March 14, 2008
HP-878

Remarks by Treasury Deputy Assistant Secretary Mark Sobel
at the Symposium of the Bretton Woods Committee on China

Washington, DC--At the outset, I wish to thank Bill Frenzel and the Bretton Woods Committee for affording me this opportunity to speak on a range of issues pertaining to Chinese currency developments.

Engagement with China

When one visits Beijing or Shanghai, one immediately feels the energy and vibrancy of a dynamic country and fast-growing economy. Indeed, China's growth in recent decades is an extraordinary success story that has sustained a particularly blistering pace of global growth this decade.  But China's growing weight and presence on the global scene inevitably leaves an ever-noticeable footprint that is a source of admiration and angst.

As Secretary Paulson has often stated, ensuring a productive U.S.-China relationship is essential for managing the challenges of the 21^st Century and that requires continuous high-level engagement.  To this end, President Bush and Chinese President Hu created the Strategic Economic Dialogue, led by Secretary Paulson on the U.S. side, which brings a diversity of Cabinet-level officials in both China and the United States together.

Our economic discussions with China in the SED focus on a broad range of issues, including the need for China to rebalance its economy away from exports and investment by boosting domestic demand-led growth and reducing national saving; promoting financial sector reform; and achieving monetary policy autonomy, including through RMB appreciation and greater currency flexibility.   

Let there be no doubt, important progress is being made. While it is sometimes hard to discern the progress amid the daily focus on China and its ups and downs, rapid change is a constant.  The risk, though, to China is still that the pace of reform is too gradual.

• Chinese saving consumes over half of national income.  This is the structural basis for China's large current account surpluses.  Part of this can be explained by the dismantling of the social safety net once provided by China's large state-owned enterprises -- the so-called "iron rice bowl" – putting a heavy burden on households to save for basic needs such as health care, retirement, and education.  China has begun to take some early but important steps towards addressing the problem, including through the introduction of universal free education through high school, upping the share of a patient's health spending covered by the state, and expanding the coverage of China's minimum income guarantee program.  Enterprise saving is also high.  Here, China announced a policy at the end of last year requiring state-owned enterprises to pay a portion of their profits as dividends back to the government.  Much more work is needed -- but these are important steps forward.
• On the financial sector front, change is afoot.  Major banks are making progress in reducing non-performing loans (NPLs) and improving risk management practices. This process has been aided by recapitalizations, foreign firms taking strategic stakes, and IPOs which have led to improved transparency and accounting standards.  Efforts to develop the corporate bond market and consumer finance are picking up.  Make no mistake, there is still a long road ahead, especially in offering consumers meaningful products and returns and in building a vibrant capital market which can provide a viable alternative to firms and individuals from bank dominated finance. And absolutely critical, China can and should do far more to open its entire financial system to much greater foreign participation. 

Perhaps the most nettlesome aspect of our rebalancing discussions lies in the realm of monetary policy, including the exchange rate regime.  Simply put, a more autonomous and effective monetary policy -- which fundamentally requires RMB appreciation and much greater currency flexibility -- is in China's own self-interest. It is needed to better control domestic liquidity and inflation, dampen swings in the investment cycle, improve the health of the financial sector, and ultimately reduce prospects for boom-bust cycles.  I think this central point is increasingly recognized by China's leadership. 

In contrast, heavy foreign exchange market intervention by China to manage the currency has led to excess reserve accumulation and rapid increases in domestic liquidity, which is not easily sterilized. This is part of the story behind the recent sharp increases in Chinese consumer prices.  China's current exchange rate policy heightens the risk of asset bubbles, renewed build-up in NPLs, and further banking sector stress.  This policy also perpetuates a model of growth that depends heavily on exports and industrial investment rather than domestic household consumption.  As Treasury stated in its last semi-annual Foreign Exchange Report, the substantial undervaluation of the RMB poses risks for the Chinese economy.  As I have said before, Chinese currency adjustment is a matter of international responsibility, with significant implications for the smooth functioning of the international monetary and trading systems, of which China is increasingly a part.

Here too, progress is being made. Cumulative RMB appreciation since July 2005, including the RMB's revaluation at the time, totals 16-3/4%.  This appreciation has accelerated markedly in the last months.  For example, in the last 90 days, the RMB has appreciated at an annualized rate of nearly 17%.  China's foreign exchange market is also developing – in recent years, RMB fluctuations have been greater, foreign currency hedging instruments are emerging, and the market is deepening.

That said, the RMB's trade-weighted appreciation has been much less. The RMB has actually depreciated against the euro. The RMB's adjustment is far from complete.  While the recent accelerated pace of appreciation is welcome, it should continue.

While RMB appreciation may to some extent reduce the U.S. bilateral trade deficit with China, the U.S. and Chinese global trade imbalances are rooted in the structure of our economies, and in imbalances in our relative levels of saving and investment.  That is why we need to continue engaging through the SED across the broad swath of policies. 

Currency Legislation?

While we share the frustrations of many with the pace of reform in China, we believe that continued intensive bilateral and multilateral engagement is the best means of making meaningful progress in building a productive U.S.-Chinese relationship for the 21^st Century.  We do not believe that currency legislation would strengthen the hand of the United States in achieving the goal, which the Administration and Congress share, of faster Chinese economic reform. 

Indeed, we believe legislation would be counterproductive and could lead to unintended adverse consequences.

Multilateral Engagement

Bilateral engagement is an essential element of U.S. financial diplomacy, and Secretary Paulson and other Treasury officials have pursued the need for RMB appreciation and greater currency flexibility relentlessly with the Chinese, both privately and publicly.  But experience also teaches us that China can respond defensively to bilateral pressure and is often more open to multilateral engagement. 

While the recent stepped-up pace of Chinese currency appreciation importantly reflects a Chinese response to rising inflation and the large current account surplus, we are working on the multilateral front to accelerate the reform of China's currency practices.  We are making progress and this work has had an impact. 

• The G-7 has joined the United States, sharpening its message on Chinese currency practices.  At its recent Tokyo meeting, the G-7 stated: "We welcome China's decision to increase the flexibility of its currency, but in view of its rising current account surplus and domestic inflation, we encourage accelerated appreciation of its effective exchange rate."   This statement reflects the strong consensus in the G-7 on the need for greater appreciation and flexibility of the RMB.
• The United States has also worked hard to strengthen the IMF's focus on currency surveillance.  In mid-2007, the IMF modernized its 30-year old operational rules for conducting this duty.  The new decision sent a strong and welcome message that the IMF is to put firm exchange rate surveillance back at the core of its duties.  Since then, the IMF has started sharpening its work on exchange rate analytics.  But this is clearly a work in progress.  As Under Secretary McCormick recently said: "The IMF must now step fully through the door it has opened and make exchange rate issues the priority they deserve to be." 

More generally, I believe that the discussions held with many Chinese leaders over recent years on currency issues have been instrumental in persuading them and creating a growing consensus on the merits of currency appreciation, moving to greater currency flexibility and building the deeper financial markets needed to support a more autonomous monetary policy regime.

Legislative action aimed at China, in contrast, runs the risk that the results of our engagement, even if less than we desire, will be weakened and that China will retrench from engagement.

U.S. Economic Interests

The United States is increasingly a part of a global economy, in which technology and globalization are potent drivers of change. These forces have undoubtedly led to difficult adjustments for some American workers and we have enormous and deep sympathy for those facing these pressures.  China must play by the rules of the game. Still, while China may be the poster child for globalization, neither RMB appreciation nor currency legislation will remove these underlying potent forces.  

In recent years, export growth has been an important factor underlying U.S. economic growth. Indeed, growth in many emerging markets, including China, shows continued resilience, helping to support increased U.S. exports.  China is our most rapidly growing export market, taking over $65 billion in U.S. exports last year, creating high-paying jobs for many Americans.

The adoption of currency legislation that might be perceived abroad as unilateralist and directed at China could pose significant further risks to and have profoundly adverse consequences for the U.S. economy, including increased costs for U.S. consumers.  Unilateral action would likely undermine confidence in the openness of our capital markets, diminish capital inflow into the United States, and further upset financial markets, potentially putting upward pressure on interest rates and prices.  Nothing could be more unwelcome at any time, but especially right now given U.S. and global financial market turmoil. 

Further, we must recognize the precedent we might create and the possibility for foreign retaliation, if we adopt such legislation.  Others might seize on a U.S. precedent to adopt unilateral measures against other countries, including the United States.  If that were to occur, what might then happen to U.S. exports of aircraft, agricultural products, machinery and high-tech exports, and the jobs supported by these exports?  This too would have severe adverse results for the smooth functioning of the international monetary system.

Currency Misalignment and the WTO

Many legislative proposals involve determinations as to the extent of "misalignment" of a currency as a basis for remedial measures, including through the WTO. 

In assessing currency "misalignment", economists use models to calculate real "equilibrium exchange rates" and then the degree of under- or over-valuation as deviations from these real equilibrium exchange rates.

It is important to recognize that models make various assumptions.  What is a "normal" payments position for a country?  What price index should be used to deflate nominal prices?  How should an effective exchange rate index be constructed?  Depending on the answers to these and many more questions, one can get varying answers.  

Equilibrium exchange rate analysis will not yield precise results.  But it is still a worthwhile undertaking.  Especially if many multilateral exchange rate models point in a similar direction and suggest a broadly comparable range of deviation, that is very valuable and useful information.  Further, such results, when complemented by other analysis, can allow one to render more definitive judgments.  For example, buttressing such analytic work with a review of current account positions, reserve accumulation, movement in exchange rates, and dependence on external demand, can create a basis for more consistent judgments.  In the final analysis, there is an element of judgment inherent in rendering assessments of currency valuations, but that does not mean that one can shirk the responsibility of having a view.  

On matters regarding the WTO, Treasury defers to USTR.  We are advised, though, that using currency calculations, which admittedly lack precision and reliability, to determine trade remedies could raise serious concerns with respect to U.S. compliance with WTO obligations.

Conclusion

Let me conclude by commending Congressman Levin and others for consistently raising the issue of China's currency practices.  It is a critical and completely legitimate public policy issue and it is one that should be – and is – high on radar screens.  The United States is fully engaged with China through the Strategic Economic Dialogue across a broad front of issues. This engagement is yielding material results.  Robust bilateral and multilateral engagement with China is the best path forward for the United States.   

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