One of the most striking aspects of the global economy today is the large and growing current account deficits accrued by the United States and other economies. While some analysts believe that such deficits will deteriorate slowly over time, there is a probability that a sudden change in investor sentiments in international financial markets could precipitate an acute and disruptive adjustment of these current account imbalances (Ahearne et al, 2007).
Current account adjustment is necessary for the United States to avoid these consequences of continued external deficits. There must be three components to this adjustment process. First, unfair trade practices by China, which artificially boost the Sino-American current account deficit, must be addressed. Second, US domestic consumption habits must be changed. The US has a large preference for consumption of foreign goods and an extremely low propensity to save disposable income. These characteristics of US consumers worsen the American current account position. Finally, the dollar must be devalued to boost exports and check growing imbalances.
In the following paper, I will first describe the phenomenon of rising global imbalances and explain how Chinese economic policy plays a key role in exacerbating these imbalances. I will then explain Chinese intervention in currency markets and argue that it is imperative that the Chinese revalue the renminbi. A discussion of US policy options to countervail Chinese currency manipulation will follow. Following this analysis of China, I will address the issue of the US role in global imbalances more generally and outline a strategy to curtail the problem. I will end with a discussion as to why dollar devaluation is strategic for the United States and how the international monetary system can be modified to promote long-term US interests as well as improve the outlook on global monetary stability and economic growth.
Pressures on exchange rates around the world are an obvious consequence of persistent global imbalances. Obstfeld and Rogoff (2005) argue that the risks of collateral damage beyond just exchange rate stability have gone up due to a combination of low US savings, the federal government’s poor fiscal trajectory, and a dependence on Asian central banks to finance deficits. They warn of a global financial meltdown, perhaps precipitated by debt liquidity crises, in the case of exchange rate swings. Cline (2005) argues that because borrowing now finances consumption instead of investment, foreign inflows and trade deficits are fundamentally less sustainable than in previous decades.
There are also those with less dire views. Greenspan (2004) claims that global financial integration brought on by foreign capital inflow might soften the fall if a crisis were to occur. Croke, Kamin, and Leduc (2005) find that large current account imbalances in industrialized countries typically resolve themselves in harmless ways. Of course, this study utilized a definition of a sustained current account imbalance and reversal that was smaller than that seen in the US today, primarily because the magnitude of the trade imbalance in the US is unprecedented.
There have been many proposals to resolve these rising global imbalances. Feldstein (2008), Bergsten (2009), and others claim that the US needs more savings and a weaker dollar in order to adjust. Ahearne et al (2007) point toward the undervaluation of Asian currencies and their large trade surpluses and argue that revaluation of these currencies is critical for a rebalancing of trade. Indeed, Baily and Lawrence (2006) argue that the high value of the dollar in these and other markets is the primary cause of the growing trade deficit, not any fundamental reduction in the competitiveness of US firms. These proposals and others are discussed in this paper.
The US current account deficit reached an estimated $668.9 billion in 2008 and $378.4 billion in 2009, the largest deficits in the world for both years (CIA World Factbook, 2012). Although these deficits reflect the severe consequences of the 2008 Financial Crisis, the outlook has hardly improved despite a modest global recovery. The US current account deficit in 2010 climbed to $470.9 billion in 2010, and stood at 473.4 billion at the end of 2011. (CIA, World Factbook, 2012) The persistence of external deficits by the United States will lead to an accumulation of a massive amount of foreign liabilities by the United States and an equally massive accumulation of US assets by the Chinese and other Asian economies that finance the US debt.
However, this cannot continue indefinitely. As sovereign wealth funds grow deeper in dollars, governments will divest away from US sovereign debt to diversify national portfolios. Additionally, as more US sovereign debt is accumulated, investors might begin to question the US government’s ability to service the debt, and the US might be subject to the same kind of sovereign debt crisis currently faced Greece and other countries in the Eurozone. These effects will eventually demand higher returns on investment and drive interest rates up in the United States, which would undercut domestic investment.
By virtue of the large and growing volume of trade between the United States and China (and, indeed, China and many other industrialized countries), Chinese trade practices play an increasingly important role in exacerbating global current account imbalances. The following section describes how Chinese trade practices are unfair and how they contribute to these imbalances.
The domestic savings rate in China is extremely high and consumption is correspondingly low. This is due to a variety of factors, including poorly developed social safety programs, costly education, and healthcare costs, all of which incentivize the public to save. Because Chinese production exceeds consumption, surplus capacity is exported to foreign consumers in order to maintain domestic employment. As such, China runs a large trade surplus with the United States and most other industrialized countries in the world. The natural market response to such persistent trade surpluses would be an appreciation of the renminbi because of high foreign demand for Chinese exports and therefore Chinese domestic currency. However, such an appreciation would undermine the export sector by making Chinese exports more expensive to foreign consumers.
To keep its exports competitive in global markets, the People’s Bank of China (PBC) regularly intervenes in the currency market by buying the excess dollars it receives from the United States through the bilateral current account deficit and exchanging these for renminbi. To control inflation, the PBC simultaneously “sterilizes” these exchanges by reducing liquidity through other means, such as selling government assets or reducing bank lending through authoritarian means. The dollars that the bank purchases are added to China’s foreign currency reserves. To accumulate interest payments on these holdings at low risk, China purchases US Treasury Securities with these dollars and in this way contributes to large capital inflows into the United States.
Chinese currency manipulation confers an unfair advantage to Chinese export industries because it allows Chinese exports to price foreign competition out of foreign markets. As a consequence of artificially cheap Chinese goods, some US producers exit the market. Some estimates claim that the U.S. trade deficit with China has led to the loss or displacement of 2.4 million jobs in the manufacturing sector in the United States (Economic Policy Institute, 2010), and at least 500,000 of these jobs can be returned if the renminbi were to be revalued to market equilibrium levels (Bergsten, 2010).
Renminbi undervaluation also puts pressure on other fledgling Asian economies to undervalue their currencies in order to compete with Chinese exports on the global market. In particular, Hong Kong, Malaysia, Singapore, and Taiwan all have significantly undervalued currencies (Cline & Williamson, 2010). This prevents the depreciation of the dollar relative to these currencies and therefore reduces the competitiveness of US exports throughout East Asia (Morrison & Labonte, 2010). The aggregate effects of pricing foreign firms out of the global market has a negative impact on resource allocation in the global economy and therefore a negative impact on global production. In fact, Paul Krugman claims that global economic growth would be about 1.5% higher if China stopped manipulating its currency and creating global imbalances (Christie, 2010).
There is no widespread consensus as to how undervalued the renminbi is and by how much it should be allowed appreciate in order to eliminate the effects of currency intervention by the PBC. This uncertainty is due to a number of factors. PBC currency interventions are not transparent, so the exact magnitude of interventions is unclear. There is no consensus as to the exact figure of the Chinese trade surplus, largely due to ambiguities regarding trade with Taiwan and exports that originate in China but are shipped through Hong Kong before arriving at their final destination. There is no consensus as to how sensitive Chinese imports and exports would be to exchange rate fluctuations. Finally, strict capital controls make it difficult to estimate China’s equilibrium current account balance. Nevertheless, estimates using the fundamental equilibrium exchange rate (FEER) method and the purchasing power parity (PPP) theory determine that the renminbi is undervalued by about 20%.
Another indicator of growing global imbalances caused by China is the burgeoning foreign exchange reserves that continue to expand due to the constant exchange of dollars for renminbi facilitated by the PBC. These foreign exchange reserves are the largest in the world, estimated to be worth around $2.4 trillion in 2009. At the end of December 2009, China was also the world’s second largest holder of US Treasury Securities, holding at least $755.4 billion (Johnson, 2010). Rapidly expanding foreign exchange reserves are an indication that a currency imbalance exists because it could represent central bank intervention in currency markets. Based on this evidence and estimates of renminbi undervaluation based on FEER and PPP analyses, it is safe to assume that the renminbi is undervalued by about 20% and that this contributes significantly to global current account imbalances.
It is unlikely that the Chinese will pursue renminbi appreciation in an adequately short timespan to stop and reverse growing global current account imbalances. Chinese policy is designed to maximize employment opportunity and thereby promote domestic social stability. An appreciating renminbi could cause employment to fall and may lead to social unrest. The Chinese are unlikely to adjust this policy even though it leads to a suboptimal global outcome. Given the unwillingness of the Chinese to revalue the renminbi to correct the global imbalances they have caused, Chinese trading partners must collectively take action to renormalize current accounts with China (Bergsten, 2007).
FEER and PPP analyses, combined with the observation of quickly expanding Chinese foreign exchange reserves, demonstrate that the Chinese are actively manipulating the renminbi to sustain an export advantage and trade surpluses. However, the US Treasury Department has yet to identify China as a currency manipulator in its semiannual exchange rate policies report. It will be difficult to galvanize international support and to legitimately take international action to pressure China to revalue the currency without formally declaring the country a currency manipulator. Indeed, the very act of the formal designation might send a signal to China and the international community that the current currency policies cannot be tolerated. The US Treasury Department should formally designate China a currency manipulator to define and clarify US trade policy toward China.
Several advanced and emerging economies have agreed that China needs to revalue the renminbi to normalize trade imbalances. The commitment to increase exchange rate flexibility was formalized at the G-20 summit in November 2010 and was agreed upon by all nations present, including China (IMF, 2010a). The Mutual Assessment Process proposed in Seoul emphasizes increasing exchange rate flexibility, boosting domestic demand in developing economies, and decreasing fiscal deficits in advanced economies (IMF, 2010b). The US should engage in diplomatic efforts to pressure China to enact reforms in accordance with these strategies.
In addition to a revaluation of the renminbi, international pressure should be applied to reform key social programs in China to boost domestic consumption. Chinese consumers save primarily to be able to afford education, healthcare, and costs of living after retirement. If social programs were to be enacted to lessen these costs for Chinese consumers, domestic consumption in China would rise, which would reduce China’s dependency on exports. To the extent that it is possible, G-20 countries should pressure China to accelerate these reforms as well as appreciate the renminbi to address China’s trade surplus. The United States can lead this charge.
In addition to this international pressure to appreciate, the United States can counter PBC currency manipulations by directly intervening in the renminbi market itself. Just as the PBC buys dollars and sells renminbi to devalue the renminbi relative to the dollar, the US can intervene in the renminbi market by buying non-deliverable forward contracts for renminbi and renminbi-denominated securities in Hong Kong in exchange for dollars (Bergsten, 2010) in an effort to counteract PBC action. At the very least, this would drive down the price of renminbi-denominated assets and thereby place even more inflationary pressure on China to appreciate. Though pressure through international bodies and currency markets for renminbi appreciation is ideal because it is the most direct method of correcting the current account imbalance, the Chinese have historically ignored international calls for currency appreciation. Because the IMF lacks enforcement tools of its own, the US and allies can turn to the World Trade Organization (WTO) to seek permission to enact countervailing trade policy to offset the depreciated currency.
There are two routes by which this case can be brought to the WTO. First, members can indict China under Article XV of the General Agreement on Tariffs and Trade (GATT). Section 7 of this article prohibits countries from “frustrating the intent of the provisions of this Agreement by exchange action” (WTO, 1994). Successful prosecution of China under this article would authorize members to legally retaliate against Chinese exports using import tariffs and other such protectionist measures. Given that currency manipulation plays such a large role in the growth of current account imbalances, it may be necessary to revise Article XV of the GATT to explicitly include cases of currency manipulation. Indeed, there is a strong argument to be made for currency controls and sovereign wealth funds to be brought under WTO oversight (Mattoo & Subramanian, 2008). The United States and allies should pursue both the general indictment under Article XV and reform of the GATT.
Second, countries may individually choose to regard the Chinese currency undervaluation as an export subsidy and submit a legal complaint under the Code on Subsidies and Countervailing Duties (Bergsten, 2010). This would authorize countries to take countervailing action. If a sound legal case for regarding the currency undervaluation as an export subsidy can be made, China would have to individually challenge each ruling to reverse these decisions. Aggressive action by a multilateral coalition of China’s trading partners in the G-20, IMF, and WTO to both pressure China to allow exchange rate flexibility in the renminbi and, should China refuse, enact countervailing measures on Chinese imports around the world, is the most effective American international economic policy. There have been several unilateral policy suggestions, including imposing Section 301 trade sanctions against China, applying U.S. countervailing laws to Chinese imports under the premise that currency manipulation amounts to an export subsidy, and applying estimates of currency undervaluation to US antidumping measures (Morrison & Labonte, 2008). However, unilateral action will do little to address the core issue of rising global imbalances due to a growing US trade deficit.
Either renminbi appreciation or widespread global countervailing measures would have the effect of making US exports to third markets more competitive with Chinese exports. This would simultaneously lower the US trade deficit and reduce the Chinese trade surplus, which is precisely the outcome required to resolve one major current account imbalance. Unilateral trade restrictions would increase US competitiveness in domestic sectors competing with Chinese imports to the United States but would do little to combat the unfair advantage that an undervalued renminbi confers to China in third markets. The American trade deficit with China might decrease, but absent any other fundamental changes in American trading patterns, this would do much less to decrease our overall trade deficit. In fact, we may even see our trade deficit with other countries simply rise as a result of a falling deficit with China (Baily & Lawrence, 2006). A much more comprehensive approach that addresses core domestic issues is required to correct US trade imbalances more generally.
Over the past five years, the United States has run a current account deficit averaging about $600 billion, the largest in the world. Deficits have persisted for over a decade. As has been explained in section II, these deficits represent large global imbalances and are growing unsustainably. These imbalances have economic and political ramifications. The Obama administration has announced a plan to increase exports and remove the US from the role of the global “importer of last resort.” There are three primary causes of our overall trade deficit. First, there is a discrepancy between domestic savings and investment in the United States, which causes capital inflow and a negative balance of payments. Because the US consumes more than it produces, it needs to import capital from the rest of the world to fuel business investment. The primary cause of this lack of savings is the marginal propensity to save of US households. US household saving was essentially zero – 0.5% of disposable income in 2007. For this reason, the US needs to rely on capital from the rest of the world and run a large current account deficit (Feldstein, 2008).
Second, persistent and large government deficits cause trade imbalances as well. There are two mechanisms by which fiscal deficits can cause trade deficits, which are together known as the “twin deficits.” An increase in government deficit spending designed to increase household income will also increase imports by a factor equal to the marginal propensity to import, which for the US is extremely high. In addition, financing the deficit creates upward pressure on interest rates in the market, which attracts foreign investment and creates a financial account surplus. This surplus balances out with a trade deficit through a number of mechanisms, including appreciation of the dollar. Finally, an overvalued dollar is an important cause of the trade deficit. In fact, Baily and Lawrence (2006) report “the exchange rate of the dollar is the major factor leading to the trade deficit rather than any structural ability of US manufacturing or services to compete.” A depreciated dollar would make all US exports more competitive in global markets and would reduce the purchasing power of American consumers. Both of these effects would dramatically lower the trade deficit and reduce global current account imbalances.
The US government can take measures to manage these issues. First, policy can be constructed to incentivize household savings. There is some precedent for a tax credit to be given for saved income. Enacting this kind of tax credit plan can be an effective way to simultaneously promote savings and allow the market to allocate investment funds instead of the government. Additionally, the US can shift its national taxation system toward consumption rather than income by instituting a national value added tax (VAT). This would dis-incentivize consumption and thereby promote savings. It would also provide extra government income to reduce government deficits.
Second, US fiscal policy is perhaps the most effective and direct tool by which the government can control the growing trade deficit. As explained above, government deficits can lead to trade deficits through the twin deficit phenomenon. What is perhaps even more dangerous is that interest rates demanded by investors in US sovereign debt are probably not reflective of the actual risk associated with holding Treasury Securities. This is true for a multitude of reasons, including the continued purchase of securities by the Chinese and other sovereign wealth funds and sustained global demand for dollars owing to the dollar’s role as the global reserve and vehicle currency. If US sovereign debt continues to be issued at artificially low interest rates, the US may suddenly find itself subject to an illiquidity crisis similar to that of Greece and other Eurozone countries as the debt to GDP ratio continues to grow. The US fiscal position needs to be strengthened by minimizing deficit spending.
Third, weakening the dollar has been cited as a necessity to resolve global current account imbalances in virtually every discussion on the issue. A devalued dollar will make US exports in all export industries more competitive globally and will help to reduce our trade imbalance by increasing exports and decreasing imports. A devaluation of the dollar has a major strategic advantage over the imposition of trade restrictions and the application of pressure for China to allow the renminbi to appreciate. A devalued dollar will promote investment and job creation in exports sectors that largely represent the comparative advantage of the United States in the global economy. According the Heckscher-Ohlin model of international trade, the US should export capital-intensive, high value-added products – what Baily and Lawrence (2006) call “the industries of tomorrow.” A devalued dollar will promote growth in these sectors. Trade restrictions and renminbi appreciation might help preserve low-skill intensive manufacturing industries in the United States and alleviate trade asymmetries in the short and medium run. However, China has a comparative advantage in low-skill intensive goods and should, in the long run, export these goods to the US and elsewhere. Moving the US economy up the value-added chain must be a strategic objective of economic policy. Devaluing the dollar is a sound method of achieving this objective. The multilateral trade restrictions and renminbi revaluation described above will relieve trade imbalances in the short and medium run, but because of fundamental differences in the comparative advantages of China and the US, they can do little to help move US export sectors upstream.
A cause of a persistently high-valued dollar is the constant demand for dollars by countries looking to expand foreign exchange reserves. Currently, the dollar represents 65% of national reserves (Bergsten, 2009). The demand for dollars due to this function ensures that any increase in the foreign currency reserves of a country must be financed by gross debt from the Untied States (Williamson, 2009). This increased demand for dollars also increases the exchange rate of the dollar to make exports less competitive.
There are, of course, benefits of the dollar as the reserve currency. The dollar reserve system ensures a constant demand for US Treasury Securities that the US can issue in dollar denominations. French President Charles de Gaulle and his economic advisor Jacques Reuff used to refer to the ability of the US to issue debt in the domestic currency as an “exorbitant privilege.” Furthermore, the demand for US assets allows borrowers in the US to enjoy low interest rates on large amounts of borrowing.
I believe these benefits to the reserve currency status of the dollar should be sacrificed, and a new global monetary system that includes a more diverse array of currencies in national reserves should be pursued. The “exorbitant privilege” conferred on the US only amounts to an estimated $40-$70 billion per year (McKinsey Global Institute, 2009). This relatively small sum should be traded off with better export competitiveness due to a devalued dollar that would come about by diversifying national reserves. And while interest rates on US Treasury Securities would rise, this might help the US avoid a sovereign debt crisis in the future by assigning a more realistic market value to the risk associated with US Treasuries as sovereign debt continues to accumulate.
As international trade proliferates, other currencies will likely rise in prominence and be utilized in sovereign wealth funds. This will naturally diminish the role of the dollar as the international reserve currency. To accelerate this process, the United States should push for the expanded issuance of Special Drawing Rights (SDRs) by the IMF to be used as a global reserve currency. The idea of using Special Drawing Rights as the international reserve currency is not new; SDRs were created as a fiat reserve currency almost 40 years ago. To date, however, only about 21.4 billion SDRs are in existence. Because the use of SDRs in the accumulation of sovereign wealth funds allows the growth of these funds without adverse effects on currency valuations and the propagation of global imbalances, some claim that if the rate of SDR creation could satisfy the reserve-accumulation objectives of all countries, global imbalances as a whole could be eliminated (Williamson, 2009). Regardless of whether SDRs or simply another currency is used to diversify the accumulation of foreign reserves, the move away from the dollar as the international reserve currency will depreciate the dollar, allow US exports to compete more effectively on the world market, and reduce the US current account imbalance.
In this paper, I have presented the rise of global imbalances and the role of the US trade deficit in the persistence of these imbalances. I discussed why currency manipulation by China exacerbates these imbalances and what actions the United States and its allies can take to address this currency manipulation. I then explained why the US trade deficit with China is not the only cause of our unsustainable trade and described other aspects of the US economy that contribute to our rising current account imbalance. Finally, I detailed policy that can be pursued to address these more fundamental issues dealing with trade and trade policy in the United States.
There are several outstanding points to be addressed. First, the premise of the argument that the renminbi needs to be revalued can be questioned. An undervalued renminbi benefits consumers of imported Chinese goods and borrowers of incoming Chinese capital alike. Revaluing the renminbi will reduce both of these benefits. However, this sacrifice should be made for the sake of more balanced trade. Reduced consumption of more expensive Chinese goods will lower our trade deficit and perhaps even promote savings. A reduction in freely available foreign capital will more appropriately assign risk to investments. Both of these effects generate positive outcomes in the long run.
Second, it is possible to make the argument that the Chinese will be forced to revalue the renminbi even if the US does nothing to pressure the change. Constant undervaluation of the renminbi places severe inflationary pressure on markets in China. Though the use of capital controls and sterilization techniques mitigate this effect to a small extent, over time these techniques will become less effective, and appreciation will become the only viable way to control inflation. However, given the state of the global economy, the ongoing recovery of the US economy, and the continued growth of sovereign wealth funds, action to appreciate the renminbi is required immediately. The US and other economies might face the consequences of persistent global imbalances before the Chinese consider it necessary to revalue the renminbi if no immediate action is taken.
Third, it is possible to imagine a scenario in which a transition to a floating exchange rate for the renminbi causes depreciation of the currency instead of appreciation. Predictions of appreciation are largely based on trade figures, but if large amounts of capital moved out of China following the removal of capital controls, the renminbi might lose value. This capital flight might occur due to more attractive investment opportunities elsewhere or fear of risk in Chinese investment. However, most agree that this is unlikely, especially given that the Chinese are nationalistic and are unlikely to move money out of China in great quantities.
Finally, there are some who believe that the fact that the Chinese hold a vast amount of dollar assets confers upon them some kind of strategic advantage over the United States. Specifically, many argue that they could precipitate a collapse of the dollar if they begin a widespread selloff of these assets. However, this is highly unlikely, primarily because doing so would destroy the value of the Chinese investment portfolio. In addition, there are few other assets available for investment with the same low level of risk associated with US Treasury Securities. China could retaliate against the US government by purchasing dollar assets from entities other than the US government, but doing so would reduce spreads on those assets relative to Treasuries and help private US borrowers in the long run.
The point of this paper is not to advocate for a confrontational, unilateral trade policy toward China. Indeed, the effects of such unilateral action are likely to be deleterious. Instead, I argue for a multilateral approach to China to force currency appreciation or a reduction in their trade advantage as an effort to reduce trade imbalances. However, the real work must be done domestically. The United States requires a fundamental shift in consumption patterns and economic policy to avoid the negative consequences of long-term global current account imbalances.
 Based on this method of analysis, the renminbi may be undervalued by 17.3% (Cline & Williamson, 2010), 12% (Reisen, 2009), 25% (Rodrick, 2009), or 50% (Ferguson & Moritz, 2009). These estimates differ because of the difficulty in determining equilibrium current account targets.
 Based on this method, the renminbi is undervalued by 30% (Subramanian, 2010). The concern with using the PPP method rests on the fact that, while PPP is a powerful theoretical tool to analyze long-term trends in exchange rates, it is unreliable in practice, especially in the short- and medium-run.
 The Treasury Department has not yet designated China a currency manipulator primarily because of ambiguity in current US trade law. According to the Treasury Department, there must be a clear intent to seek an unfair competitive advantage in currency manipulation before a country can be deemed a currency manipulator. To address this issue, a bill was introduced in the 111thCongress (S. 3134, 2010) that would amend the criteria to require the Treasury to identify “fundamentally misaligned currencies” instead of manipulated currency based on competitive intent. This bill should be passed.
 Widespread capital controls and tight regulation of the renminbi make it impossible to intervene in renminbi currency markets directly. To work around this issue, US authorities can identify and purchase proxy assets instead, such as NDF contracts for renminbi and renminbi-denominated securities in Hong Kong. This necessity would limit the US ability to fully countervail Chinese currency manipulations. However, it would send a strong signal to markets themselves.
 A general indictment of China under Article XV presents some legal concerns. The specific text of the provision makes it difficult to equate the Chinese currency manipulation to “frustrating the intent of the provisions…by exchange action.” However, this represents a weakness in the GATT, not a weakness in the case to be brought to the WTO concerning China.
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