IFT PROJECT

IS THE CHINESE YUAN READY

FOR REVALUATION?

Submitted By-
Eklavya Gogia (09BSHYD0269)
Jayant. K. Agarwal (09BSHYD0334)

Date- 07 September 2010

ABSTRACT
This policy paper intends to focus on the burning issue of whether the Yuan is ready for a
revaluation and what are the merits and demerits of the same. At the same time it also studies
that who actually benefits and who losses from the revaluation with an extra emphasis on USA
and China. Does the market of China support the revaluation of Yuan which has from long been
constantly pressurized by the developed nations to go for the revaluation?

Our analysis believes that the fundamentals of the Chinese economy are still not strong enough
to support the revaluation and a lot needs to be done to improve its financial and banking system.
The underdeveloped currency markets have a major role to play in implementing the free float
exchange rate system and the non availability of the same makes things more difficult for China.
Moreover the slow down in exports due to the recession and the lack of domestic demand are
also 2 factors that need to be looked upon before China decides to revalue the Yuan. Another
issue with China is it’s expansionary monetary policy and any tempering with same to correct
the exchange rate would lead to higher levels of inflation, something China has not seen in recent
times. The only alternate is the gradual revaluation as also been announced by the Chinese
authorities. From a long term perspective the Chinese system is structurally and fundamentally
not ready to let the Yuan float freely in the market. Though China has been a dominant part of
the global financial integration but the functionality of it’s capital markets is always under cloud.
Moreover it is commonly believed that the government is not very open in how it manages the
system at the top and is always reluctant to give the true picture of their state. Unemployment
could also be a consequence of the revaluation as decreased exports might force some of the
players to move away from China and being a global manufacturing hub, this would cause a loss
of several jobs which China might be unwilling to accept and logically so until and unless it
readies itself for some alternate form of employment. China has accumulated several US dollar
denominated assets and its reserves have swollen past 600 billion USD as a result it would not
like to depreciate their value by allowing a revaluation of the Yuan. But would this actually solve
the problem for the USA? Is Chinese revaluation the end of USA’s woes? The US manufacturers
claim that they are facing a big price war against their Chinese counterparts. They claim that this
would also help the USA reduce its trade deficit with China. But we don’t buy this. The product
profile of the Chinese exports to the US is of consumer utilities which US has always been
importing and will do so in times to come. If they stop importing from China they would do the
same business with some other country and all will be back to square one.

China to solve this issue needs to instigate domestic consumption and private investments. It
desperately needs to do some institutional and structural reforms. The financial and banking
system needs to be made more responsible and more efficient markets need to be developed.
Also acceptance of the Yuan as the international currency will play a dominant role in its future
and we are already seeing some steps by China to make it so. The policies have been dealt much
more elaborately in the text.
BACKGROUND
Chinese Yuan has been pegged with US dollar for many years. Today China is facing immense
international pressure to revalue or appreciate their currency Yuan. US is leading the way to
pressurize China to revalue the currency with dollar or move out from the peg it has maintained
with the dollar. Most of them believe that China has deliberately undervalued their currency
which has led to the global trade imbalance and thus its consequences. This paper aims to
examine whether the fundamentals of Chinese Economy are strong enough to move into a
floating exchange rate with dollar. Is China prepared for that policy? Is what we aim to discuss in
this paper. To begin let us take a backdrop of how the exchange rate system has worked in china
from the 1950’s till recently. China’s exchange rate policy in the 50’s and 60’s was mostly
determined by the nation’s geo-political, security, and strategic interests and economic
calculations played no or little role in the exchange rate determination. Starting 1970 the
exchange rate was fixed at 2.46 Yuan to a dollar when China substituted 10,000 renminpiao for
one renminbi. But after the collapse of the Bretton Woods system pressure grew on Yuan
revaluation and was thus revalued at 2.26 to a dollar. The rapidly depreciating dollar in the world
forced the china government to tie the Yuan to the Hong Kong dollar and the British Pound.But
this didn’t stay for long because of the rapid depreciation of the Hong Kong dollar./China in 74
finally decided to peg the Yuan to a trade weighted basket of 15 currencies. With the beginning
of the economic reforms in China markets were allowed to play a dominant role in the exchange
rate and starting 1981 a dual exchange rate system emerged where the official exchange rate was
complemented with the market determined exchange rate. The setting up of swap centers in 1988
in China helped to centralize all the foreign currency transactions of the exporters and importers.
But the Yuan again had to be revalued due to sharp appreciation in the currency and the official
rate was set at 8.7 Yuan to a dollar. At this point of time the exchange rate regime was defined as
a managed floating system. This was the time when daily fluctuation band for the Yuan was set
at 0.3%. The new rate remained stable till 2005 when it revalued the Yuan by 2.1% tom 8.11
Yuan per dollar and switched from a dollar–peg to a basket-peg and would allow for more
flexible floating of the currency. Since then the Yuan has appreciated against the dollar by a little
more than 7% and as of now the Yuan stands at 6.80 against the dollar.
LITERATURE REVIEW
1.Xiohe Zhang, School of Economics, The University if New Castle in his paper titled The
Economic Impact of the Chinese Yuan Revaluation has put on arguments on how and to what
extent the official rate of the Yuan should be further revalued. He has argued that due to the de
facto real appreciation of the Yuan relative to its neighbor countries since 1994, the
competitiveness of the Chinese exports have decreased and therefore would be very difficult for
the Chinese authorities to allow the Yuan to revalue considerably in the near future. The paper
also used a quantitative evaluation of several possible policy scenarios with respect to Yuan
revaluation through simulating a Multi – Country Macro-econometric model(The Fair Model).
The results of the simulation suggests the revaluation of Yuan to be not very useful to the
Chinese and expects further deflation, reduction in the competitiveness of China’s exports and
the reduction in the growth of GDP. It points out the adverse impact in terms of the decrease in
the Corporate Profitability, deflation in the agricultural sector specifically, increase in the
unemployment and also reduction in the foreign direct investment. It suggests the need of the
better and enhanced financial and banking system as a pre requisite for the Yuan to appreciate.
According to him the Yuan revaluation will have little impact on the trade balance of the US or
the global economy as the gap in the reduced Chinese imports in the US could be easily filled by
increased imports from other developing countries suggesting the lack of self sustenance of the
US economy.

2.Maria Maneula Neveda Decosta, Department of Economics, University of Wisconsin – Eau

Claire and Jenifher Ping Ngoh Foo, Finance Department, Stetson University in their paper
China’s Financial System: Two Decades of Gradual Reform examined the Chinese efforts to
transform its financial system to support an emerging market economy. IT focuses on the history
of the Chinese Financial system and shows the different stages of reform after 1984 when
People’s Bank of China was separated from other Commercial Banks which marked the
movement from a centrally administered monobank system to a diversified financial institutions
framework. Though the aim of the Chinese government was to carry out financial reforms that
could covert the planned economy into the market economy, their gradualist approach in reforms
methods did not help their cause. The paper believes that still the Chinese financial system is not
adequate enough sustain the growing economy. It is believed that the Chinese market reform in
the real sector has outpaced the growth in the financial sector. The core to financial system that is
the banking system is rife with problems such as pervasive linkages between the government
budget financing and policy lending, inadequate regulation and supervision of the financial
sector, lack of autonomy of People Bank of China and other banks and insufficient competition.
Despite of problems, China has been able to maintain economic growth due to the high captured
domestic saving (an average of 40% of the income is saved), low public debt and negligible
domestic debt, the inconvertibility of the Yuan and the large foreign exchange reserves. However
Chinese banks are vulnerable to domestic banking crisis from the expanding non performing
loans and the increased exposure to future external sources due to the WTO regime. The
financial and fiscal functions of the government should be distinct and though the control of the
monetary transmission channels have changed but still the basic administrative control and
mechanisms which are still prominent should be abolished for better future.

3.Abdol S. Soofi, Department of Economics, University of Wisconsin, USA in his article titled
“China’s exchange rate policy and the United State’s trade deficits” discusses the Chinese
financial and capital control reforms of recent years and can /should China go for a major Yuan
revaluation? The critics of China’s exchange rate policy claim that pegging of the Yuan to the
US Dollar is the main reason for the trade imbalances in favor of China. The author discusses the
Chinese perspective by arguing that the trade imbalance with USA is the result of productivity
differential between the 2 countries with exchange rate having little impact on the current
accounts of the 2 countries. Moreover the revaluation , if any, will have only a temporary effect
on the trade balance unless and until it is accompanied by deflationary monetary policy relative
to the USD. But China is least expected to pursue any such policy as it would lead to deflation,
low interest rates and a liquidity trap, much like the Japan way. Talking about the exchange rate
policy from the Chinese perspective, he questions if at all the revaluation would push the
Chinese authorities towards market based policies and if it would have a destabilizing impact on
the country’s financial system in the absence of a weak currency markets? He also mentions the
other socio-political factors and the effect on the agriculture of the country which stand s
hindrance to the Yuan revaluation. The other issue discussed is the sequencing of capital account
liberalization and floating ex change rate policies. In China’s case, the capital account
convertibility is being followed by flexible exchange rate regime but this has lead to speculative
inflows and inflation in the country. Moreover a flexible exchange rate is not possible till China
has a well developed currency market. This reflects a fundamental difference between the USA
and China. Towards the end of the article he validates the same with some empirical results.

4.Tomoyuki Nakagawa, in his paper “Internationalization of the Yuan” discusses the change
in international environment that surrounds the Yuan today with increasing capital inflows
combined with increasing current account surplus and huge FDI being the major 2. As a result of
which the forex reserves of China have swollen to the tune of more than 600 billion dollars. He
goes on to explain 3 major demand from the nations ton review its exchange rate policies and the
difference in the objectives of the three-1.Revaluation of the exchange rate (to reduce the current
account), 2. Switch to a floating exchange rate system and 3.To liberalize capital account
transactions. The objectives of the last 2 being that China should shoulders the responsibility of
the current trade imbalances in the world on account of its political and economic clout and push
China to a market based system. The author argues that the Yuan revaluation will only be of little
advantage to the developed nations like Japan and the USA and moreover it is very difficult to
define an appropriate level for the Yuan –Dollar exchange rate. The degree to which the Yuan is
devalued against the dollar is theoretically impossible. Even for international companies with
manufacturing and sales facilities in China it would be difficult to ignore the impact of
revaluation. Moreover the increase in exports from China have been more than 50% contributed
by the MNC’s that have set up facilities there, therefore a revaluation would lead to increased
processing and production costs at these manufacturing facilities. This would hence force these
multinationals to rethink their FDI in China and probably alter them. It is unfair for developed
nations to ask for a Yuan revaluation to protect their industrial sectors and maintain their
competitiveness with China.

5.Gary Becker professor of economics and sociology at Chicago university in his article titled
Should China revalue its currency talks about the two of the closely related economic issues-
the value of the Yuan and the huge assets accumulated by China, in the form of United States
Treasury bills and other US government assets. He believes that the USA has little to complain if
China wants to hold such high levels of low interest-bearing USA government assets in exchange
for selling inexpensive goods to the USA. China's willingness to save so much reduces the need
for the Americans and others to save more. China's huge levels of foreign assets put it more at
the mercy of American and other countries' policies. He argues that the exchange rate of 6.9
Yuan per dollar is considerably above a free market rate that would be determined in a regime of
flexible exchange rate, he therefore believes that China is intentionally holding the value of its
currency below the rate that would equate supply and demand. The developed nations believe
that greater demand from China for their exports, due to a revalued Yuan, will help them resume
sizable economic growth and reduce the high levels of unemployment as they recover from
severe recession. He is of the opinion that most Americans benefit rather than being hurt by a
devalued Yuan as China majorly exports consumer durable goods to the USA at a much cheaper
rate now which largely benefits the lower and middle income groups of USA. If the Americans
want to export more to China it would be less beneficial as they employ a lesser number of
people for the same capacity, leading to high unemployment numbers there. He recommends that
the USA should threaten to inflate some of the real value of its dollar-denominated assets and
inflation would lower the exchange value of the dollar, and also of the Yuan as long as it is tied
to the greenback. That would further increase the current account surpluses of China, and
inducing it to hold more US and other foreign assets.
ANALYSIS
We believe that the fundamentals of Chinese economy or the macroeconomic conditions are yet
not strong enough for Yuan to completely come in a floating regime. We would rather support a
gradual revaluation or appreciation of Yuan that the Chinese government has thought about. We
would like to support our argument in the short term and long term perspective and how Yuan at
present cannot be brought into a complete floating regime.

For the revaluation of Yuan in the short term period, we believe that their should be the
fulfillment of certain conditions like the sustained growth in the export (which is still not at the
peak achieved in 2007-2008), the further weakening of the dollar with respect to the Emerging
Market Foreign Exchange (EMFX), rapid increase in the domestic demand in China and also the
resurgence of high consumer price inflation.

China is a export based economy. With the recent financial downturn the Chinese exports did
suffer in the last couple of years as the majority of exports were to the US. Exports from China
have increased in the recent months, in absolute level but they are still far below the levels
reached in July 2008 when the Yuan appreciation was halted. Until and unless the exports reach
the previous level, the Chinese authorities would be reluctant to appreciate their currency which
would add further pressure on their export based industries.

Another important aspect could be the further weakening of the dollar. In recent times especially
from the first quarter of 2009 the EMFX has seen a rapid advance. If this shall continue
suggesting further weakening of the dollar, the Chinese Yuan can afford appreciation due to the
improved competitiveness. The political pressure from the emerging market would also increase
in this situation for China to revalue. However from the starting of 2010 the Dollar has regained
its position thus showing a negative sign for China.

One of the other important aspects would be the private consumption and there is less possibility
that the Chinese government would revalue the Yuan without seeing a robust growth in the
domestic demand. Though signs are there that the private consumption has started to increase but
suspicion arises whether they are to those levels which would be able to maintain the current
employment rate in the absence of a recovery of exports. Since it is a time consuming process the
possibility of Yuan getting revalued rapidly is less.

China from the year 2009 and early 2010 has pursued expansionary monetary policy or has
aimed at monetary expansion which is expected to continue in the late 2010 as well (though the
intensity is expected to reduce). This might result in the acceleration of consumer price index.
Thus if the PBOC comes with the tightening of monetary policy through the interest rate
mechanism, it could result in the increment of speculative dollar flows. This would result in a
requirement to print more Yuan to keep stability and thus further increase in the inflation.
However the inflation pressure on the Chinese economy till now has not been seen prominent or
threatening enough for the authorities to take those steps.
Even if we look at the long term perspective, for the Chinese Yuan to come into a complete
floating regime there is a long way to go. First of all the Chinese Financial System is very weak.
Though the whole world is reaping the benefits of rising financial integration but China is not
able to. The functionality of the capital market, the strength of banking and financial institutions,
the availability of financial instruments, etc are some aspects that do not support a strong Yuan.
The financial system is fully controlled. The financial system currently at place will not be strong
enough to handle the dynamics associated with floating Yuan.

Yuan appreciation might also result in huge amount of unemployment in China. Discouraged
exports would hit the Chinese companies with the problem of overcapacity and falling corporate
profits. Most of the dominant export industries are labor intensive. This would result in the
layoffs and reduction in the employment opportunities. Apart from that the industries were also
solving the problem of underemployment that was prominent in the rural parts of the country as
most were dependent on agriculture. Appreciating the currency might intensify the problem until
there is the availability of domestic demand to compensate for the lost business. Moreover
foreign institutions also have huge investments in these industries thus creating a possibility of
increase in the capital flight which in turn would affect the foreign exchange reserves negatively.
The appreciation might also result in increase flow of “hot money” to capitalize on the Yuan
revaluation, rather than long term investment on capital projects.

Another aspect that would not support the appreciation of Yuan would be the huge amount of
foreign exchange reserve that China has and also the foreign currency denominated asset. China
has foreign exchange reserve worth more than $600 Billion and most of them are in dollars. An
appreciated Yuan would definitely reduce the domestic value of those assets. In order to mitigate
the vulnerability associated with huge amount of dollar assets, Chinese government has indeed
started diversifying the reserves. They have started accumulating commodities like gold for the
purpose. Chinese government according to World Gold Council in 2009 had increased its gold
reserve to 1054 Tonnes which is 166% more than what it had in year 2000. But still it shall take
time for China to diversify completely from the dollar denominated assets or to a safe level when
it can allow the Yuan to float fully.

The appreciation of Yuan might also result in the possibility of deflation in the Chinese
economy. Chinese has suffered from prolonged years of falling prices for many years since 1994.
Deflation further can produce a lot of problems like shrinking investment and consumption,
rising jobless rate and mounting bad loans which could further hit the banking system hard. It
shall also further affect the domestic demand negatively as consumers expecting further price
declines may choose to defer consumption. If we see the real cost of capital also increases and
returns decreases as a result the investment is curbed further having further negative impact to
the economy.

Many economists today around the world are pressurizing Chinese Authorities to appreciate the
Yuan to overcome the problem of global trade imbalance or more focused on the US trade
deficit. Generally we might assume that with an appreciated Yuan, the export for US would be
competitive and import would be costly due to the revaluation however, in the short run,
appreciated Yuan would increase the cost of imports thus negatively affecting the trade deficit.
In the long run however we can imagine the amount of import to US from China to decrease.
Since US is more dependent on Chinese products than the Chinese depending on the US
products the impact to China will be less. US do not produce what China wants and thus the
trade deficit of US with China might reduce but a complete recovery of it to surplus is
questionable. Most of the exports that from China to US are from industries which has US
investment and mostly done for only take advantage of the cost efficiency. Thus with an
appreciated Yuan, this shall increase the prices of goods in US and thus more consumption. I
think it is the increment of saving in US that would be more detrimental to correct the imbalance.
An immediate appreciated Yuan might not be that conducive to the US as well. As a whole we
believe that the problem of trade imbalance cannot be solved only from the narrow focus on
exchange rate mechanism rather some broad aspects that includes the medium and long term
structural changes in US and China are to be focused on.

The huge amount of social welfare benefits that the Chinese government has along with the
growing age of old population (demographics) also does not provide positive sentiments for the
Chinese authorities to go on a complete floating regime. Moreover looking at the fundamentals
of China and the growing international pressure for revaluation might also hint towards the
creation of new Japan. Japan as we know has been suffering from 1985, when they were asked to
revalue their currency to correct the US trade deficit. So Chinese need to be aware and careful
and should adopt gradual steps and more important strengthen the fundamentals of their
economy before they can really come in a completely float with dollar.
POLICY RECOMMENDATIONS
On the basis of our analysis we would not recommend China to go into a complete float
immediately. A gradual process towards attaining a complete floating regime would be more
appropriate. However we would recommend some policies that China can follow for moving into
a floating regime:

a) China till today is very much controlled economy. Getting into a floating rate regime
means that it shall be vulnerable to various external forces, as well as other aspects of a
free market. China needs to open it real economy a bit. Increasing trend of privatization,
liberalization of its economic policies, promoting private investments, etc could be some
of the methods that China can follow. China has also taken an entry into WTO. However
to meet its requirements a huge amount of structural as well as institutional reforms need
to be there.
b) The banking and financial system should also be developed at a faster pace. Gradual
development in its regards is not helping the cause. The pace of reform is much slower
than the growth rate of real sector economy. Independence of Central bank and other
banks, institutional reforms and promotion of the capital market is critical for the success.
Efficient capital market is the pre-requisite for the development of any economy. People
in China do have a good propensity to save but then investment opportunities are very
less. Efficient capital market will provide them with an opportunity. This shall also result
in better investments with the fight for the resources. Centrally held allocation of
resources by the government will not always result in better outputs. New and innovative
financial instruments must be brought. The planned distribution of economic resources
particularly credit is contradictory with the structure and functions of the market
economy. An effective financial and monetary policy transmission is crucial to the
market economy because China’s control over the aggregate demand and price level
depends to a large extent to the level of control it can exert over the money supply.
c) It is very important for Chinese authorities to increase the domestic demand. For that the
standard of living of the people of China should be increased. The wage level in China is
very less, that might be one of the advantage for the corporate in establishing a unit there
but as a nation it is not helping the cause. The ILO has been regularly demanding the
authorities there to increase benefits provided to the labor. Higher wages would definitely
help in the increment of consumption. The demand of different goods shall increase. That
shall help the domestic producers with good opportunity in the domestic market. But
many might argue that China will loose their competitive advantage by increasing the
wage, but the wage level there are far below the International standard, a planned
increase in the wages at different stages can be beneficial. Low cost business model in
China has increased the exports and corporate profits but low wages have depressed the
private consumption and created social stress. Even the labors in China have started
 raising their voices and are striking against the rampant exploitation and have thus been
able to win double – digit pay increase.
d) Promotion of private investment can be also one important aspect. Chinese people do
save a lot but then they don’t have access to proper investment opportunities. Efficient
financial system along with active capital market can definitely serve their purpose.
Moreover the people there are not very much thoughtful about the life about retirement
and source of it. The system of gratuity fund, pension fund is missing. Such mechanisms
need also be developed. That would also help the authority to lower its huge amount of
social welfare cost which has been accumulating since long.
e) There are claims that there is an increase in the imports in the last decade, though imports
are increasing in China, they are not able to increase the consumption of people or the
households. If we see the total amount of imports, one third of imports are destined for
the re-export like the buying of semi conductors and motherboards which are assembled
and exported again, next one third is on commodities and the remaining one third remains
on goods like turbines from Germany, excavators from Japan, etc. Thus such activities
are helpful for the real growth of the economy but not in terms of growth of the people.
Thus imports should be targeted to also increase the consumption habit of general people.
That will also result in the enhancing the competitiveness of the domestic industry.
f) Yuan needs to be accepted as an international currency for China to reap more benefits.
Thus China can start using Yuan as a currency of invoicing for the International trade.
Doing this the dollar will loose its importance to a certain extent as a global trade
currency, the only assumption being that the International community also accepts Yuan
as the trade currency. Chinese government to get its acceptance has also increased its
effort towards it in the recent years. In the year 2008-2009, China had currency swaps
with six countries in Asia amounting to 650 billion Yuan to facilitate bilateral trade and
investment in Yuan and not in dollars.
g) China can also start creating and investing in Yuan denominated assets which allows the
Chinese officials to conduct an ever increasing portion of its financial transactions in its
own currency. This will help China by pass the requirement of currency convertibility
that is needed for the internationalization of any currency.
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