multilateral, rather than unilateral, approach, although there is no
guarantee that the WTO would rule in favor of the United States.57
In 2004, the Bush Administration rejected two Section 301 petitions on China’s
exchange rate policy: one by the the China Currency Coalition (a group of U.S.
industrial, service, agricultural, and labor organizations) and one filed by 30
Members of Congress. Both petitions sought to have the United States bring a case
before the WTO against China in the hope that the WTO would rule that China’s
currency peg violated WTO rules. The Bush Administration has expressed doubts
that the United States could win such a case in the WTO and contends that such an
approach would be “more damaging than helpful at this time.”58
Utilize Special Safeguard Measures. Another option might be to utilize
U.S. trade remedy laws relating to special provisions that were part of China’s
accession to the WTO. For example, the United States could invoke safeguard
provisions (under Sections 421-423 of the 1974 Trade Act, as amended) to impose
restrictions on imported Chinese products that have increased in such quantities that
they have caused, or threaten to cause, market disruption to U.S. domestic
55 For example, the language in H.R. 3269 states that the peg violates Article XV of the
General Agreement on Tariffs and Trade (GATT) agreement dealing with exchange
arrangements and the WTO Agreements on Subsidies and Countervailing Measures. Other
critics charge the peg violates Article XXIII of the GATT dealing with nullification or
impairment of the benefits of a trade agreement.
56 Dispute resolution in the WTO is carried out under the Dispute Resolution Understanding
(DSU). See CRS Report RS20088, Dispute Settlement in the World Trade Organization,
by Jeanne J. Grimmett.
57 Many trade analysts argue that countries are more likely to comply with rulings by
multilateral organizations to which they are parties (and whose rules they have agreed to
comply with) than accede to the wishes of another country under the threat of unilateral
sanctions.
58 USTR press release, November 12, 2004.

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producers.59 This option could be used to provide temporary relief for U.S. domestic
firms that have been negatively affected by a surge in Chinese exports to the United
States (regardless of its cause).60 Broadly speaking, any imposed U.S. trade
restrictions of Chinese goods would likely reduce overall U.S. economic welfare,
because the reduction in the welfare of U.S. consumers (as import prices rise) would
likely exceed the increase in welfare of U.S. producers.
Other Bilateral Commercial Issues
A number of policy analysts have argued against pushing China too hard on the
peg, either because it would not serve U.S. economic interests, or because U.S.
pressure would likely be ineffective as long as the Chinese government believed
changing the peg would damage China’s economy.61 Such analysts argue that U.S.
policymakers should address China’s currency peg as part of a more comprehensive
U.S. trade strategy to persuade China to accelerate economic and trade reforms and
to address a wide range of U.S. complaints over China’s trade practices. Many U.S.
firms and policymakers have expressed disappointment with China’s record on WTO
implementation. In a speech before the American Chamber of Commerce in Beijing
on October 28, 2003, then U.S. Commerce Secretary Don Evans stated that U.S.
patience on China’s WTO compliance was “wearing thin” and warned of “growing
protectionist sentiments” in the United States against China. Major WTO-related
issues of concern to the United States include market access, inadequate protection
of U.S. intellectual property rights (IPR), tax rebates for certain exporting industries,
and indirect subsidization of Chinese state-owned enterprises by China’s banking
system.
! Market Access Issues. U.S. officials have been critical of Chinese
policies that have prevented U.S. firms from gaining market access
promised under China’s WTO commitments. Major policies
affecting market access include the administration of tariff rates and
quotas, health and safety regulations on agricultural products,
excessive capitalization requirements for foreign providers of
services, restrictions on trading and distribution rights, continued
technology transfer requirements on U.S. joint ventures in China,
and insufficient regulatory transparency.
59 See CRS Report RS20570, Trade Remedies and the U.S.-China Bilateral WTO Accession
Agreement, by William H. Cooper.
60 The U.S. International Trade Commission is in charge of making market disruption
determinations under the safeguard provisions for most products (with the exception of
textiles and apparel, which are handled by the Committee for the Implementation of the
Textile Agreements, an inter-agency committee chaired by the U.S. Commerce Department).
Import relief is subject to presidential approval. The Bush Administration has invoked the
special China safeguard provisions on certain textile and apparel products.
61 There is also the danger that if China made changes to its peg (such as appreciating the
yuan to the dollar) in order to ease political pressure from the United States, it would expect
something in return, such as easing U.S. pressure on China on other trade issues.

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! IPR. Under the terms of its WTO accession, China agreed
immediately to bring its IPR laws in compliance with the WTO
agreement on Trade Related Aspects of Intellectual Property Rights
(TRIPS). U.S. business groups continue to experience significant
IPR problems in China, especially in terms of illegal reproduction of
software, retail piracy, and trademark counterfeiting. It is estimated
that counterfeits account for 15 to 20% of all products made in
China. Chinese enforcement agencies and judicial system often lack
the resources (or the will) needed to vigorously enforce IPR laws;
convicted IPR offenders generally face minor penalties. In addition,
while market access for IPR-related products has improved, high
tariffs, quotas, and other barriers continue to hamper U.S. exports;
such trade barriers are believed to be partly responsible for illegal
IPR-related smuggling and counterfeiting in China. Industry
analysts estimate that IPR piracy in China cost U.S. firms $2.5
billion in lost sales in 2004. The piracy rate for IPR-related products
in China (such as motion pictures, software, and sound recordings)
is estimated at around 90%.62
! Tax Rebates. The Chinese government has attempted to use tax
rebates (since 1985) to promote the development of certain export
industries and to provide temporary relief to firms during economic
slowdowns.63 U.S. firms have argued that this policy is unfair and a
violation of WTO rules because it provides a de facto subsidy to
exporting firms in China and because it discriminates against
imported products (which are not eligible for the tax rebates). For
example, the value-added tax on imported semiconductors is 17%.
Tax rebates are given to domestic producers of semiconductors, such
that chips made in China are assessed a VAT rate of 6% and chips
designed and made in China pay a 3% VAT.64 According to Chinese
government figures, export tax rebates totaled $29.8 billion in
2002.65 In October 2003, the Chinese government announced plans
to roll back the average rebate on its export tax by an average of
three percentage points.66
! Industry Subsidies. Another major concern to U.S. businesses is
the Chinese government’s continued financial assistance to its state-
owned enterprises (SOEs). Although China agreed to make SOEs
62 International Intellectual Property Alliance, Country Reports, China, 2003.
63 The Chinese government attempted to use tax rebates on value-added taxes (VAT) to
assist certain domestic industries during the 1997-1998 Asian financial crisis and during the
outbreak of Severe Acute Respiratory Syndrome (SARS) in 2003.
64 Inside U.S. Trade, October 22, 2003.
65 China Daily, October 15, 2003.
66 This move appears to be motivated in part by a desire on the part of the Chinese
government to reduce U.S. pressure on China’s currency and to lessen the financial drain
the rebates have on the central government’s budget.

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operate according to free market principles when it joined the WTO,
U.S. officials contend that such enterprises are still being heavily
subsidized through the banking system.67 This is seen as a
significant problem since nearly half of China’s exports come from
SOEs. The use of subsidies is viewed as giving Chinese firms an
unfair trade advantage.
Many analysts contend that an intensified effort toward inducing China to fully
comply with its WTO commitments could result in substantial new trade and
investment opportunities for U.S. firms, and hence could help reduce trade tensions
between the two countries. In addition, because China’s WTO commitments are
clear and binding, and there is a legal process within the WTO to seek compliance
with trade agreements, the United States is in a stronger position to get China to
liberalize its economy and open its markets than it would be if it tried to push China
to reform its currency regime (where multilateral rules and options on the issue are
less clear). Finally, supporters of this policy argue that China’s leaders are more
likely to respond to pressures to adhere to international rules of conduct than to
perceived direct U.S. pressure.
Legislation in the 109th Congress
Eleven bills were introduced in the 108th that sought to address China’s currency
policy or to take action against countries that “manipulated” their exchange rates.
A number of bills have been introduced in the 109th Congress to address the currency
issue.
! S. 14 (Stabenow), S. 295 (Schumer), and H.R. 1575 (Spratt) directs
the Secretary of the Treasury to negotiate with China to accept a
market-based system of currency valuation, and imposes an
additional duty of 27.5% on Chinese goods imported into the United
States unless the President submits a certification to Congress that
China is no longer manipulating the rate of exchange and is
complying with accepted market-based trading policies.
! S. 377 (Lieberman) directs the President to negotiate with those
countries determined to be engaged most egregiously in currency
manipulation and to seek an end to such manipulation. If an
agreement is not reached, the President is directed to institute
proceedings under the relevant U.S. and international trade laws and
to seek appropriate damages and remedies for the U.S.
manufacturers and other affected parties.
On April 6, 2005, the Senate failed (by a vote of 33 to 67) to table an
amendment, S.Amdt. 309 (Schumer) to S. 600 (Foreign Affairs Authorization Act),
67 China’s banking system is largely controlled by the central government. Banks are
directed by the government to extend loans to SOEs to help keep them financially afloat.
However, in many cases, SOEs fail to repay the loans. Thus, many analysts view this
system as a direct government subsidy.

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which would impose a 27.5% tariff on Chinese goods if China failed to substantially
appreciate its currency to market levels. In response to the vote, the Senate
leadership moved to allow a vote on S. 295 (which has same language as S.Amdt.
309) no later than July 27, 2005 as long as the sponsors of the amendment agree not
to sponsor similar amendments for the duration of the 109th Congress.
Opponents of legislation that would imposed additional tariffs against China for
not appreciating its currency charge that it would violate WTO rules. Many analysts
contend that China’s currency peg violates a number of WTO provisions and have
urged the Bush Administration to initiate a WTO dispute resolution case against
China. On April 20, 2005, a coalition of 35 Members of Congress filed a Section
301 case with the USTR calling on the United States to bring a trade dispute case
against China in the WTO over its currency peg policy.
Some Members of Congress support changing U.S. law to apply countervailing
laws to nonmarket economies so that U.S. firms are able to take action against unfair
government subsidies, especially in regards to China. They further contend that
China’s currency peg constitutes a government exports subsidy that should be
actionable under U.S. countervailing laws. H.R. 1216 (English) and S. 593 (Collins)
would apply U.S. countervailing laws to nonmarket economies. H.R. 1498 (Tim
Ryan) would apply U.S. countervailing laws to countries that manipulate their
currencies.
Conclusion
The current debate among U.S. policymakers over China’s currency peg has
been strongly linked to concerns over the growing U.S. trade deficit with China, the
sharp decline in U.S. manufacturing employment over the past few years, and the rise
of China as a major economic power. Most economists agree that China’s currency
would appreciate against the dollar if allowed to float. If it did, there is considerable
debate over the net effects this policy would have on the U.S. economy since it may
benefit some U.S. economic sectors and harm other sectors, as well as consumers.
In addition, U.S. trade with China is only one of a number of factors affecting
manufacturing employment, including increased productivity growth, employment
shifts to the service sector, and the overall trade deficit. It is also not clear to what
extent production in certain industrial sectors has shifted to China from the United
States, as opposed to shifting to China from other low-wage countries, such as
Mexico, Thailand, and Indonesia.68 The extensive involvement of foreign
multilateral corporations in China’s manufactured exports further complicates the
issue of who really benefits from China’s trade, as well as the implications of a rising
U.S. trade deficit with China (since a large share of U.S. imports are coming from
68 Even in cases where jobs have shifted from the United States and China, there are still
questions as to the net impact to the United States. If the United States is no longer
internationally competitive in certain industries, it may be better to shed those industries and
to focus more on economic activities where the United States has a greater comparative
advantage. The challenge for policymakers is how to help displaced workers get the training
they need to find well-paying jobs that are comparable to or better than the jobs they lost.

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foreign firms, including U.S. firms, that have shifted production from one country to
China). Thus, there is considerable debate over what policy options would promote
U.S. economic interests since changes to the current system would produce both
winners and losers in the United States (as well as in China).
Chinese officials are reluctant to change their currency peg, largely because it
has facilitated economic stability, a contributing factor to China’s rapid economic
growth over the past several years. Such growth has substantially raised living
standards and reduced poverty. The World Bank estimates that Chinese economic
reforms have helped lift 402 million people out of poverty (based on a $1 per day
expenditure level). However, as of 2002, there were still 88 million Chinese living
in poverty.69 China, like many other developing countries, is largely relying on
exporting as a key factor in its economic growth and employment strategy, especially
as it attempts to scale back the involvement of SOEs in the economy. Chinese
leaders (and many foreign economists) contend that, given the poor state of China’s
banking system, a move toward a fully convertible currency could spark an economic
crisis in China, and could even cause the yuan to depreciate if there were a loss of
confidence in the banking system. At the same time, however, maintaining the peg
likely entails a number of costs to the Chinese economy. Thus, in the long run, it is
in China’s own economic interests to reform its banking system and move towards
a fully convertible currency in order to ensure the most efficient allocation of
resources within the economy. However, it is unclear how quickly China can achieve
these two goals.
Much of the debate over China’s peg is linked to the question of how China’s
economic development is affecting, or will affect, U.S. economic interests.70 In the
past, most U.S.-China trade was considered complementary, that is, most of the
goods the United States imported from China were consumer-oriented, labor
intensive products that were no longer being produced in the United States. In recent
years, an increasing level of U.S. imports have been advanced technology products.
China has made it a top priority to develop a number of industries, such as computers
and autos, which has raised concerns that the United States faces a “competitive
threat” from China similar to the perceived “competitive threat” the rise of the
Japanese economy in the 1970s and 1980s posed to several U.S. economic sectors.
The divergent experience of the U.S. and Japanese economies since the 1990s
suggests that the competitive threat from China is questionable. In the long run,
China’s economic development and exchange rate regime poses little threat to
America’s ability to achieve healthy economic growth and full employment.
A rapidly growing and modernizing Chinese economy would be detrimental to
the United States economically if the United States experienced a significant decline
in its terms-of-trade (the terms on which U.S. labor and capital can be exchanged for
69 The World Bank, China: Promoting Growth with Equity, October 13, 2003, p. 9.
70 Political arguments have been made that an economically developed China would become
more peaceful and democratic. Others argue that an economically stronger China would be
a more dangerous China to U.S. strategic interests.

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Chinese labor and capital).71 However, a case can be made that the terms-of-trade
would move in favor of the United States as China develops since Chinese markets
for many of the products the U.S. specializes in producing (e.g., services, luxury
goods) are small now, but would presumably expand as Chinese disposable income
continues to rise. According to the World Economic Forum, the United States
currently ranks as the world’s second most competitive economy (after Finland) in
terms of its ability to sustain long-term economic growth (based on a number of
factors, such as macroeconomic policy, efficiency of public institutions, and
technological development). China ranks 44th out of 102 countries surveyed.72
Many argue that, because China is becoming such a large player in the world
economy, it must be made to “play by the rules” to ensure a “level playing field” for
U.S. firms and to prevent them from being harmed by unfair Chinese trading
practices. A major challenge for U.S. policymakers is to pursue macroeconomic and
trade policies that promote economic efficiency and maximize the benefits of trade
for the U.S. economy.
71 A decline in the U.S. terms of trade would mean that prices for U.S. exports would decline
vis-à-vis import prices. Thus, it would take more U.S. exports to obtain a comparable level
of imports. A decline in the term of trade implies a relative (but not absolute) loss in
national welfare.
72 See World Economic Forum, Global Competitiveness Report, 2003-2004, October 2003.

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