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entitled 'International Trade: Treasury Assessments Have Not Found 
Currency Manipulation, but Concerns about Exchange Rates Continue' 
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Report to Congressional Committees: 

April 2005: 

International Trade: 

Treasury Assessments Have Not Found Currency Manipulation, but Concerns 
about Exchange Rates Continue: 

[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-05-351]: 

GAO Highlights:

Highlights of GAO-05-351, a report to congressional committees:

Why GAO Did This Study:

The 1988 Trade Act requires the Department of the Treasury to annually 
assess whether countries manipulate their currencies for trade 
advantage and to report semiannually on specific aspects of exchange 
rate policy. Some observers have been concerned that China and Japan 
may have maintained undervalued currencies, with adverse U.S. impacts, 
which has brought increased attention to Treasury's assessments. In 
2004, Congress mandated that Treasury provide additional information 
about currency manipulation assessments, and Treasury issued its report 
in March 2005. Members of Congress have continued to propose 
legislation to address China currency issues.

We examined (1) Treasury's process for conducting its assessments and 
recent results, particularly for China and Japan; (2) the extent to 
which Treasury has met legislative reporting requirements; (3) experts' 
views on whether or by how much China's currency is undervalued; and 
(4) the implications of a revaluation of China's currency for the 
United States.

In commenting on a draft of this report, Treasury emphasized it does 
consider the impact of the exchange rate on the economy, and factors 
influencing exchange rates also affect U.S. production and 
competitiveness.

What GAO Found:

Treasury has not found currency manipulation under the terms of the 
1988 Trade Act since it last cited China in 1994. Treasury officials 
make a positive finding of currency manipulation only when all the 
conditions in the Trade Act are satisfied--when an economy has a 
material global current account surplus and a significant bilateral 
trade surplus with the United States, and is manipulating its currency 
with the intent to gain an unfair trade advantage. Treasury said that 
in its 2003 and 2004 assessments, China did not meet the criteria for 
manipulation, in part because it did not have a material global current 
account surplus and had maintained a fixed exchange rate regime through 
different economic conditions. Japan did not meet the criteria in 2003 
and 2004 in part because its exchange rate interventions were 
considered to be part of a macroeconomic policy to combat deflation.

Chinese Renminbi and Japanese Yen Exchange Rates with U.S. Dollar 
(nominal):

[See PDF for image]

[End of figure]

Treasury has generally complied with the reporting requirements for its 
exchange rate reports, although its discussion of U.S. economic impacts 
has become less specific over time. Recent reports stress the 
importance of broad macroeconomic and structural factors behind global 
trade imbalances, which Treasury officials contend meets the intent of 
economic impact requirements.

Many experts have concluded that China's currency is undervalued, but 
by widely varying amounts, while some maintain that undervaluation 
cannot be determined. The significant variation in estimates can be 
attributed in part to different methodological approaches, but experts 
also believe that exchange rate assessments are especially challenging 
for rapidly developing economies such as China's. Among experts who 
believe China's currency is undervalued, views on policy steps to 
correct the imbalance differ.

A revaluation of China's currency could have implications for various 
aspects of the U.S. economy, although the impacts are hard to predict. 
They depend on multiple factors, including how much appreciation is 
passed through to higher prices for U.S. purchasers and the extent to 
which reduced imports from China are replaced with imports from other 
countries. In addition to affecting trade-related sectors, a 
revaluation could have implications for U.S. capital flows.

www.gao.gov/cgi-bin/getrpt?GAO-05-351.

To view the full product, including the scope and methodology, click on 
the link above. For more information, contact Loren Yager at (202) 512-
4128 or yagerl@gao.gov.

[End of section] 

Contents: 

Letter: 

Results in Brief: 

Background: 

Treasury Has Not Found Recent Instances of Currency Manipulation: 

Treasury Has Generally Complied with Reporting Requirements, but Its 
Approach to Assessing the Impact of Exchange Rates on the U.S. Economy 
Has Changed: 

Estimates of the Undervaluation of China's Currency Vary Widely, and 
Views on Policy Steps Differ: 

The U.S. Impact of a Renminbi Revaluation Would Depend on Multiple 
Factors: 

Observations: 

Agency Comments and Our Evaluation: 

Appendixes: 

Appendix I: Objectives, Scope, and Methodology: 

Appendix II: Omnibus Trade and Competitiveness Act of 1988: 

Appendix III: Conditions that Led to the Determination of Currency 
Manipulation and Removal: 

Appendix IV: Overview of China and Japan's Recent Economic Conditions: 

China: 

Japan: 

Appendix V: Commonly Used Methods to Determine Equilibrium Exchange 
Rates: 

Purchasing Power Parity (PPP) Approach: 

Fundamental Equilibrium Exchange Rate (FEER) Approach: 

Macroeconomic Balance Approach: 

External Balance Approach: 

Behavioral Equilibrium Exchange Rate (BEER) Approach: 

Qualitative Approaches: 

Appendix VI: Factors Influencing the Final Impact of Exchange Rate 
Changes: 

Appendix VII: Net Foreign Purchases of U.S. Securities: 

Appendix VIII: Comments from the Department of the Treasury: 

Appendix IX: GAO Contacts and Staff Acknowledgments: 

GAO Contacts: 

Acknowledgments: 

Tables: 

Table 1: Treasury's Reporting on 1988 Trade Act Exchange Rate 
Requirements: 

Table 2: Estimates of Undervaluation of the Renminbi: 

Table 3: Illustrative Scenarios of Upward Revaluation of the Renminbi 
on the U.S. Trade Deficit: 

Table 4: Conditions Treasury Cited in Earlier Determinations of 
Currency 
Manipulation: 

Table 5: China's Balance of Payments: 

Table 6: Real Net Purchases of U.S. Securities by China: 

Table 7: Real Net Purchases of U.S. Securities by Foreigners, Selected 
Countries: 

Figures: 

Figure 1: Economies with the Largest Bilateral Merchandise Trade 
Surpluses with the United States, 2004: 

Figure 2: Global Current Account Balance as Percent of GDP for Selected 
Economies, 2004: 

Figure 3: Percentage of U.S. Treasury Securities Held by Japan and 
China, 2004: 

Figure 4: Net Purchases of U.S. Securities by Select Economies, 2001- 
2004: 

Figure 5: China's Real GDP Growth Rate, 1996-2004: 

Figure 6: China's Current Account Surplus in Billions of U.S. Dollars 
and as a Percentage of GDP, 1996-2004: 

Figure 7: China's Total Foreign Exchange Reserves, 1995-2004: 

Figure 8: Chinese Renminbi/Dollar Exchange Rate, 1989-2004: 

Figure 9: Real Effective Exchange Rate Indexes (China and the United 
States), 1994-2004: 

Figure 10: Japan's Real GDP growth rate, 1996-2004: 

Figure 11: Japan's Current Account Surplus in Billions of U.S. Dollars 
and as a Percentage of GDP, 1996-2004: 

Figure 12: Japan's Total Foreign Exchange Reserves, 1995-2004: 

Figure 13: Yen/Dollar Interventions, January 2000-December 2004: 

Figure 14: Real Effective Exchange Rate Index for Japan, 1994-2004: 

Figure 15: Total Reserves for Selected Economies, 2000-2004: 

Figure 16: Total Trade Weights (broad index of the foreign exchange 
value of the dollar): 

Figure 17: Percentage of U.S. Merchandise Trade Deficit Accounted for 
by Selected East Asian Economies, 1999-2004: 

Figure 18: Hourly Compensation Costs for Production Workers in 
Manufacturing in U.S. Dollars, 2002: 

Abbreviations: 

BEER: Behavioral Equilibrium Exchange Rate: 

FDI: Foreign Direct Investment: 

FEER: Fundamental Equilibrium Exchange Rate: 

GDP: Gross Domestic Product: 

GNP: Gross National Product: 

IMF: International Monetary Fund: 

PPP: Purchasing Power Parity: 

TIC: U.S. Treasury International Capital: 

Letter April 19, 2005: 

The Honorable Olympia J. Snowe: 
Chair: 
Committee on Small Business and Entrepreneurship: 
United States Senate: 

The Honorable Donald A. Manzullo: 
Chairman: 
Committee on Small Business: 
House of Representatives: 

A significant portion of the recently growing U.S. merchandise trade 
deficit[Footnote 1]--36.4 percent--is made up of large bilateral 
deficits with China and Japan. In response to earlier concerns 
regarding exchange rate policies of certain Asian countries and their 
trade with the United States and the world, Congress passed the Omnibus 
Trade and Competitiveness Act of 1988[Footnote 2] (the 1988 Trade Act), 
which mandates that the Secretary of the Treasury annually analyze the 
exchange rate policies of foreign countries and consider whether any 
manipulate their currencies to gain an unfair trade advantage. A 
separate provision of the 1988 Trade Act requires that Treasury report 
to Congress on specific international economic policy and exchange rate 
issues. Some observers are concerned that China and Japan have 
intervened in currency markets to maintain an undervalued currency and 
that these actions adversely affect U.S. output and employment, 
particularly for small manufacturers. Because of these concerns, 
Treasury's currency manipulation assessments have attracted increased 
attention, and Congress recently mandated that Treasury report on how 
statutory requirements about currency manipulation could be clarified 
to result in a better understanding of currency manipulation.[Footnote 
3]

You asked us to review Treasury's efforts to meet its requirements 
under the 1988 Trade Act and related issues. Specifically, we examined 
(1) the process Treasury uses to conduct its assessments of currency 
manipulation and the results of recent assessments, particularly for 
China and Japan; (2) the extent to which Treasury has met the 1988 
Trade Act reporting requirements; (3) experts' views on whether or by 
how much China's currency is undervalued; and (4) the implications of a 
revaluation of China's currency for the United States. 

To determine the process Treasury uses to conduct its assessments of 
currency manipulation and recent results, particularly for China and 
Japan, we reviewed the 1988 Trade Act, its legislative history, and 
Treasury's analysis of foreign currency manipulation. In addition, we 
interviewed responsible Treasury officials to better understand the 
assessment process and Treasury's reasoning behind its analyses for 
China and Japan. To determine the extent to which Treasury has met 1988 
Trade Act reporting requirements, we analyzed the reports Treasury has 
issued since 1988 that are required by the Trade Act. Finally, to 
determine experts' views on whether or by how much China's currency is 
undervalued and the implications of its revaluation for the United 
States, we reviewed academic papers, other studies, and congressional 
testimonies by economists with expertise in this area, and we 
interviewed experts with a range of opinions on the matter. We also 
analyzed relevant country economic data and macroeconomic indicators 
used by many of these experts. For a complete description of our scope 
and methodology, see appendix I. We conducted our work from September 
2003 through February 2005 in accordance with generally accepted 
government auditing standards. 

Results in Brief: 

Although China and Japan have engaged in economic activities that have 
led to concerns about currency manipulation, the Department of the 
Treasury has not in recent years found that either country meets all 
the legal criteria for manipulation under the terms of the 1988 Trade 
Act. More broadly, Treasury has not made a positive finding of currency 
manipulation since it last cited China in 1994. Treasury officials 
stated that they make a positive determination on currency manipulation 
only when all the conditions specified in the Trade Act are 
satisfied.[Footnote 4] Treasury has significant flexibility in making 
its determinations, including determining the intent of any 
manipulation. Treasury officials told us that they do not make an 
official determination of undervaluation as a part of their 
manipulation assessments although, according to their March 2005 report 
to Congress, they do consider measures of undervaluation. With respect 
to China, Treasury officials told us that China did not meet the Trade 
Act's definition for currency manipulation for the purposes of 
Treasury's 2003 and 2004 assessments, in part because it did not have a 
material global current account surplus and had maintained a fixed 
exchange rate regime since 1994 through different economic conditions. 
However, Treasury has stated that China should move from its long-term 
fixed exchange rate toward a more flexible exchange system and has 
entered into discussions with China to this end. Treasury also did not 
find that Japan met the Trade Act's definition for currency 
manipulation in 2003 and 2004. Treasury officials told us that they 
viewed Japan's exchange rate interventions as part of a macroeconomic 
policy aimed at combating deflation in Japan, and they expressed 
general skepticism about the efficacy of intervention to affect the 
yen's value. 

Treasury has generally complied with the requirements in the 1988 Trade 
Act that it report to Congress on several specific issues related to 
international economic and exchange rate policies, although its 
discussion of U.S. economic impacts has become less specific over time. 
Treasury has consistently met four of the reporting requirements, and 
two others allow Treasury to report at its discretion.[Footnote 5] 
Treasury's analysis and discussion in response to a remaining 
requirement, that it assess the impact of the exchange rate on the U.S. 
economy, have changed. From 1988 through the 1990s, Treasury generally 
discussed at least some elements of the exchange rate impact reporting 
requirement, which includes impacts of the exchange rate of the dollar 
on the U.S. current account and production and employment. Treasury's 
impact-related analyses after the 1990s have generally cited the 
importance of broad macroeconomic and structural factors behind global 
trade imbalances. These reports have not directly discussed the impact 
of exchange rates on aspects of the U.S. economy set forth in the 1988 
Trade Act, although Treasury's December 2004 report did identify 
exchange rate flexibility for certain Asian economies as an area of 
policy the administration is following to reduce global imbalances. 
Treasury officials stated that they consider the impact of the exchange 
rate on areas such as U.S. production and employment while conducting 
their analysis and that their current approach meets the intent of the 
exchange rate impact reporting requirements. 

Many experts have concluded that China's currency is undervalued, by 
amounts ranging from a few percentage points to almost 50 percent, 
while some maintain that undervaluation cannot be determined. The 
significant variation in estimates can be attributed in part to 
different methodological approaches, but similar methodologies can also 
yield differences. Treasury officials, and some other experts we spoke 
with, stated that exchange rates assessments are especially challenging 
for developing economies with rapidly changing economic structures, 
such as China. Even among experts who believe that China's currency is 
undervalued, there is no consensus on how and when China should move to 
a more flexible exchange rate regime and whether or not loosening 
controls on capital flows--such as restrictions on Chinese citizens 
investing abroad--should be a part of that process. 

A revaluation of the Chinese currency, the renminbi, could have 
implications for various aspects of the U.S. economy--with both costs 
and benefits--although the impacts are hard to predict. A higher-valued 
renminbi would make China's exports to the United States more expensive 
and U.S. exports to China cheaper (in terms of renminbi), which could 
increase U.S. production and employment in certain sectors, but the 
extent of these impacts depends on many factors. One key factor, for 
example, is the degree to which Chinese exports to the United States 
would be replaced by imports from other countries. Some groups could be 
negatively affected by a higher-valued renminbi, including U.S. 
producers who use imports from China in their own production and would 
face higher prices and costs of production. Consumers in the United 
States could also face higher prices. Finally, an upward revaluation of 
the renminbi could affect flows of capital to the United States from 
China, which have in recent years accounted for a significant source of 
financing of the U.S. current account deficit. 

While we have no recommendations in this report, we observe that the 
level of concern over exchange rate issues--especially with respect to 
China--is not surprising in light of the rising U.S. trade deficit, the 
rapid growth of China's exports to the United States, and the recent 
depreciation of the dollar against several major currencies. As trade 
agreements reduce many of the industry-specific barriers to world 
trade, there has been a shift in attention toward the macroeconomic 
aspects of trade, such as savings and investment rates and exchange 
rates. News that China's trade and current account surpluses were 
higher than expected in 2004 increases the need for good information on 
factors affecting trade and financial flows--including exchange rates-
-and the implications of those flows for the United States. Treasury's 
March 2005 report, in response to Congress's mandate for more 
information on its assessments, provided a high-level discussion of key 
factors Treasury considers and shed additional light on the 
complexities of the assessments; but it did not provide--and was not 
required to provide--country-specific information about Treasury's 
recent assessments. Since then, Members of Congress have continued to 
propose legislation directed at China's currency issues. We believe 
that the analysis in our report enhances the basis for further 
discussion of exchange rate policy concerns. 

We provided a draft report to the Department of the Treasury. Treasury 
provided written comments, which are reprinted in appendix VIII. 
Treasury stated that the report is generally thoughtful and hopes that 
it will contribute to increased understanding of the complex issues 
covered in its exchange rate reports. Treasury also emphasized several 
aspects of its exchange rate assessments and its reports. For example, 
with respect to Treasury's reporting on U.S. economic impacts of 
exchange rates, it stated that when conducting its analysis it does 
consider how the exchange rate of the dollar affects areas such as the 
sustainability of the current account deficit, production, and 
employment. Treasury stated that it believes it is often more helpful 
to look at underlying developments that have an impact on exchange 
rates and other macroeconomic conditions rather than to achieve a false 
sense of precision by isolating the exchange rate in the analysis. 
Treasury also provided technical comments, which we incorporated in the 
report as appropriate. 

Background: 

Congress passed the Omnibus Trade and Competitiveness Act of 1988 (the 
1988 Trade Act) to achieve macroeconomic and exchange rate policies 
consistent with a sustainable current account balance.[Footnote 6] The 
law increases the executive branch's accountability for assessing the 
impact of international economic and exchange rate polices on the 
economy. Congressional concerns at the time included concern that the 
exchange rates of other countries placed competitive pressures on U.S. 
producers. 

The 1988 Trade Act directs the Secretary of the Treasury to analyze the 
exchange rate policies of foreign countries for the purpose of 
considering whether any are manipulating their currencies to gain an 
unfair trade advantage and to report on international economic 
policies, including exchange rates.[Footnote 7] To find that a country 
is manipulating the rate of exchange between its currency and the U.S. 
dollar within the meaning of the Trade Act, Treasury must determine 
that the country: 

* is manipulating the exchange rate for the purpose of gaining an 
unfair trade advantage or preventing effective balance of 
payments[Footnote 8] adjustments, and: 

* has a material global current account surplus and a significant 
bilateral trade surplus with the United States. 

If Treasury finds that a country is manipulating its currency as 
defined by the Trade Act, the act requires Treasury to initiate 
negotiations with that country to ensure a foreign currency exchange 
rate adjustment that eliminates the unfair trade advantage. Treasury's 
international policy and exchange rate reports must meet eight 
reporting requirements, including an analysis of currency market 
developments, an assessment of the impact of the exchange rate of the 
dollar on three broad aspects of the U.S. economy, and an analysis of 
capital flows. (See app. II for the exact language of the law.)

China and Japan follow different policies for determining their 
currency values. China has, since 1994, when it unified its dual 
exchange rate system,[Footnote 9] pegged the value of its currency, the 
renminbi, to the U.S. dollar.[Footnote 10] Chinese authorities maintain 
this peg by standing ready to buy and sell renminbi in exchange for 
other currencies within a narrow band around the fixed rate. When there 
is an excess supply of foreign exchange at this rate, such as from 
surpluses in trade or net private capital flows, China's purchases of 
that excess lead to an increase in its foreign reserves. China 
maintains controls on capital flows that to some extent limit the 
volume of transactions in the foreign exchange market, although these 
controls have not prevented substantial recent capital inflows. In 
contrast, the Japanese yen is on an independent float, which means that 
its value relative to other currencies is determined by demand and 
supply in the currency market. In the past, Japan has carried out 
significant interventions in the foreign exchange market through the 
sale of yen in exchange for U.S. dollars, which has put downward 
pressure on the value of the yen relative to the U.S. dollar. 
Nevertheless, from January 2002 through January 2005, the yen's value 
relative to the dollar increased 22 percent, from 132 yen per U.S. 
dollar to 103 yen per U.S. dollar. Japan has not intervened in the 
foreign exchange market since March 2004. 

Treasury Has Not Found Recent Instances of Currency Manipulation: 

Although the Chinese and Japanese governments have carried out certain 
economic policies and practices related to their currencies' values 
that have raised concerns among observers, Treasury has found in recent 
reports that neither country meets all the legal criteria for currency 
manipulation. Treasury's overall approach to determining the presence 
of currency manipulation under the terms of the Trade Act includes 
screening countries and economies using a range of indicators to 
identify some for closer examination, applying legally mandated 
criteria, and considering multiple aspects of economic conditions and 
activities. Although Treasury has cited Taiwan, Korea, and China for 
currency manipulation in the past, it has found no such instances since 
1994. 

Stages in Treasury's Assessment of Currency Manipulation under the 1988 
Trade Act: 

Treasury's Office of International Affairs begins its analysis of 
currency manipulation by soliciting input from country desk officials 
responsible for monitoring economic activity. Treasury officials stated 
that they use analyses and information obtained throughout the year as 
the basis for determining whether a country is manipulating its 
currency.[Footnote 11] Treasury officials responsible for the currency 
manipulation analysis compile available information on exchange rates 
and other economic conditions. Treasury also collects information from 
external sources, such as private sector experts, and meets regularly 
with the IMF on broad international economic policy issues. 

Treasury officials use the collected data to identify those 
economies[Footnote 12] deserving closer examination. In addition to 
including bilateral trade surplus and global current account surplus 
information in this initial consideration, they also take into account 
other factors, such as changes in currency value, capital flow 
conditions, and country size. (Fig. 1 presents the ranking of economies 
with the largest bilateral trade surpluses with the United States, and 
fig. 2 presents the ranking of those same economies according to their 
current account balance as a percentage of gross domestic product.)

Figure 1: Economies with the Largest Bilateral Merchandise Trade 
Surpluses with the United States, 2004: 

[See PDF for image] 

[End of figure] 

Figure 2: Global Current Account Balance as Percent of GDP for Selected 
Economies, 2004: 

[See PDF for image] 

Note: Estimates for Asia-Pacific, Africa and Middle East, and Latin 
America updated using Global Insight Quarterly Review and Outlook, 
March 2005. The economies shown are those with the largest bilateral 
merchandise trade surpluses with the United States in 2004. 

[End of figure] 

Treasury does not usually scrutinize economies with large, obviously 
explainable, trade balances, such as major oil-exporting nations, for 
currency manipulation. On the other hand, Treasury reviews some 
economies regardless of economic indicators. For instance, Treasury 
consistently reviews the activities of major U.S. trading partners, 
such as Japan, the European Union, and Canada. It also monitors the 
three economies that it previously found to be manipulating their 
currencies--Taiwan, Korea, and China. Treasury selectively includes 
other nations in currency manipulation assessments when it determines 
that economic conditions merit. 

Treasury officials stated that they make a positive determination on 
currency manipulation only when all the conditions specified in the 
Trade Act are satisfied. According to these officials, to reach a 
positive finding of currency manipulation under the Trade Act, Treasury 
must find that the economies have a material global current account 
surplus and a significant bilateral trade surplus with the United 
States, and they are manipulating their currency with the intent of 
gaining trade advantage. Treasury has significant flexibility in 
determining whether countries meet these criteria. Treasury officials 
told us they do not have operational definitions of a "material" global 
current account surplus or a "significant" bilateral trade 
surplus.[Footnote 13]

Treasury officials stated that they do not limit their analysis to the 
use of the material global current account surplus and significant 
bilateral trade surplus criteria listed in the Trade Act, but rather 
consider multiple aspects of the economy. Treasury officials also 
stated that they do not use a definitive checklist to make their 
determinations. Treasury officials told us that the country-specific 
economic and international trade factors they consider include: 

* restrictions and regulations governing the use and retention of 
foreign exchange and international financial flows;

* movement of exchange rates, authorities' intervention in foreign 
exchange markets, and the effectiveness of that intervention;

* accumulation of foreign exchange reserves;

* institutional development related to banking and financial sectors;

* macroeconomic indicators, including gross domestic product (GDP) 
growth rates, inflation, and unemployment rates;

* savings/investment balances and underlying factors;

* foreign investment and international portfolio investment flow 
patterns;

* trade regime barriers; and: 

* external shock factors such as financial crises, oil price hikes, or 
natural disasters. 

The 1988 Trade Act does not require Treasury to determine if a currency 
is undervalued while performing its currency manipulation assessments. 
Although Treasury has in the past included observations on whether 
currencies were undervalued,[Footnote 14] it no longer does so. While 
Treasury officials told us they do not make an official determination 
on undervaluation, in its March 2005 report to Congress (discussed 
below), Treasury included measures of undervaluation among the 
indicators it considers in its manipulation analysis. 

Upon completion of the currency manipulation assessments, managers 
within the Office of International Affairs prepare recommendations for 
the approval of the Under Secretary for International Affairs.[Footnote 
15] In the case of a positive finding of currency manipulation, 
Treasury initiates negotiations with officials of the economy in 
question, as called for by the Trade Act. 

Treasury generally summarizes the results of the currency manipulation 
assessments in its semiannual report to Congress,[Footnote 16] but does 
not explain how it weighs the multiple economic factors it analyzes 
when making its currency manipulation determinations. Over time, 
Treasury reports have included varying lists of factors the department 
considers in conducting its currency manipulation analysis.[Footnote 
17] 
 
Congressional concern over Treasury's currency manipulation assessments 
led to a mandate in the fiscal year 2005 Consolidated Appropriations 
Act requiring Treasury to report on how the statutory requirements of 
the 1988 Trade Act could be clarified administratively to enable 
currency manipulation to be better understood by the American people 
and by Congress. Treasury issued its report on March 11, 2005. In this 
report, Treasury provided a high-level discussion of factors it 
considers when conducting its currency manipulation assessments, 
including measures of undervaluation, capital controls, and trade 
balances, and also described difficulties related to rendering 
manipulation assessments. Treasury did not--and was not required to-- 
provide information on a country-specific basis about recent currency 
manipulation assessments. 

Treasury Has Not Found Recent Instances of Currency Manipulation under 
the Terms of the 1988 Trade Act: 

Since 1994, Treasury has not cited any economies for manipulating their 
currency as defined by the Trade Act. Treasury officials stated they 
have closely monitored recent economic behavior in China and Japan, due 
in part to the rapid accumulation of foreign currency reserves in those 
countries. Although Treasury has not cited China recently, it has 
engaged in discussions encouraging China to move to a more flexible 
exchange rate regime. Treasury did not find that Japan was manipulating 
its currency in 2003 and 2004. Treasury officials told us that they 
viewed Japan's interventions as a part of macroeconomic policy aimed at 
combating deflation in Japan, and they expressed skepticism about the 
efficacy of intervention to affect the yen's value. 

Before 1994, Treasury Cited Taiwan, Korea, and China for Currency 
Manipulation: 

Since the enactment of the 1988 Trade Act, Treasury has identified 
three economies--Taiwan, Korea, and China--that manipulated their 
currencies under the Trade Act's terms. Treasury first cited Taiwan and 
Korea in 1988 and China in 1992. Taiwan was cited again in 1992. Each 
citation lasted for at least two 6-month reporting periods for Taiwan 
and Korea, while China's lasted for five reporting periods. 

Treasury reported evidence that the criteria for currency manipulation 
under the Trade Act had been met in most of these cases. At the time of 
their citations, Taiwan, Korea, and, on three occasions, China had 
relatively large bilateral trade surpluses with the United States and 
relatively large global current account surpluses. However, China, on 
two later occasions in the mid 1990s, had either a substantially 
declining current account surplus or a current account deficit when 
cited by Treasury for currency manipulation.[Footnote 18]

The three economies also had other economic characteristics that 
Treasury considered when it determined they were manipulating their 
respective currencies. For instance, all three economies had also been 
rapidly accumulating foreign exchange reserves. In addition, for both 
Taiwan and Korea, Treasury found excessive restrictions on foreign 
exchange markets and capital controls and evidence of heavy direct 
intervention in foreign exchange markets by the authorities of Taiwan 
and Korea. In China's case, Treasury was concerned by Chinese efforts 
in 1991 and 1992 to frustrate effective balance of payments adjustments 
through the use of a dual exchange rate system. Treasury cited 
continued devaluations of the official exchange rate and excessive 
controls on the market rates. (See app. III for more details on 
Treasury's previous findings of manipulation for these three economies.)

As required by the Trade Act, Treasury entered into negotiations with 
Taiwan, Korea, and China, and all three made substantial reforms to 
their foreign exchange regimes. In addition, their currencies 
appreciated and external trade balances declined significantly until 
they reached the point at which the three were removed from the list of 
currency manipulators.[Footnote 19] Treasury continues to monitor the 
policies and practices of these economies for evidence of currency 
manipulation. 

Treasury's Recent Reporting on China and Japan: 

In recent reports Treasury has not found that either China or Japan 
meets the statutory criteria for currency manipulation. Since 2001 both 
countries have had periods of increasing current account surpluses and 
also periods of rapid accumulation of foreign exchange reserves. 

With respect to China, while Treasury did not report data on China's 
global current account surplus for the second half of 2003 or the first 
half of 2004, Treasury officials stated that the surplus had not 
reached a material level. In April 2004, Treasury reported that China's 
overall trade surplus had been 2.6 percent of GDP in the second half of 
2003. In December 2004, Treasury reported that for the first half of 
2004 China had an overall trade deficit of 1 percent of its 
GDP.[Footnote 20] In the same report, Treasury stated that while 
Chinese foreign exchange reserves had risen sharply, the accumulation 
was due in large part to steady foreign direct investment inflows and a 
sharp increase in other capital inflows.[Footnote 21] (See app. IV for 
more details on China's external account development in recent years.)

Treasury officials also stated that they do not think China's current 
restrictions in foreign exchange markets and other administrative 
controls on trade are comparable to conditions in the early 1990s. At 
that time, important factors in Treasury's determinations were China's 
pervasive direct controls on external trade activities and a dual 
exchange rate regime with massive restrictions and controls. Since 
then, China has removed restrictions on the convertibility of the 
renminbi for trade transactions and substantially liberalized its trade 
regime, including implementing a variety of reforms related to its 
accession to the World Trade Organization in 2001. 

Since 1994, China has followed a policy of maintaining its currency peg 
to the dollar regardless of economic conditions, according to Treasury 
officials. For example, during the Asian financial crisis of the late 
1990s, China kept the renminbi's value steady rather than depreciating 
it to stay competitive with the cheaper currencies of other Asian 
exporting economies. While this helped maintain the stability of its 
own economy and the region, it was not consistent with a policy of 
keeping a cheap currency for trade advantage, according to Treasury 
officials. 

Despite the absence of a positive determination on currency 
manipulation, Treasury has stated that China should move from its long- 
term fixed exchange rate and has engaged in discussions with China to 
advocate a shift to market-based exchange rate flexibility. The Chinese 
government has indicated its willingness to move to a flexible exchange 
rate regime after undertaking a series of preparative steps but has 
established no specific timetable to complete them. To date, China has 
taken some steps to reduce barriers to capital outflows, liberalize 
interest rates, remove investment restrictions, and strengthen its 
financial infrastructure. Treasury has provided technical assistance to 
help China develop market mechanisms needed for the transition to a 
flexible regime, including central bank supervision of currency risk 
and regulation of foreign exchange derivative markets. 

With respect to Japan, Treasury officials stated that the country's 
ongoing current account surplus reflects a long-term imbalance between 
savings and investment. In the last three exchange rate reports 
covering 2003 and 2004, Treasury noted that Japan justified its 
currency market interventions as a response to market overshooting, or 
excess volatility, and that such activity did not target particular 
exchange rate values. Treasury officials stated that Japan's 
interventions were part of a macroeconomic policy aimed at combating 
domestic deflationary pressures. In addition, Treasury officials 
expressed general skepticism about the efficacy of 
intervention.[Footnote 22] Japan has not intervened to prevent the 
appreciation of the yen since March 2004. 

Treasury Has Generally Complied with Reporting Requirements, but Its 
Approach to Assessing the Impact of Exchange Rates on the U.S. Economy 
Has Changed: 

Treasury has generally complied with the reporting requirements 
mandated by the 1988 Trade Act (see table 1), although its discussion 
of U.S. economic impacts has become less specific over time. Treasury 
exchange rate reports have consistently included information responding 
to four requirements: (1) analysis of currency market developments, (2) 
evaluations of underlying conditions in the United States and other 
economies, (3) descriptions of currency market interventions, and (4) 
analysis of capital flows.[Footnote 23] Treasury can respond to a fifth 
reporting requirement, recommendations for changes necessary to attain 
a sustainable current account balance, at its discretion. A sixth 
requirement, reporting outcomes of negotiations, is only relevant when 
Treasury makes a finding for currency manipulation under section 3004 
of the act, and Treasury has complied with this requirement when 
applicable. Treasury did not include updates for the seventh 
requirement--U.S.-IMF consultations--in six reports from 2001 to 2004. 
According to Treasury officials, by this time summaries and complete 
reports of IMF consultations with the United States had become publicly 
available on the Internet, and reporting on these consultations was 
unnecessary. The December 2004 report included an Internet link to IMF 
consultation information. 

Table 1: Treasury's Reporting on 1988 Trade Act Exchange Rate 
Requirements: 

Trade Act reporting requirements: Analysis of currency market; 
Reporting status: Reported since 1988. 

Trade Act reporting requirements: Evaluation of underlying conditions; 
Reporting status: Reported since 1988.  

Trade Act reporting requirements: Description of currency market 
intervention; 
Reporting status: Reported since 1988. 

Trade Act reporting requirements: Report on capital flows[A]; 
Reporting status: Reported since 1988. 

Trade Act reporting requirements: Recommendations for sustainable 
current account balance; Reporting status: 
Reported at Treasury discretion. 

Trade Act reporting requirements: Report on negotiation results per 
section 3004(b); 
Reporting status: Reported as needed. 

Trade Act reporting requirements: Update on U.S.-IMF Article IV 
consultation; 
Reporting status: Deemed unnecessary by Treasury from 2001 through 
2003[B]. 

Trade Act reporting requirements: Assessment of impact of the exchange 
rate on: (a) Ability of the United States to maintain sustainable 
current and merchandise trade accounts; (b) Production, employment, and 
non-inflationary growth; (c) U.S. global industrial competition and 
external indebtedness; 
Reporting status: Reports generally discussed at least some impact 
elements through 1999; Reports generally did not directly discuss 
impact elements in 2000-2004.[C]. 

Source: GAO analysis of Treasury exchange rate reports. 

[A] Treasury did not include explicit capital flow analysis in reports 
issued from 1995 to 1997. 

[B] Treasury's December 2004 report included an Internet link to IMF 
consultation information. 

[C] Treasury's December 2004 report identified exchange rate 
flexibility for certain Asian countries as one area of policy the 
administration is following to reduce global imbalances. 

[End of table]

Treasury has over time changed its approach for complying with its 
remaining requirement--an assessment of the impact of the exchange rate 
on the U.S. economy. According to Treasury officials and our analysis 
of the exchange rate reports, Treasury's view of the role of exchange 
rates on the U.S. balance of payments and the economy in general has 
changed since 1988. Treasury's reports generally discussed at least 
some elements of the impact-reporting requirement from the late 1980s 
through the 1990s. From 1988 into the early 1990's, Treasury's reports 
generally discussed exchange rate effects on U.S. external balances and 
economic growth. From 1994 through 1999 and into 2000, Treasury reports 
generally advocated a "strong dollar" policy. Reports in 1994 through 
1997 discussed specific U.S. benefits of such a policy, such as lower 
inflation and higher investment and economic growth. 

Treasury's impact-related analysis after the 1990's cited the 
importance of broader macroeconomic and structural factors behind 
global trade imbalances. Treasury viewed exchange rates as one of 
several interacting economic variables needing attention to address 
global imbalances. For example, in the October 2003 and April 2004 
reports, Treasury reported that the current account deficit represented 
the gap between savings and investment, and its sustainability depended 
on the attractiveness of U.S. capital markets to foreign investors. Its 
analysis also emphasized the importance for U.S economic interests of 
strong growth of U.S. trading partners. Treasury's most recent report 
in December 2004 did identify exchange rate flexibility for certain 
Asian economies as an area of policy the administration is following to 
reduce global imbalances.[Footnote 24]

Given its broad approach to impact-related analysis, Treasury's 
semiannual reports do not contain discrete examinations of the effect 
on the U.S. economy of changes in the dollar's value. Thus, Treasury's 
reports do not specifically address the impact of the dollar on aspects 
of economic activity listed in the 1988 Trade Act, including 
production, employment, and global industrial competition. Treasury 
states that it does consider the impact of the exchange rate on these 
variables and that their broader approach meets the intent of the 
impact reporting requirements set forth in the 1988 Trade Act. 

Estimates of the Undervaluation of China's Currency Vary Widely, and 
Views on Policy Steps Differ: 

Many experts maintain that China's currency is significantly 
undervalued, while some believe that undervaluation is not substantial 
or that calculating reliable estimates is not possible. Even among 
experts who believe that China's currency is undervalued, there is no 
consensus on how and when China should move to a more flexible exchange 
rate regime and whether or not capital account liberalization, 
including, for example, lifting restrictions on outward flows of 
Chinese capital, should be a part of that process. 

Many Experts Conclude China's Currency is Undervalued, but 
Methodological Challenges Cause Differences: 

Most of the estimates we reviewed indicated that China's currency is 
undervalued to some extent, with some experts suggesting substantial 
undervaluation and others slight misalignment. While there is no 
consensus methodology for determining whether a country's currency is 
undervalued, experts have applied a number of commonly used approaches 
to the case of China.[Footnote 25] (See app. V for details of the 
various methodologies and their limitations.) These approaches 
generally involve determining an equilibrium exchange rate, broadly 
defined as the exchange rate that is consistent with a country's 
economic fundamentals,[Footnote 26] when the country is operating at 
full employment and in a free market. As table 2 illustrates, estimates 
of renminbi undervaluation range from none to over 50 percent. Some of 
these estimates are rough calculations based on "rule-of-thumb" 
assumptions while others are based on formal models. In addition, some 
of these estimates may be most appropriately categorized as measures of 
near-term undervaluation or short-term pressure indicators. Moreover, 
the margins of error for these estimates are generally unknown. 

Table 2: Estimates of Undervaluation of the Renminbi[A]: 

Source: Lawrence Lau (Stanford)[C]; 
Estimate (percentage): Indeterminate; 
Methodology[B]: Qualitative assessment, with consideration of factors 
such as capital account restrictions. 

Source: IMF; 
Estimate (percentage): No clear evidence of substantial undervaluation; 
Methodology[B]: Macroeconomic Balance approach[D]. 

Source: Stephen Roach (Morgan Stanley); 
Estimate (percentage): Not undervalued; 
Methodology[B]: PPP (relative version) and Qualitative approaches. 

Source: Barry Bosworth (Brookings Institute)[E]; 
Estimate (percentage): Not fundamentally undervalued; 
Methodology[B]: Macroeconomic Balance approach; 

Source: Barry Bosworth (Brookings Institute)[E]; 
Estimate (percentage): 40; 
Methodology[B]: PPP (absolute version) approach. 

Source: Pieter Bottelier (Johns Hopkins)[F]; 
Estimate (percentage): 4- 5; 
Methodology[B]: External Balance approach. 

Source: Barry Eichengreen (University of California, Berkeley); 
Estimate (percentage): 5-10; 
Methodology[B]: Qualitative approach. 

Source: Jim O'Neill (Goldman Sachs); 
Estimate (percentage): 9.5-15; 
Methodology[B]: FEER/BEER approach (lower); 
External Balance approach (upper) (Trade-Weighted Renminbi). 

Source: Funke/Rahn (Hamburg University); 
Estimate (percentage): 11; 
Methodology[B]: BEER approach. 

Source: Goldstein/Lardy (Institute for International Economics); 
Estimate (percentage): 15-25; 
Methodology[B]: External Balance approach. 

Source: Gene Hsin Chang (University of Toledo); 
Estimate (percentage): 22; 
Methodology[B]: PPP (absolute version) approach. 

Source: Jon Anderson (UBS)[G]; 
Estimate (percentage): 15-25; 
Methodology[B]: External Balance approach. 

Source: Jeffrey Frankel (Harvard); 
Estimate (percentage): 35; 
Methodology[B]: PPP (absolute version) approach. 

Source: Ernest Preeg (Hudson Institute, Manufacturers Alliance/MAPI); 
Estimate (percentage): 40; 
Methodology[B]: External Balance approach. 

Source: Benassy-Quere et al. (University of Paris); 
Estimate (percentage): 47.3; 
Methodology[B]: BEER approach. 

Source: Big Mac Index (Economist)[H]; 
Estimate (percentage): 56; 
Methodology[B]: PPP (absolute version) approach. 

Source: GAO synthesis of published studies and selected communication 
with authors. 

[A] Estimates using certain methodologies are particularly sensitive to 
changes in China's balance of payments data, and thus can change as new 
information becomes available. 

[B] PPP is Purchasing Power Parity, FEER is Fundamental Equilibrium 
Exchange Rate, and BEER is Behavioral Equilibrium Exchange Rate. 
Appendix V describes these methodologies in detail. 

[C] Lau stated that no methodology can determine the true equilibrium 
rate given capital account restrictions in China. 

[D] The IMF uses at least in part the Macroeconomic Balance Approach, 
which is closely related to FEER. Its view on the renminbi is based on 
the perceptions of "most directors."

[E] Bosworth's two methodological approaches resulted in significantly 
different results. He stated that his overall conclusion is that this 
type of analysis implies a degree of precision that does not really 
exist. 

[F] Bottelier reported this estimate, using a Basic Balance approach, 
in January 2005. He stressed that there is no standard methodology for 
estimating undervaluation and such estimates are valuable primarily as 
indicators of direction of potential change. 

[G] Anderson stated that he does not have an estimate for "fundamental" 
over or undervaluation of the renminbi. 

[H] The Economist has also calculated a PPP (absolute version) index 
based on the "Tall Latte," which showed the renminbi to be undervalued 
by 1 percent. 

[End of table]

The significant variation in estimates of remninbi undervaluation can 
be attributed in part to different methodological approaches, but 
similar methodologies can also yield differences. The absolute version 
of the Purchasing Power Parity (PPP) methodology, which determines the 
exchange rate at which identical goods would trade at the same price in 
both countries, produces estimates that generally show the renminbi is 
considerably undervalued. The External Balance approach is based on 
calculating an exchange rate that would result in a country achieving a 
sustainable balance in its external accounts, such as its current 
account balance or its trade balance. In the studies we reviewed, this 
approach generally produced estimates of currency undervaluation for 
China from 4 to 25 percent, with one estimate of 40 percent.[Footnote 
27] Moreover, there are often significant differences in estimates even 
when similar methodologies are used. For example, experts who use the 
Behavioral Equilibrium Exchange Rate (BEER) approach, which uses 
econometric relationships between exchange rates and other economic 
variables to estimate an equilibrium exchange rate, have found renminbi 
undervaluation ranging from 11 to 47 percent. 

Some experts doubt that equilibrium exchange rates can be estimated and 
thus believe that whether a currency is under-or overvalued cannot be 
reliably determined. Treasury officials and some other experts we spoke 
with stated that estimating equilibrium exchange rates is especially 
challenging for developing economies with rapidly changing economic 
structures, such as China. According to Treasury, the determination of 
under-or overvaluation requires analysis of key economic variables, the 
measures for which are subject to considerable uncertainty in China. 
Moreover, determining an equilibrium exchange rate is especially 
difficult for China because China restricts the outflow of funds from 
the country. (See app. IV for a discussion of China's capital controls.)

Some observers and analysts view China's growing foreign exchange 
reserves as evidence that the renminbi is undervalued. China's foreign 
exchange reserves increased by $399 billion dollars--185 percent--from 
the end of 2001 to the end of 2004. These observers maintain that the 
reserves, which partly reflect China's surpluses in global 
trade[Footnote 28] and foreign direct investment (FDI), are evidence 
that the value of the renminbi is too low relative to the demand for 
renminbi-denominated goods, services, and other investments; as a 
result, China must purchase large amounts of dollars to keep the 
renminbi's value from increasing beyond its U.S. dollar peg. 

Using reserve accumulations as evidence of a mismatch between the 
current value of the renminbi and its long-run equilibrium value has 
limitations, however, according to several analysts. China's foreign 
reserve accumulation has several components: the current account 
balance, FDI net inflows, non-FDI net inflows (which include portfolio 
investment such as stocks and other investments), and undocumented 
capital--referred to as errors and omissions.[Footnote 29] China's 
current account surpluses and FDI inflows were the primary components 
of the $117 billion increase in its reserves in 2003, accounting 
together for about 80 percent. Net non-FDI inflows and errors and 
omissions accounted for about 20 percent of the reserve 
increase.[Footnote 30] (See further details in app. IV.)

Views on Policy Steps for China Differ: 

Treasury has urged China to move to a market-based flexible exchange 
rate and take steps to remove restrictions on capital flows. There is 
debate regarding steps and timing on both issues. With respect to 
whether and when China should change its exchange rate policy, there 
are varying views even among experts who believe the currency is 
undervalued. Some experts have recommended that China immediately 
revalue the renminbi, either relative to the U.S. dollar or to a 
broader group of currencies. Others have suggested that China should 
move to a more flexible system--with a freely floating exchange rate 
being the most flexible. Analysts have identified potential advantages 
of such policy changes for China and also for other countries. Analysts 
have also identified a number of challenges for China. For example, 
some experts have cautioned that there could be economic costs to China 
if the monetary authorities revalue the currency and guess wrong about 
how large the revaluation should be. They have stated that a small 
revaluation could encourage further speculative capital flows into the 
country in anticipation of a further revaluation, which would increase 
reserves. Some have also expressed concern that a large appreciation in 
the renminbi's value could unnecessarily slow down the Chinese economy 
and worsen labor conditions in the country, which has high unemployment 
in certain regions. 

There are also varying views on changes in China's policies regarding 
restrictions on capital flows. China currently restricts outward flows 
of Chinese capital for foreign direct investment and purchases of 
securities abroad, although it eased some restrictions in 2004. (See 
app. IV for additional information on these restrictions.) A number of 
advocates of greater exchange rate flexibility maintain that China is 
not ready for significant capital account liberalization and that the 
government should maintain some capital controls after moving to a more 
flexible exchange rate. One reason cited is that liberalization would 
expose China's financial sector to risk if, for example, banks in China 
that are not financially strong experienced erosion of their deposit 
base from investors switching funds offshore.[Footnote 31]

Several policy options advocated for China's currency involve a gradual 
or multistep process, which proponents maintain could minimize the 
potential for adverse effects of revaluation. One expert, for example, 
has advocated a two-stage currency reform process for China. The first 
stage would entail pegging the renminbi to a group of currencies, 
including the dollar, rather than pegging to the dollar alone; a 15 to 
25 percent revaluation; and setting a 5 to 7 percent band for renminbi 
fluctuation against the new currency basket. The second step would be a 
significant liberalization of capital outflows and adoption of a 
managed float. The second step would occur following adequate 
strengthening of China's banking system.[Footnote 32]

The U.S. Impact of a Renminbi Revaluation Would Depend on Multiple 
Factors: 

A revaluation of the renminbi could have implications for various 
aspects of the U.S. economy--with both costs and benefits--although the 
impacts are hard to predict.[Footnote 33] First, a higher-valued 
renminbi would make Chinese exports to the United States more expensive 
and U.S. exports to China cheaper--with the extent depending on several 
factors--which could increase U.S. production and employment in certain 
sectors. Some groups could be negatively affected by a higher-valued 
renminbi, including U.S. producers who use imports from China in their 
own production and would face higher prices and costs of production. 
Consumers in the United States could also face higher prices. Finally, 
an upward revaluation of the renminbi could also affect flows of 
capital to the United States from China, which have in recent years 
accounted for a significant source of financing of the U.S. trade 
deficit. 

Several Factors Could Significantly Influence the Impact of China's 
Currency on the U.S. Economy: 

Although a revaluation of the renminbi relative to the dollar would 
tend to make U.S. exports to China cheaper and U.S. imports from China 
more expensive, just how much more expensive China's imports would 
become--and the impact on the U.S. trade deficit, production, and 
employment--would ultimately depend on several factors. Some key 
factors include the following: 

* How much of the exchange rate appreciation is "passed-through" to 
higher prices for U.S. purchasers. Experience with other nations 
generally shows that pass-through is less than complete, particularly 
in the short term, because contracts for exports to the United States 
may be written in dollars. Longer term, the extent of pass-through 
depends on factors such as the extent to which Chinese exports to the 
United States are made up of inputs from other countries (since these 
would become cheaper with a stronger renminbi),[Footnote 34] and the 
extent to which Chinese exporters reduce their costs or profit margins. 

* The extent of the U.S. market response to the higher prices. In some 
markets, U.S. purchasers may continue to buy nearly the same volume of 
Chinese imports at the higher prices, while in others U.S. purchasers 
may decide to sharply reduce their purchases. The less responsive the 
overall U.S. demand is to price changes of Chinese imports, the less 
changes in the renminbi-dollar exchange rate will affect the U.S. trade 
balance, production, or employment.[Footnote 35] The same is true on 
the other side of the market; if Chinese demand for U.S. exports is 
unresponsive to the lower prices of U.S. goods, Chinese buyers will not 
buy much more in the short run even if prices of U.S. exports have 
fallen. 

* The extent to which products now being manufactured in China would be 
produced in other countries rather than in the United States. It is 
probable that goods from other countries with low labor costs would 
replace a portion of Chinese exports to the United States if the 
renminbi were to increase in value, thus reducing the impact on the 
U.S. economy. Specifically, some experts believe that decreased imports 
from China would be largely replaced by slightly higher-priced imports 
from other low-income countries such as Sri Lanka, Vietnam, Bangladesh, 
and Pakistan, among others, instead of being manufactured in the United 
States. 

* Whether other countries follow China and adjust their policies. Some 
analysts contend that the renminbi's peg to the dollar induces other 
East Asian countries to intervene in currency markets to keep their 
currencies weak against the dollar so that they can remain competitive 
with China. Some believe that a revaluation by China might encourage 
other countries to change their exchange rate policies as 
well.[Footnote 36] This would magnify the impact of a revaluation on 
the United States. 

* The time period necessary for these adjustments to take place. While 
a currency appreciation has some immediate effects, the impacts on the 
trade statistics, production decisions, and employment generally take a 
longer time. In the short term, the U.S. trade deficit may increase as 
it takes more dollars to buy the same amount of Chinese products. As 
the higher prices are factored into new purchasing decisions, the 
appreciation would lead to effects on U.S. production and employment 
that could occur over a period of months or years. 

(See app. VI for an additional discussion of these and other factors 
affecting the extent of revaluation impacts.)

A Renminbi Revaluation Could Have Both Costs and Benefits for the U.S. 
Economy: 

Changes in the value of a currency like the renminbi could affect the 
U.S. economy in a variety of ways, and assessing the effects is 
complex. For example, an increase in the renminbi's value could affect 
the mix of jobs in certain sectors, benefiting those sectors that 
compete directly with foreign products. However, in terms of 
employment, many experts believe that a rise in the value of the 
renminbi relative to the dollar would be unlikely to have much, if any, 
effect on aggregate employment in the United States. This is because 
the overall level of U.S. jobs is generally viewed as being largely 
determined by factors such as the domestic labor supply and broader 
macroeconomic factors such as U.S. monetary policy. In addition, an 
increase in the value of the renminbi could have other types of impacts 
that affect the economy more broadly, such as influencing the prices of 
goods and interest rates. 

Examples of groups that would be expected to benefit from an upward 
revaluation of the renminbi include: 

* U.S. firms and workers exporting to China--U.S. exports would become 
cheaper for Chinese consumers. 

* U.S. firms and workers producing goods that compete with Chinese 
imports--Chinese imports would become more expensive for U.S. 
consumers. 

* Low-wage countries other than China--Their exports could displace 
Chinese exports to the United States. 

* U.S. investors in China--The value of assets in China would increase. 

Examples of groups that would be expected to experience some losses 
from an upward revaluation of the renminbi include: 

* U.S. consumers--Imports from China would cost more. 

* Certain U.S. producers--Firms that import Chinese components in the 
production of final goods would pay more for those components. 

* Borrowers in U.S. capital markets--A possible decrease in capital 
flows from China could increase pressure on U.S. interest rates. 

* Multinational firms in China--The cost of production in dollars would 
increase and possibly raise the prices of final goods shipped to the 
United States. 

Analysis of Impacts of a Renminbi Revaluation on the U.S. Deficit and 
Manufacturing Sector Illustrates the Importance of Methodological 
Assumptions: 

Discussions of a revaluation of the renminbi have tended to focus on 
the outcome for workers in the U.S. manufacturing sector because U.S. 
employment in this sector has shrunk considerably in recent years and 
is believed to be sensitive to international trade.[Footnote 37] 
Predicting the manufacturing sector production and employment effects 
of a change in the renminbi's value is complex and is related to 
changes in trade flows. Therefore, some analysts have used estimates of 
changes in the U.S. trade deficit to estimate potential manufacturing 
production and employment effects, at least over the short run, 
although such linkages involve further uncertainties. 

The following exercise illustrates how possible impacts of a renminbi 
revaluation on the U.S. trade deficit could vary under different 
assumptions.[Footnote 38] The estimates use as a starting point an 
assumption for the relationship between the overall exchange rate of 
the dollar and the U.S. trade deficit[Footnote 39] from the IMF's April 
2004 World Economic Outlook and then illustrate the impact of 
additional assumptions regarding exchange rate pass-through, import 
displacement, and follow-on exchange rate adjustments (see table 3). 

These assumptions are not analytically precise, and other researchers 
have used different assumptions.[Footnote 40]

Table 3: Illustrative Scenarios of Upward Revaluation of the Renminbi 
on the U.S. Trade Deficit: 

Scenario: Scenario 1: 
Baseline assumption,[A] with no additional assumptions about exchange 
rate pass-through, shift to other foreign sources, or follow-on 
exchange rate adjustments; 
Decrease in U.S. trade deficit (dollars in billions): 5 percent upward 
revaluation: $2.8; 
Decrease in U.S. trade deficit (dollars in billions): 20 percent upward 
revaluation: $11.1. 

Scenario: Scenario 2: 
50 percent exchange rate pass-through and no shift to other foreign 
sources[B]; 
Decrease in U.S. trade deficit (dollars in billions): 5 percent upward 
revaluation: $1.4; 
Decrease in U.S. trade deficit (dollars in billions): 20 percent upward 
revaluation: $5.5. 

Scenario: Scenario 3: 
50 percent exchange rate pass-through and 40 percent shift to other 
foreign sources; 
Decrease in U.S. trade deficit (dollars in billions): 5 percent upward 
revaluation: $0.8; 
Decrease in U.S. trade deficit (dollars in billions): 20 percent upward 
revaluation: $3.3. 

Scenario: Scenario 4: 
Follow-on exchange rate adjustments (Korea, Taiwan, and Japan)[C] plus 
50 percent exchange rate pass-through and 40 percent shift to other 
foreign sources; 
Decrease in U.S. trade deficit (dollars in billions): 5 percent upward 
revaluation: $3.3; 
Decrease in U.S. trade deficit (dollars in billions): 20 percent upward 
revaluation: $13.3. 

Source: GAO analysis based on assumptions specified. 

[A] These estimates employ a rough assumption discussed in the IMF's 
April 2004 World Economic Outlook that a 10 percent depreciation in the 
dollar would lead to an improvement in the U.S. trade balance 
equivalent to 0.5 percent of GDP. 

[B] Specifically, this scenario assumes that the exchange-rate pass- 
through is 50 percent less than any pass-through level represented in 
scenario 1. 

[C] The follow-on exchange rate adjustments are assumed to be half as 
large, in percentage terms, as the renminbi revaluation. 

[End of table]

As shown in the table, with a hypothetical upward revaluation of 20 
percent, the estimates for trade deficit reduction due to a revaluation 
of the renminbi under these assumptions range from $3.3 billion to 
$13.3 billion, depending on pass-through, the displacement effect, and 
follow-on exchange rate adjustments. Estimates outside of the range of 
estimates provided here could be obtained using different assumptions. 
These estimates could change further by accounting directly for other 
factors such as the sensitivity of U.S. demand to price changes of 
Chinese imports. 

Some analyses have drawn conclusions about the impact of exchange rate 
changes on U.S. manufacturing jobs by using additional assumptions to 
those employed above. For example, one analysis used the assumption 
that a $1 billion increase in the U.S. trade deficit would lead to a 
decline in U.S. manufacturing jobs of about 15,000.[Footnote 41] 
Applying such a value to estimates of a 20 percent renminbi 
revaluation, under the assumptions shown in scenario 3, would lead to 
estimates of manufacturing sector job impacts of about 49,800 
jobs.[Footnote 42] Under scenario 4, with the additional assumption of 
follow-on exchange rate adjustments if the renminbi were revalued, the 
manufacturing sector job impact estimate would be 199,000. These 
analyses have limitations. Researchers have observed that trade affects 
the demand for manufacturing labor in complex ways, particularly with 
respect to imported goods and components. Moreover, as noted above, the 
long-run level of employment in the economy is generally viewed as 
being determined by demographic and broader macroeconomic factors such 
as monetary policy. Thus, to the extent there are manufacturing sector 
job impacts of a renminbi revaluation, they may be offset by job losses 
in other sectors of the economy. 

An Upward Renminbi Revaluation Could Have Implications for U.S. Capital 
Flows: 

Capital flows must also be considered in an assessment of the 
implications of a renminbi revaluation. The U.S. bilateral trade 
deficit with China--and its maintenance of a fixed exchange rate to the 
dollar--has been accompanied by an inflow of funds into U.S. capital 
markets from China.[Footnote 43] This has occurred during a period of 
an overall rise in inflows of foreign capital accompanying increasing 
U.S. trade and current account deficits. To the extent that a 
revaluation of the renminbi would lead to a decrease in the U.S. global 
current account deficit, it would also be associated with lower capital 
inflows. Such capital inflows--U.S. borrowing from foreign sources--can 
benefit the United States by lowering interest rates and stimulating 
investment and consumption. However, U.S. interest payments on this 
foreign-held debt are sent abroad.[Footnote 44] In addition, some 
analysts believe that U.S. dependence on inflows of foreign capital 
carries risk because of the potential for foreign investors to decide 
to hold or purchase less U.S. debt. The potential for, and consequences 
of, a widespread withdrawal of investment funds from U.S. markets has 
recently been debated. While some analysts believe that the effects of 
a foreign withdrawal from U.S. financial markets--or a reduction in 
foreign purchases of U.S. debt--would have limited effects over the 
long run, some acknowledge that short-run disruptions, such as the loss 
of value of assets and higher interest rates, could be significant. 

According to Treasury data, about 44 percent of the total value of 
outstanding U.S. Treasury securities held by the public is held by 
foreigners. At the end of 2004, China held 4.2 percent of the total 
holdings of outstanding U.S. Treasury securities, which is about 10 
percent of these securities held by foreigners (see fig. 3).[Footnote 
45] By far the largest holder of U.S. Treasury securities is Japan, 
which holds 16.6 percent. The United Kingdom, with 3.0 percent, is 
third behind China.[Footnote 46]

Figure 3: Percentage of U.S. Treasury Securities Held by Japan and 
China, 2004: 

[See PDF for image] 

Note: These percentages are approximate because of data limitations 
detailed in appendix I. Estimates are as of the end of the third 
quarter, 2004. 

[End of figure] 

As figure 4 illustrates, China was one of the largest purchasers of 
U.S. Treasury securities from 2001 to 2004--$95.4 billion, compared to 
$367.4 and $168.1 billion for Japan and the United Kingdom, 
respectively. Like other foreign central banks, China's central bank 
has chosen to purchase large quantities of U.S. Treasury securities 
with renminbi in part because it can buy and sell them quickly with 
minimal market impact. Figure 4 also shows that, in recent years, China 
has been a strong purchaser of other types of U.S. securities, 
especially agency bonds,[Footnote 47] according to data from the 
Treasury International Capital (TIC) reporting system. Between 2001 and 
2004 China purchased on net about $243.5 billion in total U.S. 
securities, behind the United Kingdom and Japan. (See app. VII for more 
data on net purchases of U.S. Treasury securities by China and other 
countries). 

Figure 4: Net Purchases of U.S. Securities by Select Economies, 2001- 
2004: 

[See PDF for image] 

Notes: Figures are adjusted for inflation using the GDP deflator. Data 
includes commissions and taxes associated with each transaction. 
Reporting procedures for the collection of these data lead to a bias 
toward overcounting flows from economies that are major financial 
centers and undercounting flows from other economies. Errors may also 
occur due to the manner in which repurchases and securities lending 
transactions are recorded within the TIC system. See appendix I for 
data limitations. 

[End of figure] 

Observations: 

While we make no recommendations in this report, we believe that our 
analysis provides important insights into the debate over exchange 
rates and U.S. government assessments of currency manipulation. The 
debate involves several issues that are related, but distinct. The 
first is currency manipulation. Assessing currency manipulation under 
the terms of U.S. law is complex and involves both country-specific and 
broader international economic factors. A second issue is 
undervaluation of currencies. Countries with undervalued currencies are 
presumed to obtain trade benefits from the undervaluation and therefore 
are often assumed to be manipulating their currencies to maintain these 
benefits. Many experts tend to focus on undervaluation--which Treasury 
is not required to determine. A third issue is the policy response that 
is expected from nations that are the focus of the debate. For example, 
experts who believe that China's currency is undervalued have varying 
views about what action China should take, including whether certain 
policy options entail risks to China's economy. In this report, we have 
tried to keep these issues distinct, because we believe it aids in 
clarifying the debate. 

The level of concern over exchange rate issues--especially with respect 
to China--is not surprising given the continuing growth of the U.S. 
trade deficit, the rapid growth of China's exports to the United 
States, and the recent depreciation of the dollar against several major 
currencies. In addition, as trade agreements reduce many of the 
industry-specific barriers to world trade, there has been a shift in 
attention toward the macroeconomic aspects of trade, which include 
exchange rates as well as national savings and investment rates. News 
that China's trade and current account surpluses were higher than 
expected in 2004 increases the need for good information on factors 
affecting international trade and financial flows, especially with 
respect to China, and the implications of these flows for the United 
States. Congress recently required Treasury to provide information on 
aspects of its reporting under the 1988 Trade Act, to facilitate better 
understanding by the American people and Congress. Treasury's March 
2005 report in response to this mandate provided a high-level 
discussion of key factors Treasury considers in its currency 
manipulation assessments and sheds light on the complexities of the 
assessments but did not provide--and was not required to provide-- 
country-specific information about Treasury's recent assessments. Since 
then, Members of Congress have continued to propose legislation to 
address China currency issues. We believe that the analysis in this 
report provides a basis for further discussion of currency manipulation 
concerns. 

Agency Comments and Our Evaluation: 

We provided a draft report to the Department of the Treasury. Treasury 
provided written comments, which are reprinted in appendix VIII. 
Treasury stated that the report is generally thoughtful and hopes that 
it will contribute to increased understanding of the complex issues 
covered in its exchange rate reports. Treasury also emphasized several 
aspects of its exchange rate assessments and its reports. For example, 
with respect to reporting on U.S. economic impacts, Treasury stated 
that when conducting its analysis it does consider how the exchange 
rate of the dollar affects areas such as the sustainability of the 
current account deficit, production, and employment. Treasury stated 
that it believes it is often more helpful to look at underlying 
developments that affect exchange rates and other macroeconomic 
conditions rather than to achieve a false sense of precision by 
isolating the exchange rate in the analysis. Treasury also provided 
technical comments, which we incorporated in the report as appropriate. 

As agreed with your office, unless you publicly announce its contents 
earlier, we plan no further distribution of this report until 30 days 
from the date of its issuance. At that time, we will send copies of 
this report to interested congressional committees, the Secretary of 
the Treasury, and other interested parties. We will make copies 
available to others upon request. In addition, the report will be 
available at no charge on the GAO Web site at [Hyperlink, 
http://www.gao.gov]. 

If you or your staffs have any questions concerning this report, please 
contact me at (202) 512-4128 or at [Hyperlink, yagerl@gao.gov]. Other 
GAO contacts and staff acknowledgments are listed in appendix IX. 

Signed by: 

Loren Yager: 
Director, International Affairs and Trade: 

[End of section]

Appendixes: 

Appendix I: Objectives, Scope, and Methodology: 

The Chairs of the Senate Committee on Small Business and 
Entrepreneurship and the House Committee on Small Business asked us to 
review the Department of the Treasury's efforts to fulfill its legal 
obligations under the 1988 Trade Act and related issues. We examined 
(1) the process Treasury uses to conduct its assessments of currency 
manipulation and the results of recent assessments, particularly with 
respect to China and Japan; (2) the extent to which Treasury has met 
the 1988 Trade Act reporting requirements; (3) experts' views on 
whether or by how much China's currency is undervalued; and (4) the 
implications of a revalued Chinese currency for the United States. 

To determine the process Treasury uses to conduct its currency 
manipulation assessments and the results of recent assessments, 
particularly with respect to China and Japan, we reviewed the legal 
provisions of the 1988 Trade Act requiring Treasury to analyze foreign 
currency manipulation, and the act's legislative history. We also 
interviewed responsible Treasury officials to better understand the 
assessment process. In addition, we reviewed Treasury exchange rate 
report findings on whether other countries are manipulating their 
currencies. Specifically, we examined the conditions cited in the 
Treasury reports that led to determination of currency manipulations 
for Taiwan, Korea, and China from 1988 to 1994. We also examined the 
changes in the economies' conditions that led to removals of citations 
or, in some cases, subsequent citations for these economies; and we 
interviewed Treasury officials to understand Treasury's reasoning 
behind its findings for China and Japan. We interviewed IMF officials 
to obtain information on Treasury's consultive process with IMF. To 
gain a broader perspective on the economic conditions of China and 
Japan, we examined recent domestic and international economic data and 
information on those two countries' current exchange rate regimes and 
practices. 

To determine the extent of Treasury's compliance with reporting 
requirements, we reviewed all of Treasury's exchange rate reports since 
1988. We analyzed the reports and categorized our assessment of 
Treasury's compliance for each of the eight reporting requirements. In 
addition, we interviewed Treasury officials to discuss Treasury's 
recent efforts to address the requirement to assess the impact of the 
exchange rates on the U.S. economy. Finally, for verification, we 
compared statements of Treasury officials with the exchange rate 
reports. 

To obtain experts' views on whether or by how much China's currency is 
undervalued and the value's implications for the United States, we 
identified studies and views of economists with expertise in the area 
that had been cited in congressional testimony and in other prominent 
policy forums, reviewed those and related studies, and interviewed a 
selection of experts spanning the spectrum of opinions on Chinese 
currency valuation. GAO economists reviewed these research papers and 
testimonies solely to describe the analyses and differences among them. 
The inclusion of the results of these studies is to show that estimates 
of undervaluation for China vary widely and that the analysis of the 
impact on the U.S. economy is complex; their inclusion does not imply 
that we deem them definitive. To describe and analyze country economic 
data and indicators used by many of these experts, we used data from 
the International Monetary Fund's (IMF) World Economic Outlook and 
other sources, including the Bureau of Labor Statistics and the Federal 
Reserve Board. We also obtained foreign exchange reserve data from 
Global Insight and data on Japanese interventions for the 2000 to 2004 
period from Japan's Ministry of Finance. We used U.S. trade statistics 
compiled by the Department of Commerce's statistical agencies to 
analyze the composition and trends in the U.S. merchandise trade 
deficit. We note that there are significant differences between U.S.- 
China bilateral trade data reported by the United States and that 
reported by China. We did not conduct an evaluation of these 
differences, which others have attributed to general differences in how 
imports and exports are valued, how the United States and China record 
imports and exports shipped through Hong Kong, and the quality of 
Chinese statistics. The reliability of Chinese statistics may also 
impact IMF's statistics because much of the data used by IMF is self- 
reported by member countries. We determined that these data are 
sufficiently reliable for our purposes of presenting and analyzing 
trends in trade patterns and basic economic trends for China. 

In addition, to describe a range of views on how China might move to an 
alternative exchange rate value or regime, we identified several 
representative policy suggestions from the studies we reviewed and the 
experts we consulted regarding assessments of whether China's currency 
is undervalued. 

To describe the implications of a revalued Chinese currency for the 
United States, we identified and reviewed studies that had been cited 
in congressional testimony and other policy forums, and by research 
institutions including the IMF. We discussed these studies with several 
experts spanning a range of views. To illustrate how estimates of the 
effects of exchange rates on U.S. manufacturing jobs depend on key 
assumptions, we identified assumptions from studies we reviewed and 
made illustrative calculations using different assumptions. These 
assumptions are not analytically precise, and we did not present 
particular estimates as being superior to others. Alternative 
combinations of assumptions or alternative assumptions can yield impact 
estimates outside the ranges presented in our analysis. The 
hypothetical percentages of undervaluation and assumptions are for 
illustrative purposes; the illustration does not imply that GAO has 
taken a position on the value of China's currency or its actual impact 
on the U.S. economy. 

We also obtained data on hourly compensation costs from the Bureau of 
Labor Statistics to provide background for our discussion of the role 
of labor costs in international competitiveness. We determined that the 
data are sufficiently reliable for the purpose of illustrating 
substantial variations in labor costs across countries. However, the 
data are partially estimated and thus the statistics should not be 
considered precise measures of comparative costs and are subject to 
revision. For some foreign economies, the estimates are based on less 
than one year of data. There may also be variations in the definitions, 
scope, coverage, and methods used in compiling the data and in its 
presentation. These include the treatment of the financing of social 
security and the systems of taxes or subsidies. 

In addition, we calculated the portion of U.S. Treasury bills and 
corporate equities held by the two countries using the U.S. Treasury 
International Capital Reporting System (TIC) and the Federal Reserve 
Board's Flow of Funds data to present information on China and Japan's 
weight in U.S. capital markets. We used these data because they 
constitute the only data available for these transactions, but we note 
in presenting the information that because of the way the data are 
collected there is a bias toward overcounting flows to countries that 
are major financial centers and toward undercounting flows to other 
countries.[Footnote 48] As a result, excessive foreign holdings may be 
attributed to some countries that are major custodial centers, such as 
the United Kingdom, Switzerland, Belgium, and Luxembourg. Moreover, 
because the Bureau of Economic Analysis adjusts the TIC data somewhat 
before it reaches the Federal Reserve Board and because of timing 
issues, the data on total foreign holdings from the two sources have 
slight but insignificant differences. We determined that the data are 
sufficiently reliable for our purpose of illustrating whether China and 
Japan are major holders or purchasers of U.S. securities. We note, 
however, that as a result of the limitations identified, GAO 
calculations of the percentage of U.S. securities held by Japan and 
China based on the primary TIC and Federal Reserve data should be 
viewed as approximations. 

In addition to the bias detailed above, the raw transactions data (net 
purchases) documented in figure 5 and the associated tables in appendix 
VI may contain errors due to the manner in which repurchase and 
securities lending transactions are recorded within the TIC system. 
Because these transactions are known to be substantial, producers of 
the data note that this could produce significantly inaccurate data. 
Moreover, because these data include commissions and taxes associated 
with each transaction, the result is a slight overestimation of net 
purchases. These data are also revised periodically. The TIC system is 
the official source of this data, it is widely used by outside experts, 
and the limitations are not particular to any one country. Therefore we 
determined that they were sufficiently reliable for a comparison of net 
purchases of U.S. securities by China with other major purchasers and 
generally assessing the role of China in U.S. financial markets. 
However, the data must be interpreted with caution because recent 
transaction data may have overstated net foreign purchases of U.S. 
securities, especially debt instruments. 

To verify the reliability of most data sources, we performed several 
checks to test the data's accuracy or we reviewed limitations, wherever 
possible. We reviewed agency or company documents related to their 
quality control efforts and conferred with GAO's statistical expert for 
relevant data. For several sources, we tracked secondary data to the 
source data and reviewed other experts' uses and judgments of that 
data. For several sources, we compared the raw data, or the descriptive 
statistics computed using the data, with equivalent statistics from 
other sources. We determined that the data sources we used were 
sufficiently reliable for the purposes of this audit. Although in many 
cases there were limitations, they are generally minor in the context 
of this report. We were unable to conduct a review of the Japanese 
Ministry of Finance intervention data. However, given that the Ministry 
of Finance is the primary and official source of these data and they 
are widely used by outside experts and policymakers, including the 
Federal Reserve Bank of New York, we have included some of the data in 
this report for illustrative purposes. 

We conducted our work from September 2003 through February 2005 in 
accordance with generally accepted government auditing standards. 

[End of section]

Appendix II: Omnibus Trade and Competitiveness Act of 1988: 

Omnibus Trade and Competitiveness Act of 1988[Footnote 49] (Pub. L. No. 
100-418, §§ 3004(b) and 3005): 

Sec. 3004. International Negotiations on Exchange Rate and Economic 
Policies. 

(b) Bilateral Negotiations--The Secretary of the Treasury shall analyze 
on an annual basis the exchange rate policies of foreign countries, in 
consultation with the International Monetary Fund, and consider whether 
countries manipulate the rate of exchange between their currency and 
the United States dollar for purposes of preventing effective balance 
of payments adjustments or gaining unfair competitive advantage in 
international trade. If the Secretary considers that such manipulation 
is occurring with respect to countries that (1) have material global 
current account surpluses; and (2) have significant bilateral trade 
surpluses with the United States, the Secretary of the Treasury shall 
take action to initiate negotiations with such foreign countries on an 
expedited basis, in the International Monetary Fund or bilaterally, for 
the purpose of ensuring that such countries regularly and promptly 
adjust the rate of exchange between their currencies and the United 
States dollar to permit effective balance of payments adjustments and 
to eliminate the unfair advantage. The Secretary shall not be required 
to initiate negotiations in cases where such negotiations would have a 
serious detrimental impact on vital national economic and security 
interests; in such cases, the Secretary shall inform the chairman and 
the ranking minority member of the Committee on Banking, Housing, and 
Urban Affairs of the Senate and of the Committee on Banking, Finance 
and Urban Affairs of the House of Representatives of his determination. 

Sec. 3005. Reporting Requirements. 

(a) Reports Required--In furtherance of the purpose of this title, the 
Secretary, after consultation with the Chairman of the Board, shall 
submit to the Committee on Banking, Finance and Urban Affairs of the 
House of Representatives and the Committee on Banking, Housing, and 
Urban Affairs of the Senate, on or before October 15 each year, a 
written report on international economic policy, including exchange 
rate policy. The Secretary shall provide a written update of 
developments six months after the initial report. In addition, the 
Secretary shall appear, if requested, before both committees to provide 
testimony on these reports. 

(b) Contents of Report--Each report submitted under subsection (a) 
shall contain: 

(1) an analysis of currency market developments and the relationship 
between the United States dollar and the currencies of our major trade 
competitors;

(2) an evaluation of the factors in the United States and other 
economies that underline conditions in the currency markets, including 
developments in bilateral trade and capital flows;

(3) a description of currency intervention or other actions undertaken 
to adjust the actual exchange rate of the dollar;

(4) an assessment of the impact of the exchange rate of the United 
States dollar on: 

(A) the ability of the United States to maintain a more appropriate and 
sustainable balance in its current account and merchandise trade 
account;

(B) production, employment, and noninflationary growth in the United 
States;

(C) the international competitive performance of United States 
industries and the external indebtedness of the United States;

(5) recommendations for any changes necessary in United States economic 
policy to attain a more appropriate and sustainable balance in the 
current account;

(6) the results of negotiations conducted pursuant to section 3004;

(7) key issues in United States policies arising from the most recent 
consultation requested by the International Monetary Fund under article 
IV of the Fund's Articles of Agreement; and: 

(8) a report on the size and composition of international capital 
flows, and the factors contributing to such flows, including, where 
possible, an assessment of the impact of such flows on exchange rates 
and trade flows. 

[End of section]

Appendix III: Conditions that Led to the Determination of Currency 
Manipulation and Removal: 

At different times during the period from 1988 to 1994, Treasury found 
that Taiwan, Korea, and China manipulated their currencies under the 
terms of the 1988 Trade Act. The conditions leading to their first 
citations and the changes in conditions that later led to their removal 
are listed below. 

Table 4: Conditions Treasury Cited in Earlier Determinations of 
Currency Manipulation: 

Conditions: Bilateral trade surplus with U.S; 
Taiwan: (first half of 1988): $17.4 billion (18% of GNP) in 1987; 
Korea: (first half of 1988): $9.4 billion in 1987 (8.3% of GNP); 
China: (second half of 1991): $12.7 billion in 1991, second only to 
Japan, grew rapidly. 

Conditions: Current account surplus (% of GNP); 
Taiwan: (first half of 1988): $18.1 billion (18.5% of GNP) in 1987); 
Korea: (first half of 1988): Near $10 billion (8.3% of GNP) in 1987; 
China: (second half of 1991): $12.2 billion (3.3% of GNP) in 1990. 

Conditions: Other indicators highlighted; 
Taiwan: (first half of 1988): Strong economic fundamentals and rapidly 
rising foreign exchange reserves; Insufficient currency appreciation 
(40% since 1985 Plaza Accord, less than 92% appreciation by Japanese 
yen, and 60% by German mark); Undervaluation, resulting from 
interventions, capital controls, and administrative mechanisms 
preventing further appreciation; 
Korea: (first half of 1988): Strong economic fundamentals, prepayment 
of external debt, and rising foreign exchange reserves; Insufficient 
currency appreciation (26% since 1985 Plaza Accord, less than 92% 
appreciation by Japanese yen and 60% by German mark); Undervaluation, 
resulting from interventions, capital controls, and administrative 
mechanisms preventing further appreciation; 
China: (second half of 1991): Rising foreign exchange reserves, $44 
billion in 1991, enough to cover 10 months of imports; Dual exchange 
rate regime--continued devaluations of the fixed official exchange rate 
and excessive controls on the dual market determined rates. (China 
claimed these actions were aimed at eliminating costly export subsidies 
and unifying dual rates.) 

Conditions: Activities considered as potential manipulation or 
conditions considered as constraining market forces in foreign exchange 
market; 
Taiwan: (first half of 1988): Substantial capital and exchange 
restrictions under the managed float system; Heavy direct interventions 
(buy or sell) by the central bank in foreign exchange markets; 
Korea: (first half of 1988): Substantial capital and exchange 
restrictions under the managed float system; Established currency value 
administratively based on undisclosed basket (combination) of 
currencies; 
China: (second half of 1991): Pervasive administrative controls over 
external trade; Treasury interpreted Chinese repeated devaluations and 
controls on dual market rates as efforts to frustrate effective balance 
of payment adjustments. 

Conditions: Number of 6-month periods continuously cited for 
manipulating currency; 
Taiwan: (first half of 1988): 2; 
Korea: (first half of 1988): 3; 
China: (second half of 1991): 5. 

Conditions: Changes in conditions that led to removal of citation; 
Taiwan: (first half of 1988): 12% more appreciation of currency since 
first citation; Reduction of global current account surplus by 43% 
(8.5% of GNP); Implemented a new exchange rate system (5 months before 
the Treasury report was issued) that liberalized the system and reduced 
capital controls; No evidence of substantial interventions, but concern 
remained on potential interventions by government controlled banks; 
Korea: (first half of 1988): Global current account surplus reduced to 
$5.1 billion (2.5% of GNP); Bilateral surplus reduced to $6.3 billion 
in 1989; Introduction of new "market average rate" system of exchange 
rate determination in March (1 month before Treasury report was 
issued); Initiation of the bilateral Financial Policy Talks during the 
period; 
China: (second half of 1991): Current account turned from negative in 
1993 to small surplus in 1994; Bilateral surplus projected to be $28.7 
billion for 1994; Foreign exchange reserves $39.8 billion, can cover 5 
months of imports; Unified the dual exchange rate regime and 
liberalized domestic firms' access to foreign exchanges in; 1994; 
Government approval of foreign exchange purchases by foreign-funded 
enterprises remained; Treasury determined that China was not 
manipulating exchange rate but maintained capacity to do so in the 
future. 

Conditions: Changes in conditions that led to additional citation and 
its removal; 
Taiwan: (first half of 1988): 

Additional Citation; 

(Second half of 1991 and first half of 1992); 

* Current account surplus rose to $12 billion (6.7% of GNP) in 1991; 
* Bilateral surplus $9.8 billion; 
* Official foreign exchange reserves rose significantly to $83.2 
billion in Feb 1992, the world's largest, and enough to cover 17 months 
of imports; 
* Continued intervention to moderate upward pressure; 
* Remaining restrictions prevent full market forces in foreign exchange 
market; 
* Strong economic fundamentals; 

Removal; 

* Current account surplus fell to $7.9 billion (3.8% of GNP) in 1992; 
* Bilateral surplus declined slightly to $9.4 billion in 1992; 
* Foreign exchange reserves declined slightly to $82.3 billion, second 
to Germany; 
* Remaining foreign exchange restrictions and capital controls no 
longer constrained currency appreciation; 
* It appears that Chinese authorities engaged in direct interventions 
in foreign exchange markets to prevent currency depreciation; 
Korea: (first half of 1988): N/A; 
China: (second half of 1991): N/A. 

Source: GAO analysis of Treasury exchange rate reports. 

[End of table]

[End of section]

Appendix IV: Overview of China and Japan's Recent Economic Conditions: 

This appendix presents an overview of recent economic conditions for 
China and Japan that are relevant to exchange rate policies. These 
include economic growth, external account balances, foreign exchange 
reserves, exchange rate movements, currency exchange rate regimes, and 
direct interventions in foreign exchange markets by national 
authorities. 

China: 

Economic Growth and Trade Balance: 

China has experienced high rates of economic growth in recent years. 
According to IMF-reported country data, the Chinese economy grew at 
annual rates of 7.1 percent to 9.6 percent during 1996 to 2004 (see 
fig. 5). Although economists have questioned the quality of Chinese 
national account statistics, there is a general consensus that the 
Chinese economy has grown rapidly during the past 2 years. In fact, the 
Chinese government has implemented policies since mid-2003 to slow 
economic growth because of concerns about overheating the economy. 

Figure 5: China's Real GDP Growth Rate, 1996-2004: 

[See PDF for image] 

Note: The 2004 value is an estimate from Global Insight. 

[End of figure] 

China's economic growth has been accompanied by a large total trade 
volume, which was 59 percent of gross domestic product (GDP) in 2003 
and 73 percent of GDP according to preliminary 2004 data. The large 
trade volume has been accompanied by China's consistently positive 
current account balance.[Footnote 50] While China's current account 
surplus declined from around 3.3 percent of (GDP) in 1998 to less than 
2 percent in 1999 to 2001, it rose to 2.8 percent in 2002 after 
accession to the World Trade Organization and then to 3.2 percent in 
2003. Preliminary data for 2004 indicated a surplus of 4.2 
percent.[Footnote 51] (See fig. 6.)

Figure 6: China's Current Account Surplus in Billions of U.S. Dollars 
and as a Percentage of GDP, 1996-2004: 

[See PDF for image] 

Note: The 2004 value is an estimate from Global Insight. 

[End of figure] 

Foreign Exchange Reserves: 

The Chinese government has rapidly accumulated foreign exchange 
reserves in recent years, which some observers have seen as evidence of 
currency undervaluation and manipulation. China's total foreign 
exchange reserves (excluding gold and other assets at the IMF) reached 
$614.5 billion by the end of 2004. As figure 7 shows, this represents 
approximately three times the level of China's reserves in 2001. 

Figure 7: China's Total Foreign Exchange Reserves, 1995-2004: 

[See PDF for image] 

Note: Values represent total foreign exchange reserves, minus gold. 

[End of figure] 

Changes in China's foreign exchange reserves have several components: 
changes in the current account balance, changes in net flows of foreign 
direct investment (FDI), changes in net non-FDI flows, and undocumented 
capital--or errors and omissions. Both China's current account surplus 
and net FDI inflows were major components of the reserve increases from 
2001 through 2003. (See table 4.) In addition, changes in non-FDI net 
inflows (defined as portfolio investment and other investment) and 
errors and omissions have also been important to the reserve increases. 
These components had been strongly negative--meaning significantly 
greater outflows than inflows--in 1999 and 2000, which had worked to 
dampen China's reserve accumulation. However, the balance changed and 
in 2003 non-FDI flows and errors and omissions were strongly positive. 
One reason for the increase in these inflows into China is large 
speculative inflows that may be driven by expectations of an upward 
revaluation of the renminbi. 

Table 5: China's Balance of Payments: 

Balance of payments concepts: Current account balance; 
1999: $21.1; 
2000: $20.5; 
2001: $17.4; 
2002: $35.4; 
2003[A]: $45.9. 

Balance of payments concepts: Capital and financial account balance; 
1999: $7.6; 
2000: $2.0; 
2001: $34.8; 
2002: $32.3; 
2003[A]: $52.8. 

Balance of payments concepts: Net foreign direct investment; 
1999: $37.0; 
2000: $37.5; 
2001: $37.4; 
2002: $46.8; 
2003[A]: $47.2. 

Balance of payments concepts: Net portfolio investment; 
1999: - $11.2; 
2000: - $4.0; 
2001: - $19.4; 
2002: - $10.3; 
2003[A]: $11.4. 

Balance of payments concepts: Net other investment[B]; 
1999: - $20.5; 
2000: - $31.5; 
2001: $16.9; 
2002: - $4.1; 
2003[A]: - $5.9. 

Balance of payments concepts: Errors and omissions[C]; 
1999: - $17.6; 
2000: - $11.7; 
2001: - $4.7; 
2002: $7.5; 
2003[A]: $18.0. 

Balance of payments concepts: Overall balance (increase in foreign 
exchange reserves); 
1999: $8.7; 
2000: $10.7; 
2001: $47.5; 
2002: $75.3; 
2003[A]: $116.6. 

Balance of payments concepts: Basic balance (Current account + FDI); 
1999: $58.1; 
2000: $58.0; 
2001: $54.8; 
2002: $82.2; 
2003[A]: $93.1. 

Source: IMF. 

[A] 2003 is the most recent year for which complete data on the balance 
of payments component are available. 

[B] Other investment includes trade credits, loans, and currency and 
deposits. 

[C] Errors and omissions often reflect undocumented capital flight. 

[End of table]

Balance of Payments: 

The basic relationship between China's current account balance and 
capital and financial account flows is also depicted in table 4. For 
2003, the last year for which complete data is available, China had a 
current account surplus of $45.9 billion accompanied by a capital 
account surplus of $52.8 billion. Maintaining large surpluses in both 
current and capital accounts is relatively unusual compared to other 
countries. For example, the United States has had in recent years a 
current account deficit financed by a capital account surplus; that is, 
the United States borrows from foreigners to purchase goods. Japan, in 
contrast, has generally had in recent years a current account surplus 
and a deficit in its capital account, including a net outflow of FDI. 
China's net capital inflow in 2003 was predominantly in the form of 
direct investment. This is in part because China has a relatively open 
door policy on FDI but restricts other forms of foreign investment. 

China's Exchange Rate: 

China has, since the fall of 1994, had a de facto fixed exchange rate 
regime, as classified by the IMF, with its exchange rate pegged to the 
dollar (see fig. 8). Prior to that point, China maintained a dual 
exchange rate regime with an official fixed rate and market-negotiated 
rates. The official fixed rate was devalued several times before it was 
unified with the prevailing market rate in early 1994, and the exchange 
rate regime was officially changed to a managed float.[Footnote 52] The 
renminbi began to appreciate slightly (to 8.3 renminbi per U.S. dollar) 
soon after the unification, mainly due to export growth caused by a 
wave of foreign direct investment. Chinese authorities decided to hold 
the rate within a small band of 0.25 percent. By 1998, the exchange 
rate had been allowed to appreciate slightly to 8.28 renminbi per U.S. 
dollar, with a narrow band, where it has stayed until the present. 

Figure 8: Chinese Renminbi/Dollar Exchange Rate, 1989-2004: 

[See PDF for image] 

[End of figure] 

Between 1986 and 1994, China had a dual exchange rate regime in which 
the official fixed exchange rate coexisted with the market-negotiated 
rates in Foreign Exchange Adjustment Centers (also called swap 
centers).[Footnote 53] The official rate applied to trade transactions 
and other activities that were controlled by state planning. Market 
rates, which were significantly lower than the official rate, 
suggesting overvaluation of the official rate, applied to all other 
activities. By 1993, the official rate was 5.7 renminbi per U.S. dollar 
and the market rate was 8.7 renminbi per U.S. dollar. 

It is the real effective exchange rate that affects Chinese products' 
trade competitiveness.[Footnote 54] Although the nominal exchange rate 
of Chinese currency has remained relatively stable since 1994, the real 
effective exchange rate of Chinese currency has shown variations since 
1994 (see fig. 9). The variation is parallel to that of the U.S. dollar 
because the renminbi has been pegged to dollar. 

Figure 9: Real Effective Exchange Rate Indexes (China and the United 
States), 1994-2004: 

[See PDF for image] 

Note: JP Morgan indexes, 2000=100: 

[End of table]

Foreign Exchange and Capital Controls: 

Chinese authorities keep controls on foreign exchange earned from 
exports and other current account activities through "repatriation and 
surrender requirements" on foreign exchange proceeds. Under these 
controls, some exporters must sell a significant portion of their 
previous year's foreign exchange earnings to authorized banks at a 
fixed rate for China's currency.[Footnote 55] China also maintains 
controls on the use of foreign currencies related to imports and other 
outward flows for investment purposes. For instance, importers must 
provide proof of import needs and commercial bills to obtain foreign 
currencies. Overall, these measures are less restrictive than those in 
place in the early 1990s. 

In addition to controls related to current account transactions, other 
restrictions continue to apply to most capital transactions. For 
instance, only certain qualified foreign institutional investors can 
bring in foreign capital to invest in the segment of Chinese domestic 
security markets denominated in renminbi. Foreign entities can purchase 
securities denominated in U.S. dollars more freely. China maintains an 
"open door" policy with respect to inbound FDI, but outward investment 
is limited and requires government approval. Chinese purchases of 
capital and money market instruments abroad are restricted to selected 
institutions and enterprises. In 2004, China eased some restrictions on 
outward capital flows, including allowing domestic insurance firms to 
invest a portion of their portfolios offshore and permitting 
multinational companies to transfer foreign exchange among 
subsidiaries. 

Japan: 

Growth Rate and Trade Balance: 

Japan suffered from recession and deflation in the years immediately 
following the 1997 to 1998 Asian financial crisis (see fig. 10). Its 
economy recovered briefly with a 2.8 percent annual growth rate in 
2000, declined in 2001, and stagnated in 2002 before picking up again 
in 2003. Despite inconsistent growth, Japan has maintained a consistent 
current account surplus, which fluctuated between 2.1 percent and 3.6 
percent of GDP during 1998 to 2004 (see fig. 11). Nevertheless, Japan's 
trade volume as a percentage of GDP was 18 percent in 2003 and 20 
percent according to preliminary 2004 data, both of which were less 
than one-third that of China for the same years.[Footnote 56]

Figure 10: Japan's Real GDP growth rate, 1996-2004: 

[See PDF for image] 

Note: The 2004 value is an estimate from Global Insight. 

[End of figure] 

Figure 11: Japan's Current Account Surplus in Billions of U.S. Dollars 
and as a Percentage of GDP, 1996-2004: 

[See PDF for image] 

Note: The 2004 value is an estimate from Global Insight. 

[End of figure]

Foreign Exchange Reserves: 

Japan's total foreign exchange reserves increased from $215.5 billion 
in 1998 to $663.3 billion in 2003 and $833.9 billion in 2004 (see fig. 
12). The rapid increase reflected a reversal of net capital flow 
direction--from a net outflow to a net inflow. The rapid accumulation 
of foreign exchange reserves in 2003 is attributable to an increase in 
non-FDI capital inflows. This increase was due to an equity market 
rally caused primarily by Japan's economic recovery,[Footnote 57] an 
increase in the Japanese interest rate in the summer of 2003, and 
market anticipation of further yen appreciation. In contrast to China, 
Japan has had a steady FDI outflow over time. It ranged from $23 
billion to $32 billion from 2000 to 2003. 

Figure 12: Japan's Total Foreign Exchange Reserves, 1995-2004: 

[See PDF for image] 

Note: Values represent total foreign exchange reserves, minus gold. 

[End of figure] 

Japan's Exchange Rate: 

The Japanese yen is on an independent float, with the exchange rate 
primarily determined by market forces.[Footnote 58] Japanese 
authorities have periodically carried out large interventions in the 
foreign exchange market through the sale of yen in exchange for U.S. 
dollars, resulting in slower yen appreciation.[Footnote 59] Japanese 
authorities intervened frequently in its foreign exchange markets in 
2002,[Footnote 60] increased the frequency and magnitude of 
interventions in 2003, and continued interventions into early 2004 (see 
fig. 13). U.S. Treasury officials told us they did not think such 
interventions led to lasting effects on the yen exchange rate. Since 
2003 Treasury has reported that it actively engages Japanese 
authorities to urge greater exchange rate flexibility. 

Figure 13: Yen/Dollar Interventions, January 2000-December 2004: 

[See PDF for image] 

Note: GAO did not assess the reliability of the Ministry of Finance 
data. This is quarterly data. 

[End of figure] 

The yen's real effective exchange rate has fluctuated over the past 
decade (see fig. 14). Some market appreciation pressure on the nominal 
value of the yen during this period was due to larger capital inflows, 
particularly a large inflow from Europe in 1999 and another large 
inflow in 2003 due to prospects of higher stock market prices. Strong 
inflows continued into early 2004. 

Figure 14: Real Effective Exchange Rate Index for Japan, 1994-2004: 

[See PDF for image] 

Note: JP Morgan indexes, 2000=100. 

[End of figure] 

[End of section]

Appendix V: Commonly Used Methods to Determine Equilibrium Exchange 
Rates: 

Economists use various methods to analyze whether exchange rates are 
misaligned. In general, determining whether a country's currency is 
under-or overvalued involves first determining the country's 
equilibrium exchange rate as a reference or baseline. This is complex 
because estimating the equilibrium exchange rate requires information 
on what value the exchange rate would attain if it were consistent with 
a country's economic fundamentals at a particular point in time. 
Different approaches to estimating equilibrium exchange rates and under-
and overvaluation can yield widely varying results, especially for 
developing countries, and even similar approaches can result in 
different outcomes depending upon which assumptions and economic 
judgments are used. Thus, estimates of undervaluation for China vary 
substantially--from 0 to 56 percent. This appendix outlines some of the 
methodologies commonly used to estimate the extent of undervaluation of 
the renminbi. 

Purchasing Power Parity (PPP) Approach: 

One methodology commonly used to define equilibrium exchange rates and 
determine if a currency is under-or overvalued is the Purchasing Power 
Parity (PPP) approach. The PPP approach is rooted in the law of one 
price, which states that identical goods in different countries should 
trade at the same price. Thus, the equilibrium exchange rate is defined 
as the exchange rate at which the general level of prices will be the 
same in every country and is calculated as the ratio of the domestic 
and foreign price levels. The goods and services analyzed are typically 
those that make up the GDP of each country. In some cases, narrower 
units have formed the basis of PPP comparisons, such as the "Big Mac" 
index which is a widely cited shortcut version that analyzes one 
standardized good across countries. Unfortunately, the law of one price 
has limitations; it does not hold across nations of sharply differing 
levels of development and is biased toward finding undervaluation for 
low-income countries compared to their higher-income 
counterparts.[Footnote 61] Additionally, the approach ignores other 
important factors that lead to inequality in prices, such as trade 
barriers and nontraded goods. Many experts maintain that PPP measures 
are more useful for analyzing cost-of-living differences than inferring 
the extent of currency misalignment. 

A variation of the absolute PPP approach discussed above is the 
relative version of the PPP methodology, which is based on the 
hypothesis that changes in the exchange rate are determined by the 
difference between inflation rates in the two countries--or, 
equivalently, the real exchange rate between two currencies remains 
constant over time.[Footnote 62] The technique involves choosing a 
point in time that corresponds to equilibrium and then projecting the 
new equilibrium rate using the inflation differentials between 
countries. This analysis is based on trade-weighted exchange rate 
indexes because they are better indicators of overall competitiveness. 
One limitation of the approach is that it is very sensitive to the type 
of price index used for base calculations (e.g., the consumer price 
index vs. the producer price index), and the results depend on the time 
periods selected as the base year. The methodology also ignores 
structural changes in the economy that might cause the real exchange 
rate to change over time. 

Fundamental Equilibrium Exchange Rate (FEER) Approach: 

The FEER approach to assessing currency valuation is based on the 
relationship between the current account and capital flows.[Footnote 
63] The FEER is defined as the exchange rate that will bring the 
current account balance (consistent with domestic full employment) into 
equality with the "normal" or sustainable capital account 
balance.[Footnote 64] Thus, it is the value of the exchange rate that 
is consistent with both internal and external economic equilibrium. The 
FEER calculation requires macroeconomic or trade models to obtain the 
current account position that is consistent with internal balance, 
known as the "trend" current account. The second stage involves 
determining the real exchange rate changes necessary to ensure balance 
between medium-term capital flows and the trend current account. Within 
this framework, the equilibrium exchange rate is deemed "fundamental" 
in the sense that it is related to the fundamental economic 
determinants over the medium term. 

Significant limitations of this approach are that it requires extensive 
modeling to capture the major trade relationships and economic 
judgments that are criticized by some as ad hoc (including a decision 
about "normal" or sustainable capital flow levels) and that it relies 
on estimates of the sensitivity of demand to prices that are difficult 
to make. In addition, changes in the structure of the economy that 
affect the current account and the equilibrium exchange rate may 
introduce further uncertainty in the estimates. This is important in 
China's case because many economic conditions and institutions are 
rapidly changing in the move toward a market-based economy. Also, this 
approach is difficult to apply to China because of limitations in the 
quality of Chinese statistics. 

Macroeconomic Balance Approach: 

This methodology is based on the premise that there is an appropriate 
current account position (external balance) associated with the 
equilibrium savings and investment balance within a country (internal 
balance). Once the full employment savings-investment position is 
established and its associated current account is determined, this 
approach uses estimated trade models to determine how much the real 
exchange rate would have to change to generate the required external 
balance. The approach is related to the FEER concept because the 
equilibrium exchange rate is associated with internal and external 
economic balances.[Footnote 65] Similar to the FEER, this methodology 
also requires considerable modeling and economic judgment, and the 
results are highly sensitive to variations in key parameters. The IMF 
notes that in its macroeconomic balance modeling approach assumptions 
are used to assess the current account positions and exchange rates 
that may not be entirely appropriate for developing countries. 
Moreover, the IMF industrial country methodology largely abstracts from 
the impact that structural policies and adjustments could have on the 
equilibrium savings investment position.[Footnote 66] Again, this is 
important in China's case because of the many structural adjustments 
the country is currently undergoing. 

External Balance Approach: 

Similar to the FEER and Macroeconomic Balance approaches, this method 
is based on the premise that there is an appropriate external account 
position. That is, there is a particular level of the current account 
that balances the "normal" capital flows so that there is no change in 
international reserves. It differs from these two approaches in that it 
does not consider internal equilibrium. This approach involves 
determining the sustainable external account balance--meaning one 
appropriate for a country's economic situation.[Footnote 67] Once the 
relevant external balance is identified, estimated trade models or rule-
of-thumb relationships[Footnote 68] are used to determine the exchange 
rate change needed to generate the target outcome. This method is 
highly dependent upon which portion of China's external balances is 
considered. For example, the selection of China's current account 
balance might lead to a finding that the renminbi is not significantly 
undervalued, while the broader basic balance might lead to a finding of 
substantial undervaluation. The approach also relies on elasticities 
that are difficult to estimate or rules of thumb that are not 
analytically precise. Moreover, the approach does not include an 
explicit consideration of a country's internal economic equilibrium 
situation, such as whether the country is at full employment. 

Behavioral Equilibrium Exchange Rate (BEER) Approach: 

Under this approach, equilibrium exchange rates are determined through 
observing long-run relationships between real exchange rates and the 
economic variables that determine them. That is, the BEER approach uses 
econometric relationships to model the equilibrium exchange rate, based 
on predicted economic relationships derived from an array of relevant 
theories.[Footnote 69] Misalignment of a currency is measured as the 
difference between the actual exchange rate and that predicted by the 
model variables. However, the determinants of exchange rates and their 
links to any underlying notion of economic fundamentals are neither 
well understood nor easily predicted. Thus, many complex BEER models do 
not predict exchange rates any better than simpler techniques.[Footnote 
70] The BEER approach also uses a number of simplifying assumptions and 
precludes the identification of many other key parameters important to 
explaining the economic system. This makes it difficult to judge the 
plausibility of its estimates. 

Qualitative Approaches: 

Some analysts do not formally define an equilibrium exchange rate, but 
look at trends in certain data to determine whether or not a country's 
currency is misaligned. One of the most widely cited trends used to 
infer currency misalignment is foreign exchange reserve growth. Some 
observers have noted that China has been accumulating reserves at a 
rapid pace and conclude that the renminbi must be undervalued. While it 
is true that China's foreign exchange growth has outpaced all other 
countries, with the exception of Japan (see fig. 15), using China's 
reserve accumulations as a measure of currency misalignment has 
limitations. For example, some analysts have noted that a significant 
portion of the capital inflow into China has been short-term 
speculative money, triggered by expectations of a renminbi 
appreciation. Given China's commitment to a fixed exchange rate regime, 
the government must absorb this excess foreign exchange.[Footnote 71] 
Moreover, if China removes restrictions on capital account 
transactions, as many have been advocating, some analysts believe the 
currency may depreciate due to capital outflow. Thus, while rapid 
reserve growth indicates upward pressure on the currency, it does not 
necessarily suggest by itself that the current value of the renminbi is 
lower than its long-run equilibrium value. 

Figure 15: Total Reserves for Selected Economies, 2000-2004: 

[See PDF for image] 

Note: Values represent total foreign exchange reserves, minus gold. 

[End of figure] 

[End of section]

Appendix VI: Factors Influencing the Final Impact of Exchange Rate 
Changes: 

An undervalued currency relative to the dollar would tend to make U.S. 
exports more expensive and U.S. imports less expensive. However, just 
how much cheaper imports would be and the degree of impact on the U.S. 
trade deficit, production, and employment would ultimately depend on 
complex factors. This appendix discusses some of these important 
factors. 

The impact of China's currency on the U.S. economy would first depend 
on a number of factors that can weaken the exchange rate pass through-
-that is, the extent to which a change in the value of China's currency 
changes the price of exports to the United States. These include: 

* The import content of Chinese exports to the United States. A large 
portion of China's export operations consists of the final assembly of 
products using components produced in other countries, especially 
Japan, Korea, and Taiwan. Some experts believe that the import content 
of Chinese exports to the United States may be 35 to 40 percent of the 
total value, and others have estimated as much as 80 percent. An 
appreciation of the renminbi could thus have limited impact on the 
prices of these exports to the United States because the currency 
change would leave the imported portions of the products (as much as 80 
percent) unaffected, while a smaller portion (20 percent) would become 
more expensive.[Footnote 72]

* The flexibility of the Chinese labor market. Some researchers believe 
that Chinese laborers might willingly take wage cuts to keep their jobs 
given the high unemployment rate in the country. Thus, the extent to 
which an increase in the value China's currency increases the price of 
exports to the United States would depend on whether a revaluation of 
the renminbi leads to lower wages. 

* The response of foreign-invested enterprises (multinational companies 
operating in China). The response of import prices to the exchange rate 
would also be smaller if foreign producers absorb the exchange rate 
movements in their profit margins to sustain their U.S. market share. 
According to Chinese statistics, foreign firms, some of them U.S.- 
owned, produced more than 50 percent of all exports in 2002 and 
accounted for 65 percent of the total increase in Chinese exports from 
1994 to mid-2003. 

Once the impact on import prices is determined, the impact on trade 
flows, production, and the U.S. economy would still depend on 
additional factors. 

* Elasticity of demand. The sensitivity of U.S. demand for Chinese 
goods and of China's demand for U.S. goods to price changes are also 
important factors. If U.S. consumers are sensitive to price changes of 
Chinese imports (i.e., elasticity of import demand is high), then an 
increase in import prices would significantly reduce the demand for 
Chinese goods and improve the bilateral trade deficit with China. 
Similarly, if the Chinese elasticity of demand for U.S. goods is low, 
an appreciation of the renminbi may not result in an increase in the 
demand for the cheaper U.S. products. 

* China's weight in the U.S.'s overall trade. The trade-weighted dollar 
is a measure of the dollar's value with respect to its major trading 
partners. Such indexes are useful for discussion of the relationship 
between exchange rates and the aggregate trade balance.[Footnote 73] 
According to the Federal Reserve Board, the renminbi carries a weight 
of approximately 10 percent in the trade-weighted real effective 
exchange rate (see fig. 16).[Footnote 74] Therefore, a 20 percent 
change in the value of the renminbi means the Federal Reserves' trade- 
weighted dollar would change by roughly 2 percent. Thus, some maintain 
that a revaluation of the renminbi must be accompanied by an increase 
in the value of other currencies to have a significant impact on the 
United States' global trade deficit. 

Figure 16: Total Trade Weights (broad index of the foreign exchange 
value of the dollar): 

[See PDF for image] 

Note: These weights are those in use between December 16, 2003, and 
February 2, 2005. The index weights, which change over time, are 
derived from U.S. export shares and from U.S. and foreign import 
shares. 

[End of figure] 

* How countries react to China's exchange rate policies. Some analysts 
contend that China's currency peg to the dollar induces other East 
Asian countries to intervene in currency markets to keep their 
currencies weak against the dollar so that they can remain competitive 
with China, thus magnifying the impact of China's currency on the 
United States. Moreover, they conclude that a revaluation by China 
would encourage other countries to follow. As a result, there could be 
a large enough change in the trade-weighted dollar to impact the United 
States' global trade deficit. 

* Labor-intensive tasks once performed in other countries are now being 
performed in China.[Footnote 75] As figure 17 shows, while the portion 
of the U.S. merchandise trade deficit accounted for by Japan and the 
rest of East Asia has fallen since 1999, China's share has risen. This 
reflects the fact that exports from Japan and other East Asian 
countries to the United States are now increasingly finished and 
exported from China. For example, from 2000 to 2002, U.S. imports from 
China increased by $25.2 billion, while imports from Japan fell $24.5 
billion. The extent to which Chinese exports to the United States are 
substituting for exports that would otherwise have entered the United 
States from alternative low-cost countries makes the impact on the U.S. 
economy difficult to quantify. 

Figure 17: Percentage of U.S. Merchandise Trade Deficit Accounted for 
by Selected East Asian Economies, 1999-2004: 

[See PDF for image] 

Note: Other East Asia is Korea and Taiwan. 

[End of figure] 

* The role of cheap labor. Many believe that China competes primarily 
in terms of low labor costs. There are also a number of other countries 
whose manufacturing wages are only a fraction of those in the United 
States (see fig. 18). As a result, some believe a renminbi appreciation 
would not induce increased output in American factories. Instead, U.S. 
imports from other low-wage foreign suppliers would increase. If this 
is true, the bilateral trade deficit with China would decrease, but the 
trade deficits with other low-wage countries would increase, leaving 
the overall trade deficit unchanged (or slightly worse due to more 
expensive imports). 

Figure 18: Hourly Compensation Costs for Production Workers in 
Manufacturing in U.S. Dollars, 2002: 

[See PDF for image] 

Note: Europe denotes the EU-15. These statistics should not be 
considered as precise measures of comparative compensation costs given 
the data limitations including the fact that compensation is partially 
estimated for some countries. See appendix I for details. 

[End of figure] 

* Degree of competition. The effects of the exchange rate are stronger 
when countries compete in similar markets. Some researchers maintain 
that the overlap between the production of China and the United States 
is small; that is, relatively few imports from China compete with 
domestic production in the United States. Others believe that the 
market competition is high enough that Chinese imports have displaced 
U.S. workers. 

Lastly, potential income effects on China and economic interdependence 
between major trading partners are relevant to exchange rate impacts. 
For example, some experts have concluded that an appreciation of the 
renminbi would reduce employment, income, and growth in China, thereby 
affecting Chinese demand for U.S. exports. Similar forces must be 
considered for the United States, although it is unclear whether they 
would be significant given the distinct effects on the various sectors 
of the economy. Some believe that an appreciation of the renminbi 
(especially if accompanied by the elimination of capital restrictions) 
would lead to economic and financial instability in China and 
jeopardize other Asian countries that rely in part on exports to China 
to sustain their economies. Such instability in East Asia, if it were 
to occur, would likely have negative repercussions on the U.S. and 
global economies. 

[End of section]

Appendix VII: Net Foreign Purchases of U.S. Securities: 

China has in recent years purchased substantial amounts of U.S. 
securities, mostly agency bonds and U.S. Treasury securities (see table 
5). However, China's net purchases are not as large as those of the 
United Kingdom and Japan. Like other foreign central banks, China's 
central bank has chosen to purchase large quantities of U.S. Treasury 
securities with renminbi in part because it can buy and sell them 
quickly with minimal market impact. According to monthly data compiled 
by the Treasury International Capital System, China's investment in U.S 
securities climbed sharply during the 2000 to 2003 period, but was 
lower in 2004. This appendix presents detailed tables on foreign 
transactions in U.S. securities. While these transactions data are 
useful for showing China's relative size in overall securities 
purchases, they have certain reliability limitations which are noted in 
the table and are further discussed in appendix 1. 

Table 6: Real Net Purchases of U.S. Securities by China: 

Dollars in millions. 

1989; 
U.S. Treasuries: -$274; 
U.S. agencies: -$18; 
U.S. corporate bond: $26; 
U.S. corporate stocks: $12; 
Foreign bonds: -$138; 
Foreign equity: $0; 
Total: -$392. 

1990; 
U.S. Treasuries: $457; 
U.S. agencies: -$4; 
U.S. corporate bond: -$15; 
U.S. corporate stocks: $1; 
Foreign bonds: $224; 
Foreign equity: -$1; 
Total: $662. 

1991; 
U.S. Treasuries: $142; 
U.S. agencies: $59; 
U.S. corporate bond: $19; 
U.S. corporate stocks: $8; 
Foreign bonds: $554; 
Foreign equity: $0; 
Total: $782. 

1992; 
U.S. Treasuries: $4,254; 
U.S. agencies: $608; 
U.S. corporate bond: $870; 
U.S. corporate stocks: $14; 
Foreign bonds: $507; 
Foreign equity: $5; 
Total: $6,258. 

1993; 
U.S. Treasuries: $553; 
U.S. agencies: $678; 
U.S. corporate bond: $188; 
U.S. corporate stocks: -$54; 
Foreign bonds: -$270; 
Foreign equity: -$131; 
Total: $963. 

1994; 
U.S. Treasuries: $14,649; 
U.S. agencies: $598; 
U.S. corporate bond: $125; 
U.S. corporate stocks: -$25; 
Foreign bonds: $247; 
Foreign equity: -$706; 
Total: $14,888. 

1995; 
U.S. Treasuries: $827; 
U.S. agencies: $1,006; 
U.S. corporate bond: $16; 
U.S. corporate stocks: -$13; 
Foreign bonds: -$323; 
Foreign equity: -$188; 
Total: $1,324. 

1996; 
U.S. Treasuries: $16,683; 
U.S. agencies: $3,181; 
U.S. corporate bond: $297; 
U.S. corporate stocks: -$2; 
Foreign bonds: $39; 
Foreign equity: -$73; 
Total: $20,125. 

1997; 
U.S. Treasuries: $9,263; 
U.S. agencies: $1,939; 
U.S. corporate bond: $79; 
U.S. corporate stocks: $70; 
Foreign bonds: $60; 
Foreign equity: -$548; 
Total: $10,864. 

1998; 
U.S. Treasuries: $2,919; 
U.S. agencies: $980; 
U.S. corporate bond: $53; 
U.S. corporate stocks: $1; 
Foreign bonds: $1,927; 
Foreign equity: -$9; 
Total: $5,871. 

1999; 
U.S. Treasuries: $9,066; 
U.S. agencies: $9,236; 
U.S. corporate bond: $576; 
U.S. corporate stocks: $226; 
Foreign bonds: $372; 
Foreign equity: -$246; 
Total: $19,230. 

2000; 
U.S. Treasuries: -$4,302; 
U.S. agencies: $20,389; 
U.S. corporate bond: $875; 
U.S. corporate stocks: -$112; 
Foreign bonds: $1,959; 
Foreign equity: -$272; 
Total: $18,537. 

2001; 
U.S. Treasuries: $20,226; 
U.S. agencies: $27,485; 
U.S. corporate bond: $7,076; 
U.S. corporate stocks: $3; 
Foreign bonds: $4,267; 
Foreign equity: $42; 
Total: $59,099. 

2002; 
U.S. Treasuries: $25,058; 
U.S. agencies: $30,457; 
U.S. corporate bond: $6,205; 
U.S. corporate stocks: $168; 
Foreign bonds: $3,642; 
Foreign equity: -$39; 
Total: $65,491. 

2003; 
U.S. Treasuries: $31,176; 
U.S. agencies: $30,282; 
U.S. corporate bond: $4,728; 
U.S. corporate stocks: -$79; 
Foreign bonds: $2,524; 
Foreign equity: -$10; 
Total: $68,622. 

2004; 
U.S. Treasuries: $18,895; 
U.S. agencies: $16,387; 
U.S. corporate bond: $12,341; 
U.S. corporate stocks: -$290; 
Foreign bonds: $3,603; 
Foreign equity: $-614; 
Total: $50,322. 

Source: GAO calculations based on the U.S. Treasury's International 
Capital (TIC) reporting system. 

Notes: Figures are adjusted for inflation using the U.S. GDP deflator. 

Data includes commissions and taxes associated with each transaction. 

[End of table]

Reporting procedures for the collection of these data lead to a bias 
toward over-counting flows to countries that are major financial 
centers and undercounting flows to other countries. Errors may also 
occur due to the manner in which repurchases and securities lending 
transactions are recorded within the TIC system. 

U.S. agencies include bonds issued by government-sponsored agencies 
such as Freddie Mac and Fannie Mae. 

China's net purchases slowed during a portion of 2004, giving rise to 
speculation that China's willingness to invest in U.S. Treasury 
securities or other assets had decreased. However, China's purchases 
were relatively strong during the last quarter of 2004. 

Table 7: Real Net Purchases of U.S. Securities by Foreigners, Selected 
Countries: 

Dollars in millions. 

1993; 
UK: -$46,773; 
Japan: $35,646; 
China: $963; 
Canada: -$8,457; 
Hong Kong: $3,738; 
Germany: -$14,767; 
Korea: -$2,519; 
Mexico: -$14,842. 

1994; 
UK: $81,198; 
Japan: $22,822; 
China: $14,888; 
Canada: -$2,624; 
Hong Kong: $3,934; 
Germany: $8,683; 
Korea: -$1,649; 
Mexico: -$7,565. 

1995; 
UK: $84,361; 
Japan: -$10,077; 
China: $1,324; 
Canada: -$7,654; 
Hong Kong: $5,260; 
Germany: $10,982; 
Korea: $2,599; 
Mexico: $2,171. 

1996; 
UK: $106,748; 
Japan: $56,883; 
China: $20,125; 
Canada: $1,568; 
Hong Kong: $1,361; 
Germany: $18,114; 
Korea: -$1,179; 
Mexico: -$3,330. 

1997; 
UK: $166,494; 
Japan: $27,822; 
China: $10,864; 
Canada: $1,092; 
Hong Kong: $21,921; 
Germany: $41,485; 
Korea: -$15,349; 
Mexico: -$409. 

1998; 
UK: $159,179; 
Japan: $20,797; 
China: $5,871; 
Canada: $134; 
Hong Kong: $9,059; 
Germany: $16,646; 
Korea: $11,971; 
Mexico: $1,332. 

1999; 
UK: $186,843; 
Japan: -$300; 
China: $19,230; 
Canada: $13,347; 
Hong Kong: $12,092; 
Germany: $23,446; 
Korea: $11,014; 
Mexico: $1,740. 

2000; 
UK: $147,455; 
Japan: $79,062; 
China: $18,537; 
Canada: $16,040; 
Hong Kong: $8,804; 
Germany: $31,642; 
Korea: $5,403; 
Mexico: $10,085. 

2001; 
UK: $164,452; 
Japan: $38,588; 
China: $59,099; 
Canada: $17,867; 
Hong Kong: $30,073; 
Germany: $22,322; 
Korea: $325; 
Mexico: $8,831. 

2002; 
UK: $199,715; 
Japan: $84,668; 
China: $65,491; 
Canada: $7,105; 
Hong Kong: $15,149; 
Germany: $24; 
Korea: $13,524; 
Mexico: $10,607. 

2003; 
UK: $165,864; 
Japan: $152,387; 
China: $68,622; 
Canada: $36,399; 
Hong Kong: $19,844; 
Germany: $14,528; 
Korea: $12,745; 
Mexico: $11,025. 

2004; 
UK: $165,528; 
Japan: $218,623; 
China: $50,322; 
Canada: $26,761; 
Hong Kong: $22,154; 
Germany: $18,877; 
Korea: $12,758; 
Mexico: $31,229. 

Source: GAO calculations based on the U.S. Treasury's International 
Capital (TIC) reporting system and data from the Congressional Research 
Service. 

Notes: Figures are adjusted for inflation using the GDP deflator. Data 
includes commissions and taxes associated with each transaction. 
Reporting procedures for the collection of these data lead to a bias 
toward over-counting flows to countries that are major financial 
centers and the undercounting flows to other countries. Errors may also 
occur due to the manner in which repurchases and securities lending 
transactions are recorded within the TIC system. See appendix I for 
data limitations. 

[End of table]

[End of section]

Appendix VIII: Comments from the Department of the Treasury: 

DEPARTMENT OF THE TREASURY: 
WASHINGTON, D.C. 20220: 

April 1, 2005: 

Loren Yager: 
Director: 
International Affairs and Trade: 
Government Accountability Office: 

Dear Mr. Yager: 

Thank you very much for the opportunity to review the draft report 
entitled "International Trade: Treasury Assessments Have Not Found 
Currency Manipulation but Concerns about Exchange Rates Continue." The 
draft report is generally thoughtful, and we hope it will contribute to 
increased understanding of the complex issues covered in the Treasury 
reports. 

It is important to underscore that Treasury does not view the exchange 
rate as a policy instrument. Exchange rates are determined through the 
complex interplay of macroeconomic and microeconomic forces throughout 
the world. As you know, it is not Treasury's policy to target a 
specific value for the dollar or a current account objective. 

The focus of Treasury's policy efforts is to promote good macroeconomic 
management, to maintain a healthy environment for Americans to produce 
goods and services, to strengthen the openness of our economy and to 
reinforce the depth and liquidity of the U.S. financial system. By 
keeping its own affairs in order, the United States can both enhance 
growth and employment at home and contribute to the health of the 
global economy and financial system. Strong and persisting foreign 
demand for U.S. financial assets is emblematic of the strength of the 
U.S. economy. 

Treasury does indeed consider the impact of the exchange rate on such 
areas as the sustainability of the current account deficit, production, 
employment, and industrial competitiveness in the United States. Allow 
me to make two specific comments in this regard: 

The sustainability of any country's current account deficit depends 
directly on the strength of the country's economy and the 
attractiveness of its investment environment. A strong economy, 
particularly one like that of the United States with persistently high 
productivity growth, creates jobs, fosters profitable investment 
opportunities and attracts capital from the rest of the world. 

* Regarding the interplay between the exchange rate and real economy, 
some of the most important basic influences on exchange rates - such as 
the flexibility of labor markets, the inflation rate, and productivity 
growth - also affect production, employment and competitiveness. 
Instead of trying to achieve a false precision by isolating the 
exchange rate in the analysis, it is often more helpful to look at 
underlying developments that have an impact on both exchange rates and 
other macroeconomic conditions. The U.S. experience of the late 1990s, 
when the dollar appreciated even as production and employment rose, 
illustrates the utility of this approach. 

The draft report's description of the complex issues that must be 
examined in assessing China's exchange rate regime is valuable, as is 
the discussion of the wide range of modeling results produced by a 
large number of analysts. Treasury's analysis takes into account, among 
other things, the maintenance of China's peg through widely varying 
international economic conditions and recent developments in China's 
current account, international reserve growth, capital flows and 
controls on capital flows. However, Treasury's policy analysis also 
concludes that, while China's peg may have been useful in the past, 
given the changes that have taken place in the Chinese economy and its 
greatly increased role in the international trade and financial 
systems, China should now move to a market-based flexible exchange 
rate. This would benefit both the Chinese and international economies. 

Finally, I would note that Treasury has provided in past reports under 
Section 5304 considerable detail about the reasoning behind its 
currency manipulation conclusions. Treasury will continue to do so in 
its future reports, supported by the draft report's helpful 
suggestions. 

Thank you once again for the effort that went into this draft report 
and the opportunity to comment on it. 

Sincerely,

Signed by: 

Mark Sobel: 

Deputy Assistant Secretary: 
International Monetary and Financial Policy: 

[End of section]

Appendix IX: GAO Contacts and Staff Acknowledgments: 

GAO Contacts: 

Celia Thomas, (202) 512-8987; 
Anthony Moran, (202) 512-8645: 

Acknowledgments: 

In addition to the persons named above, Lawrance Evans, Jr., Jane-yu 
Li, Jamie McDonald, Donald Morrison, and Richard Seldin made major 
contributions to this report. 

(320226): 

FOOTNOTES

[1] The U.S. merchandise trade deficit for 2004 was $650.8 billion, 
compared to $532.3 billion for 2003, according to the U.S. Census 
Bureau. 

[2] Pub. L. No. 100-418, §§ 3001-06, 102 Stat. 1372 and following. 

[3] Pub. L. No. 108-447, Div. H, title II, § 221, 118 Stat. 3242, 
required Treasury to report on how the statutory requirements of the 
1988 Trade Act could be clarified administratively to enable currency 
manipulation to be better understood by the American people and 
Congress. Treasury issued its report on March 11, 2005. 

[4] The conditions are (1) manipulating the exchange rate for the 
purposes of gaining an unfair trade advantage or preventing effective 
balance of payments adjustments and (2) having a material global 
current account surplus and a significant bilateral trade surplus with 
the United States. The global current account surplus is the current 
account surplus of merchandise, services, and transfers with all other 
countries, while the bilateral trade surplus is the surplus in goods 
and services trade with one trading partner country only. 

[5] One requirement pertained to reporting on certain U.S.- 
International Monetary Fund consultations, information about which was 
not publicly available in 1988. Treasury officials noted that the 
International Monetary Fund now makes information on these 
consultations available through the Internet. 

[6] The current account balance is a summary measure of a country's net 
balance over a period of time with all other countries in trade of 
goods and services, income, and unrequited transfers (such as foreign 
aid payments and workers' remittances). The balance of trade in goods 
and services is a subset of the current account balance. 

[7] The language pertaining to Treasury's manipulation assessment and 
exchange rate reporting obligations is in sections 3004(b) and 3005, 
respectively. 22 U.S.C. § 5304(b). 

[8] The balance of payments is a summary measure of a country's total 
trade, other economic transactions, and financial flows. It is made up 
of the current account (current transactions), the capital and 
financial account (capital and financial transactions), and a balancing 
item to even out difficulties in recording international transactions. 

[9] The dual exchange rate system consisted of an official rate that 
applied to state-controlled transactions including trade, and a lower 
market rate that applied to all other activities. See appendix IV for 
more details. 

[10] The pegged rate has not varied from 8.28 per U.S. dollar since 
1998. 

[11] Treasury does not have formal departmental guidance for performing 
its assessment of manipulation under the 1988 Trade Act. According to 
Treasury, it provides guidance to desk officers for country analysis, 
specifying a set of indicators to be examined. Senior staff coordinate 
desk officer submissions to ensure that countries are analyzed in a 
consistent manner. 

[12] Technically, not all the economies monitored by Treasury (e.g., 
Hong Kong) are countries. 

[13] In its March 2005 report to Congress, Treasury defined these 
concepts generally. It defined "material global current account 
surplus" as a large current account surplus, measured as a percent of 
an economy's GDP. It defined "significant bilateral trade surplus" as a 
large bilateral trade surplus with the United States, relative to the 
size of U.S. trade. 

With respect to data for China, Treasury stated it uses official 
Chinese statistics when determining China's global current account and 
trade balances, but it has also examined trade statistics reported by 
China's trading partners. China's global current account and trade 
balance statistics differ markedly from the aggregate statistics of its 
trading partners. One reason is that much trade to and from China 
travels via Hong Kong, and while both China and its trade partners 
usually report the actual source of their imports, they often record 
the destination of their exports as Hong Kong, even though the goods 
may go on to other markets. Treasury is analyzing these data 
discrepancies, according to Treasury officials. 

[14] In October 1988, Treasury reported that the Taiwanese and Korean 
currencies were undervalued. 

[15] According to Treasury officials, approval ultimately rests with 
the Secretary of the Treasury. 

[16] While Treasury is only required to make a manipulation assessment 
on an annual basis, it includes an assessment in each of the semiannual 
exchange rate reports that will be discussed in the next section. 

[17] For example, the October 2001 report listed two economic factors 
that Treasury considered to determine currency manipulation, the 
October 2003 report listed none, and the April and December 2004 
reports listed seven. 

[18] For the fourth and fifth findings of manipulation against China, 
covering 1993 and 1994, Treasury reported that China's current account 
had, in the first instance, declined substantially, and, in the second 
instance, gone into deficit. Treasury officials observed that in those 
cases, mandated negotiations that had begun earlier were still being 
carried out and institutional changes deemed necessary to remedy 
conditions were incomplete. 

[19] Taiwan's global current account surplus declined from 18.5 percent 
(1987) of gross national product (GNP) to 8.5 percent (1988) during the 
first period it was on the list of manipulators, and from 6.7 (1991) to 
3.8 (1992) during the second period. Korea's current account surplus 
declined from 8.3 percent GNP (1987) to 2.5 percent (1989), and China's 
declined from 3.3 (1990) percent to a small surplus (1994). 

[20] China reports its current account balance on an annual basis, with 
a lag of several months after the end of the year. In July 2004, the 
IMF reported that based on preliminary data China had a global current 
account surplus of 3.3 percent of GDP for 2003. Also in July 2004, 
Global Insight's estimate for China's 2004 current account surplus was 
1.0 percent of GDP. Recent estimates from Global Insight for China's 
global current account surplus for 2004 are higher. 

[21] The IMF defines foreign direct investment as the acquisition of a 
lasting interest in an enterprise operating in an economy other than 
that of the investor and characterized by an effective voice in 
management of the enterprise. The Organization for Economic Cooperation 
and Development states that a 10 percent or greater ownership stake 
would satisfy this requirement. 

[22] Treasury officials noted that between late February 2002, when the 
Federal Reserve's trade-weighted index of the dollar reached its most 
recent maximum, and the end of June 2004, the dollar depreciated by 
18.7 percent against the yen, broadly similar to its 22.6 percent 
depreciation against the major currency component of the index over the 
same period. 

[23] Explicit capital flow analysis was not included in reports issued 
from 1995 to 1997. 

[24] The other policies cited were increasing U.S. public and private 
sector savings and improving global economic growth. 

[25] Some of these include the Purchasing Power Parity (PPP), 
Fundamental Equilibrium Exchange Rate (FEER), Behavioral Equilibrium 
Exchange Rate (BEER), Macroeconomic Balance, and External Balance 
approaches. 

[26] These analyses can focus on different sets of economic 
fundamentals to determine the equilibrium rate. 

[27] The economic profession has no consensus on the model to be used 
in determining what the appropriate or sustainable external balance 
should be for a given country. Some experts have pointed out that 
certain external account balance standards, such as an overall balance 
of zero in a country's balance of payments accounts, would require that 
China run a trade deficit to meet that standard in order to offset the 
net investment flows into the country. 

[28] China's current account surpluses were 1.5 percent, 2.8 percent, 
and 3.2 percent of GDP in 2001, 2002, and 2003, respectively. Its 2004 
current account balance, not yet officially reported, is 4.2 percent of 
GDP, according to a March 2005 Global Insight estimate. 

[29] These non-FDI inflows and undocumented capital are believed to 
include speculative inflows in anticipation of a renminbi revaluation. 

[30] Also in 2003, China used $45 billion of its foreign exchange 
reserves to support, or recapitalize, its banks. 

[31] A related concern that has been expressed is that if China's 
restrictions on capital outflows were lifted, bad news about the 
banking system or the economy more generally could cause large-scale 
capital flight from China and sharp currency depreciation. 

[32] This two-stage approach has been proposed by Morris Goldstein. 
(See Morris Goldstein, "China and the Renminbi Exchange Rate," in C. 
Fred Bergsten and John Williamson, ed., Dollar Adjustment: How Far? 
Against What? Institute for International Development, Washington, D.C: 
2004.) Goldstein also summarizes other proposed approaches, including 
(1) a "go-slow" approach, combining a series of trade, capital account, 
and tax measures with a very small revaluation; (2) floating the 
currency but maintaining controls on capital outflows, and (3) open 
capital markets with a floating exchange rate. 

[33] The discussion in this section presumes that if China did change 
its nominal exchange rate, it would result in a change in its inflation-
adjusted, or real, exchange rate. That is, it assumes that the real 
exchange rate is an instrument over which Chinese authorities have some 
control. This is in contrast to an assumption in traditional economic 
theory that under free market conditions countries' real exchange rates 
are determined by broader economic relationships, and governments 
cannot control them in the long run. Many analyses of developing 
economies with significant economic controls still in place, such as 
China, presume that governments in these economies do have some ability 
to affect real exchange rates over some period of time. 

[34] It also depends on other factors, such as the flexibility of the 
Chinese labor market and the strategic pricing decisions of 
multinational enterprises. 

[35] In fact, the total import bill and thus the trade deficit could 
rise in the short run rather than fall, in response to a revaluation of 
the renminbi, if prices of Chinese imports go up faster than demand for 
Chinese goods falls. Economists have found empirical evidence of this 
short-term effect of exchange rate changes, which is sometimes called 
the J-curve. 

[36] There are differing views about how a revaluation of the renminbi 
might affect the exchange rates of other Asian countries. One view is 
that if China revalued its currency against the dollar, other Asian 
economies, including Korea, Taiwan, and perhaps Japan, would also let 
their currencies appreciate relative to the dollar. In contrast, some 
experts, citing modeling exercises, maintain that these currencies are 
unlikely to strengthen relative to the dollar if the renminbi 
appreciates and, in fact, might weaken, which would have opposite 
implications for the U.S. balance of payments. 

[37] The number of jobs in the U.S. manufacturing sector declined by 
about 2.8 million, or 15.9 percent, between 2000 and 2003, according to 
the Bureau of Labor Statistics. One recent study estimated that about 
314,000 of those jobs were lost due to U.S. trade with all countries. 
(See Martin Bailey and Robert Lawrence, "What Happened to the Great 
U.S. Job Machine? The Role of Trade and Electronic Offshoring" 
Brookings Papers on Economic Activity; 2004; 2: Washington, D.C. One 
study that looked directly at the relationship between U.S. 
manufacturing employment and exchange rates estimated that for each 1 
percent increase in the real trade-weighted value of the dollar, the 
number of workers employed in U.S. manufacturing falls by 0.12 percent 
(or by about 17,400 jobs in 2003). (See Robert Blecker, "The Benefits 
of a Lower Dollar," EPI Briefing Paper, 2003.) 

[38] We use these percentages of revaluation for illustrative purposes 
only. 

[39] This assumption is that a 10 percent depreciation in the real 
(inflation-adjusted) trade-weighted value of the dollar leads to an 
improvement in the U.S. trade balance equal to 0.5 percent of GDP. 

[40] For example, prominent analysts have used an estimate for changes 
in the value of the dollar relative to changes in the trade deficit 
that is about double the rule employed in this illustration--that a 1 
percent decline in the trade-weighted value of the dollar would lead to 
a $10 billion reduction in the U.S. trade deficit (implying a 10 
percent decline leads to a $100 billion reduction in the trade deficit-
-roughly 1 percentage point of GDP). See Morris Goldstein (2004), 
"China and the Renminbi Exchange Rate" in C. Fred Bergsten and John 
Williamson, ed., Dollar Adjustment: How Far? Against What?, Institute 
for International Economics, Washington, D.C.: 2004. See also Ernst H. 
Preeg, "Exchange Rate Manipulation to Gain an Unfair Competitive 
Advantage: The Case of Japan and China" in C. Bergsten and J. 
Williamson (eds.) Dollar Overvaluation and the World Economy, Institute 
for International Economics, Washington, D.C.: 2003. 

[41] That value is similar in magnitude to job-multiplier analyses used 
in other studies, including a 1997 government analysis of NAFTA job 
impacts that assumed that about 13,000 jobs are supported for every $1 
billion in increased U.S. exports. 

[42] According to the U.S. Bureau of Labor Statistics, total employment 
in the U.S. manufacturing sector was about 14.3 million at the end of 
2004. 

[43] When the United States runs a current account deficit, it 
necessarily borrows from the rest of the world by having a net inflow 
of foreign capital. 

[44] Some analysts have focused on the broader issue of the overall 
level of the U.S. debt owed to both citizens and foreigners and the 
implications of future interest obligations more generally for the U.S. 
government and the U.S. economy. They note that inflows of foreign 
capital accompanying the U.S. current account deficit are one 
manifestation of a relatively low U.S. savings rate. 

[45] These values are based on data from the U.S. Treasury and the 
Board of Governors of the Federal Reserve System. 

[46] China and Japan collectively held roughly 1 percent of outstanding 
U.S. corporate equity at the end of 2003. 

[47] Agency bonds are bonds issued by government and government- 
sponsored agencies, including Fannie Mae and Freddie Mac. 

[48] This is because the sale or purchase of a financial asset is 
attributed to the country in which the transaction was conducted rather 
than the residence of the buyer. As a result, a Chinese resident's 
purchase of a U.S. security using an intermediary in Hong Kong would be 
reported as a Hong Kong purchase of a U.S. security. For a discussion 
of the system used to estimate foreign holdings, including 
methodological limitations, see William L. Griever, Gary A. Lee, and 
Francis E. Warnock, "U.S. System for Measuring Cross-Border Investment 
in Securities: A Primer with a Discussion of Recent Developments," 
Federal Reserve Bulletin (Washington, D.C.: October 2001). 

[49] This appendix only includes language relevant to Treasury's 
manipulation assessment criteria and exchange rate reporting 
requirements. 

[50] The current account balance is a summary measure of a country's 
net balance over a period of time with all other countries in trade of 
goods and services, income, and unrequited transfers (such as foreign 
aid payments and workers' remittances). 

[51] These preliminary data are Chinese statistics reported by Global 
Insight, Monthly Outlook Asia-Pacific, issued in March 2005. 

[52] According to the IMF, under a pure managed float regime, the 
monetary authority can influence the movement of the exchange rate 
through active intervention in the foreign exchange market without 
specifying, or precommitting to, a pre-announced path for the exchange 
rate. 

[53] Multiple market-negotiated rates existed because the arbitrage 
among swap centers was imperfect. 

[54] The real effective exchange rate is the real, or inflation- 
adjusted, exchange rate between a country and its trade partners, 
computed as a weighted average of bilateral real exchange rates. 

[55] Since May 2004, this portion has been 50 percent to 70 percent. 
Before that, it was 80 percent. Some special-purpose transactions, such 
as donations, are exempted from this requirement. 

[56] These trade volume data are from Global Insight. 

[57] The recovery was driven by stronger Chinese market demand for 
Japanese goods, among other factors. China, not including Hong Kong, 
has become the second largest market for Japanese exports. 

[58] As classified by the IMF. 

[59] According to the IMF, countries with independent floating exchange 
rates can intervene in foreign exchange markets if the goal is to 
moderate the rate of change and prevent undue fluctuations in the 
exchange rate. 

[60] Japanese authorities intervened eight times in the first half of 
2002. 

[61] This is mainly due to the fact that low productivity, wages, and 
income in developing nations are often not accounted for properly. 

[62] For example, if U.S. inflation is 5 percent a year, while 
inflation in China is 2 percent a year, relative PPP dictates that the 
dollar should depreciate against the renminbi by 3 percent a year. 

[63] The balance of payments identity states: Current Account = - 
Capital and Financial Account. This means that any change in a 
country's current account (trade in goods and services plus 
miscellaneous items) must be balanced by an offsetting change in the 
capital and financial account, with the exception of changes in foreign 
exchange reserves. 

[64] The capital and financial account tracks the movement of funds for 
investments and loans into and out of a country. The capital and 
financial account makes up part of the balance of payments. The current 
account, which makes up the other part, records the flow of current 
transactions, including goods, services, investment and other income, 
and current transfers between countries. 

[65] However, this approach is rooted in the national income accounting 
identity: (Domestic Savings - Domestic Investment) = Current Account. 
This identity holds true because any excess of investment above 
national savings must be made with foreign savings (capital inflows). 
Changes in capital flows must be balanced by changes in the current 
account. 

[66] See IMF (2001), Methodology for Current Account and Exchange Rate 
Assessments, Occasional Paper 209. 

[67] Different analysts consider different portions of a country's 
external accounts. For example some use the current account while 
others use the basic balance (current account plus foreign direct 
investment flows) or broader balance of payment measures. 

[68] One such rule of thumb analysts have used is that a 1 percent 
depreciation of the dollar leads to a $10 billion improvement in the 
U.S. trade balance. Another such rule of thumb is that a 10 percent 
depreciation in the real effective exchange rate of the dollar leads to 
an improvement in the U.S. trade balance equal to .5 percent of GDP 
over a period of 2 to 3 years. 

[69] Analysts typically identify a small number of key relationships 
describing some behavioral relationships between major economic 
variables and then combine these to derive a single equation to explain 
the determination of the observed exchange rates over time. 

[70] Federal Reserve Board Chairman Alan Greenspan before the Economic 
Club of New York stated that despite extensive efforts, "No model 
predicting directional movements in exchange rates is significantly 
superior to tossing a coin" (New York, N.Y.: Mar. 2, 2004). 

[71] Some believe that the capital inflow is unsustainable and that 
further inflow may induce excessive investment and asset price bubbles. 

[72] An increase in the value of the renminbi also implies that China 
would be able to purchase inputs from other Asian countries and other 
foreign territories more cheaply. 

[73] However, such indexes omit industry-specific distinctions and thus 
ignore the distributional effects of bilateral exchange rate movements. 
As we discussed earlier, bilateral exchange rate changes impact 
different producers differently. 

[74] According to a recent Chicago Federal Reserve Board study, China's 
manufactured goods accounted for 2.7 percent of the U.S. domestic 
market (domestic production plus imports) in 2001, up from .4 percent 
in 1989. See W. Testa, J. Liao, and A. Zelenev, "Midwest Manufacturing 
and Trade with China," Chicago Fed Letter, No. 196 (2003). 

[75] According to the Congressional Budget Office, its analysis based 
on data from 1997 through 2002 showed that over 80 percent of the 
increased U.S. imports from China displaced imports from other 
countries rather than U.S. production. See D. Holtz-Eakin, "The Chinese 
Exchange Rate and U.S. Manufacturing Employment," CBO Testimony before 
the Committee on Ways and Means, October (2003), 19. 

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