core sector communique

Treasury Dept. on China's Economic and Exchange Rate Policies

Report to Congress on International Economic and Exchange Rate Policies

U.S. Department of the Treasury

Office of International Affairs

December 27, 2011

Key Findings

The Omnibus Trade and Competitiveness Act of 1988 (the "Act") requires the Secretary of the Treasury to provide semiannual reports on the international economic and exchange rate policies of the major trading partners of the United States. Under Section 3004 of the Act, the Report must consider "whether countries manipulate the rate of exchange between their currency and the United States dollar for purposes of preventing effective balance of payments adjustment or gaining unfair competitive advantage in international trade." This Report covers developments in the first half of 2011 and, where pertinent and available, data through mid-December 2011. Treasury has concluded that no major trading partner of the United States met the standards identified in Section 3004 of the Act during the period covered in the Report.

The pace of U.S. economic growth slowed markedly during the first half of 2011, to just 0.9 percent at an annual rate, due partly to temporary factors, then picked up in the third quarter to a 1.8 percent annualized rate of growth. Private sector forecasters are projecting growth of 2.25 percent in 2012. Unemployment is still high at 8.6 percent, although 2.9 million private sector jobs have been added over the past 21 months. Boosting growth and creating jobs in the near term remains a key Administration priority. At the same time, the Administration is firmly committed to putting U.S. government finances on a sustainable trajectory. Significant deficit reduction was recently ensured by the Budget Control Act, which became law on August 2, 2011, but additional deficit reduction is clearly necessary to restore long-term fiscal sustainability.

Following modest global growth in the first half of 2011, driven principally by emerging market economies, rising financial stress in the euro area dampened the global outlook. Economic and financial stresses in the euro area have spread to some of its largest economies, with sharp increases in sovereign bond yields and indicators of banking stress. This has adversely affected credit, confidence, and growth in the euro area. Many private sector forecasters are now projecting negative growth over the next several quarters in some euro area economies.

Global financial markets are strongly interconnected. The deepening of Europe's crisis has already impacted global capital flows and the currency markets. Although most emerging market currencies appreciated against the dollar in the first half of 2011, in many cases that appreciation was more than unwound in the second half of 2011 as risk aversion increased. The European crisis remains a significant risk to the global recovery. Growth forecasts for 2012 have been repeatedly reduced. Consensus Forecasts in early December projected just 2.7 percent global growth in 2012, down from 3.2 percent projected in September.

This report reviews the exchange rate policies of ten economies accounting for 70 percent of U.S. foreign trade. Foreign exchange markets have functioned well and in an orderly manner over the past year despite broader turmoil in the global economy, and real effective exchange rates for the major advanced economies are in line with historic norms. All of the major advanced economies have fully flexible exchange rates, although in a notable change from recent practice, Japan twice announced it intervened unilaterally in the past year. Among major emerging market economies, a select few have more tightly managed exchange rates, with varying degrees of management. This Report highlights the need for greater exchange rate flexibility in these economies and most notably in China.

Over the past decade, China has resisted very strong market pressures for RMB appreciation. China's real effective exchange rate has exhibited persistent and substantial undervaluation, although the estimated range of misalignment has narrowed over the course of the past 18 months.

China held more than $3.2 trillion in foreign exchange reserves at the end of September 2011 - with $373.1 billion of foreign exchange reserves accumulated in the first three quarters of 2011. In the fourth quarter of 2011, reserve accumulation likely slowed significantly, and the RMB has at times traded at or near the bottom end of the trading band, as capital inflows to China and other emerging markets diminished, and as increased uncertainty about the global economy reduced market expectations of continued RMB appreciation against the dollar.

These recent events reflect the particular conditions and risks facing the global economy at this moment, as well as investors' expectations of likely Chinese policy responses, and are not an indication that the process of required adjustment has been completed in China. Slowing growth and diminished import demand in Europe has already begun to slow the exports of China and other emerging markets. Increased prices for China's commodity imports have also significantly reduced China's trade surplus.

Despite these short-term forces, the underlying factors that distort China's economy and constrain global growth remain. China continues to increase its global export market share, it remains heavily dependent on exports, and it has made little progress in making the required shift to domestic consumption. China's large foreign reserve accumulation has prolonged the misalignment in China's real effective exchange rate and hampered progress toward global rebalancing, including among economies that compete with China for exports.

While China's real exchange rate has appreciated, the process of appreciation remains incomplete. China's long-standing pattern of reserve accumulation, the persistence of its current account surplus and the incomplete appreciation of the renminbi, especially given rapid productivity growth in the traded goods sector, indicate that the real exchange rate of the renminbi is persistently misaligned and remains substantially undervalued.

It is in China's interest to allow the exchange rate to continue to appreciate, both against the dollar and against the currencies of its other major trading partners. A lack of continued appreciation by China would prevent the exchange rate from serving as a tool to encourage consumption so as to maintain strong, sustainable growth, further complicate the adjustment needed for broader financial sector reform, and undermine China's stated goal of strengthening domestic demand.

The Chinese leadership has identified shifting away from growth driven by exports toward a greater reliance on domestic consumption as a critical goal for sustaining growth in the medium term. At the G-20 Leaders Summit in Cannes in November, G-20 members, including China, committed to, "move more rapidly toward more market-determined exchange rate systems and enhance exchange rate flexibility to reflect underlying economic fundamentals, avoid persistent exchange rate misalignments and refrain from competitive devaluation of currencies." China also stated that its rebalancing actions "will be reinforced by ongoing measures to promote greater exchange rate flexibility to better reflect underlying economic fundamentals, and gradually reduce the pace of accumulation of foreign reserves."

Since the authorities decided in June 2010 to allow the exchange rate to appreciate, the renminbi has appreciated by a total of 7.5 percent against the dollar, as of December 16. Taking into account the higher rate of domestic inflation in China than in the United States, the renminbi has appreciated against the dollar on a real, inflation-adjusted basis by nearly 12 percent since June 2010 and nearly 40 percent since China first initiated currency reform in 2005.

Based on the ongoing appreciation of the renminbi against the dollar since June 2010, the decline in China's current account surplus, and China's commitments at the G-20 and the U.S.-China Strategic and Economic Dialogue (S&ED) asserting that it will continue to promote faster RMB exchange rate flexibility, Treasury has concluded that the standards identified in Section 3004 of the Act during the period covered in this Report have not been met with respect to China.

Nonetheless, in light of the persistent misalignment of the RMB at a substantially undervalued level, Treasury assesses that movement of the RMB to date is insufficient and more progress is needed. Treasury will continue to closely monitor the pace of RMB appreciation and press for policy changes that yield greater exchange rate flexibility, level the playing field, and support a pronounced and sustained shift to domestic-demand led growth.

(Distributed by the Bureau of International Information Programs, U.S. Department of State.)