David Harquist, Jeffrey Beckington, and Ariel Collis, “China's Policy of Substantially Undervaluing the Renminbi: A Challenge for the International Monetary and Trading System,” September 15, 2008

Introduction

The international community is no stranger to enforced undervaluation of currencies by some countries. These experiences, it can reasonably be said, have generally been unpleasant, have generated considerable controversy, and, when extreme enough, have put substantial strain on trade and investment across national boundaries, even to the point of creating dangerous, destructive imbalances and situations. The problem in the first place is that there are self-serving gains, at least for a time, that a country will realize from engaging in this practice, albeit at the expense of its trading partners, particularly increases in exports and foreign direct investment, curtailment of imports, and consequently greater foreign exchange reserves, larger corporate profits, and more employment than would be the case if the country allowed its currency to reflect the market's fundamentals of supply and demand.

This paper explores some of the recent history of this phenomenon and the international efforts that have been made, beginning in World War II, to understand and discourage measures that can be described by various names such as competitive currency depreciation, exchange-rate undervaluation, and currency manipulation. What emerges from this review is the somewhat curious picture of a global system that is relatively tolerant of competitive currency depreciation despite the considerable damage that can result and that, on occasion, has resulted from such behavior.

The basic thesis of this paper is that competitive currency depreciation is a hybrid in nature - a national monetary measure that has a direct impact on international trade and investment - and that regulatory efforts in this area accordingly should include international oversight that takes this duality into account more fully than has been the case to date. During and after World War II, the drafters of both the Articles of Agreement of the International Monetary Fund ("IMF") and the General Agreement on Tariffs and Trade ("GATT") recognized that no international trading system can function and prosper without a stable international exchange system. The critical importance of this interrelationship was one of the central lessons drawn from the stagnant economic conditions that prevailed globally between the two World Wars, due in no small part to a number of countries' enforced undervaluation of their currencies.

In establishing the IMF and implementing the GATT in the mid- and latter 1940s, the international community took the first steps of putting in place an international framework for dealing with competitive currency depreciation. This framework has been expanded upon to a degree since then, but - in the absence for many years of rampant competitive currency depreciation - has been little utilized and so remains largely untested, especially as to how the IMF and the World Trade Organization ("WTO") might collaborate to identify and address particularly pronounced instances of exchange-rate undervaluation.

As Justice Oliver Wendell Holmes, Jr., wrote, all life is an experiment,' and what can be seen as the unfinished work of the IMF and the WTO as to competitive currency depreciation illustrates the point. Over the last decade or so, a number of countries, most notably the People's Republic of China ("China"), have succumbed to the temptations noted above that are offered by exchange-rate undervaluation. This activity by the Chinese government and others has occurred on such a protracted and large scale that the issue of how best to deal with competitive currency depreciation has come to the fore once again and assumed a renewed urgency. It is hoped that this paper will shed light on what adjustments might most effectively be implemented to hold competitive currency depreciation in check and to avoid a weakening of international trade and investment like that in the 1930s between the two World Wars.

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