China Labeled as a Currency Manipulator
—Whither the Chinese Yuan?

After some twists and turns, the U.S.-China trade war that broke out in March 2018 came to a temporary ceasefire at the U.S.-China summit meeting held on June 29, 2019, on the sidelines of the G20 summit in Osaka. However, it has flared up again since President Trump announced on August 1 that an additional 10% in tariffs will be imposed on 300 billion dollars' worth of Chinese products on September 1 and China retaliated by suspending purchases of U.S. agricultural products. Against this background, the Chinese yuan broke through the 7-yuan-per-dollar level on August 5 on the foreign exchange market, falling to the lowest level since May 2008. In response, the United States designated China as a currency manipulator on the same day, turning the U.S.-China trade war into a currency war.

Under Section 3004 of the Omnibus Trade and Competitiveness Act of 1988, the U.S. Treasury Department is required to analyze whether or not other countries are manipulating exchange rates against the dollar for the purposes of preventing effective balance of payments adjustments or gaining an unfair competitive advantage in international trade. As a result of such analysis, the Treasury Department announced on August 5, 2019, that Treasury Secretary Mnuchin, under the auspices of President Trump, determined that China is a currency manipulator (U.S. Treasury Department, "Treasury Designates China as a Currency Manipulator," Press Release, August 5, 2019, hereafter referred to as "the U.S. Treasury's statement"). This was the first designation of a foreign country as a currency manipulator by the Treasury Department since China was designated as such in 1994.

Usually, the designation of a country as a currency manipulator is announced in the Treasury's semiannual foreign exchange rate report to Congress (hereafter referred to as the "exchange rate report"). It was extraordinary that the timing of China's designation as a currency manipulator by the Treasury Department was unrelated to the exchange rate report. At any rate, this action means that President Trump has delivered on the promise made when he was campaigning for presidency in 2016, to designate China as a currency manipulator if he was elected.

The United States' designation of China as a currency manipulator is part of its maneuvering in dealing with escalating trade friction with China. Its most powerful weapon in the ongoing trade war is the imposition of additional tariffs on imports from China. By designating China as a currency manipulator, the United States is apparently trying to warn the Chinese government against offsetting the negative impact of additional tariffs on U.S.-bound exports from China through the devaluation of the yuan.

At the same time, the United States also desires a weaker dollar because it is worried about a possible expansion of the U.S. trade and current account deficits that result from a strong dollar. Therefore, the United States cannot tolerate the yuan's decline against the dollar. As pointed out in the treasury's latest exchange rate report ("Report to Congress, Macroeconomic and Foreign Exchange Policies of Major Trading Partners of the United States," U.S. Department of the Treasury, Office of International Affairs, May 2019), the dollar's real effective exchange rate at the end of 2018 was 4.5% higher than a year before and 8% higher than the average over the past 20 years. The U.S. government views the yuan's decline against the dollar as one of the factors behind the dollar's strength. In a Twitter post on August 8, President Trump called for the Federal Reserve Board (FRB) to help to weaken the dollar through interest rate cuts, insisting that because the FRB is keeping interest rates at a high level relative to the rates in other countries, the dollar remains strong, putting U.S. companies at a disadvantage in international competition.

Section 3004 of the Omnibus Trade and Competitiveness Act of 1988 and the Trade Facilitation and Trade Enforcement Act of 2015 provide the legal basis of the U.S. designation of a foreign country as a currency manipulator. While Section 3004 does not lay down clear criteria for designation, the Trade Facilitation and Trade Enforcement Act stipulates that a country which meets the following criteria should be designated as a currency manipulator:
(i) Having a significant trade surplus with the United States
(ii) Having a material current account surplus
(iii) Engaging in persistent and one-sided intervention in the foreign exchange market

In the April 2016 exchange rate report, the U.S. Treasury Department for the first time set numerical benchmarks for the above three criteria as follows:
(i) Having a goods trade surplus (excluding services) of at least 20 billion dollars with the United States
(ii) Having a current account surplus equivalent to 3% or more of GDP
(iii) Having conducted net purchases of foreign currency in at least eight of the past 12 months totaling at least 2% of GDP.

In the May 2019 exchange rate report, the threshold level of current account surplus was revised to 2% or more of GDP from 3% or more, while the threshold number of months of net purchases of foreign currency was revised to six months from eight months.

The U.S. Treasury Department designates a country that meets all of the three criteria as a currency manipulator. When a country meets two of the three criteria, it is placed on the monitoring list, which means that the country comes under enhanced monitoring.

However, as China meets only criterion (i), it does not deserve even to be placed on the monitoring list, let alone to be designated as a currency manipulator. As mentioned in the May 2019 exchange rate report, China's trade surplus with the United States in 2018 was 419 billion dollars, much higher than the threshold of 20 billion dollars, whereas its current account surplus in 2018 was equivalent to 0.4% of GDP, lower than the threshold of 2%. As for the exchange intervention criteria, the stable level of its foreign exchange reserves suggests that China has been refraining from intervention since 2017 (Figure 1).

Source: Compiled by the author based on the CEIC database (raw data were prepared by the State Administration of Foreign Exchange of China and People's Bank of China).

However, in the May 2019 exchange rate report, China was placed on the monitoring list, together with Japan, South Korea, Germany, Italy, Ireland, Singapore, Malaysia and Vietnam (Table 2). This was based on the new criterion presented in the April 2017 exchange rate report—that the government should "add and retain on the monitoring list any major trading partner that accounts for a large and disproportionate share of the overall U.S. trade deficit even if that economy has not met two of the three criteria laid down in the Trade Facilitation and Trade Enforcement Act of 2015. This "fourth criterion" is obviously targeted at China. Even so, China was not designated as a currency manipulator in the latest exchange rate reports.

Note: The above figures are for the most recent four quarters. The figures in the shaded areas are higher than the criteria thresholds.

Source: Compiled by the author based on "Macroeconomic and Foreign Exchange Policies of Major Trading Partners of the United States," U.S. Department of the Treasury, Office of International Affairs, May, 2019.

When designating China as a currency manipulator, the U.S. Treasury Department invoked Section 3004 of the Omnibus Trade and Competitiveness Act of 1988, which lacks clear criteria and therefore gives the Treasury Secretary wider discretion, instead of the Trade Facilitation and Trade Enforcement Act of 2015 and related criteria, which fail to provide a sufficient legal basis for taking such an action. In the U.S. Treasury's statement, the following justifications were given for the designation of China as a currency manipulator.

· China has a long history of facilitating an undervalued currency through protracted, large-scale intervention. China has taken concrete steps to devalue its currency in early August, while maintaining substantial foreign exchange reserves despite active use of such tools in the past. The context of these actions and the implausibility of China's market stability rationale confirm that the purpose of China's currency devaluation is to gain an unfair competitive advantage in international trade.

· The Chinese authorities have acknowledged that they have ample control over the exchange rate of the yuan. In a statement issued on August 5, the People's Bank of China noted that it "has accumulated rich experience and policy tools, and will continue to innovate and enrich the control toolbox, and take necessary and targeted measures against the positive feedback behavior that may occur in the foreign exchange market" ("RMB Exchange Rate Is Undoubtedly Able to Remain Basically Stable at an Equilibrium and Adaptive Level-PBC Official Answers Press Questions on RMB Exchange Rate," Website of the People's Bank of China, August 5, 2019). This is an open acknowledgement by the People's Bank of China that it has extensive experience manipulating its currency and is prepared to do so on an ongoing basis.

· This pattern of actions is a violation of the country's commitment to refrain from competitive currency devaluation.

In response to the U.S. Treasury Department's designation of China as a currency manipulator, the People's Bank of China issued a statement expressing deep regrets at the designation and saying that "such a label is not consistent with the quantitative criteria set by the U.S. Treasury itself for the so-called currency manipulator. As a capricious act of unilateralism and protectionism, it will severely undermine international rules and have material impacts on the global economy and finance" ("Statement of the People's Bank of China on US Treasury Department Designating China as a Currency Manipulator," August 6, 2019). In this statement, the People's Bank of China defended its own stance of exchange rate policy and criticized the U.S. decision as follows.

· China's exchange rate system is a managed floating system based on market supply and demand with reference to a basket of currencies. There is no such issue as exchange rate manipulation, as the yuan's exchange rate is determined by market supply and demand. The yuan's depreciation since the beginning of August has been driven and determined by market forces and reflects shifts in market dynamics and volatilities in global foreign exchange markets amid global economic developments and escalating trade frictions.

· The People's Bank of China is committed to keeping the yuan's exchange rate basically stable at an equilibrium and appropriate level . According to the data of the Bank for International Settlements (BIS), during the period between the beginning of 2005 and June 2019, the yuan's nominal effective exchange rate and real effective exchange rate appreciated by 38% and 47%, respectively. The yuan has been the strongest currency among the G20 economies throughout that period. The size of its appreciation is also among the largest among all currencies. In the just concluded Article IV consultation, the IMF pointed out that the yuan has been broadly in line with the fundamentals. In the 1997 Asian financial crisis and 2008 global financial crisis, China stayed true to its commitment of maintaining the yuan's stability, and lent strong support to the stability of the financial market and the global economic recovery. Though the United States has continued to escalate the trade dispute since 2018, China has kept its promise of not carrying out competitive devaluation. China has never used and will not use the yuan's exchange rate as a tool to deal with the trade frictions.

· China opposes the United States' designation of China as a currency manipulator in total disregard of the facts as it harms the interests of both China and United States. It will seriously undermine the international financial order and give rise to financial market volatility. Furthermore, it will obstruct international trade, cut into the recovery of the world economy, and ultimately hurt the self-interest of the United States. This unilateral act has undermined the multilateral consensus on exchange rates and will have negative and serious impacts on the stable functioning of the international monetary system. The Chinese side urges the United States to turn back from this wrong path and return to a rational and objective track.

Section 3004 of the Omnibus Trade and Competitiveness Act of 1988, which forms the legal basis of the designation of China as a currency manipulator, does not provide for specific sanctions against designated countries. The U.S. Treasury's statement cited the following actions to be taken but did not mention further measures that may be taken if desired results are not achieved: (1) Secretary of Treasury Mnuchin will engage with the International Monetary Fund (IMF) to eliminate the unfair competitive advantage created by China's latest actions; (2) the Treasury Department places significant importance on China adhering to its G-20 commitments to refrain from engaging in competitive devaluation and to not target China's exchange rate for competitive purposes; and (3) the Treasury Department continues to urge China to enhance the transparency of the yuan's exchange rate and its reserve management operations and goals.

On the other hand, the Trade Facilitation and Trade Enforcement Act of 2015 requires the president to implement the following measures if it is determined one year after the commencement of the Treasury Department's negotiations with a country designated as a currency manipulator that the country has failed to adopt appropriate policies to correct problems such as the undervaluation of its currency and its trade surplus: (1) prohibit the Overseas Private Investment Corporation (OPIC) from approving any new financing (including any insurance, reinsurance, or guarantee) with respect to a project located in that country; (2) prohibit the federal government from procuring goods or services from that country. However, given that China is neither a major borrower of OPIC nor a major procurement source for the U.S. government, those measures, even if implemented, will have only a small impact. Even so, the fact that the United States has expressed a strong resolve to prevent the yuan's depreciation by designating China as a currency manipulator is expected to impose some constraints on China's future foreign exchange policy.

At a time when the yuan is under pressures in opposite directions from the market and from the U.S. government, China may have to change its foreign exchange rate policy and choose from the following three options.

(1) Return to the dollar peg system
China could shift from the current managed floating system back to the dollar peg system, a de facto fixed rate system that had been in place until July 2005. In fact, China overcame the global financial crisis by adopting a similar policy from around the time of the collapse of Lehman Brothers in September 2008 to February 2010. Under this system, the authorities keep the daily benchmark midpoint rate between the yuan and the dollar unchanged and are resolved to conduct exchange market intervention in order to demonstrate their strong commitment to exchange rate stability. If the yuan comes under downward pressure, dollar-selling, yuan-buying intervention will become necessary, and China's foreign exchange reserves will dwindle as a result. China's holding of foreign exchange reserves amounting to 3 trillion dollars would help the country maintain the dollar peg system.

(2) Devaluation of the yuan
China could allow the yuan to fall gradually against the dollar, or implement a relatively large one-time devaluation. This would, to a certain extent, help offset a decline in the international competitiveness of Chinese products due to the imposition of additional U.S. tariffs. However, not only is it expected that it would invite opposition from the United States, but it could also induce a global chain reaction of competitive devaluation.

(3) Shift to a freely-floating exchange rate system
China could shift to a freely-floating exchange rate system, under which the authorities refrain from exchange intervention and leave it to market forces (supply and demand) to determine the exchange rate. In this case, while the exchange rate would fluctuate, China's foreign exchange reserves would remain at a constant level. The independence of monetary policy would increase because money supply would not be affected by fluctuations of the monetary base that would be caused by foreign exchange intervention. However, a shift to a freely-floating exchange rate system could cause a steep fall of the yuan in the midst of very weak market sentiment.

Of the above three options, the return to the dollar peg system is the most realistic and could be adopted as an emergency measure. The devaluation of the yuan poses the greatest uncertainty. The shift to a freely-floating rate system is a goal for which China should aim over the medium to long term.

The original text in Japanese was posted on August 22, 2019.