The Chinese government modified its currency policy on July 21, 2005. It announced that the yuan's exchange rate would become "adjustable, based on market supply and demand with reference to exchange rate movements of currencies in a basket," (it was later announced that the composition of the basket includes the dollar, the yen, the euro, and a few other currencies), and that the exchange rate of the U.S. dollar against the yuan would be immediately adjusted from 8.28 to 8.11, an appreciation of about 2.1%. Since July 2005, China has allowed the yuan to appreciate steadily, but slowly. The overall value of the dollar has fallen significantly, to the point where some economists and policymakers fear that a further fall could be destabilizing to the U.S. economy. Concerns Over China's Currency Policy and Recent Action

Many U.S. policymakers, business people, and labor representatives have charged that China's currency is significantly undervalued vis-à-vis the U.S. dollar by as much as 40%, making Chinese exports to the United States cheaper, and U.S. exports to China more expensive, than they would be if exchange rates were determined by market forces. They further argue that the undervalued currency has contributed to the burgeoning U.S. trade deficit with China, which has risen from $30 billion in 1994 to $256 billion in 2007, and has hurt U.S. production and employment in several U.S. manufacturing sectors (such as textiles and apparel and furniture) that are forced to compete domestically and internationally against "artificially" low-cost goods from China. Furthermore, many analysts contend that China's currency policy induces other East Asian countries to intervene in currency markets in order to keep their currencies weak against the dollar to remain competitive with Chinese goods. Trends and Factors in the U.S.-China Trade Deficit

Critics of China's currency peg often point to the large and growing U.S.-China trade imbalance as proof that the yuan is significantly undervalued and constitutes an attempt to gain an unfair competitive advantage over the United States in trade. These factors have led many analysts to conclude that much of the increase in U.S. imports (and hence, the rising U.S. trade deficit with China) is a result of China becoming a production platform for many foreign companies (who are the largest beneficiaries from this arrangement), rather than unfair Chinese trade policies. Economic Consequences of China's Currency Policy

If the yuan is undervalued against the dollar, as many critics charge, then there are benefits and costs of this policy for the economies of both China and the United States. Rather, it leads to a compositional shift in U.S. production, away from U.S. exporters and import-competing firms toward the firms that benefit from the lower interest rates caused by Chinese capital inflows. The U.S.-China Trade Deficit in the Context of the Overall U.S. Trade Deficit

While China is a large trading partner, it accounted for only about 17% of U.S. imports in 2007 and 29.0% of the sum of the bilateral trade deficits (or 32% of the total U.S. trade deficit, including countries where the United States has a trade surplus). This would reduce spending on interest-sensitive purchases, such as capital investment, housing (residential investment), and consumer durables. If the yuan were to appreciate, there is considerable debate over the net effects this policy would have on the U.S. economy since it may benefit some U.S. economic sectors and harm other sectors, as well as consumers. The extensive involvement of foreign multilateral corporations in China's manufactured exports further complicates the issue of who really benefits from China's trade, as well as the implications of a rising U.S. trade deficit with China (since a large share of U.S. imports are coming from foreign firms, including U.S. firms, that have shifted production from one country to China).
The continued rise in China's trade surplus with the United States and the world, and complaints from U.S. manufacturing firms and workers over the competitive challenges posed by Chinese imports have led several Members to call for a more aggressive U.S. stance against certain Chinese trade policies they deem to be unfair. Among these is the value of the China's currency (the renminbi or yuan) relative to the dollar. From 1994 to July 2005, China pegged its currency to the U.S. dollar. On July 21, 2005, China announced it would let its currency immediately appreciate by 2.1% and link its currency to a basket of currencies (rather than just to the dollar). Although the yuan has appreciated 16% since 2005, many Members complain that China continues to "manipulate" its currency in order to gain an unfair trade advantage, resulting in U.S. job loss. Numerous bills have been introduced to induce China to adopt a more flexible currency policy.
If the yuan is undervalued against the dollar (as many analysts believe), there are likely to be both benefits and costs to the U.S. economy. It would mean that imported Chinese goods are cheaper than they would be if the yuan were market determined. This lowers prices for U.S. consumers and dampens inflationary pressures. It also lowers prices for U.S. firms that use imported inputs (such as parts) in their production, making such firms more competitive. When the U.S. runs a trade deficit with the Chinese, this requires a capital inflow from China to the United States, such as Chinese purchases of U.S. Treasury securities. This, in turn, lowers U.S. interest rates and increases U.S. investment spending. On the negative side, lower priced goods from China may hurt U.S. industries that compete with those products, reducing their production and employment. In addition, an undervalued yuan makes U.S. exports to China more expensive, thus reducing the level of U.S. exports to China and job opportunities for U.S. workers in those sectors. However, in the long run, trade can affect only the composition of employment, not its overall level. Thus, inducing China to appreciate its currency would likely benefit some U.S. economic sectors, but would harm others. U.S. data indicate that in 2008, imports from China have slowed significantly and that import prices have risen sharply. Some economists are now concerned that the overall fall in the dollar, which a stronger yuan would exacerbate, could become economically destabilizing.
Critics of China's currency policy contend that the large and growing U.S. trade deficit with China ($256 billion in 2007) is evidence that the yuan is undervalued and harmful to the U.S. economy. However, the relationship is more complex. First, an increasing level of Chinese exports are from foreign-invested companies in China. Second, the deficit masks the fact that China has become one of the fastest growing (and is now the third largest) market for U.S. exports. Finally, the trade deficit with China accounted for 29% of the sum of total U.S. bilateral trade deficits in 2007, indicating that the overall U.S. trade deficit is not caused by the exchange rate policy of one country, but rather the shortfall between U.S. saving and investment. That being said, there are a number of reasons why a more flexible currency policy could benefit both countries. For a brief summary of this report, see CRS Report RS21625, China's Currency: A Summary of the Economic Issues, by [author name scrubbed] and [author name scrubbed].