Chinese Exchange Rate controversy: The Legal Application of the Staiger-Sykes Model

Among the more debated issues in international economic law in recent times has been the Chinese currency rate ‘manipulation’. Opinio Juris summarises the recent developments on the issue here. Opinio Juris has highlighted scholarly writings on the issues by Prof. Staiger and Prof. Sykes; and this post is an attempt to put the Staiger-Sykes model into a legal context. I apologise for the detailed referencing – readers will be able to ignore the footnotes without missing any of the substance; however, the footnotes are required for complete referencing.

Chinese economy being a centrally planned economy, China applied an extremely strict policy of foreign exchange restrictions and controls. This strict control policy continued till around 1978.[1] Since that time, the Chinese exchange rate system was transformed to result to a dual exchange rate system being applied. Under this dual system, a fixed rate and a market rate co-existed. This dual system was abolished in 1994,[2] and China began to (at least formally) operate a managed floating.[3] This managed float was in fact “a strict peg against the US dollar”.[4] Through the next decade, until July 2005, China fixed the external value of its currency against the US dollar. This fixed peg was at an exchange rate of 8.28 yuan to 1 US dollar. In July 2005, this decade-long peg was removed and China appreciated the yuan by 2.1% against the dollar.[5] It then began a policy of “gradual managed evaluation”,[6] with heavy interventions by the People’s Bank of China.[7] Developments following this are best summarised by Hermann, who notes that by the end of 2008, “the yuan’s dollar value had increased by roughly 20%, with the yuan trading at 6.83 against 1 US dollar. At the same time, with a bilateral monthly trade surplus of 17.5 billion US dollar (September 2008) in its trading relations with the United States, China accumulated foreign reserves of 1.9 trillion US dollar (estimate, October 2008), equating to almost 20% of the United States’ public debt.”[8] In effect, literature indicates that Chinese currency is undervalued by almost 20% primarily because of interventions by the Chinese central bank – the People’s Bank of China.[9] China buys dollars and other foreign currencies — worth several hundred billion dollars a year — by selling more of its own currency, which then depresses its value. Chinese foreign exchange reserves were recently over US$ 1.7 trillion – this might perhaps indicate that the Chinese central bank is actually creating a huge artificial demand and is creating an undervalued currency.[10]

 

Undervaluation in Exchange Rate theory

 

We can begin by taking note of what exactly is meant by undervaluation.[11] Let us consider first exchange rate valuations in terms of purchasing power parity (PPP exchange rate). As we have discussed that Chinese currency was pegged for a long time to the US dollar, we shall examine currency valuation in these terms. In exchange rate theory, the PPP exchange rate is defined as “that rate which equalizes the cost of a market basket of goods between two countries…”[12] The basic idea underlying PPP is that, in a situation with no external costs, the prices of internationally traded goods should be equal in every country. Consequently, the exchange rate between any two currencies should be the ratio of the prices of the goods (or the prices of a market basket) in the two countries. In sum, saying that the US dollar is be overvalued with respect to the Chinese yuan means that goods and services are relatively more expensive in the US than in China and relatively cheaper in China than in the US.[13]

While scholarly literature has often agued that Chinese currency is undervalued, some academicians have disputed this view.[14] It might be useful to consider this argument before proceeding further. The argument in this regard is essentially that “U.S. trade deficits with China have been affected by many factors (such as China’s low labor cost, its market structure, and U.S. economic sanctions) other than the exchange rate. China’s surpluses in both its trade and current accounts are relatively small and do not indicate that the currency is in misalignment.”[15] However, it is noteworthy that these surpluses are not really “relatively small”. Indeed, without the interventions of the People’s Bank of China in the exchange rate system, the massive capital inflows and trade surplus could not persist at the same time, neither theoretically nor practically.[16] Empirically, the IMF has noted that the movement in the real value of the Chinese currency over a consistent period of time “has not been in line with most fundamental factors that are generally considered to be important in determining the exchange rate’s real value… all of these developments point to the currency as being undervalued…”[17]

 

The alleged inefficiency of currency manipulation

 

The effects of undervaluation can also be understood in a further manner – in relation to trade balance. Let us assume that a country, say China, has a trade deficit. Now, if the value of the Chinese currency were to fall, then foreign goods would be relatively more expensive to Chinese residents. This would tend to reduce Chinese imports. In effect, to the Chinese buyer, the effect is a rise in price of foreign goods. The same fall in the value of the Chinese currency would also cause Chinese goods to become relatively cheaper in foreign markets. This would tend to raise Chinese exports.[18] Consequently, artificial determination of exchange rates can be a manner of indirectly affecting both import and export, altering the trade balance.^[19]  “Most of the world’s large economies are stuck in a liquidity trap – deeply depressed, but unable to generate a recovery by cutting interest rates because the relevant rates are already near zero. China, by engineering an unwarranted trade surplus, is in effect imposing an anti-stimulus on these economies, which they can’t offset.”[20] It is also argued by several scholars that that exchange rate manipulation has effects which parallel a combination of an export subsidy and an import tariff.[21] This point has been made forcefully by several scholars.[22] MacDonald thus argues, Based on these effects, scholars have argued, “undervalued exchange rates are de facto protectionist trade policies because they are a combination of export subsidies and import tariffs.”[23] Based on this idea, scholars have been quick to point out that each of these two –export subsidies and import tariffs – are frowned upon by international economic law; “but their lethal combination in an undervalued exchange rate is not…”[24]

The question nonetheless arises – is this alleged combination actually as lethal as it is made out to be? If one were to attempt to verify the claims empirically, the attempt to portray the Chinese policies as extraordinarily lethal does not withstand rigourous scrutiny. In particular, studies have highlighted that gains also accrue to Chinese trading partners in the form of cheaper availability of goods.[25] “The loss to American producers comes with a gain to the many millions of American consumers who prefer to pay less for the goods they buy.”[26] Particular studies on empirical effects have also shown that the correlation between increase trade deficits of countries vis-à-vis China and the rate of Chinese currency manipulation do not suggest a tangible inference of a causal connection between the two.[27] Thus, “The bilateral trade deficit increased from $202 billion in 2005 to $268 billion in 2008… But the proportion of that increase ascribable to renminbi appreciation is very much debatable…”[28] Why may this be so? An explanation may perhaps be forthcoming in another economic model.

 

The Staiger-Sykes hypothesis

 

What exactly are the effects, then, of undervaluation? It is widely argued that undervaluation – because it makes domestic exports cheaper – is actually a measure which has effects similar to those of an export subsidy.[29] On this analysis, it would seem that a currency undervaluation has trade-distorting effects. However, one further point needs to be considered, and this arises in connection with Lerner’s symmetry theorem. Staiger and Sykes, for instance, argue, “it is often asserted that China’s currency policies have real effects that are equivalent to an export subsidy. In fact, however, if prices are flexible, the effect of exchange rate intervention parallels that of a uniform import tariff and export subsidy, which will have no real effect on trade, an implication of Lerner’s symmetry theorem. With sticky prices, the real effects of exchange rate intervention and the translation of that intervention into trade-policy equivalents depend critically on how traded goods and services are priced.”[30]

In order to appreciate this argument, it might be useful to begin by looking at a scenario where prices of goods are flexible, and then asking in reverse – what are the trade policies which would exactly replicate the effects of currency devaluation? The general answer is that the effects of devaluation will be exactly replicated by introducing a uniform ad valorem export subsidy on all export goods and import tariff on all imported goods.[31] Staiger and Sykes argue, however, that “the effects of such policies in tandem are dramatically different from their effects in isolation.” Now, an import tariff and an export subsidy acting individually can have trade-distorting effects. How is it that a combination of the two in an undervalued currency has no such effects? The answer is that, “as with a devaluation, the particular package of trade policy interventions which is equivalent to the devaluation do not alter relative prices…”[32]

In order to explain this further, we can consider the implications of Lerner’s symmetry theorem. Without going into the mathematical reasoning behind this proposition, the basic philosophy underlying this theory appears to be that an export subsidy causes resources to move towards exporting; and an import tariff causes resources towards the import competing sector.[33] When the two policies are of equal magnitude, their effects tend to cancel each other out exactly.[34]

 

An examination of the Staiger-Sykes model

 

It is noteworthy that the Staiger-Sykes model described above holds true only when prices are flexible. The essential assumption of flexible pricing essentially also means that an important basis for the Staiger-Sykes hypothesis to hold true is that the law of one price must hold true. In other words, producers must receive the same price for their product, when translated into a common currency, no matter where they make the sale.[35] This condition will be satisfied in a flexible price world.[36] When prices are flexible, a devaluation is simply a change in the monetary unit of account with no real effects.[37] However, it is noteworthy that again on the empirical side, there is a large body of evidence suggesting that the law of one price does not always hold true at the international level.[38] In the case of China, it in unclear as to how far prices can be taken as being flexible. This point is acknowledged by Profs. Staiger and Sykes themselves. They claim that the rationale behind this assumption is not that there exists a belief that all prices are fully flexible at every moment in time. Indeed, they admit that such a belief is probably misplaced. Instead, the broader rationale on which the flexible-price assumption is based seems to be that economic analysis is best carried on and best designed in a scenario where long-term problems are to be tackled. In the long term, an assumption that prices are flexible appears reasonable. While this may well be true, it is submitted that such a rationale has some problems when applied to the understanding of a specific legal problem. If one were to take a decision of the legality of Chinese currency undervaluation, the decision must be taken at the time when the issue arises for adjudication. It is not useful – nor will it be possible in law – to defer such a decision to the long term when prices actually become flexible. The decision must be based on the facts as they are; without taking into account of how the facts might subsequently change. Consequently, while the Staiger-Sykes model is important as a means of understanding the effects of currency manipulation and is an important word of caution about automatic assumption of alleged negative impacts thereof, the model cannot be taken as conclusive in specific fact situations. What the model is useful for is that it underscores the point that economic effects of currency undervaluation cannot be taken as a given in every individual situation. This point is important to bear in mind as we move towards questions of assessing the legality of the Chinese policies.

In sum, while a strong theoretical debate exists as to the effects of Chinese currency undervaluation, empirical verification is not clear on either of the sides of the debate. Thus, it is noteworthy that it cannot be conclusively said that Chinese policies have had an identifiable effect – whether they have had such an effect, and the extent of that effect, will depend in a large part on the degree of flexibility of prices. Thus, an important question which must be answered in specific legal cases by Tribunals and adjudicatory bodies is the extent to which prices are flexible at the relevant points in time. It is this enquiry which is essential to appreciate the real effect of the Chinese currency undervaluation; and as will now be seen, a legal analysis de hors a correct appreciation of the economic effect will be incomplete. Legal scholars have argued that the legality of Chinese currency policies can be assessed in the abstract without the need to prove the real economic effects by treating the legality as a question of law and not a question of economics.[39] The eagerness to deal with the issue as a pure question of law capable of an answer in the abstract outside of specific factual considerations is seen on both sides – scholars who contend that the Chinese policies are illegal as well as those who contend that the Chinese policies are legal have both discussed the issue extensively in the abstract.[40] In the discussion which follows, it will be seen that the correct interpretation of the applicable legal provisions itself requires the questions to be answered not as pure legal issues, but as legal issues in a particular economic and factual background.

We will attempt to do that in a subsequent post.

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[1] Herrman, Don Yuan: China’s “Selfish” Exchange Rate Policy and International Economic Law, (2010) European Yearbook of International Economic Law 31.

[2] Hermann, supra.

[3] See, Release of the Federal Release, Foreign Exchange Rates, available at http://www.federalreserve.gov/releases/h10/hist/dat96_ch.txt

[4] Hermann, supra.

[5] Hale & Hale, Reconsidering Revaluation – The Wrong Approach to the US-Chinese Trade Imbalance, (2008) 1 Foreign Affairs 57.

[6] Hermann, supra.

[7] Goldstein, Renminbi Controversies, (2006) 2 Cato Journal 251; from Binneau, Remnibi Misalignments, available at http://www.cerdi.org/uploads/sfCmsContent/html/317/Bineau.pdf

[8] Hale & Hale, supra.

[9] Also see for a general overview: Dellas, Swamy & Tavals, The Collapse of Exchange Rate Pegs, (2002) The Annals of the American Academy of Political and Social Science 53.

[10] Also see: U.S. Department of the Treasury, Report to Congress on International Economic and Exchange Rate Policies, at 18, Nov. 2005.

[11] Following discussion draws heavily from Suranovic, International Finance Theory and Policy, Chapter 30-6.

[12] Suranovic, supra

[13] See generally, Suranovic, supra. The text is available online at

http://internationalecon.com/Finance/Fch30/F30-6.php

[14] Yang & Besnainou, Is the Chinese Currency Undervalued?, (2006) 2 International Research Journal of Finance and Economics 106.

[15] Yang & Besnainou, supra.

[16] Hermann

[17] See also Rajan. Remarks on Global Current Account Imbalances and Financial Sector-Reform with Examples from China, Address to the Cato Institute, Nov. 3, 2005.

[18] See generally, Sharobeem, Biting the Hand that Feeds us, (2007) 19 Florida Journal of International Law 697 and the literature cited therein.

[19] Of course, several different factors would affect this besides just exchange rates.

[20] Krugman, Taking on China, New York Times (March 14, 2010).

[21] See the literature reviewed in Staiger-Sykes.

[22] Goldstein, Testimony before the Subcommittee on Domestic and International Monetary Policy, Trade, Technology Committee on Financial Services available at http://www.iie.com/publications/papers/goldstein1003.htm

[23] MacDonald, A Development Perspective on China’s Currency – and a Fresh WTO Solution, available at http://blogs.cgdev.org/globaldevelopment/2010/03/a-development-perspective-on-china%E2%80%99s-currency-%E2%80%93-and-a-fresh-wto-solution.php

[24] Subramanium, China versus the rest of the World?, Peterson perspectives Edited Trascript (February 4, 2010)

[25] Also see: European Commission, Bilateral Trade Relations, China Trade Statistics, http://ec.europa.eu/trade/issues/bilateral/countries/china/indexoen.htm.

[26] Mankiw, It’s no time for Protectionism, New York Times (7 February, 2009).

[27] See generally, Bhala, Virtue, the Chinese Yuan, and the American Trade Empire, (2008) 38 Hong Kong Law Journal 183; Mercurio, Is China a ‘Currency Manipulator’? The Legitimacy of China’s Exchange Regime Under the Current International Legal Framework, (2009) 4 (3) The International Lawyer 1257; Zimmerman, Jurisdictional Competition Between the IMF and the WTO and Its Impact on the Prevention of Monetary Protectionism, SIEL Working Paper, 16/08 (2008).

[28] Ikenson, China and Currency Valuation, National Review (17 March, 2010).

[29] See the literature cited in Hermann and Staiger & Sykes, supra.

[30] Staiger & Sykes, supra.

[31] See the literature cited in Staiger & Sykes, supra.

[32] Staiger & Sykes, supra.

[33] Staiger & Sykes, supra.

[34] Staiger & Sykes, supra.

[35] Staiger & Sykes, supra.

[36] Zimmerman, Exchange Rate Manipulation under Contemporary International Law, IMF Working Paper Draft (2010).

[37] Staiger & Sykes, supra.

[38] Zimmerman, supra.

[39] See for instance the methodology adopted in the analysis in Leviton, Is it a Subsidy? (2006) 23 UCLA Pacific Basin Law Review 243.

[40] See for example, the arguments used in Chinese Currency Coalition, The Section 301 Petition, available at www.chinacurrencycoalition.org/petition.html and in Leviton, supra; Also see, Lou, Challenging China’s exchange Rate Regime: An Analysis of U.S. Options, (2005) 28 Hastings Intl. & Comp. L. Rev. 455; Bivens & Scott, China Manipulates Its Currency – A Response is Needed, EPI Policy Memorandum No. 116, Economic Policy Institute (Sept. 26, 2006) available at http://www.epinet.org.