Els EUA. Department of the Treasury recently reported to Congress that no major trading partner met the technical requirements for designation as a manipulator of the exchange rate of its currency to the dollar. Most of the media and political attention focused on China as a manipulator, but the complete report shows that exchange rate impacts on trade are complex and it would be in Chinas best interest to change policies.

The report covered the first half of 2006 and is a semi-annual report required under the Omnibus Trade and Competitiveness Act of 1988. It is part of a larger charge to the Administration for negotiations to coordinate macroeconomic policies. The report is required to assess the impact of exchange rates on the U.S. current account and merchandise trade account; production, employment, and economic growth in the U.S.; the international competitiveness of U.S. industries; and the external indebtedness of the U.S.

The report explains that trade imbalances are not unique to the U.S. and China. The economies with the largest external surpluses in 2005 were the seven largest oil exporters (Saudi Arabia, Russia, Norway, Iran, Venezuela, the UAE, and Kuwait) a $325 mIL mILIONS, followed by Japan at $167 mIL mILIONS, China at $161 mIL mILIONS, and Germany at $113 mIL mILIONS. The oil exporters and China have increasing surpluses for 2006, while Japan and Germany have stabilized. The surpluses in Japan and Germany are mostly related to slow internal growth. de 1995-2005, domestic demand grew an average of 3.7 percent annually in the U.S., compared to 1.2 percent in Japan and 2.0 percent in the Euro area. The oil exporters could reduce imbalances by spending more on oil production capacity, increasing investments to diversify their economies, and adopting flexible exchange rates.

China is the worlds third largest trading nation and has depended on export markets to fuel economic growth. The domestic savings rate in China is estimated to be close to 50 percent which is far too high for any country. China should not be exporting savings to the rest of the world through a merchandise trade surplus and accumulation of hard currency reserves. The report calls on China to continue modernizing its financial institutions to develop a flexible exchange rate without disrupting economic growth. Despite all the talk about China, it accounted for only 14.7 per cent de U.S. imports for July 2005 though June 2006, compared to Canada at 17.3 percent and Mexico at 10.4 per cent.

The Treasury Department has developed indicators to measure the appropriateness of exchange rate policies including such factors as the current account balance, foreign exchange reserves and real exchange rates. Treasury established three weightings for these factors and ranked 23 major developed and developing countries. In two of the rankings, Malaysia and Saudi Arabia were the top countries; China was third in one ranking and sixth in the other. China was tenth in the third ranking, behind countries like Singapore, Germany and Norway.

The report notes that trade flows are dwarfed by financial market activities. Global trade in goods and services for all of 2005 era $12 trillion, while each week more than $15 trillion in transactions flow through foreign exchange markets. Thailands recent attempts to control investment flows to limit influences on their exchange rate is an example of investment flows affecting trade flows. Thailand has also complained that a more flexible Chinese exchange rate could reduce dollar adjustment pressures on the Thai baht.

The reports authors also analyzed the holding of hard currency reserves by the central bank of China and seven other countries. Reserves are generally thought of as insurance against currency crises that could destabilize an economy. China and all of the other countries analyzed (Taiwan, Corea del Sud, Russia, Índia, Mexico and Malaysia) held more reserves than necessary. This reduces economic growth by tying up resources that could be put to better use and may make managing monetary policy more difficult.

Based on the Treasury report, China and a number of other countries should allow their respective currencies to adjust to their relative strengths in world markets. Those conclusions are nothing new. While the U.S. has pushed for that with the belief that such actions would lower the U.S. merchandise trade deficit, the two most important reasons for China and other countries to better align their currency values is to avoid investing in productive assets that may not have long-term economic value and to increase the standard of living of the nations citizens.

Huge trade and investment flows will eventually force government officials to realign currencies. Plants and equipment designed to take advantage of export markets that are only profitable with a low currency value will be priced out of business and lose value. These failed enterprises will put financial pressures on banks and suppliers and leave workers unemployed.

Developing countries have low incomes and unmet consumer needs. By keeping domestic demand so depressed that China has a savings rate approaching 50 per cent, Chinese workers are not allowed to participate in a rising standard of living resulting from years of rapid economic growth.

Exchange rates of currencies are an issue, but they are not the issue. China and other developing countries have the same mercantilist views of trade common in the U.S. that exports are always good and imports are always bad. That view encourages government leaders in China to inadvertently suppress their standard of living by preventing international market adjustments in investments and trade.