A reciprocity requirement: The easy and legal way to stop currency manipulation by Daniel Gros

Overall it seems that the rest of the world with free capital markets can do little to stop the Central Bank of the People’s Republic of China to continue "steering" its exchange rate by accumulating more and more international reserves - it does not matter whether these are US or Japanese. The US, Japan, or the ECB cannot do the same because China has capital controls and there are simply no significant renminbi assets that foreigners are allowed to invest in.
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But there is another way. The US (and Japan) could easily prevent the Chinese Central Bank from continuing its intervention policy without breaking any international commitment. The US and Japan only need to invoke the principle of reciprocity and declare that they will limit sales of their public debt henceforth to only include official institutions from countries in which they themselves are allowed to buy and hold public debt. Instead of the "moral suasion", tried in vain by the Japanese, the Chinese authorities would just be told that they can buy more US T-bills Japanese bonds only if they allow foreigners to buy domestic Chinese debt.

Imposing such a "reciprocity" requirement on capital flows would be perfectly legal - although the US (and Japan and all EU member countries) have notified the IMF that they have liberalised capital movements under Article VIII of the IMF. Yet, in contrast to the area of trade, there are no legal constraints on the impositions of capital controls.

This "reciprocity" measure would of course be equivalent to a very specific form of controls on capital inflows. Capital controls are always somewhat leaky, but not in this case because the Chinese Central Bank would find it difficult to hide its huge investments going through western financial institutions. No reputable financial institution would dare to become a hidden intermediary for the Chinese given that no institution bidding for hundreds of billions of T-Bill would take the risk of secretly fronting the Chinese government or central bank as it would have to certify that the beneficial owner is not from a country in which foreigners cannot buy and hold public debt instruments.

As a practical matter the introduction of the reciprocity requirement should provide a grand fathering of the existing stocks of Chinese official assets abroad (already above $2,500 billion). However, the Central Bank of China would still not be able to continue its interventionist policy - and that is what counts for foreign exchange markets.

(via Mark Thoma)

China does have capital controls unlike other countries. If the US blocks China and they in turn buy from Japan who has to in turn buy from the US, then we can block Japan also.

It's important to point out that the world economy is working under exceptional circumstances as Krugman continuously points out. There's too much savings and too much unemployment and not enough demand. China and Germany are exacerbating the problems with beggar-thy-neighbor policies.

Stephen Roach argues that China should adopt policies to boost its consumer spending. 

China’s gross domestic saving rate is 54 percent of national income, the highest in the world for a major economy. But its consumption share of G.D.P. is only about 36 percent, the lowest for a major economy and about half the 70 percent ratio in the United States.

I would therefore urge China to opt for aggressive and immediate pro-consumption structural policies. Stimulating domestic consumer demand would be a far more direct - and potentially a far less destabilizing - way of reducing saving and trade imbalances than a currency realignment would be.

These policies should include an expanded social safety net, with a public retirement program, private pensions and medical and unemployment insurance. China should also provide major support for rural incomes through tax policy and land ownership reform, as well as enhanced initiatives to encourage rural-urban migration. And it should encourage the creation of service-oriented jobs in industries like retail and wholesale trade, domestic transportation, leisure and hospitality.