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Currency “manipulation” and world trade: A caution

Many critics argue that Chinese currency undervaluation amounts to an export subsidy and import tariff responsible for global trade imbalances. This column cautions against that equivalence. In the long run, currency devaluation does not alter export volumes, and in the short run, its effects depend on firms’ invoicing decisions. Policymakers should take care before turning to trade sanctions as a remedy.

The Chinese yuan was pegged from 1994 until mid-2005 at 8.28 yuan to the US dollar. China shifted in 2005 to a policy of loosely pegging the yuan to a basket of major currencies. Since then the yuan has appreciated against the dollar, and the current yuan/dollar exchange rate stands at roughly 6.84. Over the same period, the yuan generally depreciated against the euro, falling from 10.06 in June 2005 to 10.79 in June 2008. With the recent financial crisis, however, the euro has depreciated and the yuan/euro exchange rate presently stands at 8.99. Throughout this period, China has intervened actively in foreign exchange markets to prevent the yuan from appreciating faster by selling yuan and buying other major currencies (mostly dollars). As a result of this policy, its foreign exchange reserves grew from $403 billion at the end of 2003 to $1.9 trillion at the end of 2008.1

A number of economic commentators argue that China’s policies amount to market-distorting currency manipulation. For example, C. Fred Bergsten of the Peterson Institute for International Economics recently suggested that the yuan must appreciate approximately 40% against the dollar to correct current “global imbalances,” and urged the US to take multilateral and if necessary unilateral action to pressure China to change its ways (Bergsten, 2008). Michael Mussa has expressed similar views (Mussa, 2007), as has Arvind Subramanian (Subramanian 2008).

Politicians have gotten into the mix. Officials on both sides of the Atlantic have argued that Chinese currency practices unfairly distort trade, amounting to the equivalent of a subsidy to exports and a tariff on imports that each would violate WTO rules if imposed directly. President Obama stated in October 2008, for example, that China’s current trade surplus is “directly related to its manipulation of its currency’s value.” He concurrently promised to “beef up US enforcement efforts against unfair trade practices.” Similar comments were made on various occasions by former EU Trade Commissioner Peter Mandelson.

Various proposals for action against China have been put forward in the US Congress over the past few years, running the gamut from insisting that the Treasury Department refer the matter to the IMF to requiring the US Trade Representative to bring a formal complaint to the WTO to treating China’s alleged currency manipulation as a source of dumping or countervailable subsidies that would permit the imposition of antidumping or countervailing duties on Chinese imports. For many of these proposals, a common – and critical – ingredient for practical implementation involves a translation of China's exchange rate policies (and specifically the magnitude of its exchange rate “misalignment”) into equivalent real trade policies – such as export subsidies and/or import tariffs – that could then be more readily evaluated under the rules of the WTO, either to identify the appropriate response by the WTO itself or to assess the WTO-consistency of unilateral responses.

In a recent paper (Staiger and Sykes 2008), we offer three reasons for caution regarding the claims that have been made by the economic commentators and the proposed countermeasures under discussion in the political arena.

Equivalence between a devaluation and a tariff-cum-subsidy need not imply that a devaluation warrants WTO action

The translation of currency practices into equivalent trade policies is straightforward in the long run when all prices are fully flexible. As is well known, currency market intervention has no real effects in that environment due to the long-run neutrality of money – prices in a country that devalues its currency will adjust so that the real effects of the devaluation and implied price changes cancel out, leaving import and export volumes unchanged. Nevertheless, a devaluation in this environment is equivalent to the imposition of a tariff on all imports and a subsidy to all exports. Just as with the devaluation, the tariff-cum-subsidy policy leads to price adjustments that cancel each other out and leave import and export volumes unchanged (an implication of Lerner symmetry).

Two specific points follow. First, exchange rate intervention need not imply real trade effects. Indeed, because China’s currency policies are longstanding and the yuan has, if anything, appreciated against the dollar in recent years, it is at least possible that any trade effects of Chinese policy have largely washed out in accordance with this long-run scenario.

Second, the oft-heard claim that devaluations (or the prevention of appreciations) are equivalent to the imposition of a tariff-cum-subsidy is not by itself sufficient to establish a case for WTO- or WTO-consistent- action against such currency interventions. From the long-run perspective considered here, the equivalence does exist, yet no action in response to the currency intervention is warranted.

The trade-policy equivalent of a devaluation in the short run hinges on the details of the invoicing decisions of firms

In the short run, with sticky prices, a devaluation will have real effects, but these effects – and hence translation of a devaluation into trade policy equivalents – depend importantly on how internationally traded goods are priced. Moreover, the impact of trade policies such as tariffs in a sticky-price environment can be quite different from the impact of tariffs in the long run, which adds a further layer of complications in assessing whether exchange market intervention can be said to upset the WTO bargain.

For example, suppose that all producers invoice goods in their domestic currency. Competitive producers will set their prices such that their returns from sales are the same regardless of where they occur (the law of one price holds). Now imagine that the Chinese government undertakes measures that produce an unanticipated devaluation during the period when producer prices are sticky. The price of exports to China rises in yuan, and the price of Chinese exports falls measured in units of foreign currency. The ratio of the price of exports to China relative to the price of Chinese exports thus rises in any common currency, inducing some expenditure switching between them. In this case, the equivalence between a devaluation and a tariff-cum-subsidy continues to hold, just as in the long run (flexible price environment).

Yet the effects of the tariff-cum-subsidy in this case differ importantly from the long-run effects that trade policies are ordinarily thought to have. There is no inefficient wedge driven between prices in the two markets as would be the case with a conventional import tariff. And from the perspective of countries exporting to China, the terms of trade improve, an effect that would by itself generate a welfare gain for the nations exporting to China and that runs counter to the usual effect associated with internationally inefficient trade policy intervention.

Alternatively, suppose that producers set their export prices in the currency of their foreign customers, while setting their domestic prices in their home currency. Initially, those prices are also set such that the returns expected from sales in each market are the same. Assume once again that these prices are sticky in the face of an unanticipated devaluation by China. Firms exporting to China now earn fewer units of domestic currency on their Chinese sales, while Chinese exporters now earn more yuan on their export sales. Here, the ratio of prices in each currency remains the same as before the devaluation and there is no expenditure switching, but the terms of trade improve for China. In this case the devaluation is equivalent to an import tariff alone: there is now no role whatsoever for an export subsidy when translating the devaluation into equivalent trade policy intervention. The effects of the tariff in this case will also differ from their ordinary effects, as there are now no expenditure-switching effects between Chinese goods and other goods.

Existing estimates of exchange-rate misalignment are not reliable for quantification of WTO-relevant effects

It follows from the points above that, one simply cannot make a leap from equilibrium exchange rate models, which may suggest that China’s currency is undervalued by some percentage, to the proposition that China’s policies are the real economic equivalent of an illegal import tariff increase and an illegal export subsidy in that same percentage. Either policy, if undertaken by itself, would have real trade effects and likely violate China’s WTO commitments. But such policies taken together would cancel each other out in the long run and have no real effects. Thus, they could not impair the WTO bargain in the long run.

In the short run, the real equivalents of China’s exchange market policies hinge on the details of pricing practices, and existing estimates of misalignment do not incorporate information that would be critical in the WTO legal context. For example, it is possible that China’s currency policies are equivalent to placing an implicit tariff on its imports, as we have observed. But in this case, only the portion of the estimated misalignment that could not have been reasonably anticipated at the time of China’s accession to the WTO in 2001 would be relevant for assessing whether its currency policies have upset the WTO bargain.


For these reasons, we question whether China’s trading partners can readily make a convincing case that China has violated its WTO commitments by intervening in currency markets in a manner that frustrates the intent of GATT. Similarly, the suggestion that one can characterise China’s policies as the equivalent of an illegal tariff and an illegal export subsidy is problematic. We do not necessarily advocate that China’s policies be ignored, but urge a great deal of caution toward proposals that would sweep them into the domain of unfair trade practices and bring to bear the attendant arsenal of unilateral or multilateral trade sanctions.

Editors' note: This column is a Lead Commentary on Vox's Global Crisis Debate where you can find further discussion, and where professional economists are welcome to contribute their own Commentaries on this and other crisis-linked topics.

Bergsten, C. Fred (2007), The Global Imbalances and the US Economy, Testimony before the Subcommittees on Trade, Ways and Means Committee: Commerce, Trade and Consumer Protection, Energy and Commerce Committee; and Domestic and International Monetary Policy, Trade and Technology, Financial Services Committee of the House of Representatives, May 9.

Mussa, Michael (2007), “IMF Surveillance over China’s Exchange Rate Policy”, Peterson Institute of International Economics Working Paper.

Staiger, Robert W. and Alan O. Sykes (2008). Currency Manipulation and World Trade, NBER Working Paper No. 14600.

Subramanian, Arvind (2008), “Imbalances and undervalued exchange rates: Rehabilitating Keynes”, FT.com, November 9.


1 “Foreign exchange reserves decline in October” China Economic Review, 14 January 2009

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