Chinese Exchange Rate Policy - Essay Example

THE CHINESE EXCHANGE RATE POLICY By [Student’s Name] [Code + Course Name] [Name of Tutor] [Name of University] [City, State] [Date of Submission] Introduction In china, the exchange rate of its currency is controlled by government authorities, in this case the country’s central bank, the People’s Bank of China. Controlling the exchange rate is done by fixing the CNY/USD rate on every trading day. This rate is the one that is used in trade flows that enter or leave the country (Duttagupta, Fernandez & Karacadag 2005). The decision to control the value of the Renminbi versus that of the United States dollar was made in response to the 1998-1999 Asian Crisis. This pushed the country to switch to a managed float of USD/ CNY, in which case the value of the Renminbi rose in comparison to that of the dollar, causing the USD/CNY to decline gradually. In a span of a three year period, the Chinese currency had strengthened by a whopping 21 percent against the US dollar. Around August 2008, a change was introduced into the exchange rate policy after the United States started mounting pressure on China’s export sector. This was after the United States subprime crisis that gave rise to a vast decline in world trade. In a bid to protect their exporters from additional competitive pressures, China again re-pegged its currency in comparison to the US dollar, and it was only in June 2010 that the PBoC made an announcement stating that the rate of exchange would be made less rigid. After this announcement, the USD/CNY steadily appreciated at a rate of 5 percent annually. Since June 2010, the daily fluctuations in USD/CNY barely exceed 0.5 percent, though most of the trading day sees lesser changes in relation to the maximum allowed fluctuation. The pace at which the USD/CNY has depreciated since June 2010 has been approximately 7 percent on an annualized basis (Soofi, AS 2009). Over the past decade, China has been running huge current account surpluses. These current account surpluses have been run alongside a tightly controlled exchange rate and a ban to freely trade foreign assets for the private sector. Experts have argued that these current account surpluses are a significant reflection of undervaluation of the country’s currency, the Renminbi. This undervaluation has over time created major conflicts with countries like the United States, who are of the argument that China puts the value of the RMB low artificially. This helps in boosting the exports and trade surplus from China, and this is often at the expense of the country’s trading partners. In a number of instances, the United States has just stopped referring to China as a currency manipulator in its reports to Congress (Liu & Fan 2010). In addition, it has continued to put pressure on China to allow the Renminbi fluctuate more freely in accordance with market forces, and also allow it to appreciate at a faster pace. The World Bank and the IMF in conjunction with numerous economists have also taken the step of negotiating with the Chinese government for a less rigid exchange rate policy and faster currency appreciation. Since mid-2005, china allowed the currency to rise by approximately 25 percent against the dollar, and it is believed that the reasons behind this were mainly for domestic considerations, though in part, the country was responding to pressure from external forces. All in all, the appreciation rate still remains slow, especially for the United States and other states in Latin America and Europe whose sectors of manufacturing face augmenting competition from low priced products coming from China (Tong 2011). The chief rationale behind this move is that, if the currency value remains lower in comparison with that of the country’s trade partners, then it translates to cheaper exports for China which then become more attractive to their potential markets. The country believes that, in order to sustain a high rate of growth for the economy, such an exchange rate policy is necessary. As such, much of China’s growth can be attributed to this managed exchange rate, which is responsible for increasing exports. A stable exchange rate further eliminates a significant amount of uncertainty for the country’s exporters, importers as well as other trading partners (Yip 2008). Implications of Maintaining an ‘Undervalued’ Exchange Rate As stated earlier, the Chinese fixed exchange rate policy creates a competitive advantage of their exports against those of other countries in Latin America, the United States and Europe. However, this may not go on if the exchange rate policy is not maintained. Maintaining this fixed exchange rate is costly because it requires vast amounts of reserves as the central bank is frequently buying or selling the domestic currency. Before China revoked its fixed rate scheme in 2010, its foreign exchange reserves increased significantly every year, and this was in a bid to maintain the dollar peg rate. The growth tempo was so rushed that it only took the country a few years to surpass Japan in its foreign exchange reserves. By January 2011, Beijing owned a whopping $2.8 trillion in reserves, an amount which at the time was double that of Japan (Morrison & Labonte 2013). If china could allow its currency to be flexible in accordance with the market, it could become a fully functional member of the international payments system. However, this cannot be the case until that time when China begins to run an overall deficit in its payments and trade (Scarfe 2011). According to foreign expert observers, constant interventions by the country to sustain the exchange rate significantly lower than that of the market level creates a distortion that prevents global markets from functioning well. If the country goes ahead to maintain the perverse policies, then internal inflation and global recession will continue to grow. Thus, maintaining its exchange rate with the dollar will only cause its competitive advantage to unwind via inflation. Sadly, this may happen to almost all countries with the current account surpluses of China contributing to recessions of many other nations (Zhang 1999). According to Liu and Fan (2010), China has attempted to perpetuate its payments and trade surplus by sterilizing inflows from foreign exchange. The country has done this by gradually increasing its requirements for reserve deposits of its commercial banks with the PBoC. The move helps to reduce the amount of inflation that a hasty money supply would create for the country. This move has not been overly successful because a sterilization of this form has its limits, and inflation continues to invade the country, while obtaining credit for small scale borrowers continues to get difficult by the day. These are signs that from within the country itself, the monetary and exchange rate policy is perverse (Liu & Fan 2010). Main Opposing Arguments in Regard to the Value of the Chinese Currency The maintenance of vast currency reserves led to the creation of unfavorable economic side effects such as an increase in inflation. This is because increased currency reserves create wider monetary supply, or increased levels of money in circulation. Increased money supply leads to decrease in the value of money locally, and this eventually causes an increase in prices of commodities in the country, a factor that can create mayhem for a country seeking economic stability. In China, consumer inflation had escalated to 5 percent by December 2010, soon after the introduction of the policy. The continued undervaluation of the Chinese currency has been described by several economic experts as a potential threat to the global economy. This is due to the controversy it creates from the escalating foreign investments that continue to be set up within its borders, which could destabilize the entire world trading system. As it is, Chinese organizations have a virtually zero marginal labor cost workforce. In the recent past, lower labor costs have attracted massive investments, especially in the manufacturing sector. This has come as organizations seek to maximize on lower costs of production thereby maximizing on profitability. In the global economy, though, the massive and the mindless flow of investment funds into the country cause an increase in global deflationary pressure on manufactured products. This scenario further leads to dislocations in job markets and the manufacturing industry in both the G7 states, and also, in the developing countries. Globally, consumers benefit from lower prices of commodities, though jobs and profits are being lost in large quantities. Questions also arise as to whether the manufacturing facilities owned by Western states will be able to repatriate their profits. Chinese plants may turn out to be a big sinkhole for the Western economy (Anonymous, 30-36). The value of the Chinese currency also has an effect on the economy of the United States, as has been observed by economists. For some time now, the dollar has been in the process of correcting its value against other major currencies of the world; the euro, the yen; Canadian dollar; Australian dollar and the sterling pound. However, this has not happened with the Chinese Currency simply because the government controls its value. Other currencies that have not experienced the correction are Taiwan, South Korea and Singapore, all of which run huge trade surpluses with the US. This move has left China as the only single economy with the largest contribution to the US trade deficit. China’s economy is characterized as having a trade surplus (external imbalance) and a speedy economic growth with incipient inflation (internal imbalance), situations which can be corrected by currency revaluation. On the other hand, the economy of the United States has a large trade deficit (external imbalance), while internally, it is characterized by unemployment and excess capacity (domestic imbalance). Revaluation of the Chinese currency will help sort the problems of the two countries from these negative and diverse economic situations (Anderson, 16-20). In further explanation of the above, devaluation of the Chinese Yuan may cause decreased global economic equilibrium. The East Asian economies stated above with substantial amounts of trade deficits with the United States may be apprehensive in relation to revaluing their currencies because they are afraid that if they do so, they could lose competitiveness relative to China. In this regard, if China led the way by revaluing their currency, they would break the logjam and those other economies (Taiwan, South Korea and Singapore) would revalue theirs too. This would ultimately accelerate and enhance the dollar adjustment process, thereby creating equilibrium in the global economy. In addition, failure to revalue the Chinese currency may cause economic disruption. This is because it forces other major economies such as the euro zone and Japan to assume a bigger burden of adjustment in order to correct the US trade deficit. If China contributed to their share of adjustment by revaluing their currency, then other currencies would be spared the strain on their economies, as well as the global economy (Anonymous, 37). What is going to Happen to the Current Account Balance if China Moves to a Flexible Exchange Rate in the Future? In an attempt cope with the above negative implications of having a fixed exchange rate, China needs to correct the situation by moving to a flexible exchange rate. In a freely floating exchange rate system, the currency exchange rates are not influenced by government authorities. For this reason, foreign exchange reserves do not increase to the levels that China’s have reached currently. As such, even in situations where the current account runs surplus, they are often compensated and offset by deficits in the same current account. This is the current situation observed in Japan, an example which china could learn from. Therefore, if Chinese authorities refrained from interfering with the exchange rate of their currency and leaving its value to be determined by market forces, then foreign reserves would surely stop increasing, and the exchange rate would eventually appreciate (Rieti.go.jp). A curbed increase in foreign exchange reserves would also decrease the level of the money supply in the country, which as stated earlier, is a major cause of inflation. Increased money supply in any economy causes a reduction in the value of the currency, and eventual inflation. Also, when internal inflation pressures heighten, the price of imports could be easily brought down with the help of a stronger domestic currency. The role of an exchange rate in easing inflation in a country like China is crucial because the country has a strong demand for importing primary products as a result of an unfavorable resource endowment. Adoption of a flexible exchange rate policy in the country will also serve long term interests. This is due to the fact that the gains of stability and long-term price stability exceed costs of restructuring particular industries, or getting rid of obsolete capacities (Zhang 1999). Increased flexibility in the exchange rate helps in improving the monetary policy transmission mechanism. Since 2005, the exchange rate policy that has advanced in a controllable, gradual and self-initiated manner has boosted awareness of the market players to adapt to movements of exchange rates, while at the same time making them be more responsive to changes in the market. Foreign exchange and money markets have grown abundantly, and for this, adaptation of flexible exchange rates will allow financial institutions to strengthen their risk management. In addition, there will be improved financial services and a wider range of financial products. These improvements will go a long way in improving the transmission of monetary policy on the market and micro levels, and also play a constructive role in the enhancement of monetary policy effectiveness (Xiaolian 2010.). Reference List Anonymous, 2004. ‘China’s currency impact. Textile World, vol. 154, no.12, pp.36-38. Duttagupta R, Fernandez G & Karacadag C 2005, Moving to a flexible exchange rate: How, when and how fast? IMF, Viewed 1st February 2014, http://www.imf.org/external/pubs/ft/issues/issues38/ei38.pdf Liu X & Fan C 2010, The model and empirical estimation of the optimal flexibility of RMB exchange-rate regime: A study based on the price stabilization. Frontiers of Economics in China, vol.5, no. 2, pp. 187-209. Morrison W & Labonte M, 2013, China’s currency policy: An analysis of the economic issues. Congressional Research Service. Viewed 1st February 2014, https://www.fas.org/sgp/crs/row/RS21625.pdf Research Institute of Economy, Trade & Industry, IAA. 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