China has stepped up its purchases of U.S. treasuries in recent years, and in September 2008, it surpassed Japan as the largest holder of U.S. debt. This has fueled a relationship of dependency between the United States and China, whereby China has lent to the United States to help fuel its export industry, and U.S. consumers have, in turn, demanded more Chinese imports and further access to cheap credit. The relationship attracted increasing scrutiny in the aftermath of the global financial crisis, as the United States' massive stimulus outlays and loose monetary and fiscal policies fueled doubts about the U.S. economy and the value of its debt. Economists have warned that the relationship has contributed to a large U.S. current account deficit--$470.2 billion for 2010--and an expanding Chinese current account surplus--$306.2 billion for 2010--putting pressure on the global economy. In 2010, the U.S. goods trade deficit with China hit a record high of $273.1 billion. Some U.S. economists and policymakers have blamed the trade imbalance on China for allegedly holding its currency well below market value. In a highly contested move, the U.S. Senate moved to sanction China for being a "currency manipulator" in October 2011. China responded by threatening a so-called trade war. The measure is unlikely to pass the House of Representatives, but economists say it is indicative of a growing strain of protectionism in U.S. economic policy.
China's U.S. Debt Holdings
As of August 2011, China held $1.14 trillion (Xinhua) of its $3.26 trillion in foreign reserves in U.S. treasuries. This figure represents enormous growth in China's U.S. dollar holdings over the past decade, which, in January 2001, amounted to less than $100 billion.
Many economists attribute the buildup to China's export-led growth strategy and exchange rate policies over the past decade. China began pegging its currency to the dollar in the wake of the Asian financial crisis in 1998. That peg continued until July 2005, as China bought or sold as many dollar-denominated assets as were needed to stabilize its exchange rate against the dollar. By mid-2004, China had developed a large trade surplus with the United States. After facing the prospect of an economic slump during the SARS pandemic in 2005, when China pumped money into the economy to stimulate growth, it announced in July of that year that it would allow a 2.1 percent revaluation of the yuan to ease the inflationary pressures caused by excess liquidity.
The yuan appreciated by nearly 20 percent against the dollar (Economist) between 2005 and 2008 in a so-called managed float. At that point, many economists say, China moved back to a fixed exchange rate to prevent its export markets from collapsing during the global financial crisis. Chinese authorities did not announce an official change in policy during this period. Instead, experts "infer it from the fact that the rate hasn't moved," says CFR's Adjunct Senior Fellow for International Economics Steven Dunaway.
An Undervalued Yuan
U.S. policymakers, businesses, and labor groups have argued that the Chinese currency is undervalued by as much as 40 percent against the dollar, making Chinese exports--such as steel pipes and tires--to the United States cheaper, while putting massive dollar flows in the hands of the Chinese. Critics contend that undervaluation of the yuan has expanded the U.S. trade deficit with China, hurting U.S. manufacturers and depressing U.S. employment, which continues to hover above 9 percent. As evidence that the yuan is "significantly undervalued" (PDF), the U.S.-funded nonpartisan Congressional Research Service cited the sharp increase in China's foreign exchange reserves from $403 billion to $1.5 trillion between 2003 and 2007, and China's large trade surplus totaling $268 billion in 2007. In 2010, the country's foreign exchange reserves had climbed to around $3.2 trillion, and its trade surplus had narrowed to $183.1 billion.
U.S. financial regulatory failures ultimately forced trade surpluses on China. --Albert Keidel
According to Uri Dadush, director of the international economics program at the Carnegie Endowment for International Peace, the main indicator that the yuan is undervalued is that China continues to accumulate large foreign exchange reserves. That, Dadush says, is "indicative of China's intervention in the market to keep the yuan from rising."
Others disagree with the notion that an undervalued yuan is the root cause of China's trade surplus and buildup of U.S. dollar reserves. The Atlantic Council's Albert Keidel argues China's buildup of U.S. dollar reserves is not a result of its exchange rate policy but derives instead from the lax U.S. financial regulations that fueled highly leveraged over-borrowing and overconsumption of Chinese exports. "U.S. financial regulatory failures ultimately forced trade surpluses on China," says Keidel. Governments build foreign exchange reserves to fend off speculation against their currencies as they liberalize their financial markets, he says.
A Currency "Manipulator"?
Some economists question whether China's exchange rate policies vis-à-vis the United States and its use of U.S. dollar reserves can be considered "predatory"--designed to depress the value of the yuan and push cheap Chinese goods into U.S. markets. Under the 1988 Omnibus Trade and Competitiveness Act, the Treasury Department is required to report annually on the exchange rate policies of countries with large trade surpluses with the United States to determine if they "manipulate" their currencies against the dollar to prevent "effective balance of payments adjustments or to gain an unfair competitive advantage in international trade."
The Treasury Department has not labeled China, or any other country, a currency manipulator. Treasury reports since China's July 2005 policy change have been increasingly critical of China but have avoided using the term "manipulation," which could prompt a dispute at the World Trade Organization. In Senate hearings at his nomination for U.S. Treasury secretary in January 2009, Timothy Geithner responded to allegations of China's alleged currency manipulation by saying it was a "significant issue" and that China should have "a more flexible exchange rate system."
While the Obama administration has taken a relatively cautious approach to dealing with the currency issue, congressional leaders on both sides of the aisle have been more aggressive. On October 11, 2011, the U.S. Senate passed a bill that would impose tariffs (PDF) on Chinese imports to the United States in an effort to pressure China to allow its currency to appreciate at a faster pace. The speaker of the House of Representatives, John Boehner, has said his chamber will not take up the legislation. For its part, China deemed the Senate measure protectionist (BBC) and warned that the bill "obstructs China-U.S. economic relations and trade."
Dadush says the Senate's move is a misguided effort to force China's hand. He argues that a weak Chinese currency does not fully explain the U.S.-Chinese bilateral trade deficit. "It's a simplistic interpretation." Plus, he notes, China's currency has appreciated by 6 percent (NYT) in the past year. "It is moving in the right direction," he says.
Similarly, data compiled by the Congressional Research Service (PDF) demonstrates that the Chinese trade surplus is more complicated than simple currency devaluation. The report cites data showing that increasing productivity in Chinese export firms--a factor unrelated to exchange rates--has contributed to Chinese export growth.
There is also evidence to suggest that much of the U.S. trade deficit from China comes from the many export-oriented U.S. multinational companies that have moved production to China to take advantage of its low labor costs. In 1986, only 1.9 percent of China's exports came from foreign-investment enterprises in China; in 2006, the share rose to 58.2 percent (PDF), a CRS report notes.
Some economists argue that the use of foreign inputs in Chinese exports also dilutes the relationship between exchange rates and U.S.-China imbalances. In a November 2010 paper, analysts Yuqing Xing and Neal Detert use U.S. company Apple and its highly successful iPhone product to illustrate how structural shifts in global production networks (PDF) have transformed conventional trade patterns. Technological software for iPhones is developed in the United States, while completed iPhones are exported by China to the United States. China is merely an assembly center, adding $6.50 to the $178.96 wholesale value of the product, they say, but when trade statistics are calculated, it ends up getting credit for the full value of the iPhone. "Conventional trade statistics greatly inflate bilateral trade deficits between a country used as an export-platform by multinational firms and its destination countries," they write.
At the same time, in a 2010 white paper on doing business in China, the American Chamber of Commerce in China said it was "concerned that the [United States] is placing disproportionate emphasis on [yuan] valuation." Revaluing China's currency "would likely result only in a modest decrease in the current trade deficit" between the United States and China, whereas "focusing on other price distortions, such as factor pricing [the cost of labor or resources] in China, would possibly result in greater adjustments."
Risks to the U.S. and Global Economies
Critics of China's exchange rate policies and its trade surplus say the resulting buildup of China's dollar reserves threatens growth and stability in the U.S. economy. The Peterson Institute's C. Fred Bergsten has said that China's policy of keeping the yuan undervalued leads to a "sizeable dollar overvaluation" and rising trade deficits. These deficits in turn provoke industry leaders to ramp up pressure for protectionist U.S. trade policies.
Without addressing the root of the problem--America's chronic saving shortfall--it is ludicrous to believe that there can be a bilateral solution for a multilateral problem. --Stephen S. Roach
Another concern is whether the United States can continue to rely on China to buy U.S. debt as U.S. deficits grow. Some analysts contend that the U.S. economy would suffer a significant blow if it lost the favorable interest rates offered by China to finance its debt. In August 2011, credit rating agency Standard and Poor's downgraded U.S. debt by one notch for the first time in history, igniting a debate over whether U.S. treasuries will still remain the safest asset in the world. Following the unprecedented move, China sold $36.5 billion in U.S. treasuries, bringing it to $1.137 trillion, its lowest level in a year. Still, experts say there are few other choices besides the United States in which China can safely invest its large foreign reserve holdings. "The alternatives," says Carnegie's Dadush, "are European government bonds and Japanese government bonds, neither of which are very appetizing."
U.S. Policy Implications
Many U.S. policymakers have called for China to wean itself off export dependence and build up domestic consumption to correct the "global imbalances" that drew so many U.S. dollars to China in the first place. The Obama administration and G20 leaders, including Chinese President Hu Jintao, pledged at September 2009's Pittsburgh summit (PDF) to develop a program to address these imbalances and undertake "monetary policies consistent with price stability in the context of market-oriented exchange rates."
In addition to the recent U.S. Senate legislation targeting China, U.S. congressional leaders have also proposed ways to act against China through international bodies, including the International Monetary Fund and the WTO. "The IMF has never labeled a country a currency manipulator, but it's something they need to think about, because if there's no pressure, there's no change," says Dunaway, a former IMF official on Asia. He says China returned to a largely fixed exchange rate in 2008 in part because "the issue dropped off the agenda" globally.
Other experts question the efficacy of appeals to international institutions. In a December 2008 paper (PDF), Stanford University's Robert Staiger and Alan Sykes write that proving China's violation of WTO commitments vis-à-vis its currency policies would be difficult. They dispute the notion that currency devaluation alters trade balances in the long run.
Some say focusing on China's currency is merely a distraction from other drivers of U.S. debt, such as structural fiscal deficits and a low level of personal savings. Morgan Stanley Asia Chairman Stephen S. Roach notes that the United States runs trade deficits with eighty-seven other countries (GulfNews). "Without addressing the root of the problem--America's chronic saving shortfall--it is ludicrous to believe that there can be a bilateral solution for a multilateral problem."