Commentary | Trade and Globalization

China’s currency defiance

Opinion pieces and speeches by EPI staff and associates.


China’s currency defiance

By Robert E. Scott

Early this morning the U.S. and China concluded their third “Strategic Economic Dialogue” in Beijing, and there was no reason to expect significant progress on one key issue of contention: China’s refusal to significantly revalue its currency, the yuan, despite widespread agreement among economists and G-8 officials that its substantial undervaluation is suppressing imports.

Unfortunately, Treasury Secretary Henry Paulson’s approach has been unlikely to move China on the currency issue or to address other urgent issues on the table, including food and product safety. The administration needs to work with the G-8 leading industrial nations and other key trade partners to negotiate an international currency accord with China and other currency manipulators, and be prepared to use real threats of sanctions to persuade them to abandon currency manipulation.

Despite a sharp decline in the value of the U.S. dollar against the euro and other major foreign currencies, it remains heavily overvalued against the Chinese yuan, the Japanese yen, and the currencies of other Asian developing nations and oil-exporting countries. China alone is on track to purchase more than $500 billion worth of U.S. treasury bills and other foreign exchange this year to artificially cheapen its currency. This Chinese peg restrains other important trading partners such as Japan from letting their currencies rise to sustainable levels against the dollar for fear of losing export sales.

The U.S. trade deficit with China is projected to exceed $260 billion in 2007, a 15 percent increase over 2006. This deficit will be more than one-third of the overall U.S. current account deficit, the broadest measure of our goods, services and income payments, which will exceed $750 billion in 2007.

The U.S. must borrow or sell more than $3 billion worth of net assets every business day to finance the current account deficit. The housing crisis is making this harder to do, and both raise the risk of a run on the dollar and flight from U.S. capital markets. This could cause interest rates to soar, consumption and business investment to fall, and pitch the U.S. into a severe recession.

In September 1985, the United States also suffered from large trade deficits, and the dollar was similarly overvalued, especially versus the Japanese yen. Then Treasury Secretary James Baker abandoned the unilateral, “Free Market” approach of the first Reagan administration and shocked financial markets by negotiating the Plaza Accord with other members of the G-5. These countries then jointly intervened in currency markets (by selling dollars and buying up other currencies), driving the dollar down 17 percent until the Louvre Accord was negotiated in February 1987, which stabilized the dollar at its new lower level. The yen appreciated 36 percent under the Plaza Accord, a reflection of how effective such agreements can be in realigning pegged currencies.

Ironically, the Plaza Accord might never have happened were it not for strong congressional pressure. The House twice passed its version of the Rostenkowski-Gephardt-Bentsen trade act, which would have imposed a 25 percent import surcharge on countries such as Japan, Brazil, Korea and Taiwan that maintained large trade surpluses with the United States.

A new Plaza Accord should be negotiated, and it should be based on clearly established target values for the dollar and other foreign currencies. Currency intervention alone will not be enough to reverse the damage from foreign currency manipulation. China and other currency manipulators, as well as other members of the G-8, will need to increase consumption at home since they will no longer be able to depend on ever-increasing trade surpluses with the United States to support economic growth.

The U.S. will also need to increase competitiveness in manufacturing, which produces most traded goods, by increasing R&D spending, clean energy investments and steps to address the health-care crisis.

Growth of the U.S. trade deficit with China alone has eliminated 1.8 million U.S. jobs since 2001. Halting currency manipulation could prevent further job loss and support millions of new jobs in manufacturing and other trade-related industries. A new Plaza Accord could cut the risks of a U.S. recession by boosting exports and eliminating a possible dollar crisis.

The first step should be to begin currency negotiations with major trading partners. Congress could jump-start the process by passing tough trade legislation. This would force the administration to act, and give it a credible threat and negotiating leverage with China and other currency manipulators.

Bilateral talks aren’t working with China. It’s time for a new approach based on the strong leadership of the original Plaza Accord.

Robert E. Scott is senior international economist at the Economic Policy Institute in Washington, D.C.


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