The Coup in the Kremlin
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For much of the past decade, the United States has begged, pleaded, and threatened China to change its disruptive currency practices, which artificially make Chinese exports cheap and foreign goods sold in China expensive.
Today, in the midst of prolonged economic weakness, with the U.S. trade deficit rising and unemployment persistently high -- and Chinese-owned U.S. debt probably exceeding $2 trillion -- legislative pressure is again growing to raise trade barriers against Chinese goods. Since June 2010, China has allowed its currency, the renminbi, to rise nearly five percent against the dollar. But there has been no slowdown in its manipulative purchases of U.S. assets, implying that the renminbi remains deeply undervalued.
The United States clearly needs to ratchet up the pressure on China, and the next installment of the U.S.-China Strategic and Economic Dialogue, scheduled for early May in Washington, provides a natural opportunity. But what action can the United States take to persuade China to stop its harmful behavior? Minor trade measures, such as a few more antidumping or countervailing duty cases to levy penalty duties on U.S. imports of Chinese paper or steel, will not make an appreciable dent in the trade deficit or the unemployment rate. And major trade measures, such as a tariff or quota against all Chinese exports, would likely be ruled illegal by the World Trade Organization and would almost certainly provoke Chinese retaliation against U.S. exporters. Moreover, a trade war across the Pacific would quickly create vested interests among protected U.S. and Chinese industries, making the retaliatory measures hard to unwind. For these reasons, it is no surprise that U.S. policymakers have been reluctant to launch a trade war with China; officials in Beijing understand this reluctance well and, accordingly, have viewed U.S. threats as bluffs.
A more productive course would be to tax Chinese currency manipulation rather than Chinese exports. In order to undervalue the renminbi against the dollar, China drives the dollar's value up by buying dollar-denominated financial assets, principally U.S. Treasury bills and bonds. To discourage China from doing so, the U.S. government should tax the income on Chinese holdings of U.S. financial assets. For example, the U.S. Treasury would withhold tax on interest paid on Treasury bonds held by China. For every $10 billion of Treasury bond interest paid to the People's Bank of China (the central bank), the U.S. Treasury could withhold 30 percent, or $3 billion, in tax.
Such a tax is allowed under international rules and would not distort international trade, although it would require the United States to follow proper procedures in amending or canceling its tax treaty with China. To impose the tax as of January 2012, the United States would have to deliver notice to China by July 2011 of its intention to cancel the treaty. The Obama administration should invoke this possibility in the meetings with Chinese officials next month.
Taxing Chinese assets would certainly raise hackles in China, yet Chinese leaders would have no way to retaliate in kind, as U.S. holdings of Chinese assets are less than ten percent of the value of Chinese holdings of U.S. assets. Moreover, the United States would retain the ability to impose trade sanctions -- a club in the closet, so to speak -- if China resorts to unfair treatment of U.S. exporters, such as an arbitrary tariff. Congress could draft the legislation authorizing the tax broadly, moreover, so that it could be applied to assets held by any country that manipulates its currency.
By taxing the precise actions that cause distorted exchange rates, the United States would increase the incentive for China and other currency manipulators to allow the values of their currencies to reflect market fundamentals. The tax rate should start at the normal statutory rate of 30 percent and could be increased at the discretion of the U.S. Treasury secretary until a government engaged in manipulation ceased the practice. In the meantime, the U.S. government would enjoy a few billion dollars per year of extra revenue to reduce its budget deficit, and these revenues would grow to tens of billions per year as interest rates return to more normal levels over time, especially if Washington raised the withholding tax rate.
An important benefit of this approach is that it would explode the myth, commonly held in China, that the United States wants or needs China to buy U.S. Treasury bonds. Many ordinary Chinese citizens do not connect China's currency policy with its purchases of U.S. assets. They see China's purchases of U.S. Treasury bonds as a favor to the United States. But, in fact, these purchases are the mechanism by which China both subsidizes its exports to the United States and discourages U.S. exports to China. Without massive Chinese purchases of U.S. Treasury bonds and the resulting undervaluation of the renminbi, U.S. firms would be much better able to compete against their Chinese counterparts.
What is more, taxing China's investments in the United States would likely create public support inside China to stop manipulative purchases of U.S. Treasury bonds by the People's Bank. In order to buy U.S. bonds, the Chinese government has to borrow money in China. And because interest rates in China are higher than those in the United States, the Chinese government loses money on its U.S. bonds. Many middle-class Chinese are unhappy that their government is subsidizing loans to the United States when there are many willing borrowers in China. A U.S. tax on the income from Chinese holdings of U.S. assets -- technically speaking, a U.S. withholding tax -- would increase the losses from China's currency manipulation and make it clear that Chinese purchases of U.S. assets are not welcome.
If China were to stop manipulating its currency, the dollar would decline against the renminbi, boosting U.S. exports and economic growth. William Cline, a senior fellow at the Peterson Institute for International Economics, estimates that a 20 percent appreciation of the renminbi would reduce the U.S. current account deficit by between $50 billion and $125 billion, with a corresponding increase of between 300,000 and 750,000 jobs. The effect on U.S. interest rates would depend on the extent to which the Federal Reserve moved to purchase the Treasury securities that China otherwise would have bought. Clearly, a faster economic recovery would advance the rate at which the Federal Reserve would allow a return to more normal interest rates, but the initial effect on interest rates would likely be small.
How would the mechanics of this tax actually work? As the administrative and legal processes leading to a tax are unfolding, the Chinese authorities would have time to preemptively change their currency practices -- a win-win outcome. The first step to instituting the tax would be for the United States to give notice, consistent with the treaty itself and prior to July 2011, that the U.S.-China tax treaty will be canceled as of January 2012. The second step would be for the U.S. Congress to amend several sections of the U.S. Internal Revenue Code that ensure tax-free treatment of income derived from financial assets held by the Chinese government and other official Chinese entities. This amendment would allow the United States to impose a withholding tax at rates determined by the Treasury Department, so long as China's currency manipulation continued.
If other currency manipulators -- such as Singapore and Taiwan -- do not absorb the implied lesson, their bilateral tax treaties with the United States could also be canceled and the amendment applied to them as well. Thanks to years of experience at combating money laundering and terrorist financing, which involves far smaller sums than the trillions of dollars that China has invested in U.S. financial assets, the U.S. Treasury Department should have no problem tracking and identifying any attempts at evasion.
Given the long U.S. history of investor-friendly policies and the targeted nature of this measure, the climate for direct foreign investment in the United States is unlikely to suffer. Nor would the new policy discourage financial investment from countries that maintain reasonable currency regimes. In fact, Chinese officials and other currency manipulators may well change their harmful practices while the United States is working through the mechanics, long before a withholding tax is actually imposed. Lastly, such a tax would have two important advantages over other measures that have been proposed to stop currency manipulation: it would not violate international rules, and it would work.