Order Code RS21625
Updated February 13, 2007
China’s Currency:
A Summary of the Economic Issues
Wayne M. Morrison
Foreign Affairs, Defense, and Trade Division
Marc Labonte
Government and Finance Division
Summary
Many Members of Congress charge that China’s policy of buying foreign reserves
to influence the value of its currency constitutes a form of currency manipulation
intended to make its exports cheaper and imports into China more expensive than they
would be under free market conditions. They further contend that this policy has caused
a surge in the U.S. trade deficit with China and has been a major factor in the loss of
U.S. manufacturing jobs. Threats of possible congressional action led China to make
changes to its currency policy in July 2005, which has resulted in a modest appreciation
of the yuan. However, many Members have expressed dissatisfaction with the pace of
China’s currency reforms and have warned of potential legislative action. This report
summarizes the main findings CRS Report RL32165, China’s Currency: Economic
Issues and Options for U.S. Trade Policy and will be updated as events warrant.
From 1994 until July 21, 2005, China maintained a policy of pegging its currency
(the renminbi or yuan), to the U.S. dollar at an exchange rate of roughly 8.28 yuan to the
dollar. The Chinese central bank maintained this peg by buying (or selling) as many
dollar-denominated assets in exchange for newly printed yuan as needed to eliminate
excess demand (supply) for the yuan. As a result, the exchange rate between the yuan and
the dollar basically stayed the same, despite changing economic factors which could have
otherwise caused the yuan to either appreciate or depreciate relative to the dollar. 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. 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. The sharp increase in China’s
foreign exchange reserves (which grew from $403 billion at the end of 2003 to nearly $1.1
trillion at the end of December 2006) and China’s large trade surplus (which totaled $178
billion in 2006) are indicators that the yuan is undervalued.

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China Reforms the Peg. The Chinese government modified its currency policy
on July 21, 2005. It announced that the yuan’s exchange rate would become “adjustable,
based on market supply and demand with reference to exchange rate movements of
currencies in a basket,” (it was later announced that the composition of the basket
includes the dollar, the yen, the euro, and a few other currencies), and that the exchange
rate of the U.S. dollar against the yuan would be immediately adjusted from 8.28 to 8.11,
an appreciation of about 2.1%. Unlike a true floating exchange rate, the yuan would
(according to the Chinese government) be allowed to fluctuate by 0.3% on a daily basis
against the basket.1 Since July 2005, China has allowed the yuan to appreciate steadily
but very slowly. It has continued to accumulate foreign reserves at a rapid pace, which
suggests that if the yuan were allowed to freely float it would appreciate much more
rapidly. The current situation might be best described as a “managed float” — market
forces are determining the general direction of the yuan’s movement, but the government
is retarding its rate of appreciation through market intervention.
U.S. Concerns Over China’s Currency Policy
Many U.S. policymakers and business and labor representatives have charged that
China’s currency is significantly undervalued vis-à-vis the U.S. dollar (even after the
recent revaluation), 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
$233 billion in 2006) 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 policy induces other
East Asian countries to intervene in currency markets in order to keep their currencies
weak against the dollar in order to compete with Chinese goods. Critics contend that,
while it may have been appropriate for China during the early stages of its economic
development to maintain a pegged currency, it should let the yuan freely float today, given
the size of the Chinese economy and the impact its policies have on the world economy.
China’s Concerns Over Modifying Its Currency Policy
Chinese officials argue that its currency policy is not meant to favor exports over
imports, but instead to foster economic stability through currency stability, as many other
countries do. They have expressed concern that floating its currency 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
1 Theoretically, fixing the yuan to a basket of currencies does not rule out the possibility that the
yuan could depreciate or appreciate against the dollar. When the other exchange rates in the
basket depreciate against the dollar, so will the yuan, but to a lesser extent. How closely the yuan
moves with the dollar against other currencies will depend on how large a weight the dollar has
in the basket (which has not been revealed by the Chinese government).

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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.
Concerns have also been raised over the effects an appreciating yuan would have on
farmers (due to lower-priced imports). Chinese officials view economic stability as
critical to sustaining political stability; they fear an appreciated currency could reduce
employment and lower incomes in various sectors, and thus could cause worker unrest.
However, Chinese officials have indicated that their long-term goal is to adopt a more
flexible exchange rate system and to seek more balanced economic growth through
increased domestic consumption and the development of rural areas, but they want to
proceed at a gradual pace to ensure economic stability.
Implications of China’s Currency Policy for its Economy
If the yuan is undervalued vis-a-vis the dollar, 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. 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. Another major problem is that
the Chinese government must expand the money supply in order to keep purchasing
dollars, which has promoted the banks to adopt easy credit policies. In addition, “hot
money” has poured into China from investors who are speculating that China will
continue to appreciate the yuan.2 At some point, these factors could help fuel inflation,
overinvestment in various sectors, and expansion of nonperforming loans by the banks
— each of which could threaten future economic growth.3
Implications of China’s Currency Policy for the U.S. Economy
Effect on Exporters and Import-Competitors. When exchange rate policy
causes the yuan to be less expensive than it would be if it were determined by supply and
demand, it causes Chinese exports 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. (Many of the affected
2 For the most part, China has been able to avoid the potential inflationary impact of its currency
policy through “sterilization” (i.e., by issuing bonds to remove yuan from the economy),
increasing the level of reserves that banks are required to maintain, and by using administrative
action to reduce investment in certain “overheated” sectors.
3 The currency policy significantly restricts the ability of the government to use monetary policy
to limit inflation growth and to promote the most efficient distribution of credit in the economy.

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firms are in the manufacturing sector.)4 This causes the trade deficit to rise and reduces
aggregate demand in the short run, all else equal.5
Effect on U.S. Consumers and Certain Producers. 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 through an improvement in the terms-of-trade.
Since changes in aggregate spending are only temporary, from a long-term perspective the
lasting effect of an undervalued yuan is to increase the purchasing power of U.S.
consumers. Imports from China are not limited to consumption goods. U.S. producers
also import capital equipment and inputs to final products from China. An undervalued
yuan lowers the price of these U.S. products, increasing their output.
Effect on U.S. Borrowers. An undervalued yuan also has an effect on U.S.
borrowers. When the U.S. 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 November 2006) held $347 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
4 There is a long run trend that is moving U.S. production away from manufacturing and toward
the service sector. 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 10.4% in December 2006. 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) and comparative
advantage.
5 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 untalented at producing. As
trade expands, production of goods with a comparative disadvantage will decline in the U.S., 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.

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country on net, and the government would have to find other buyers of U.S. Treasuries.
This would likely increase the government’s interest payments.
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 Chinese capital flows. 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 U.S. had a historically large and
growing trade deficit throughout the 1990s at a time when unemployment reached a three-
decade low. 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. And 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.
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. This
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. The deficit with China has not prevented
the U.S. economy from registering high rates of growth since 2003.
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 15.4% of U.S.
merchandise imports in 2006 and 26% of the sum of all U.S. bilateral trade deficits. Over
a span of several years, a country with a floating exchange rate can consistently run an
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. On the
one hand, the U.S. 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 investment opportunities in the United States; the trade
deficit is the result.6 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.7
6 Nations, such as the United States, that fail to save enough to meet their investment needs must
obtain savings from other countries with high savings rates. By obtaining foreign investment (in
effect, borrowing), the United States can consume more (including more imports) than it would
if investment were funded by domestic savings alone — this results in a trade deficit.
7 China on the other hand has one of the world’s largest savings rate. U.S. officials have urged
China to take steps to boost domestic consumption (and hence increase imports).

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According to Chinese statistics, more than half of what China exports to the world
is produced by foreign-invested firms in China, including U.S. companies, which, in many
cases, have shifted production to China in order to gain access to China’s low-cost labor.
(The returns to capital of U.S. owned firms in China flow to Americans.) Such firms
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. Overall,
in 2006, China had an estimated $55 billion trade deficit with the world excluding the
United States. These factors imply that much of the increase in U.S. imports (and hence,
the rising trade deficit with China) is largely the result of China becoming a production
platform for many foreign companies, rather than unfair Chinese trade policies.8
Most Recent Events
In September 2006, President Bush and President Hu agreed to establish a Strategic
Economic Dialogue (SED) in order to have discussions on major economic issues at the
“highest official level.” China’s currency policy was a major topic during the first SED
meeting held in December 2006. The two sides agreed to work to reduce global
imbalances through increased savings in the United States and increased domestic
consumption and exchange rate flexibility in China. The Treasury Department’s
December 2006 report on exchange rate policies said that China had made progress in
2006 in making its currency more flexible, but that reforms were “considerably less than
needed.” According to the Bank of China, from July 21, 2005, to January 30, 2007, the
dollar-yuan exchange rate went from 8.11 to 7.75 (yuan), an appreciation of about 4.6%.
Congressional Action
In the 110th Congress, H.R. 321 (English) would increase tariffs on imported Chinese
goods if the Treasury Department determined that China manipulated its currency, and
would require the United States to file a WTO case against China over its currency policy
and to work within the WTO to modify and clarify rules regarding currency manipulation.
H.R. 782 (Tim Ryan) and S. 354 (Rockefeller) would apply U.S. countervailing laws
(dealing with government subsidies) to products imported from non-market economies
(such as China) and would make exchange rate manipulation actionable under such laws.
H.R. 782 would also establish an alternative methodology for estimating the amount of
government subsidy benefit provided if information is not available on the amount of
subsidies given to various industries in that country, requires the Treasury Department to
determine whether a currency is misaligned in its semi-annual reports to Congress on
exchange rates, prohibits the Department of Defense from purchasing certain products
imported from China if it is determined that China’s currency misalignment has disrupted
U.S. defense industries, and would include currency misalignment as a factor in
determining safeguard measures on imports of Chinese products that cause market
disruption.
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8 Of concern to many economists is not the high U.S. trade deficit with China or the amount of
capital coming from China, but rather the low U.S. savings rate that makes the United States so
reliant on foreigners to finance its investment opportunities. If the United States did not borrow
from China, it would still have to borrow from other countries.

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