The Pegging Of China Yuan And Us Dollar Economics Essay

Introduction

For the past 30 years, China’s have changed their economy which from a centrally planned market system which didn’t encourage the international trade to the more open-market orientated. The main idea of open market system is to encourage more Foreign Direct Investment (FDI) and also to develop their country private sector business. Since then China have become one of the major player in the world economy which in the recent year they are the second largest economy in the world lacking behind United States ( CIA, 2010). http://www.theodora.com/wfbcurrent/china/china_economy.html

The Pegging of China Yuan – US Dollar.

In the early days when China just about to open their market, they will need to find a good and better currency to maintain and stabilize their currency value. Therefore they find themselves a partner in hand which is the United States Dollar. In an article written by Brian Twowey ,by pegging the yuan to the USD in 1985, China able to increase the imports to U.S which totaling to almost $4million for the particular year. With the pegging system implemented, China has gain investor confidents in investing into their country. Without the peg, China’s economy rise will be much slower because the yuan is much considers worthless comparing with other leading economic country in the world (Twomey,n.d).

As pegging to USD proved crucial to the economy advantage for China, China government pegged their yuan to USD at the very low rate. This is because as other main economic nations using interest rates as their monetary tools, China uses their banks’ reserve requirement to price their currency. The Chinese government uses this policy because by increasing the reserve requirement serves to reduce the amount of currency in the economy, meanwhile decreasing requirement increases the amount of money available for used. This enable them to maintain their yuan/rmb steadily on a fixed exchange rate regime rather than allowing it to float freely on the open market or appreciate or depreciate based on interest rates (Twomey, n.d) http://www.investopedia.com/articles/forex/09/chinas-peg-to-the-dollar.asp

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Fixed- currency policy have help developing country like China to expand its exports while likely to distort the markets. The Chinese goods can attracts foreigners because they are cheap, not because that they are the best. By producing goods which is artificially cheap is unfair competitors to other country, argues critics generally. The China’s policies have caused a large appreciation of Euro against Yuan and create a situation where European firms unable to compete with Chinese’s low cost goods [6: FORBES 2010]

China pegged the yuan to USD in just over eight to the dollar. This action enables their exporter to understand how much of income they able to generate if they were to manufacture their product for foreign market especially for the U.S market. By applying pegged exchange rate system to Dollar, China attempt to attract new investment from overseas so that their competitiveness in the market can be increase. China has product almost everything from toys to most advance technology such as microelectronics (Bronson,2008).

Freezing the exchange rate also meant that the Chinese manufacturers wouldn’t worry about a weaker dollar, this is because it would easy for Chinese products to be sold to Americans, which indirectly allowing them to expand confidently. Mark Zandi, chief economist and cofounder of Moody’s Economy.com even mentioned that “China mercantilist approach is consider a normal approach for developing economies” . Indonesia and other developing countries also interfere with markets currency to influence the exchange rates. Even Switzerland , a developed country does this from time to time.[6: FORBES,2010]

Pre-2005 with Pegged Exchange Rate System

Since 1995, China pegged their currency, Yuan to Dollar with the exchange rate of 8.28 Yuan to a dollar for more than a decade (Lardy, 2005). Since that China enjoy many different benefits from labour cost to account surpluses.

Stabilization of price level

With a more stable currency exchange rate, inflation rate within the China is able to be control by government. Inflation rate is measured by Consumer Price Index (CPI). Inflation rate can cause harm to economic when it reached high level. Hence China have to ensure low inflation rate within country. Figure 1 show the inflation rate after China announced pegged exchange rate system.

Figure 1 Inflation rate and Changes in 1-year Lending rate between 1995 – 2010

Source: TheStar Online (6 April 2010)

Research has been done by Ghosh et al (1996) and found that there are strong link between fixed exchange rate system and inflation rate. In order to achieve low inflation, China has to induce greater policy discipline and increase the confidence level of their currency.

With lower inflation rate, confidence on holding China’s currency will increase as well. Compare with other countries that applied other type of exchange rate system such as free floating system may not be able to get lower inflation rate as shown in Ghosh et al (1996) research.

Market uncertainty (http://sedlabanki.is/uploads/files/mb001_6.pdf)

Fluctuation of currency in market can create uncertainty and risks for those who have their operation center or production plants in China. By imposing fixed exchange rate where the rate will not be change or determine based on market forces, most of the risks can be removed and provide confidence to businessman when conducting business in China.

The Unpegging with U.S

In the year 2005, China has officially removed their dependency towards USD, and hence the yuan become gradually stronger. From the previous 1 USD – 8.35 yuan to about 1USD- 6.8 yuan which shows that they are virtually pegged to the USD[6:FORBES,2010]. And based on an announcement from the People’s Banks Of China, the exchange rate will be made in the reference of a basket of currencies. They also mention that it is marked the introduction of a more flexible mechanism for the exchange rate formation.[13 Reuters, 2005]

While Chinese leaders have been denying they manipulate the currency as letting Yuan becoming stronger is one of their objective, majority of the Western experts says that the as the China policy will resumed during the financial crisis where the yuan will remain intact at 6.8peg. Mark Zandi believes that the yuan will appreciate 20 to 30 percent if it is being floated freely.[ 6 : forbes 2010]

The monetary policy implemented by finance minister Wen Jiabao have given China a trade surplus, where their exporting is more than its imports trade, it has given China huge reserves of foreign currency. This has given China advantage as they have invested much of these earnings in the U.S. by purchasing securities issued by the Treasury and other government agencies. With all the purchases of bonds and trades, China is borrowing money to the U.S, helping the country to support its substantial budget deficit and also growing debts. High demands from China raise up the prices of fixed-income securities while maintain low interest rates, where prices and rates move toward different directions. For instant, this has made it cheap for U.S government to borrow, and helped them to keep rates down on the mortagages and other consumers’ loans. The Chinese yuan and trade policy has also helped to push up U.S economy, and help out others as they needed it badly. [6: Forbes 2010]

An “ANCHOR” During the crisis

When the global financial crisis that hit worldwide especially US stockmarket in 2008, China has halted their three years policy of giving yuan to strengths. To some degree, China have been correct in analyzing the trend of the financial situation. They have been playing very important role in ensuring stability during Asian crisis that happens in the 1990s, nevertheless they also providing stability in this current crisis as well. This can be viewed as a kind of anchor to the global financial system, as China is regarded as the first country to start recover from the financial crisis. [6:- forbes 2010]

Mark Zandi agreed that Krugman’s calculation by maintaining yuan undervalued about to costs 1.4 million American unemployed. Now it appears that the worst of financial crisis is coming to an end, reducing their high unemployment would be the top priority in the U.S. Hence the complaints about China’s currency practices, as well as their trade surplus will continue to rise.

Even if the U.S and other Western countries are able to “forced” China to change their monetary policy, rushing it to happen could backfire. According to Allen, China could reinforce their yuan by selling their currency reserves, but selling vast amounts of U.S securities will drive the securities prices down, with raising the interests rates. This will directly cause U.S long-term problems because if the rates went up even by 1% or 2%, U.S will not be able to finance its deficit and debts where it is very expensive for them to do so. therefore consumer borrowing rates will rise as well.

By having all these enormous foreign currency reserves China have gain great political advantages. As quoted by Allen, ” It means that when president Barack Obama goes to China, he will need to be careful of what he is going to says as he can’t go as straightforward as he want because China government will start selling the reserves and that will affects the value of dollar and cause massive, as well as high damage problems for U.S.

The Domestic Downside of Unpegging from USD

A Wharton management professor Marshall W.Meyer even mentioned that the China’s Exporter has enjoy benefits from weak-Yuan policy but it is bringing negative impact towards their own people. He also quoted that China would need to be more productive, but they couldn’t do it without investing on their people welfare and needs.

Keeping the yuan at a lower par value will requires some locking on the foreign currency reserves such as in Treasury securities rather than in domestic needs such as in education, health care and other macroeconomics issues. Social needs will increase the productivity of the country as the Chinese population ages, which they estimated will reduce the workforce by about one sixth 1/6 between 2015 and 2045. Currently as China economy is depending on low-cost exports while if a vice versa case it will need to emphasize more on domestic consumption for developed economies. Which that will require more imports that will benefit from a stronger yuan.

Another potential downside for China, mentioned by Ken Smetters, professor of insurance and risk management based on Wharton, is that they will face the risk of suffering big losses on the U.S Treasuries and also the similar instrument which they purchased with currency reserves. This is because most of the securities is being bought at a low interest rates, and those securities will lose their value when the world’s economic recovery which will cause the rates to go up.

Inflation which unusually in recent years, is likely to raise as U.S government prints out money to pay down its debt, where in effect China will have paid premium for U.S securities which will be paid back with USD which is worthless. This causes them to be paying at inflated prices, which is a bad deal for any investor.

Another reason to change for China to change it’s currency policy:- is to curb their currency reserves. They is gradually moving their reserves into securities with shorter maturities for easier profit gain , which are less vulnerable towards the rising interest rates and inflation threat. [6: forbes 2010].

As for China, even though they are growing rapidly, it is just because of their stimulus measures. Their reluctant to revaluate the weak-yuan policy proves to be difficult although it may be necessary is because it will worsen their employment problems. This will also caused the collapse of exports during the recessions. [ 6 :- forbes 2010]

The Approach Based on Adjustment of Global Payments Imbalances

http://books.google.com.my/books?id=Ka7rmHFt9eIC&printsec=frontcover&dq=Debating+China%E2%80%99s+Exchange+Rate+Policy&source=bl&ots=IKpTuLDz-D&sig=heqoeFMKPRsWH83grXFGYfdy9q8&hl=en&ei=GQjLS5iKFYHDrAf689i_BQ&sa=X&oi=book_result&ct=result&resnum=4&ved=0CBEQ6AEwAw#v=onepage&q&f=false (Goldstein and Lardy, 2008)

http://www.ifri.org/files/centre_asie/AV7_FanGang_US.pdf (Fan Gang 2008)

In order to solve Global Payments Imbalances, Fan Gang (2008) has suggested that China should adopt large scale of currency adjustment even this action will cause high unemployment if such action able to resolve their such large amount of imbalance.

Yet the problem remain unsolved as China currently involved in international currency system where Dollar as their base. If the value of Dollar keep on devaluing, even China adopt even larger currency adjustment, US will still facing large account deficit.

Besides that China cannot ensure that job opportunities will return back to US after they take large scale of adjustment. Those workers that lost their job may go to nearby countries such as Vietnam (Goldstein and Lardy, 2008)

Fan Gang (2008) expected that if China adopts such massive currency adjustment, US will require them to adopt another massive adjustment when Dollar faced second devaluation. By taking such action further on, China’s economy will not be able to growth but damaged badly in order for China to satisfy US Congress’s request.

IS CHINA “MANIPULATING” THE RENMINBI?

http://www.cfr.org/publication/21902/is_china_a_currency_manipulator.html (Wolverson, 2010)

Currency “manipulator” topic has become the hot topic among experts since US proposed an annual report on whether to label China as a currency “manipulator”. Some experts say that China is not while some stated that China is a currency “manipulator”.

According to an interview between Wolverson (2010) and six experts, Stephen Roach, chairman of Morgan Stanley Asia citied that US Treasury report is to prolong the denied of US major role in aiding destabilizing global imbalance. Many of US citizens didn’t save their income. According to a report, the net national save rate has dropped below zero, a record low of negative 2.5% compare to 2009.

It mean that US citizens spend most of their income in purchasing goods and services which caused the import of US increasing every year. They spend more than what they earn through working and consumption level in US increasing as the credit is easy to get with low interest rate.

Another expert, Albert Keidel, a senior fellow of the Atlantic Council stated that the caused of China trade surpluses. There two main reasons, first is US over-spending global bubble, taking large trade surpluses from other countries, not only China. Second reason is China tried to fight inflationary over-investment after the deadly SARS spread out in China. Hence China’s machinery import slowed down while US over-spending bubble maintained the same level.

Therefore China’s surpluses surged. From the statement we can say that China’s exchange rate didn’t caused trade surpluses.

WOULD A 15 TO 25 PERCENT APPRECIATION OF THE RENMINBI BE IN CHINA’S

INTEREST AND IN THE INTEREST OF THE REST OF THE WORLD? WHAT WOULD

BE IN CHINA’S INTEREST?

Banking Reform

China needs to restructure their banking system by carefully examine those borrowers’ creditworthiness. Recent year where large amount of loans have been made to public for development but yet those capital didn’t went into that particular industries and was used in speculating stock market. Hence increase the nonperforming loan.

Therefore China’s government should take strict measurement such as tighten the requirement for bank in making new loans, strict requirement on borrowers before giving out the loans and so on. Recently China’s government imposed quarterly stress tests on mortgages that given out in order to clamp down nonperforming loans and rein real estate speculations (TheStar, 2010).

Besides that, central bank has taken several actions such as sales of securities to commercial banks, ie open market operation in government bonds or sales of government’s bills in order to reduce the liquidity of monetary base. This so called sterilization operation.

Pursuit of Price Stability

China has to maintain low inflation rate as the level of income earned by China’s citizens just passed $1,000. Hence they will feel the pressure of not enough money to buy goods and services when the inflation rate almost hit double digit. Hyperinflation and upsurge of inflation rate that reached over 20% has become the reminder for China’s government to maintain their inflation rate at reasonable level.

Hence adjustment of nominal exchange rate could help them achieve their objective. Significant evidences have shown that massive increase in monetary aggregates and potential risk of inflationary. Yet these will harm their banking system.

Continued Secure Market Access for China’s Exports

China becomes the major trade partner with certain top countries such as US. Besides that, China has to maintain their unemployment rate in low as to ensure social stability. Hence revaluation of Yuan can cause effects on China’s trade account as well as their local employment.

Finally China has to determine whether to maintain their low exchange rate or to increase their market competitiveness and increase the export. Maintain their exchange rate regime will caused harms such as inflationary and domestic financial unstable.

A High and Sustainable Rate of Economic Growth

Main contributor to high and sustainable rate of economic rate is unsustainable rate of credit boom in China and export. Very soon China will implement their monetary policy by strengthen their interest rate but such policy will harm their economy growth.

Based on experience on 1990s, a revaluation on Yuan will not slow down the performance of China. Besides that China’s high saving rate, ‘openness’ economy, increase of unskilled and skilled workers, and the ability to move thousands of workers from low productivity to higher production line.

Lastly China’s Yuan revaluation will focus on what type of policy changes to strengthen the local demand. Financial intermediary’s improvement can strengthen current banking system of China. With the help of domestic virtue, a more flexible currency regime and toward more open capital account can be achieved. Yet continued undervalued currency and export focus growth are likely will lead to more international tension with it’s partners.

WHAT KIND OF CURRENCY REGIME WOULD BEST FACILITATE AN

APPRECIATION OF THE RENMINBI?

There are four alternatives have been suggested by Morris (2004):

Go-Slow Approach

China makes changing in small scale in several areas such as trade, taxes, and capital account. Central bank may consider undertake small revaluation of currency for 2 – 3% changes or adopt exchange rate band by shifting to a basket of currency rather than pegged in Dollar.

By applying exchange rate substitutes, several matters can put under consideration:

Reduction in VAT export rebate.

Promote more on tourist expenditure on aboard.

Permit bank to issue more Dollar-dominated bonds.

Reduction in foreign exchange earning.

Allowing more outward investment with fair treatment.

Permit local citizens and certain financial institutions to purchase limited amount of foreign securities.

This approach is able to reduce the amount of damage that can be caused on China’s trade especially export, inflow of FDI and short-term growth. But if the revaluation of Yuan is around 15 – 25% then this approach may not applicable as it likely unable to remove the disequilibrium.

Go-slow approach may only increase the inflow of FDI as the speculators may assume that small scale of changes will lead to larger exchange rate appreciation. Hence it will not reduce the massive expanding of lending or monetary aggregate and will not reduce the domestic financial instability.

Open Capital Markets cum a Floating Exchange Rate

China has expanded their financial integration globally and tends to increase the integration. Hence China needs to adopt a more flexibility exchange rate where they can make its monetary policy more independence for stabilization purpose.

With current situation of China, if central bank removes the barriers on restricted outflow of capital, large or massive amount of capital will flow out of China within few hours and caused the banking system to collapse. This will lead to sharp depreciation of Yuan as well. Based on several experience on Asian countries, this will not be good news for China.

Floating Exchange Rate with Control of Capital Outflow

Introducing managed floating exchange rate while remain control on capital outflow. Basically it will eliminate the link between currency-regime decision and capital-account regime decision. Yet this may not suitable as the main concern is China may apply “too much management” with “too little floats”. If it is heavily managed, then the effects will be the same as go-slow approach where disequilibrium will not be remove and lead to serious damage on economy.

Two-Stage Currency Reform

Consist of two stages:

First stage:

Pegged the currency to a basket of currency

A revaluation of 15 – 25% Yuan.

A widening currency band (5 – 7%)

Remain control of capital outflow.

Second stage (after China stabilized its banking system):

Adopted managed float.

Through implementing medium size revaluation of Yuan, capital inflow and accumulation of massive amount of reserve can be reduced. As the result, external element of monetary base will not longer serve as cross-purpose (stabilization). At the same time, exchange rate policy will work perfectly with monetary policy and banking system as well. China central bank will have enough reserve to manage new parity.

Besides that, there are several reasons why China should adopt two-stage reform:

Overall stability of exchange rate can be enhancing.

Provide incentives to other Asian countries to follow the lead.

Greater experience on managing flexible exchange rate and improve financial institution at the same time.

Increase the independence of monetary policy.

Able to solve China exchange rate policy dilemma.

http://www.petersoninstitute.org/publications/chapters_preview/382/9iie3780.pdf (Morris Goldstein)