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Macroeconomics

Assignment 2
Chinas Renminbi: Our Currency, Your
Problem?

Submitted to
Prof. Rezina Sultana

By
Group A5
Ajay Pratap Singh
Aman Pal
Kartik Saruparia
Manjeet Rathod
Sreeparna Das
Section: A
PGP 2014-16

On
08.12.2014

The Arguments of the Different Parties

Q.1 Recap the different arguments used by the U.S. and


Chinese governments about the renminbi.
I.

II.

US Government
According to the US government, Chinese Currency
exchange rate was not as per the market forces and it
should have appreciated over the years when the
Chinese economy had been growing at the rate of 9%
over the previous decade. China undervalues its
currency to maintain the value of its currency at an
artificially low value, which makes its exports cheaper
that have forced the American factories towards
bankruptcies.
China
Chinese government rejects USs allegations by
mentioning that its currency is not significantly
undervalued as pegging helps maintain a stable
economy. Also, as per China, capital inflow from China is
only partly responsible for large trade and budget deficit
of US and thus US should focus on the weakness of its
economy instead of treating China as scapegoat. Being
a sovereign country, China has all the rights to choose
its exchange rate policy.

Q.2 Why are Japan, the newly industrialized economies


(NIEs) and developing Asian countries less vocal than the US
on the valuation of the Yuan?
1

Unlike US and Europe, many Asian countries have kept


mum about this issue because of the concept of processing
trade. Processing trade refers to the business activity of
importing all or part of the raw and auxiliary materials, parts
and components, accessories, and packaging materials from
abroad in bond (to China), and re-exporting the finished
products after processing or assembly to the foreign
enterprise that are responsible for selling them.
Due to the cheaper Chinese currency, these countries are able
to generate high revenue while they re-export their finished
products to other countries. These countries have no major
benefit in the re-evaluation, moreover it is a risky measure as
they cant anticipate the future turn of events from the reevaluation and the consequences on their respective
economy.

Impact and Determinants of an Exchange Rate


Q.3

How does the exchange rate of a currency and its


volatility have a direct impact on the Economy?
Direct Impact of Exchange Rate of Currency:
Exchange Rate of Currency is one of the major determinants
of the Net Exports of the country, which constitutes a
significant part of the GDP.
I. If Exchange Rate of the country increases, then it makes
the exports of the country more expensive. This in turn
results in the less competitiveness of the countrys
exports in the Global Market. Consequently, the
countrys exports falls, net export falls and ultimately,
the countrys GDP takes a dip. The trade deficit
increases as a result of the Direct Effect. A higher
Exchange Rate decreases a countrys Balance of Trade.
II.
On the contrary if the Exchange Rate of the country
decreases, or the currency depreciates, then the export
of the country becomes cheaper and more competitive
in the Global Market. This in turn increases the countrys
exports, Net Exports and ultimately increases the
countrys GDP. The trade deficit of the country increases
as a result of the Direct Effect. A lower Exchange Rate
increases the countrys Balance of Trade.
The increased/decreases export of the company draws/loses
the foreign currency to/from the domestic economy and
increases/decreases the foreign reserve in the country.

Direct Impact of Exchange Rate of Volatility of Currency:


The Exchange Rate volatility introduces uncertainty in the
open market business.
For example, a country is export oriented like China, then a
sudden hit in the currency value would hinder its economy as
the main source of revenue, that is exports, becomes costlier
and the country loses huge unforeseen revenue, as no
country/business can be prepared for a sudden mishap in the
future speculations.
Following this uncertainty and consequent risk, the countrys
try to manage exchange rates in several ways; as China and

various other Asian countries used to do in the previous


decades by pegging their currency to US$.

Q.4

How is the Exchange Rate of a Currency determined?

The Exchange Rate of a country mainly depends on the trading


relationship between two countries. Exchange Rates are mainly
relative and they depend on several factors as described below:
I.

Differentials in Inflation
If a countrys inflation is increasing then the purchasing power
of its currency reduces at both domestic and global level. This
in turn translates in the increased exchange rate of the
currency, as relatively it depreciates with respect to the
trading partner countrys currency. The currency in such cases
would depreciate until its purchasing power matches with the
currency of the trading partner country.

II.

Current-Account Deficits
A deficit in the current account shows the country is spending
more on foreign trade than it is earning, and that it is
borrowing capital from foreign sources to make up the deficit.
In other words, the country requires more foreign currency
than it receives through sales of exports, and it supplies more
of its own currency than foreigners demand for its products.
The excess demand for foreign currency lowers the country's
exchange rate until domestic goods and services are cheap
enough for foreigners, and foreign assets are too expensive to
generate sales for domestic interests.

The Valuation of the Yuan


.

Q.5 Analyze the different components of the Chinese


balance of payment.

Chinas balance of payments is made of two factors as described


below:
Capital Account:
This account is maintained of the capital inflows and capital
outflows. PBoC invested largely in US Treasury bonds, which
was considered to be a risk free investment and giving a lowreturn. This was done to maintain the exchange rate of Yuan.

These bonds accumulated to US $1.2 trillion by the end of


March 2007. This has helped US in stabilizing their economy
by maintained interest rates.
Current Account
This account is maintained of the export of goods and
services, imports of goods and services and exchange of
unilateral receipts. China has a huge current account surplus
of $177 billion in 2006.

Q.6 Do you think the Yuan is undervalued against the US


dollar? How can China maintain the exchange rate of the
Yuan?

We believe that Yuan is still undervalued, as the Chinese


Governments policies for not letting the currency float is the major
determinant of the trend. This is evident from the Chinese Govt.s
regular purchase of US Bonds to increase the US$ reserves to
massive US$1.2 trillion. According to the BigMac Index, which is an
indicator of whether the world currencies are at their correct level or
not, the Yuan is determined to be 19% undervalued as of April 2013.
Q.7 Why does the Chinese government want to keep its
currency at an artificially low level against the US dollar?
Chinese government want to keep its currency value low level
against the US dollar in order to make its currency cheaper
and make its export products to be more competitive in the
US market. This will increase the domestic Chinese business to
help provide the employment to millions of farmers who are
migrating to Chinese cities in the search of a job. Hence even
though the Chinese GDP is increasing, they are trying to
maintain their Exchange Rate against all the external forces.
Q.8 Exchanging all of Chinas US dollars for Yuan can lead
to inflationary pressure. How does China avoid this risk?
This will increase the domestic money supply and in turn
would raise the high inflation. Therefore, Chinese government
would now allow such a measure. In order to avoid these
circumstances they were having strict legislative measures to
limit the foreign currency circulation. The foreign currency can
be traded only on Inter Bank Centralized Electronic Market,
the China Foreign Exchange Trade system. On daily basis, all

the banks have to maintain the reserve ratio. The Chinese


government invested all the foreign exchange reserves by
buying US treasury bonds. Moreover they would sell domestic
bonds to commercial banks in order to retract the increased
money supply in the China.
Q.9 Does maintaining a quasi-peg to the US dollar have a
cost for China? Does the policy of buying US Treasury
bonds have any negative impact on Chinas or the worlds
economy?
Maintaining a quasi-peg to the dollar is beneficial for China as
USA is its main trading partner and accumulating the currency
of the trading partner provides China more power over the
USA to pull strings in the future if required. It surely increases
the inflation, but PBoC curbs this speculation by selling the
Chinese Government bonds to the domestic market to reduce
money supply and reduce the consumption and increasing
price levels.
The measure has of course robbed Chinese government from
the opportunity of earning higher returns if the same money
were invested somewhere else; that is the negative effect of
the current Chinese Policy.

Q.10 Why, despite the huge US trade deficit, has the US


dollar not fallen? Do you think there is a risk of this
happening?
Even though USA experiences large trade deficits, due to the large
quantity of FDI, their capital account reflects a surplus. We know
that the foreign exchange rate depends on the overall balance and
not the individual trade balance. The deficit in trade account is
compensated by the surplus in the capital account. And thus the
overall balance shows a surplus. Hence, even in face of trade
deficit, the USA currency remains strong and will continue to
remain strong for quite sometime.

The Impact of Re-evaluation


Q.11 What would be the consequences of a revaluation for
China, western countries, Japan, NIEs and developing
countries?

Chinas Yuan revaluation would result in the increased


competitiveness of Chinese Export, that would result in the
decreased export and hence the decreased GDP of China, as a
direct Impact. It can also result in increased unemployment in
China as the expensive exports would show a gradual reduction in
Chinese cross border business.
Japan, NIEs and developing countries can prosper on this situation,
as they would be sought as the next production destination. This
would increase their net exports and in turn GDP. The Balance of
Payment and Current Account Deficit would also improve because
of the same. All these countries economy will grow significantly in
case the Chinese currency gets re-evaluated.
USA and other Western Countries will be benefitted from the
situation, as the re-evaluation of the Chinese currency will reduce
their current account deficit. But as the intermediary goods
production would become expensive in China they would later
have to find a solution for it. They can find a different country for
the production and reduce their dependence on China. In a way,
these countries can wipe their slate clean till certain level in terms
of their Balance of Payment.