Chinese Exchange Rate Policy - Article Example

QUESTION C: Chinese exchange rate policy and the implications of maintaining an ‘undervalued’ exchange rate for the current account Name: Lecturer: Course: Date: Table of Contents Table of Contents 2 Introduction 3 Ongoing debates on Chinese exchange rate 3 Whether Yuan is actually undervalued 4 Implications of Yuan undervaluation 6 Flexible exchange rate in the future 7 Conclusion 8 References 9 Chinese exchange rate policy and the implications of maintaining an ‘undervalued’ exchange rate for the current account Introduction In July 2005, the Chinese government, through the Chinese Central Bank, announced the revaluation of the Yuan from 8.11 to the initial 8.27 per United States dollar, indicating a small margin of 2.1 percent (Goujon & Guerineau 2006). The insignificant revaluation was however followed shortly by an announcement of alteration of the exchange rate regime. The central bank made a declaration that the Yuan would not be pegged on United States dollar from then on. This paper discusses the debates over the Chinese exchange rate policy with particular attention given to the implications of having an ‘undervalued’ exchange rate on the current account. Further, possible scenarios that may happen if China’s current account balance is adjusted at a more flexible exchange rate in the future are examined. Ongoing debates on Chinese exchange rate China’s exchange rate policy has triggered a contentious debate. An underlying line of argument is that China should reform its exchange rate system by shifting into a controlled floating or flexible exchange rate policy that is based entirely on the market supply and demand (Goldstein & Lardy 2008). Some observers have argued that substantial undervaluation of the exchange rate for the current account, or renminbi (TMB), contribute significantly to economic imbalances globally (Goujon & Guerineau 2006). Some researchers have also argued that undervaluation of Yuan has given China an unfair trade benefit. Hence, China has been criticised for leading “currency manipulation” tactic that has triggered losses of jobs, in Japan, UK, US and Asian countries (Corden 2009). On the other end, some commentators have asserted that any reasonable appreciation of the RMB has the potential to substantially impact positions of global current account (Goujon & Guerineau 2006). In any case, proponents of flexible exchange rate policy for China have appeared to have an upper hand arguing that such a flexible regime would be essential for internal balance as it presents policymakers with a monetary policy tool that is more effective (Morrison & Labonte 2010). Indeed, maintaining ‘undervalued’ exchange rate continues to have affected the extent of imbalances in the country’s external payments (Goujon & Guerineau 2006). Indications suggest that the country’s RMB is substantially undervalued. However, this appears to have failed to adversely affect the country’s economy to this day although some studies have estimated that the costs of maintaining low exchange rates may ascend in future (Goldstein & Lardy 2008). Amid these questions, an underlying argument is whether Yuan is really undervalued. Whether Yuan is actually undervalued In an effort to provide empirical data to support arguments on undervaluation of Yuan, some studies have attempted to assess the Yuan misalignment and the appropriateness of pegging currency to the dollar, following the Asian financial crisis where overvaluation had been suspected (Goujon & Guerineau 2006). Based on these studies, a point worth noting is that the current undervaluation is estimated to narrow if it is considered that the exchange rate had already been undervalued to reach a near equilibrium between 1997 and 1998. A more convincing argument is however on large undervaluation. Based on trade dynamism, findings from some empirical studies have indicated that Chinese exports have grown substantially (Goujon & Guerineau 2006). Indeed, towards the second half of 2005, the increase was estimated at 33 percent. Additionally, trade surpluses with the European Union countries and the United States are huge (Morrison & Labonte 2010). Concerning the current account, some studies estimated that China has been able to run surpluses for years, hence supporting the undervaluation claims (Goujon & Guerineau 2006). Additionally, since the country operates capital account surpluses, its equilibrium current account should show deficit. Accordingly, a large gap exists between the equilibrium and the underlying current account balance, which indicates a large real undervaluation (Corden 2009). Some economists have also suggested that large undervaluation could possibly have caused rapid growth of foreign exchange reserves to US750 billion in July 2005, from US150 billion in the previous year (Goujon & Guerineau 2006). In this case, if that had to happen without undervaluation, then the Chinese central bank would have purchased large amounts of dollars that could have triggered the exchange rate to increase in value under floatation. Some studies have on the other end pointed out that undervaluation is incompatible with trends in Yuan’s nondeliverable forward market. For instance, expectations for appreciation did not exist until November 2002. In addition, the Yuan forward rate discount has been low since then until the revaluation (Goujon & Guerineau 2006). In this case, even when the distortion is taken into account, the real undervaluation would not be 20 or 30 percent larger than the forward rate discount (Goujon & Guerineau 2006). In consideration of these arguments, it is conceivable that Yuan is in actual fact undervalued. Implications of Yuan undervaluation China has been blamed for undervaluing the Yuan, which has been argued to aggravate international trade imbalances, specifically on the US trade deficit. As a result, reducing trade imbalances is the key benefit that is expected from revaluation. Additionally, such an impact would depend on the kind of trade imbalances as well as the imbalances on the trade price elasticity value (Goujon & Guerineau 2006). Concerning the implication of the undervaluation on US Exporters, the exchange rate policy would cause the RMB to appear as less expensive compared to the way it would be if supply and demand had to determine it. It hence causes exports from China to be less expensive while the US export to China would be more expensive. Under this scenario, US exports that compete with China exports would fall (Goldstein & Lardy 2008). In return, trade deficit would rise in the United States and minimise aggregate demand in the short-term. On the other hand, undervalued RMB will lower the prices of Chinese imports allowing the United States to raise its consumption via enhancement in the terms-of-trade (Walter 2008). Overall, the undervalued Chinese currency also does signify some benefits to the US economy as the country can get more imports and more investment capital that can keep the economy developing (Miller 2008). Flexible exchange rate in the future A flexible exchange rate regime is a kind of monetary system that permits a country’s exchange rate to be determined by shifts in demand and supply (Zhang n.d.). A completely flexible and a permanently fixed exchange rate have different implications on a country’s current account balance. Some analysts have argued that China needs to have an exchange rate that is greatly flexible to stabilise its balance of payment and inflation (Tan 2010). A flexible exchange rate will have a range of implications on China’s current account balance. For instance, greater exchange rate flexibility may generate severe disturbances to China’s financial sector when it is not ready to manage the risks related to foreign exchange (Zhang n.d.). Further, limitations on the capital account transactions could alleviate the risks in the short-term as well as allow for time to promote banking competencies in the field. Nonetheless, it will ensure greater macro-economic stability as well as recognise the sector vulnerability. Because of such likely events, the Chinese government would be significantly reluctant to promote Yuan flexibility (Goujon & Guerineau 2006). Additionally, trade and financial openness may affect the extent to which a current account becomes flexible. In the ongoing debate concerning China’s adjustment of the exchange rate to be flexible, a rapid pace of real exchange rate appreciation would be greatly beneficial to China in regards to adjustment of external balance of payment and stabilisation of inflation (Chinn & Wei 2008). Analysis of China’s external and internal balance shows that RMB is greatly undervalued and that the country has an extensively underlying imbalance between current account flows. Some economists suggest that flexible exchange rates are less vulnerable to speculative capital that can destabilise an economy. Based on this argument, flexible exchange rates can stabilise Chinese economy (Garton, & Chang 2005). On another angle however, since China has underdeveloped financial markets and weak banking systems, having a flexible exchange rate may destabilise the economy unless the pace of adjustment is handled carefully and slowly. Banks in China may hence be exposed to currency risks because of borrowers who have been affected by the currency movements (Garton, & Chang 2005). Overall, the benefits of exchange rate flexibility on the adjustment of China’s current account seem to be greatly exaggerated. In any case, appreciation of China’s exchange rate would be separate from greater exchange rate flexibility. At the same time, greater exchange rate flexibility would be separate from dramatic adjustment of current account (Chinn & Wei 2008). Conclusion Undervaluation of Yuan has given China an unfair trade benefit. The country has hence been criticised for leading “currency manipulation” tactic that has triggered losses of jobs, in Japan, UK, US and Asian countries. An underlying line of argument is that China should reform its exchange rate system by shifting into a controlled floating or flexible exchange rate policy that is based entirely on the market supply and demand. Proponents of flexible exchange rate policy for China have argued that a flexible regime would be essential for internal balance as it presents policymakers with a monetary policy tool that is more effective. It should be argued that for China to have a feasible flexible exchange rate regime, two critical conditions must be fulfilled if a flexible regime has to be practicable. First, China has to have financial systems that are well developed. Next, the domestic asset market should be suitably integrated with an international system (Herrmann 2009). 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