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Adjusting China's Exchange Rate

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I. INTRODUCTION

During the past year, there has been considerable debate about, and much international criticism of,

China's exchange rate and its currency regime.

Yes, criticism of China in the United States would likely be more muted if the ongoing recovery

were not so "jobless," if employment in the US manufacturing sector had not (mainly for other reasons)

declined so much in the three-year run-up to this presidential election year, if so much attention were not

focused on the very large bilateral US trade deficit with China instead of China's economicallyÐ'--more

meaningful overall balance-of-payments position, and if the United States had not done such a poor job of

improving its saving-investment imbalanceÐ'--particularly in the public sector.

Yes, Euroland's criticism of China would no doubt be less pronounced if Europe had not

compiled such an anemic average growth performance over the past three years, if the European Central

Bank had been somewhat more aggressive in lowering interest rates, and, most telling, if the real tradeweighted

exchange rate of the euro had not appreciated so much (17 percent) since (the US dollar's peak

in) February 2002.

Yes, criticism of China in Japan would probably be less sharp if Japan had not been struggling

with weak economic growth (until very recently) and deflation and if Japan had not increasingly found its

leadership within Asia being challenged by a rising China. True, Japan also has been engaging in largescale,

protracted, one-way exchange market intervention to keep its currency (the yen) from rising;

indeed, Japan's intervention in the first quarter of 2004 was just about as large as China's intervention for

all of last year.

And yes, in emerging Asia where public criticism of China's exchange rate policies has been

milder than elsewhere, concerns would be lower if some of these countries had a clearer picture of how to

respond to the broader competitive challenge raised not only by China's low labor costs but also by the

skill upgrading of China's exports.

Still, this paper's theme is that criticism of China's exchange rate policy is not simply a reflection

of scapegoating, policy failures, and a lack of strategic planning outside China. China's exchange rate

policy itself is seriously flawed given its current macroeconomic circumstances and its longer-term policy

objectives. Based on ongoing research with my Institute colleague Nicholas Lardy (Goldstein and Lardy

2004), I argue below that (i) the renminbi (RMB) is currently significantly undervaluedÐ'--on the order of

15 to 25 percent; (ii) China has been "manipulating" its currency, contrary to IMF rules

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