VoxEU Column Exchange Rates

US policy approaches to China’s currency

Many US analysts argue that China’s currency is undervalued and that its policy significantly impedes global macroeconomic rebalancing. This column outlines the possible policy responses available to the US. While multilateral policies are slower, they are less likely than unilateral policies to trigger a negative political response. But first the US needs to establish a principled basis for action.

In the increasingly heated American political discourse about China’s exchange rate, there have been loud cries for action, often unaccompanied by thorough analysis. At a minimum, before adopting any given policy, the US should identify the actions it wishes China to take; it should assess which policy prompts are most likely to bring about that result; and it should carefully consider the possible ramifications of its actions.

What would the US government like China to do?

There is a strong body of opinion in the US that China’s currency is undervalued and that China’s policy significantly impedes global macroeconomic rebalancing. To those holding this view, China’s current peg to the dollar is unacceptable. But what is acceptable? And what would be optimal from a US standpoint?

In lieu of a full answer, we can consider several prominent possibilities.

One is that China could resume the pace of appreciation that it employed from 2005 to 2008, an average rate of roughly 6% per year. This policy would be unlikely to have a dramatic impact on the US in the short term. To the extent history is a guide, China’s earlier appreciation was accompanied by growing current account surpluses and foreign exchange reserve accumulation.

A second possibility is a rapid, “one-off” appreciation. Yet with undervaluation estimates ranging from 25% to 40%, such a rapid appreciation threatens massive dislocations in a Chinese economy that is ill-equipped to handle them. Moreover, it is unlikely that such a shock would stimulate Chinese consumption, at least in the short run.

A third possibility is that China could avoid the question of how quickly to appreciate by leaving it up to market forces. It could open its capital account and let the renminbi trade freely against other major currencies. However, this could just add uncertainty to the problems of economic shock described above and it is not obvious that China’s currency would appreciate. If Chinese savers were free to put their money anywhere in the world, there could be a large outflow of renminbi into other currencies and a resulting depreciation.

Where to draw the line?

A key problem for US policy is the lack of a bright line between acceptable and unacceptable Chinese behaviour. As soon as the US puts itself in the position of issuing an ultimatum, it would need to be able to distinguish between sufficient and insufficient Chinese responses. Would a 1% annual rate of appreciation be acceptable? What about a 5% rate? Is the acceptability of China’s behaviour determined by the level of the exchange rate, the pace at which it appreciates, or the extent of Chinese intervention? There are no clear economic answers to these questions.

Without such a principled basis for action, a US response will appear arbitrary. In the absence of clear economic answers, the only credible approach would be to work with like-minded major countries to clarify international rules.

What is likely to work?

For the US to adopt an optimal strategy, it must have a clear sense of China’s likely reaction. It is commonplace among analysts of Chinese politics to emphasise two sources of legitimacy for China’s current regime: economic performance and nationalism (Shirk 2007). The Chinese government must steer a difficult course between the inflation that is likely to result from a continued currency peg and the unemployment that is likely to result from an appreciation. China’s delays in correcting its currency policies have made this choice increasingly difficult.

The constraints of nationalist sentiment within China are no less real and are often linked to historical grievances. These grievances may be specific, as with China’s war with Japan, or they may relate more generally to the “century of humiliation” dating back to the opium wars of the mid-19th century – an earlier attempt to open China to trade.

The practical implication of Chinese nationalism in this context is that there remains sensitivity to slights on the international stage. Government officials thus may feel constrained in their actions and may play to this nationalist sentiment. Not only has China’s economic success of recent years emboldened its leaders, but as rising Party officials jockey for political prominence, they seek to avoid appearing weak (Wines 2010).

In the context of Chinese currency appreciation, Chinese leaders would likely consider not only the economic implications but also the domestic political repercussions of acquiescing to foreign threats or demands. From the leadership’s perspective, the worst possible outcome would be a policy concession that combined economic turmoil with a loss of face from crumbling to Western pressure.

Options for action

To date, the past two administrations have pursued a strategy of quiet diplomacy with mixed success. China did appreciate its currency by 20% from 2005 to 2008. Outside of that period, however, the RMB has remained fixed against the dollar.

Alternative policies can be grouped into unilateral and multilateral approaches, based not on the adjudicating authority in the case of a complaint, but on whether the US stands alone in pressing a case or whether it is joined by others. If the US acts alone, it will most likely trigger a negative political response from the Chinese government.

Unilateral policy options
  • Currency manipulation label

The US Treasury postponed a decision on whether China has been manipulating its currency, but will ultimately have to issue a ruling. Applying the pejorative label would make it more difficult politically for China to change its policies but would apply no additional economic pressure unless it were accompanied with more substantial measures.

  • Countervailable subsidy

Another prominent idea is to treat China’s currency undervaluation as a countervailable subsidy. There are three potential problems with such an approach. First, countervailing duty cases are generally narrow in scope and slow to conclude. This limits the extent to which they can have a significant economic impact during the current downturn. Second, it appears doubtful that this approach is consistent with WTO requirements. Gary Hufbauer (2007) of the Peterson Institute has argued that countervailable subsidies must feature a government financial contribution and must be specific rather than general. Broad exchange rate policies would seem to be general, rather than specific to an industry, and there is no precedent for considering such policies as a financial contribution1. Finally, a succession of countervailable duty decisions would likely annoy China but would not seem to be of sufficient magnitude to outweigh the concerns mentioned earlier.

  • WTO case

A third idea would be to press a case against China under WTO Article XV. That article says, in part: “Contracting parties shall not, by exchange action, frustrate the intent of the provisions of this Agreement…” If a WTO dispute settlement panel were to rule in favour of the US in an Article XV complaint, the US could be authorised to raise tariff barriers against China if the Chinese refused to change their practices. There are two major problems with this approach. First, WTO dispute settlement cases can take years; thus, this would be unlikely to get results in the near term. Second, there are no precedents for interpreting Article XV nor is there any negotiating language or guidance that would help a dispute settlement panel distinguish between acceptable and unacceptable behaviour. Thus, a panel would either decide against the US, or it would have to engage in creative elaboration of vague principles. Despite the fact that the US government has long disapproved of such overreach by panels, this strategy would require it.

  • Unilateral tariff

The boldest unilateral action would be the sort of across-the-board tariff recently advocated by Paul Krugman (2010). Compared to the other actions, this would impose the most immediate economic pain on China, but it would also maximise the likelihood of a strong nationalist backlash from China that would preclude Chinese compliance with US demands. By blatantly violating US commitments under the WTO, a unilateral tariff would do lasting damage to the rules-based multilateral economic system. This could be disastrous for a US economy that is integrated into the world economy and likely to become more reliant upon exporting for growth. Nor should one expect that the breakdown in cooperation and relations would be limited to the narrow confines of trade relations and currency.

Tariff advocates have set aside these long-term consequences and argued that a high tariff could achieve US short-term goals whether or not China complies. This is highly dubious. Such a bilateral measure could be readily circumvented by a reordering of world trade flows, effectively reversing the shift in trade patterns that accompanied China’s recent rise. For many of the low-cost goods that China produces, its chief competitors are not US firms but other developing nations. Even if the US were to enter lines of business from which China had been excluded, such adjustment takes time. Thus, there are few likely short-term benefits to offset the staggering long-term costs.

Each unilateral approach is marred by the inescapable bilateral tension that would accompany it and by the difficulty of setting global rules without a broader consensus, particularly in the absence of clear technical answers.

Multilateral approaches

Multilateral approaches avoid both these difficulties. In their stead, they present the difficulty of coordinated action, which can be slow and unwieldy.

  • Currency agreement under the WTO

Aaditya Mattoo and Arvind Subramanian (2008) have argued for new and clearer currency behaviour rules under the WTO. The appeals of WTO jurisdiction are the obvious link to trade and the potential for more effective enforcement through trade retaliation. Mattoo and Subramanian acknowledge the limited competence of the WTO secretariat in such matters, but argue that it could work in close collaboration with the IMF. There are serious obstacles to adopting such WTO rule changes in the near future, however. The most obvious vehicle for adopting such changes, the Doha Development Agenda, is stalled and, in any case, such change would need to win consensus support by WTO members, including China.

  • Firmer action by the IMF

The Managing Director of the IMF has stated the Fund’s view that the renminbi is undervalued (Wall Street Journal 2010). This is a topic on which the IMF has great expertise and its Articles of Agreement assign it a role in engaging with member countries to right such wrongs. But the IMF’s power to compel action on the part of a member is generally limited to loan conditionality. This works only when a country is seeking to borrow and has no relevance when a country like China engages in excessive lending. Setting aside enforcement problems, the IMF would be the appropriate institution under which to establish new norms for international financial behaviour, if agreement on those norms could be reached.

  • Explicit norms set by like-minded countries

If it were not possible to reach an agreement on new norms under the auspices of the IMF, an alternative would be to push for an agreement on principles through a grouping such as the G7 or the G20. While the G20 offers enhanced legitimacy by including countries like Brazil, China, and India, it necessarily makes consensus more difficult to achieve. The return to a smaller grouping could facilitate consensus and action.

None of the multilateral approaches offer a quick or easy course of action. They do, however, offer the possibility of a carefully developed set of rules for international financial behaviour that could govern the international economy for years to come. Further, by avoiding the antagonisms of bilateral conflict, a multilateral approach could make it politically easier for China to accede to the new rules.

A final possibility is that the US government shows patience and allows domestic pressures for revaluation within China to prevail. This is what the Obama administration seemed to choose with its decision to delay its report on currency manipulators. If the gamble pays off and China quickly abandons its peg, pressures should diminish. If China delays action further, the loud cries will return with even greater force.

A longer version of this argument was presented as written testimony before the Committee on Ways and Means of the US House of Representatives, “Hearing on China’s Exchange Rate Policy,” March 24, 2010.


Hufbauer, Gary (2007) The US Congress and the Chinese Yuan, Paper presented at the conference on China’s Exchange Rate Policy, Peterson Institute for International Economics, Washington DC, October 19

Krugman, Paul (2010), “Capital Export, Elasticity Pessimism, and the Renminbi (Wonkish),” The Conscience of a Liberal, New York Times, 16 March.

Mattoo, Aaditya and Arvind Subramanian (2008), “Currency Undervaluation and Sovereign Wealth Funds: A New Role for the World Trade Organization”, Peterson Institute Working Paper WP 08-2, January.

Shirk, Susan (2007), “Fragile Superpower: How China's Internal Politics Could Derail Its Peaceful Rise”, Oxford.

Wall Street Journal (2010), “IMF Strauss-Kahn: China's Currency Is Undervalued,” 17 March.

Wines, Michael (2010), “China Blames US for Strained Relations”, New York Times, 7 March.

1 “Gerard Optimistic WTO Will Uphold Currency Initiation on China,” Inside U.S.-China Trade, March 17, 2010.

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