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Post-Hearing Submission of Metals Service Center Institute (“MSCI”) Concerning Aluminum: Competitive Conditions Affecting the U.S. Industry _________________ ITC Investigation No. 332–557 October 7, 2016 The Metals Service Center Institute (“MSCI”) respectfully submits the following responses to questions posed by the International Trade Commission at the September 29, 2016 hearing in the above-referenced proceeding. Executive Summary 1. Response to question posed by Commissioner Broadbent regarding currency manipulation: It is MSCI’s position that the Chinese currency is significantly undervalued and that the Chinese currency policy has been in place for nearly two decades. We demonstrate that the actual yuan-dollar exchange has persistently differed from the equilibrium exchange rate. We document that the policy has led to the Chinese accumulation of over $3 trillion in foreign exchange reserves, an amount that is 8-9 times the level that economists suggest is needed for financial stability. We show that the Chinese reserves exceed those held by the next five largest countries combined and that China’s mercantilist exchange rate policy has caused massive current account surpluses for China and huge bilateral trade deficits for the U.S.. 2. Response to question posed by Commissioner Pinkert: “[O]n the question of currency manipulation, can one define currency manipulation without looking at flows of capital between countries?” The key issue is whether a country has a large current account surplus and is actively buying foreign currencies to prevent appreciation and maintain that surplus. There is little doubt that both are true for China, not just in the more recent 12 months but consistently for nearly two decades. It is the long run, persistent distortion of the exchange rate that has been particularly damaging for U.S. import competing industries. The Chinese mercantilist approach toward the exchange rate has caused serious damage to U.S. firms and workers. Discussion 1. Response to question posed by Commissioner Broadbent regarding currency manipulation: It is MSCI’s position that the Chinese currency is significantly undervalued. The manipulation is not a new phenomenon. A weak currency has been the policy of the Chinese government for nearly two decades. The magnitude of the undervaluation and the duration of the policy mean that the yuan-dollar exchange rate must be considered manipulated. While the Chinese exchange rate policy distorts trade with all its trading partners, it is particularly damaging to the U.S. because the yuan is explicitly pegged to the U.S. dollar. The impact of the Chinese policy on other countries is tempered because their currencies can adjust vis-à-vis the U.S. dollar. This adjustment partially offsets the distortion created by China. By contrast, U.S. import competing firms experience the full impact of the distorted exchange rate. U.S. policymakers must hold our trading partners accountable and address the resulting harm to U.S. workers and manufacturers. Before documenting China’s long term exchange rate distortion, we want to comment on our use of the term “manipulation”. The meaning of the word “manipulation” is open to dispute. We understand the Treasury Department has its own procedure for labeling a country a “currency manipulator,” and we also recognize the great political pressure on Treasury to avoid using the term. Treasury’s trepidation, however, does not change the reality that the yuan has long been, and continues to be, significantly undervalued. Even a cursory look at the long term exchange rate, capital flows, and current account imbalance makes it clear that market forces are not in play and the heavy hand of government control is being exerted. If the effects of the Chinese policy were limited to within its borders, then one might accept such a massive government intervention. But, that is not the case when we are talking about the exchange rate. Purposeful and persistent undervaluation of the yuan amounts to a government-created competitive advantage for Chinese exporters, puts U.S. firms and workers on an uneven playing field, and is inconsistent with the principles of free and fair trade. In 1977 the IMF stated that members should “avoid manipulating exchange rates or the international monetary system in order to prevent effective balance of payments adjustment or to gain an unfair competitive advantage over other members.” 1 IMF, Surveillance Over Exchange Rate Policies, Dec. No. 5392-(77/63) (Apr. 29, 1977), in IMF, Annual Report 1977, pp. 107-108 (1977). 1 -2- Unfortunately, the IMF did not formally define how one would measure or define what constitutes “manipulation”. We do not take issue with the three criteria used by Treasury to identify manipulation: bilateral trade surplus, material current account surplus, and persistent, one-sided intervention. We take issue, however, with Treasury’s narrow measure of “persistent”. Under Treasury’s approach, persistent is limited to the most recent 12 month period. The following common sense definition of currency manipulation captures the essence of the issue: Currency manipulation occurs when a government buys or sells foreign currency to push the exchange rate of its currency away from its equilibrium value or to prevent the exchange rate from moving toward its equilibrium value. The equilibrium value of a currency is that which is sustainable over the long run. An exchange rate is sustainable if the current account balance is not generating an explosive path for net foreign assets relative to both domestic and foreign wealth. Sustainability generally implies a small value of the current account balance. 2 Under this definition it is clear that China has engaged in currency manipulation for many years. First, the yuan is not near its “equilibrium value,” nor has it been for at least two decades. Second, the yuan-dollar exchange rate is not sustainable, as Chinese reserves have exploded – growing from less than $1 trillion to over $4 trillion in a ten-year period. And third, China’s trade balance vis-à-vis the U.S. is enormous, averaging well over a $300 billion surplus annually. We now elaborate on these three key elements of currency manipulation. The Yuan is Massively Undervalued What is the “equilibrium value” of the yuan-dollar exchange rate? Economists most commonly use the concept of Purchasing Power Parity (“PPP”) as the benchmark exchange rate. The PPP captures the long-run tendency for the exchange rate to imply that a market-basket of goods is priced equivalently in the two currencies. 3 Said differently, the PPP exchange rate means that, on average, Chinese goods would not be systematically underpriced relative to U.S. prices. Joseph E. Gagnon, Combating Widespread Currency Manipulation, Peterson Institute for International Economic Policy Brief, PB12-19, July 2012, pp. 1-2. 3 Robert C Feenstra and Alan M. Taylor, International Economics, Worth Publishers, 2008, Chapter 14. 2 -3- Discrepancies from the PPP are common in the short run. However, in the longer run market based exchange rates move to the PPP exchange rate. How quickly the convergence occurs is one sign of a market-based exchange rate system. The common view is that the “half-life” of a misalignment is three to five years. 4 As we will show, the yuan has been massively undervalued relative to PPP for a long time, and the conventional 3-5 year half-life adjustment finds no support in China’s exchange rate history. Figure 1 below depicts the persistent and substantial difference between the actual yuan-dollar exchange rate (solid line) and the PPP benchmark (dashed line). The enormous deviation of the actual exchange rate from the PPP benchmark is evident in the chart. The data make it clear that the deviation is not just large but persistent. There is little evidence that the deviation will be resolved in any reasonable time frame (i.e., the half-life of the yuan misalignment is measured in decades, not years). Figure 1: Yuan-Dollar Exchange Rate (Actual vs. PPP)5 9 8 Yuan-Dollar Exchange Rate 7 6 44% appreciation in Yuan still needed 5 4 3 2 Actual Exch. Rate (Yuan to US$) PPP Exch. Rate 1 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 The figure shows the yuan-dollar exchange rate was fixed at 8.27 yuan to the dollar Kenneth Rogoff, “The Purchasing Power Parity Puzzle,” Journal of Economic Literature, 34(2), (1996), pp. 647-668. 5 International Monetary Fund, World Economic Outlook Database, October 2016. 4 -4- through the end of 2004. Whether 8.27 is undervalued or overvalued depends on what the equilibrium or benchmark value is. As shown, at that time the PPP benchmark was 2.9. This means the yuan was undervalued by 67%. Due to pressure from the United States and other trading partners, the Chinese began to adjust their exchange rate beginning in 2005. By the end of 2015 the exchange rate was 6.28 yuan to the U.S. dollar. While the Chinese have moved in the right direction, they are far from equilibrium, and the progress is glacial. As of the end of 2015 the benchmark PPP was 3.5. This means the yuan is still undervalued by 44%. We have several comments on the extent of the distortion. First, the modest adjustment that has occurred over the past decade hardly exonerates the Chinese from being considered currency manipulators. If anything, it confirms the Chinese government’s orchestrated intervention. The exchange rate movement was not a result of market forces but rather purposeful political decision by the Chinese government. Second, the yuan remains substantially undervalued. The Chinese exchange rate policy gives its firms an immense pricing advantage. Even if all else were equal (i.e., no other Chinese government subsidies to its producers, no other distortions to input prices, etc.), Chinese firms would, on average, be able to undercut U.S. prices by 44% simply because of the exchange rate. This is unsustainable and harmful to U.S. firms. The U.S. aluminum industry is the best in the world and can successfully compete in the global marketplace given a fair and even playing field. The Chinese government’s persistent intervention to create a systemic pricing advantage has demonstrably and materially harmed U.S. firms and workers. Third, the additional adjustment required to bring the yuan exchange close to a market benchmark is huge. Assuming no change in Chinese government policy, the current rate of adjustment implies the yuan will not approach PPP for another 20 years. This forecast is unsustainable and will devastate the U.S. aluminum industry and all U.S. manufacturing. China’s Mammoth Foreign Exchange Reserves To push down the value of its currency, the Chinese government has sold yuan to buy dollars. Consequently, the Chinese government must hold the foreign currency acquired in the form of a foreign financial asset, typically a bond or a bank deposit. Currency manipulation can be measured in terms of the net cross-border flow of financial assets held by the official sector. Official purchases of foreign assets, or net outflows, push down the value of a currency. Figure 2 below depicts China’s massive foreign exchange reserves. In 2003 China was adding about $10 billion a month to its reserves; by 2010 China was adding -5- more than $30 billion a month. This massive intervention led New York Times columnist and Nobel Prize winner Paul Krugman to state that China’s policy “is the most distortionary exchange rate policy any major nation has ever followed”. 6 Figure 2: China Foreign Exchange Reserves (excluding gold) 7 4,500 4,000 US Dollars (Billions) 3,500 3,000 2,500 2,000 1,500 1,000 500 Jan-00 Jul-00 Jan-01 Jul-01 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14 Jan-15 Jul-15 Jan-16 Jul-16 0 While the Chinese reserves have fallen recently, the fall hardly exonerates China, nor does it disprove that it is manipulating its exchange rate. To begin with, the decline must be kept in perspective. Even after the recent fall, China’s current reserve level is larger than when Krugman declared it the most distortionary exchange policy in history. While some level of foreign exchange reserves are responsible and facilitate financial stability, China’s current levels vastly exceed what experts suggest are necessary. The Greenspan-Guidotti rule recommends that countries hold foreign Paul Krugman, “Taking on China”, New York Times, March 14, 2010, at http://www.nytimes.com/2010/03/15/opinion/15krugman.html?_r=0, October 5, 2016. 7 International Monetary Fund, Total Reserves excluding Gold for China, retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/TRESEGCNM052N, October 5, 2016. 6 -6- exchange reserves (i) equal to 100 percent of their short term external debt 8 and (ii) equal to three months of imports (or exports). 9 China’s foreign exchange reserves are at least 8 to 9 times larger than either of these benchmarks. 10 In other words, the level of China’s foreign exchange reserves cannot be explained by conventional economic rationale. More perspective on China’s outsized foreign exchange reserves is found in the following chart (Figure 3). As of mid-2016 China still has nearly three times the foreign reserves as the second largest country, Japan (a country that is also often considered a currency manipulator). In fact, as of mid-2016 China has more reserves than the next five countries (Japan, EU, Switzerland, Saudi Arabia, Taiwan) combined. Olivier Jeanne and Romain Ranciere, The Optimal Level of International Reserves For Emerging Market Countries: A New Formula and Some Applications, IMF Working Paper 06/98, 2006. 9 International Monetary Fund, Assessing Reserve Adequacy, Paper prepared by the Monetary and Capital Markets, Research, and Strategy, Policy, and Review Departments, February 14, 2011. 10 Joseph E. Gagnon, Combating Widespread Currency Manipulation, Peterson Institute for International Economic Policy Brief, PB12-19, July 2012. 8 -7- Figure 3: Comparing Foreign Exchange Reserves (mid 2016) 11 3,500,000 3,000,000 US Dollars (Millions) 2,500,000 2,000,000 1,500,000 1,000,000 500,000 0 The only way China could have accumulated such a large stock of foreign reserves – nearly all of which is held by the government – is through large and persistent intervention in the exchange market. But for the Chinese government’s massive purchase of U.S. dollars (thereby keeping the yuan value low), the yuan would have strengthened long ago, and the foreign exchange reserves would have never reached their current level. Current Account Balances The third metric of a currency manipulator is a large current account balance. As seen in the following figure (Figure 4), China’s current account surplus has swelled over the past 15 years, growing from near zero to its 2015 level of over $330 billion. The contrast between China’s massive surplus and the U.S.’ large and persistent International Monetary Fund, Total Reserves, retrieved from Wikipedia, https://en.wikipedia.org/wiki/List_of_countries_by_foreignexchange_reserves#endnote_a, October 5, 2016. 11 -8- current account deficit is quite remarkable. The chart makes it clear that, as China’s surplus has soared, so too has the U.S.’ deficit. Figure 4: Current Account Balance, U.S. and China (annual) 12 The following chart (Figure 5) makes it clear that the U.S. has suffered from China’s currency policy. Over the past 15 years China has pursued a weak currency policy to promote its exports. This has directly impacted U.S. producers, who have struggled to compete against low priced imports facilitated by China’s exchange rate policy. The bilateral merchandise trade deficit with China has quadrupled since 2000. World Bank, World Development Indicators, retrieved from World Bank, http://data.worldbank.org/indicator/BN.CAB.XOKA.CD, October 5, 2016. 12 -9- Figure 5: Bilateral Trade Deficit, U.S.-China 13 Summing Up There is no debate that China has controlled its exchange rate in such a way to artificially lower its export prices. As the above discussion has documented, the yuan-dollar has long been significantly undervalued compared to its PPP benchmark. As troubling, there is little reason to think this policy will change in the near future. The consequences of the distorted exchange rate include a soaring U.S. trade deficit with China, lost jobs, and factory closings. U.S. Census Bureau, Trade in Goods with China, retrieved from Census, http://www.census.gov/foreign-trade/balance/c5700.html, October 5, 2016. 13 -10- 2. Response to question posed by Commissioner Pinkert: “[O]n the question of currency manipulation, can one define currency manipulation without looking at flows of capital between countries?” What matters is whether a country has a large current account surplus and is actively buying foreign currencies to prevent appreciation and maintain that surplus. There is little doubt that China has done both. In the above response to the first question, MSCI documented China’s massive and sustained current account surplus and its equally massive reserve of foreign exchange (see Figures 2, 3, and 4). On the specific issue of capital flow, government purchases of foreign assets are a type of capital flow. The IMF definition places a lot of weight on such purchases, but does not absolutely require them. There are scenarios where a government imposes very asymmetric capital restrictions (e.g., different rules for private outflows than for private inflow), so in general the IMF is cautious. We note, however, that in the case of China, the large capital flow is observed. Further, the Treasury Department’s decision not to declare China a currency manipulator warrants discussion. The Trade Facilitation and Trade Enforcement Act of 2015 (P.L. 114–125) (the “Act”) set forth three criteria that must be met in order to declare a country a currency manipulator under that Act: (1) a significant bilateral trade surplus with the United States, (2) a material current account surplus, and (3) engaged in persistent one-sided intervention in the foreign exchange market. Importantly, the enforcement tools provided in that Act are in addition to, and do not supplant, Treasury’s other tools to combat currency manipulation. MSCI documented in its pre-hearing submission and in the above response to the prior question how all three criteria in the Act were clearly satisfied. Treasury found that criteria (1) and (2) were both satisfied. Treasury’s determination that that criterion (3) was not satisfied is puzzling, given the massive stockpile of foreign exchange reserves China has compiled over the past 15 years. What is the disconnect? The answer lies in the very short time window Treasury chose to use to assess persistent. In its report, Treasury limited its analysis to net purchases of foreign currency over a period of 12 months. With all due respect, MSCI strongly disagrees that 12 months is an appropriate period of time to measure “persistent”. MSCI’s position is that the longer time period discussed above in our prior answer more accurately captures the persistent nature of China’s intervention. MSCI has two additional comments regarding Treasury’s decision to not call China’s mercantilist control of its exchange rate “manipulation”. First, had the Act been in effect in 2000, Treasury would have identified China as a country engaged -11- in illegal exchange rate controls for most of the past 15 years. 14 The fact that it did not do so in its 2016 study reflects only the peculiarities of recent trends. It should not be viewed as an exoneration of China’s longer run policy. Second, we understand that for many policy-makers “currency manipulator” is a politically loaded term full of policy implications that could complicate many aspects of the U.S. relationship with China. We do not believe the ITC needs to explicitly use that term in order to acknowledge the fact that China has controlled its exchange rate in a highly mercantilist fashion for more than 15 years. The consequences of that policy have been felt across the entire U.S. manufacturing sector, and most particularly in the aluminum industry. C. Fred Bergsten and Joseph E. Gagnon, The New U.S. Currency Policy, April 29, 2016, at https://piie.com/blogs/realtime-economic-issues-watch/new-us-currencypolicy. 14 -12-