U.S. Treasury Secretary Timothy Geithner announced on April 3 that he was delaying his scheduled April 15 report to Congress on currency exchange policies of other countries. The specific issue is China and whether or not it manipulates the value of its currency, the Yuan (also known in China as the renminbi or RMB), to gain a trade advantage with the U.S. Chinese and U.S. officials will be meeting several times in coming months when these concerns can be addressed.

Under the Omnibus Trade and Competitiveness Act of 1988 the Treasury Secretary is required to report to Congress on countries that manipulate the rate of exchange of their currencies to prevent effective balance of payments adjustments or gain unfair competitive advantage in international trade. If a country has a significant global current account surplus and bilateral trade surplus with the United States, the Secretary is to initiate negotiations with the country at the International Monetary Fund or bilaterally to ensure that the exchange rate is regularly adjusted.

China maintained a fixed exchange rate of 8.28 Yuan to the dollar from 1995 to July 2005. Prior to that time China had not participated in the monetary policy era of internationally fixed exchange rates and then market set rates beginning in the 1970s. The Chinese economy was not open enough for the value of the Yuan to be market-based in 1995 and the fixed rate was a logical alternative. China kept that fixed rate during the Asian financial crises of the late 1990s as other countries devalued. After China joined the WTO in 2001 it faced growing pressure to move toward a market-based exchange rate. Rather than allow the Yuan to freely float, China allowed it to slowly increase in value by 21 percent by July 2008 when a de facto peg to the dollar was imposed as the economic crisis began to deepen.

Secretary Geithner was correct in delaying the report on currency manipulation, previous Treasury Secretaries have taken similar actions, with the intent of continuing to work with the Chinese government and other governments on a solution. The Obama Administration is also correct in rejecting the various efforts in the U.S. House and Senate to impose increased tariffs and other penalties if the Yuan is not allowed to float. Geithner should not ignore the issue, but should work with developed and developing countries who have common trade policy difficulties to find a solution of benefit to the U.S., China and the other countries.

The problem is not just currency value; it is also a capital flow issue that must be addressed before it becomes worse. The 21 percent increase in the value of the Yuan from 2005 to 2008 had little impact on the trade outcomes between the U.S. and China. Capital flows into and out of China and within the country are controlled by the government and government owned banks and businesses. Investments in industries are often based on domestic policy consideration like jobs rather than market demand analysis and expected returns from sales of products. Over investment often occurs and exports to the U.S. or other markets is the short-term solution. This causes market shocks in other exporting and importing countries.

The Wall Street Journal recently reported on a case under review by the European Commission concerning coated fine paper used for making high-quality prints. Chinese exports to Europe increased from 65,000 metric tons in 2006 to 220,000 tons in 2009. China’s production capacity is expected to double by 2013 due to incentives in China’s economic stimulus plan. The additional capacity is double the total installed capacity in the EU. Much of that additional output will end up in the EU regardless of what happens to the Yuan/Euro exchange rate. The Commission is considering several other similar cases. The U.S. International Trade Commission has concluded that U.S. industry has been materially injured by imports of coated paper from China. Albaugh, Inc, a U.S. manufacturer of glyphosate, the world’s largest selling herbicide, has complained about a similar situation with Chinese production capacity of glyphosate now estimated at 150 percent of world demand.

If the Yuan is actually 40 percent undervalued as critics believe, an overnight adjustment would immediately impact the competitive positions of substantial segments of the Chinese economy. The challenge is to encourage capital market and currency policy reforms that impact export activity without unduly disrupting economic activity. The U.S., China and every other significant exporting and importing country has a stake in finding a mutually agreeable solution. The status quo is not acceptable to China’s trading partners because of the disruptions to their economies and not acceptable to China because it causes misallocations of resources which eventually must be redirected to more productive activities.

China has been opening financial markets in recent years under terms of its ascension to the WTO. If the Yuan value is to be market based, China must open its monetary policy setting process to outside market observations. The People’s Bank of China, China’s central bank, will also need to develop a transparent policy on how much inflation it will tolerate because that influences exchange rates. China’s opening of capital markets must include allowing exporting firms to keep the foreign exchange they earn and manage their own dollar portfolios rather than requiring them to trade in the dollars for Yuan.

When the G20 group of industrial and developing countries met last summer they agreed to seek a “rebalancing” of the global economy. Allowing the Yuan to appreciate and opening China’s capital markets have to be part of that process. Other countries should agree to resist any unilateral actions on exchange rates and import tariffs as China works through these adjustments. If no action is taken by China, political forces in these countries will continue to look for solutions in exchange rates and trade policy that will leave producers and consumers in the U.S., China and the rest of world worse off.

One solution is for China to return to a slow and steady appreciation of the Yuan; no one knows with certainty what the market-based exchange rate should be. A defined path for changes in the Yuan exchange rate would remove uncertainties in capital markets as investors lose the security they had with a fixed exchange rate.