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China's Yuan Policy

Posted in Finance Articles, Total Reads: 2749 , Published on November 06, 2011

China's economic rise in the modern world began with a reformist leader in the early 1980s named Deng Xiaoping. By introducing policies that opened China to trade and economic relations with the outside world, China's economic boom over the last decade has reshaped its own country and the world. Once a country historically known for communist rule and isolationist policies, China has changed gears and become an economic global powerhouse. One of the ways China's economic rise was accomplished was to by pegging its currency, the Chinese Yuan to the U.S. dollar and having trading arrangements between the two nations. China's trade with the United States began in 1985 with imports to the U.S. totalling almost $4 million, according to the U.S. Census Bureau. This number has grown each year since that time. In 2010, imports from China total $ 369 billion. Pegging

Pegging: A method of stabilizing a country's currency by fixing its exchange rate to that of another country.

How Pegging Yuan affected Chinese economy?

From 1985 to 2010, U.S. exports to China have been equivalent to about one-third of China's exports to the U.S.. So the Chinese peg to the dollar has been quite beneficial for China's exporting businesses. In addition, pegging the yuan to the dollar made investors much more confident in China's currency. Without the peg, China's economic rise would have been much slower because the yuan was nearly worthless compared to all leading economic nations of the world.

In particular, the Chinese accomplished its fast economic rise by pegging its yuan to the dollar at a very low rate. China does not price its currency based on interest rates because interest rates are not a monetary tool used by the Chinese, unlike other leading nations. Instead, China prices its currency based on Chinese banks' reserve requirements. Rather than appreciating or depreciating the yuan based on an interest rate, or allowing the yuan to float freely on the open market, the Chinese hold their currency price steady based on a fixed exchange rate regime. Increasing reserve requirements serves to reduce the amount of currency in the economy and decreasing requirements increases the amount of money available for use.

China’s Yuan policy

The Yuan/Dollar relationship:

One of the arguments against a Yuan/dollar relationship is that it appears that China benefits more than the United States. Manufacturers in the U.S. often put pressure on Congress to lobby China to appreciate its currency, citing the difficulty of competing against artificially cheap Chinese goods as a reason for change.

The problem from China's perspective is that appreciating the Yuan could mean less foreign investment in China, deflation, lower wages and unemployment in the country. Fewer exports will also minimize China's supply of dollars for investment, both inside and outside the country. China argues that the currency peg is meant to foster economic stability and abandoning the peg could

result in an economic crisis.

America’s pressure to revalue

In addition to claims of America that “China is stealing their jobs”, another popular argument for revaluing the Yuan is that the Chinese economy is overheating, because a fixed exchange rate forces the country's authorities to run an overly lax monetary policy. Rising foreign-exchange reserves boost the money supply, causing higher inflation and excessive bank lending. A rise in the exchange rate, it is argued, would give the central bank proper monetary control. The small revaluation is likely to increase expectations of another future appreciation, attracting yet more speculative capital and swelling foreign reserves further. To discourage speculation would require a much larger revaluation than the Chinese are likely to accept.

Revaluing Chinese Yuan

Some benefits of an undervalued yuan for the U.S. include lower prices for consumers, lower inflationary pressure and lower input prices for U.S. manufactures that use Chinese inputs. Alternatively, an undervalued yuan hurts U.S. industries that compete with cheap Chinese goods, thus hurting production and employment in the U.S. Also, a low yuan makes U.S. exports more expensive to Chinese consumers and reduces exports to China.

As of 2009, the yuan/dollar mid-point was pegged at 6.8339. This means that one U.S. dollar = 6.8339 Chinese yuan. As with any commodity, if the demand for yuan increases or decreases, the central bank has to respond accordingly by supplying or removing currency from the markets to restore equilibrium and maintain the peg. The Chinese central bank will buy or sell either dollars or yuan to maintain the desired balance

Usually, central banks will buy or sell their own currency to maintain the peg, as it's U.S. dollars the Chinese wish to accumulate through balance of trade with the United States. Appreciating the yuan means the Chinese would accumulate less in foreign reserve dollars and disrupt the economic stability they have grown accustomed to since they began trading with the United States and the outside world.

Why Yuan should not be revalued?

China's overall trade surplus was a modest $32 billion last year, smaller than in the late 1990s and peanuts compared with America's trade deficit of over $600 billion. As of September, Japan’s holdings of Treasury bonds at $720.4 billion are more than four times greater than China’s at $174.4 billion. Much of the increase in reserves reflects inflows of short-term capital, from investors taking advantage of higher interest rates in China or speculating on a revaluation.In the long term, if China scrapped its controls on capital outflows, the yuan might well fall as Chinese households diversified into foreign assets.Between 1994 and 2001, it gained 30%, dragged up by a rising dollar (see right-hand chart). Those who accuse the Chinese of pursuing a cheap-yuan policy conveniently forget that during the East Asian crisis China let pass the chance to devalue its currency in line with most of its neighbours – Long run, yuan is cheap China accounts for less than 10% of America's total trade so a 10% revaluation of the yuan—as much as might be reasonably expected—would reduce the dollar's trade-weighted value by only 1%.Another reason why any plausible revaluation of the yuan would do little to reduce America's trade deficit is that China's exports have a high import content, which limits the impact of exchange-rate movements on export prices.

This article has been authored by Aditya Gangrade from NMIMS

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