International Trade: Treasury Assessments Have Not Found Currency
Manipulation, but Concerns about Exchange Rates Continue	 
(19-APR-05, GAO-05-351).					 
                                                                 
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.				 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-05-351 					        
    ACCNO:   A21979						        
  TITLE:     International Trade: Treasury Assessments Have Not Found 
Currency Manipulation, but Concerns about Exchange Rates Continue
     DATE:   04/19/2005 
  SUBJECT:   Economic indicators				 
	     Foreign currency exchanges 			 
	     Foreign governments				 
	     Foreign investments in US				 
	     International economic relations			 
	     International trade				 
	     International trade regulation			 
	     Macroeconomic analysis				 
	     Performance measures				 
	     Reporting requirements				 
	     China						 
	     Japan						 

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GAO-05-351

                 United States Government Accountability Office

                     GAO Report to Congressional Committees

April 2005

INTERNATIONAL TRADE

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

                                       a

GAO-05-351

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

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.

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 [email protected].

April 2005

INTERNATIONAL TRADE

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

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)

Renminbi per U.S. dollar Yen per U.S. dollar

8.8 8.7 8.6 8.5 8.4 8.3 8.2

             1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Source: Global Insight. Renminbi Yen

Treasury has generally complied with the reporting requirements for its

160 140 120 100 80 60

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.

Contents

  Letter

Results in Brief
Background
Treasury Has Not Found Recent Instances of Currency

Manipulation

Treasury Has Generally Complied with ReportingRequirements, 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

1 2 6

7

17

19

25 35 36

Appendixes

Appendix I:

Appendix II:

Appendix III:

Appendix IV:

Appendix V:

Appendix VI:

Appendix VII: Appendix VIII: Objectives, Scope, and Methodology 38

Omnibus Trade and Competitiveness Act of 1988 43

Conditions that Led to the Determination of Currency
Manipulation and Removal 45

Overview of China and Japan's Recent Economic
Conditions 48
China 48
Japan 56

Commonly Used Methods to Determine Equilibrium
Exchange Rates 62
Purchasing Power Parity (PPP) Approach 62
Fundamental Equilibrium Exchange Rate (FEER) Approach 63
Macroeconomic Balance Approach 64
External Balance Approach 65
Behavioral Equilibrium Exchange Rate (BEER) Approach 65
Qualitative Approaches 66

Factors Influencing the Final Impact of Exchange Rate
Changes 68

Net Foreign Purchases of U.S. Securities 75

Comments from the Department of the Treasury 77

                                    Contents

Appendix IX:	GAO Contacts and Staff Acknowledgments 79 GAO Contacts 79
Acknowledgments 79

Tables Table 1:

Table 2: Table 3:

Table 4:

Table 5: Table 6: Table 7:

Treasury's Reporting on 1988 Trade Act Exchange Rate
Requirements 18
Estimates of Undervaluation of the Renminbi 21
Illustrative Scenarios of Upward Revaluation of the
Renminbi on the U.S. Trade Deficit 30
Conditions Treasury Cited in Earlier Determinations of
Currency Manipulation 46
China's Balance of Payments 52
Real Net Purchases of U.S. Securities by China 75
Real Net Purchases of U.S. Securities by Foreigners,
Selected Countries 76

Figures Figure 1:

Figure 2:

Figure 3:

Figure 4:

Figure 5: Figure 6:

Figure 7: Figure 8: Figure 9:

Economies with the Largest Bilateral Merchandise Trade
Surpluses with the United States, 2004
Global Current Account Balance as Percent of GDP for
Selected Economies, 2004
Percentage of U.S. Treasury Securities Held by Japan and
China, 2004
Net Purchases of U.S. Securities by Select Economies,
2001-2004
China's Real GDP Growth Rate, 1996-2004
China's Current Account Surplus in Billions of U.S.
Dollars and as a Percentage of GDP, 1996-2004
China's Total Foreign Exchange Reserves, 1995-2004
Chinese Renminbi/Dollar Exchange Rate, 1989-2004
Real Effective Exchange Rate Indexes (China and the
United States), 1994-2004

                                       9

                                       10

                                       33

                                     35 48

50 51 53

55 57

58 59

60

61 67 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

Contents

Figure 16: Total Trade Weights (broad index of the foreign exchange value
of the dollar) 70 Figure 17: Percentage of U.S. Merchandise Trade Deficit
Accounted for by Selected East Asian Economies, 1999-2004 72 Figure 18:
Hourly Compensation Costs for Production Workers in Manufacturing in U.S.
Dollars, 2002 73

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

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A

United States Government Accountability Office Washington, D.C. 20548

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
deficit1-36.4 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
19882 (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.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

1The 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.

2Pub. L. No. 100-418, S:S: 3001-06, 102 Stat. 1372 and following.

3Pub. L. No. 108-447, Div. H, title II, S: 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.

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.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.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

4The 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.

5One 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.

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.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.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

o 	is manipulating the exchange rate for the purpose of gaining an unfair
trade advantage or preventing effective balance of payments8 adjustments,
and

o 	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.

6The 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.

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

8The 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.

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,9 pegged the value of its currency, the renminbi, to the U.S.
dollar. 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

9The 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.

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

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.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 economies12
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.)

11Treasury 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.

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

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

China

Euro Area

Japan

Canada

Mexico

Venezuela

Korea

Malaysia

Saudi Arabia

Nigeria

Taiwan

Thailand

United Kingdom

India

Sweden

Russia 0 20 40 60 80 100 120 140 160 180

Dollars in billions

Sources: U.S. Department of Commerce, U.S. International Trade Commission.

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

Saudi Arabia

Venezuela

Malaysia

Russia

Taiwan

Sweden

Nigeria

Korea

China

Thailand

Japan

Canada

Euro Area India

Mexico UK -4-2 0 2 4 6 810 121416

Percent of GDP

Source: Global Insight.

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.

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.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

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

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

o  accumulation of foreign exchange reserves;

o  institutional development related to banking and financial sectors;

13In 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.

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

o  savings/investment balances and underlying factors;

o  foreign investment and international portfolio investment flow
patterns;

o  trade regime barriers; and

o 	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,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.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,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

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

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

16While 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.

included varying lists of factors the department considers in conducting
its currency manipulation analysis.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

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

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.

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.

17For 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.

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.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.19 Treasury continues to monitor the policies and practices
of these economies for evidence of currency manipulation.

18For 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.

19Taiwan'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).

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.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.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,

20China 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.

21The 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.

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.22 Japan has not intervened to prevent the
appreciation of the yen since March 2004.

22Treasury 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.

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.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.

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

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

               Trade Act reporting requirements Reporting status

Analysis of currency market Evaluation of underlying conditions Reported
since 1988 Description of currency market intervention

                            Report on capital flowsa

Recommendations for sustainable current account balance Reported at
Treasury discretion

Report on negotiation results per section 3004(b) Reported as needed

Update on U.S.-IMF Article IV consultation	Deemed unnecessary by Treasury
from 2001 through 2003b

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

Source: GAO analysis of Treasury exchange rate reports.

aTreasury did not include explicit capital flow analysis in reports issued
from 1995 to 1997.

bTreasury's December 2004 report included an Internet link to IMF
consultation information.

cTreasury'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.

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.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.

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

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.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,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.

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

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

Table 2: Estimates of Undervaluation of the Renminbia

Estimate Source (percentage) Methodologyb

Lawrence Lau (Stanford)c Indeterminate	Qualitative assessment, with
consideration of factors such as capital account restrictions

IMF	No clear evidence of Macroeconomic Balance approachd substantial
undervaluation

Stephen Roach (Morgan Stanley) Not undervalued PPP (relative version) and
Qualitative approaches

Barry Bosworth (Brookings Institute)e	Not fundamentally Macroeconomic
Balance approach undervalued

40 PPP (absolute version) approach

Pieter Bottelier (Johns Hopkins)f 4-5 External Balance approach

Barry Eichengreen (University of California, Berkeley) 5-10 Qualitative
approach

Jim O'Neill (Goldman Sachs) 9.5-15	FEER/BEER approach (lower) External
Balance approach (upper) (Trade-Weighted Renminbi)

Funke/Rahn (Hamburg University) 11 BEER approach

Goldstein/Lardy (Institute for International Economics) 15-25 External
Balance approach

Gene Hsin Chang (University of Toledo) 22 PPP (absolute version) approach

Jon Anderson (UBS)g 15-25 External Balance approach

Jeffrey Frankel (Harvard) 35 PPP (absolute version) approach

Ernest Preeg (Hudson Institute, Manufacturers 40 External Balance approach
Alliance/MAPI)

Benassy-Quere et al. (University of Paris) 47.3 BEER approach

Big Mac Index (Economist)h 56 PPP (absolute version) approach

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

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

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

cLau stated that no methodology can determine the true equilibrium rate
given capital account restrictions in China.

dThe 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."

eBosworth'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.

fBottelier 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.

gAnderson stated that he does not have an estimate for "fundamental" over
or undervaluation of the renminbi.

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

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.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.)

27The 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.

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 trade28 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.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.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

28China'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.

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

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

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.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

31A 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.

second step would occur following adequate strengthening of China's
banking system.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.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:

32This 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.

33The 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.

o 	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),34 and the extent to which Chinese exporters reduce
their costs or profit margins.

o 	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.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.

o 	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.

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

35In 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.

o 	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.36 This would magnify the
impact of a revaluation on the United States.

o 	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.

36There 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.

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

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

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

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

o  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:

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

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

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

o 	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.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.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 deficit39 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).

37The 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.)

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

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

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

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

              Decrease in U.S. trade deficit (dollars in billions)

5 percent

                                                20 percent upward revaluation

Scenario

upward revaluation

                                                       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 2.8   11.1 
                                                       Scenario 2:      
             50 percent exchange rate pass-through and no shift to      
                                            other foreign sourcesb 1.4  
                                                       Scenario 3:      
              50 percent exchange rate pass-through and 40 percent      
                                    shift to other foreign sources 0.8  
                                                       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 3.3   13.3 

Source: GAO analysis based on assumptions specified.

aThese 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.

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

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

40For 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.

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 15,000.41 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.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.

41That 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.

42According 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.

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.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.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.

43When 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.

44Some 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.

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).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.46

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

Total U.S. Treasury holdings = $4.27 trillion

Japan

4.2%

China

Other Foreign

U.S.

Source: GAO calculations based on U.S. Department of Treasury and Federal
Reserve System data.

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

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

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

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,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).

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

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

                            Dollars in billions 700

                                      600

                                      500

                                      400

                                      300

                                      200

                                     100 0

UK Japan China Canada Hong Kong Germany Korea Mexico Taiwan All U.S.
Securities

                                U.S. Treasuries

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

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.

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
highlevel 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 	We provided a draft report to the Department of the
Treasury. Treasury provided written comments, which are reprinted in
appendix VIII. Treasury

Our Evaluation	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 http://www.gao.gov.

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

Loren Yager
Director, International Affairs and Trade

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

Appendix I
Objectives, Scope, and Methodology

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

Appendix I
Objectives, Scope, and Methodology

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.1 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

1This 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).

Appendix I
Objectives, Scope, and Methodology

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

Appendix I
Objectives, Scope, and Methodology

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.

Appendix II

Omnibus Trade and Competitiveness Act of 1988

Omnibus Trade and Competitiveness Act of 19881 (Pub. L. No. 100-418, S:S:
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

1This appendix only includes language relevant to Treasury's manipulation
assessment criteria and exchange rate reporting requirements.

Appendix II
Omnibus Trade and Competitiveness Act of
1988

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.

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.

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

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

                            Taiwan             Korea             China        
       Conditions       (first half of    (first half of    (second half of   
                             1988)             1988)             1991)        
                       $17.4 billion     $9.4 billion in     $12.7 billion in 
     Bilateral trade   (18% of GNP) in   1987 (8.3% of      1991, second only 
    surplus with U.S.  1987              GNP)                              to 
                                                              Japan, grew     
                                                                rapidly       
                                                                $12.2 billion 
     Current account     $18.1 billion   Near $10 billion    (3.3% of GNP) in 
surplus (% of GNP)  (18.5% of GNP) in (8.3% of GNP) in                1990 
                             1987)             1987        

Other indicators   Strong economic   Strong economic   Rising foreign      
     highlighted     fundamentals and    fundamentals,    exchange reserves,  
                     rapidly rising   prepayment of            $44 billion in 
                    foreign exchange  external debt, and      1991, enough to 
                                                                        cover 
                        reserves        rising foreign       10 months of     
                                       exchange reserves        imports       
                    Insufficient      Insufficient                            
                    currency          currency            Dual exchange rate  
                    appreciation      appreciation              regime-

(40% since 1985 Plaza Accord, less (26% since 1985 Plaza Accord, less
continued devaluations of the fixed

than 92% appreciation by Japanese than 92% appreciation by Japanese
official exchange rate and excessive

yen, and 60% by German mark) yen and 60% by German mark) controls on the
dual market determined rates. (China claimed Undervaluation, resulting
from Undervaluation, resulting from these actions were aimed at
interventions, capital controls, and interventions, capital controls, and
eliminating costly export subsidies administrative mechanisms
administrative mechanisms and unifying dual rates.) preventing further
appreciation preventing further appreciation

Activities considered as potential Substantial capital and exchange
Substantial capital and exchange Pervasive administrative controls
manipulation or conditions restrictions under the managed float
restrictions under the managed float over external trade
considered as constraining market system system
forces in foreign exchange market Treasury interpreted Chinese

Heavy direct interventions (buy or Established currency value repeated
devaluations and controls sell) by the central bank in foreign
administratively based on on dual market rates as efforts to exchange
markets undisclosed basket (combination) of frustrate effective balance of

currencies payment adjustments

Number of 6-month periods
continuously cited for manipulating
currency 2 3 5

Changes in conditions that led to removal of citation

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 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
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 foreignfunded
enterprises remained

Treasury determined that China was not manipulating exchange rate but
maintained capacity to do so in the future

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

                         (Continued From Previous Page)

Taiwan Korea China Conditions (first half of 1988) (first half of 1988)
(second half of 1991)

     Changes in conditions that led to additional citation and its removal

                              Additional Citation

(Second half of 1991 and first half of 1992)

o  Current account surplus rose to $12 billion (6.7% of GNP) in 1991

o  Bilateral surplus $9.8 billion

o  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

o  Continued intervention to moderate upward pressure

o  Remaining restrictions prevent full market forces in foreign exchange
market

o  Strong economic fundamentals

                                    Removal

o  Current account surplus fell to $7.9 billion (3.8% of GNP) in 1992

o  Bilateral surplus declined slightly to $9.4 billion in 1992

o  Foreign exchange reserves declined slightly to $82.3 billion, second to
Germany

o  Remaining foreign exchange restrictions and capital controls no longer
constrained currency appreciation

o  It appears that Chinese authorities engaged in direct interventions in
foreign exchange markets to prevent currency depreciation

                                    N/A N/A

            Source: GAO analysis of Treasury exchange rate reports.

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 China has experienced high rates of economic growth in
recent years.

Trade Balance	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

Percentage 12

10 9.6

8

7.1

6

4

2

0

1996 1997 1998 1999 2000 2001 2002 2003 2004

Source: IMF, World Economic Outlook September 2004.

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

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

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.1 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.2 (See fig. 6.)

1The 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).

2These preliminary data are Chinese statistics reported by Global Insight,
Monthly Outlook Asia-Pacific, issued in March 2005.

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

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

Dollars in billions Percentage of GDP 4.5 80

4.0 70

3.5 60 3.0

50 2.5

40 2.0

30 1.5

20 1.0

10 0.5

0 0.0 1996 1997 1998 1999 2000 2001 2002 2003 2004

                                    Billions

                                   Percentage

    Sources: IMF, World Economic Outlook September 2004, and Global Insight.

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

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.

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

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

Dollars in billions

800

700

600

500

400

300

200

100

0 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Source: Global Insight.

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

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.

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

                      Table 5: China's Balance of Payments

Balance of payments
concepts 1999 2000 2001 2002 2003a

                              Dollars in billions

                Current account balance  $21.1    $20.5  $17.4  $35.4   $45.9 
          Capital and financial account                                
                                balance      7.6   2.0    34.8   32.3  
                     Net foreign direct     37.0  37.5    37.4   46.8  
                             investment                                
               Net portfolio investment  - 11.2   - 4.0  -19.4  -10.3  
                  Net other investmentb  - 20.5  - 31.5   16.9  - 4.1    -5.9 
                  Errors and omissionsc  - 17.6  - 11.7  - 4.7   7.5   
           Overall balance (increase in                                
             foreign exchange reserves)      8.7  10.7    47.5   75.3   116.6 
                 Basic balance (Current                                
                         account + FDI)     58.1  58.0    54.8   82.2  

Source : IMF.

a2003 is the most recent year for which complete data on the balance of
payments component are available.

bOther investment includes trade credits, loans, and currency and
deposits.

cErrors and omissions often reflect undocumented capital flight.

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.

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

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.3
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

Renminbi per U.S. dollar 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999
                            2000 2001 2002 2003 2004

           Source: Board of Governors of the Federal Reserve System.

3According 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.

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

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).4 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.5 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.

4Multiple market-negotiated rates existed because the arbitrage among swap
centers was imperfect.

5The 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.

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

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

Currency index 2000 = 100 120

110

100

90

80

0 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

U.S. China

Source: Global Insight.

Note: JP Morgan indexes, 2000=100

Foreign Exchange and Capital Chinese authorities keep controls on foreign
exchange earned from

Controls

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.6 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.

6Since 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.

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

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.7

7These trade volume data are from Global Insight.

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

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

Percentage
4

3.5

3

2

1

0

-1

-1.2

-2
1996 1997 1998 1999 2000 2001 2002 2003 2004

Source: IMF, World Economic Outlook September 2004.

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

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

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

Dollars in billions Percentage of GDP

160

140

120

100

80

60

40

20

0 1996 1997 1998 1999 2000 2001 2002 2003 2004

Billions Percentage Source: IMF, World Economic Outlook September 2004.

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

3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0

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,8 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.

8The 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.

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

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

                            Dollars in billions 800

                                      700

                                      600

                                      500

                                      400

                                      300

                                      200

            100 0 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

                            Source: Global Insight.

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

Japan's Exchange Rate	The Japanese yen is on an independent float, with
the exchange rate primarily determined by market forces.9 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.10 Japanese authorities
intervened frequently in its foreign exchange markets in 2002,11 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.

9As classified by the IMF.

10According 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.

11Japanese authorities intervened eight times in the first half of 2002.

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

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

Trillions of yen

150

120

90

60

30

0 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 2000 2001
2002 2003 2004

Source: Ministry of Finance, Japan.

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

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.

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

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

Yen index 2000 = 100 130

120

110

100

90

80

0 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Source: Global Insight.

Note: JP Morgan indexes, 2000=100.

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
underor 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 higherincome counterparts.1 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

1This is mainly due to the fact that low productivity, wages, and income
in developing nations are often not accounted for properly.

                                   Appendix V
                       Commonly Used Methods to Determine
                           Equilibrium Exchange Rates

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.2 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.3 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.4 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.

2For 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.

3The 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.

4The 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.

                                   Appendix V
                       Commonly Used Methods to Determine
                           Equilibrium Exchange Rates

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.5 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.6
Again, this is important in China's case because of the many structural
adjustments the country is currently undergoing.

5However, 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.

6See IMF (2001), Methodology for Current Account and Exchange Rate
Assessments, Occasional Paper 209.

                                   Appendix V
                       Commonly Used Methods to Determine
                           Equilibrium Exchange Rates

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.7 Once the relevant external balance is
identified, estimated trade models or rule-of-thumb relationships8 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.9 Misalignment of a currency is measured as the difference
between the actual exchange rate and that predicted by the model

7Different 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.

8One 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.

9Analysts 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.

                                   Appendix V
                       Commonly Used Methods to Determine
                           Equilibrium Exchange Rates

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.10 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.11 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.

10Federal 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).

11Some believe that the capital inflow is unsustainable and that further
inflow may induce excessive investment and asset price bubbles.

Appendix V
Commonly Used Methods to Determine
Equilibrium Exchange Rates

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

Dollars in billions 900

800

700

600

500

400

300

200

100

80

60

40

20

0 China Japan Hong Korea Singapore Thailand Mexico US Canada Spain Germany
France UK Saudi

Kong Arabia

2000 2001 2002 2003 2004 Source: Global Insight.

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

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:

o 	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.1

o 	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.

o 	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.

1An 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.

Appendix VI
Factors Influencing the Final Impact of
Exchange Rate Changes

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.

o 	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.

o 	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.2 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).3
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.

2However, 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.

3According 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).

                                  Appendix VI
                    Factors Influencing the Final Impact of
                             Exchange Rate Changes

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

Indonesia Israel India Philippines Australia Switzerland Thailand Brazil
Hong Kong Singapore Malaysia Taiwan Korea Other UK China Mexico Japan
Canada Euro Area

0 2 4 6 810 1214161820 Weight percentage

Source: Federal Reserve Board.

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.

o 	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.

Appendix VI
Factors Influencing the Final Impact of
Exchange Rate Changes

o 	Labor-intensive tasks once performed in other countries are now being
performed in China.4 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.

4According 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.

Appendix VI
Factors Influencing the Final Impact of
Exchange Rate Changes

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

Percentage 25

20

15

10

5

0

Sources: U.S. Department of Commerce, U.S. International Trade Commission.

Note: Other East Asia is Korea and Taiwan.

o 	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).

Appendix VI
Factors Influencing the Final Impact of
Exchange Rate Changes

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

Hourly compensation

25

20

15

10

5

0

     U.S. Europe Japan Canada Korea Singapore Hong Taiwan Mexico Brazil Sri

Kong Lanka

Source: U.S. Department of Labor, Bureau of Labor Statistics.

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.

o 	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

Appendix VI
Factors Influencing the Final Impact of
Exchange Rate Changes

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.

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

U.S. U.S. U.S. corporate U.S. corporate Foreign Foreign Treasuries
agencies bond stocks bonds equity Total Dollars in millions

         -$274                 -$18 $26 $12 -$138                  $0   -$392 
1990    457                    -4 -15 1 224                     -1     662 
1991    142                    59 19 8 554                      0      782 
         4,254                   608 870 14 507                    5    6,258 
1993    553                  678 188 -54 -270                  -131    963 
        14,649                  598 125 -25 247                   -706 14,888 
           827 1,006 16 -13 -323                                  -188  1,324 
        16,683 3,181 297 -2 39                                    -73  20,125 
         9,263 1,939 79 70 60                                     -548 10,864 
         2,919                   980 53 1 1,927                    -9   5,871 
         9,066 9,236 576 226 372                                  -246 19,230 
        -4,302               20,389 875 -112 1,959                -272 18,537 
2001 20,226                27,485 7,076 3 4,267                 42  59,099 
2002 25,058               30,457 6,205 168 3,642               -39  65,491 
2003 31,176               30,282 4,728 -79 2,524               -10  68,622 
2004 18,895              16,387 12,341 -290 3,603              -614 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.                                  

                                  Appendix VII
                    Net Foreign Purchases of U.S. Securities

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
              UK Japan China Canada Hong Kong Germany Korea Mexico

Dollars in millions

          -$46,773 $35,646   $963   -$8,457  $3,738 -$14,767 -$2,519 -$14,842 
            81,198  22,822  14,888   -2,624  3,934   8,683   -1,649    -7,565 
            84,361 -10,077   1,324   -7,654  5,260   10,982   2,599     2,171 
           106,748  56,883  20,125   1,568   1,361   18,114  -1,179    -3,330 
1997    166,494  27,822  10,864   1,092   21,921  41,485  -15,349     -409 
           159,179  20,797   5,871    134    9,059   16,646  11,971     1,332 
           186,843   -300   19,230   13,347  12,092  23,446  11,014     1,740 
           147,455  79,062  18,537   16,040  8,804   31,642   5,403    10,085 
           164,452  38,588  59,099   17,867  30,073  22,322      325    8,831 
           199,715  84,668  65,491   7,105   15,149       24 13,524    10,607 
           165,864 152,387  68,622   36,399  19,844  14,528  12,745    11,025 
           165,528 218,623  50,322   26,761  22,154  18,877  12,758    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.

Appendix VIII

Comments from the Department of the Treasury

Appendix VIII
Comments from the Department of the
Treasury

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.

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