Currency Wars

While the World Trade Organization’s trade negotiations have failed this week in its efforts to deal with a wide variety of  issues such as standards, patents, and various nontariff barriers to trade, the 800-pound elephant in the room that directly affects United States jobs—Asian currency manipulation to undervalue exports—remains unaddressed by the international trading community.   Currency manipulation refers to government measures that maintain the value of a currency at levels differing from that which would result from the free working of market forces.  Currency wars are costing Americans jobs, and this has become a central issue in the presidential campaign.

For the United States the most salient issue is China, although currency manipulation is also being pursued by Japan and Taiwan.  Fueled by an undervalued currency of at least 40 percent pegged to the U.S. dollar at 8.28 yuan to the dollar China is now running a $125 billion trade surplus with the United States[1].     Having rebuffed the requests of the United States to revalue its currency upwards, and having made a policy decision to pursue a “beggar thy neighbor” trade policy, Beijing must now live with the legal consequences of its actions.  The U.S. Government has a series of legal responses that are necessary and appropriate under the circumstances, unilaterally, under Section 301 of the Trade Act of 1974, which permits the United States to retaliate against unfair foreign trade practices;  bilaterally, through formal consultations with the Government of China;  and multilaterally, through the International Monetary Fund and the World Trade Organization. 

The core of the problem is that China’s mercantilist currency manipulation violates the Articles of the International Monetary Fund, the rules of the World Trade Organization, and Section 301 of the Trade Act of 1974, which gives the President the power to move against the unfair trade practices of foreign governments.  China’s actions also violate the terms and conditions of its acceptance to the World Trade Organization.

Trade is supposed to take place based on the Law of Comparative Advantage[2], and international trade law proscribes trade based on currency manipulation, which is an unfair foreign trade practice.  While China possesses a comparative advantage in labor costs it is taking advantage of its currency manipulation to expand its exports to the United States and limit U.S. imports into China.   It is true that Chinese currency dumping brings lower prices to U.S. consumers, but so do subsidized articles in commerce as well as dumped goods, and the foreign trade laws of the United States apply to them as well.  While consumer welfare is an important normative value it is not the only consideration involved in determining what is an unfair foreign trade practice.

Pursuant to Article IV, Section 1 (iii) of the Articles of the International Monetary Fund signatories undertake not to manipulate their currencies in order to gain an unfair competitive advantage in international commerce. The provision states that each member shall “avoid manipulating exchange rates or the international monetary system in order to prevent effective balance of payments adjustment or to gain an unfair competitive advantage over other members.”  Indeed, the IMF was established in large part to discourage competitive currency devaluations.   Article VIII, Section 2 of the Articles also proscribes “discriminatory currency arrangements.”  By tying the yuan to the dollar at a fixed exchange rate of 8.28 yuan to the dollar China is  intentionally and automatically undervaluing the yuan against the dollar—but not other currencies such as the Euro-- and it thus distorts trade to its advantage.  Unfortunately, the IMF has not held China’s feet to the fire to force it to revise its “soft peg to the dollar” policy, although it urged China in its September 2000 Article IV consultation to pursue “greater exchange rate flexibility.”

Moreover, the General Agreement on Tariffs and Trade (GATT) also requires its signatories not to manipulate currency in order to gain a competitive advantage in international trade.   Article XV (4) of the GATT provides that “Contracting Parties shall not, by exchange action, frustrate the intent of the provisions of this Agreement….”   In addition, Article XXIII (1) of the GATT provides that the Contracting Parties are obligated not to take any actions that have the effect of nullifying and impairing the benefits of any objective of the GATT.  China’s suppression of its currency is expressly designed to nullify and impair the benefits of its prior trade concessions. The clear intention of the currency manipulation by China is to increase exports and restrict imports, i.e., to introduce an artificial element that assures that there will not be a level playing field for international trade.   China’s currency manipulation thus violates both the specific prohibition against currency manipulation and the more general ban against actions that undermine prior trade agreements.

Apart from the specific Article XV prohibitions against currency manipulation, China’s actions violate the core principle of the GATT that protection should take place solely through the use of bound tariff barriers that are applied on a non-discriminatory basis.  China’s currency manipulation, on the contrary,  is an end run around tariff protection applied in a discriminatory fashion against the United States.

Currency manipulation is accomplished by China through a state monopoly over foreign currency run by its banks and its State Administration of Foreign Exchange (SAFE).  China requires the compulsory settlement of foreign exchange, which results in the state purchasing the foreign exchange earnings of firms at the established rate of 8.28 yuan to the dollar by the Chinese Foreign Exchange Trading Center (CFETC) and placing them under the direct management of SAFE.   Moreover, the Chinese authorities continue to intervene in the forward exchange market to buy dollars with their yuan to bid up the price of the dollar and suppress the value of the yuan.

The question now is not whether China is manipulating its currency in order to gain a competitive advantage but by how much.  At the low end of the scale is Goldman Sachs, which estimates the undervaluation at 15 percent.  The estimate by the Manufacturer’s Alliance and Ernest Preeg is 40 percent.  And the purchasing power parity scale represented by The Economist’s Big Mac index (what a Big Mac served by McDonald’s would cost around the world) is 56 percent, about the same level as the World Bank estimate.  According to The Economist the yuan is the most undervalued currency in the world.

All of this would be of merely academic interest were it not for the $103 billion trade deficit that the United States ran with China in 2002, and the $125 billion trade deficit rate it is running at in 2003.  That the currency manipulation of China is a burden on U.S. commerce is demonstrated by the pressure placed by Chinese exports on one U.S. industry after another including textiles, wood furniture, paper products, metal parts and machine tools, and the fact that China, in the last 12 months, has purchased $88 billion of U.S. dollars, and now possesses $356 billion in U.S. dollars in currency reserves.  The loss of 2,200,000 manufacturing jobs over the last 32 months, and the fact that more than one in every ten American factory jobs has disappeared over the last two years, is evidence of the damage being done to the U.S. manufacturing base by China’s currency manipulation.

The time for talk is over.  The time for action is now.  The Office of the United States Trade Representative should self-initiate an investigation of China’s currency manipulation under Section 301 of the Trade Act of 1974, which permits the President to take all appropriate and necessary action, including trade sanctions, to eliminate the unreasonable and unlawful practices of foreign governments that burden U.S. commerce.   Upon initiation of the complaint the Trade Representative should promptly seek formal bilateral consultations with the Government of China on a program to fairly value its currency.  Finally, the U.S. Government should request formal IMF surveillance procedures with regard to China’s manipulation of its currency, and raise the issue with the Group of Seven..  The time has come to recognize that China, having joined the World Trade Organization, must play by its rules, which include its proscription against currency manipulation.

Bart S. Fisher is an attorney in Washington, D.C. and Professorial Lecturer in International Affairs at the Elliott School of International Affairs of George Washington University  in Washington, D.C.