The major purpose of this paper is to investigate the actual exchange rate policy as reviewed by the government of China following the Chinese exchange rate system reform on July 21 2005. Also, the paper delves into the long run effect on CNY as well as the financial growth as a result of CNY exchange rates in the international market. In addition, the paper identifies that the government of China has made a significant but too small in the economic sense but high growth rate is likely to be recorded in future as a result of appreciation of the Chinese Yuan in terms of US dollar.   

Introduction

China’s economic development has been one of the most outstanding phenomena over the last ten years. China’s impressive economic achievements derived from the reforms of 1980s and 1990s were accompanied by the government’s management of the Chinese Yuan exchange rate and the country’s capital account. As a consequence, the rapid growth of the export driven economy, has accompanied the united states trade deficit with china increasing from about $6 million to $173 billion for the first six months of the year 2010.over this time, the exchange rate to the US dollar has been adjusted, favoring China’s exporters, although more recently it has appreciated. While the peg to the US dollar was replaced by a market floating exchange rate referenced to a basket of foreign currencies, the peg was reintroduced in 2008 in response to the worsening global financial crisis. In 2010, the CNY was allowed once again to float within a basket of foreign currencies but the boundaries remain tight, with its value significantly below the expectations of the western countries (Sinnakkannu & Nassir, 2006).

There have been increasing suspicions concerning the potential misalignment of the Chinese Currency, basically the Yuan Renminbi against the US dollar. A fixed exchange rate regime was maintained by the officials since 1994 which influenced the development of the nominal effective exchange rates (Zhang, 2011).

China Yuan exchange rate in the international market

Due to China’s plan to join WTO, the dual exchange rate system was being replaced by the unified scheme that is based on a basket of currencies.  China’s WTO commitments increased the pressure on local banks to compete effectively whereby the government would offer support in cases they were not able to do so. Generally, the European Union has recently hesitated to give a critique on the side of the Chinese government in regard to keeping Renminbi pegged to USD, an aspect that constitutes a form of manipulation that maintained to make the Chinese exports cheaper and its imports more expensive. This policy has negative effects on the United States employment in many sectors (Wu, 1955).

It evident that the Chinese currency peg policy is not meant to favor exports over imports, but instead to foster economic stability by tying its currency to the U.S. dollar at a constant level, as many other countries do. They have expressed concern that abandoning the peg could spark an economic crisis in China and would especially be damaging to its export industries at a time when painful economic reforms are being implemented.  With respect to this concern, the right way of dealing with it isby looking at the Renminbi exchange rates against the Euro and the Chinese EU trade balance in past few years. Moreover, between 2002 and 2008, the EU’s trade deficit with china soared from 55 to 170 billion pounds and at the same time Chinese Yuan weakened against euro by as little as thirty per cent (Mundell, 1995).

If manufacturers are questioned concerning which country provides massive subsidies in the form of grants, tax breaks, and cheap credit from state owned bank, they will tell you it is China. These subsidies are generally behind the EU trade deficit with China. China also confines exports rare earths and reserves them for the purpose of its domestic manufacturers. This policy has greatly been challenged in the in the World Trade Organization by both EU and US (John and Huang, 2001).

An undervalued Yuan has an effect on the United States borrowers. When the U.S. runs a current account with China, an equivalent amount of capital flows from China to the United States as can be seen in the U.S. balance of payment accounts. This occurs because the Chinese central bank or private Chinese citizens are investing in U.S. assets, which allows more U.S. capital investment in plant and equipment to take place than would otherwise occur. Capital investment increases because the greater demand for U.S. assets puts downward pressure on U.S. interest rates, and firms are now willing to make investments that were previously unprofitable. This increases aggregate spending in the short run, all else equal, and also increases the size of the economy in the long run by increasing the capital stock.

EU has made it clear that it has an undervalued currency, but this should not be the main explanation as to why they have such huge exports and that we have a huge trade deficit with China. It is vital to note that government subsidies are really important in supporting exports and it is equally important that EU and WTO dealt with the current unfair business practices in the international currency market (IMF, 1998).

In one of the most favorite disputes, the EU Commission addressed an issue concerning the Option N.V.’s complaint that Huawei Technologies Co. and ZTE Corp., one of the China’s main telecommunications equipment suppliers who receive a huge government subsidies that enable them to sell wireless modems at cheaper prices and thus causing havoc in the international market.

The Commission of EU executive arm made it clear in the confidential document circulated to the China’s national government concerning China’s currency policy as Renminbi gained strength against the euro during the time when Chinese modem exports surged (John and Huang, 2001).

The exchange rate fluctuation cannot be held as a result of depreciation in price, this was also made clear in the document. And it was also made clear that the exchange rate behavior should have acted as a disincentive to the importation of the product concerned into the EU.   

The Yuan-dollar exchange rate

Nominally cheap or really dear

China’s exchange rate has been really at the fastest growth as compared to exchange rates in other countries. American producers have risen complains concerning the manner in which China undervalues it exchange rate. This is basically the nominal exchange rate which is now 6.67 Yuan to 1 dollar and has generally strengthened by 2% since September 5th

However, in real sense, China’s exchange rate has strengthened by almost 50 percent with that of US according to calculations represented in the economist chart. A real exchange rate should consider the price movement in every country and in case prices move faster in China as compared to US then exchange rate is likely to be higher whether the exchange rates remains at a constant rate. This is as a result of home advantage of prices which makes firms in China to appear less competitive in the international markets, just as if their currency has gone up.

For one to calculate the real exchange rate one needs to gauge the prices in every country and most consumers prefer using Consumer Price Index (CPI). This is because CPI contains various goods and services that can be traded abroad. The measure of real exchange rates that we are going to regularly update will depend on the labor costs or the price of labor per widget. These costs when increased can in turn lead to rise in the levels of production (John and Huang, 2001). According to the Bureau of Statistics, the Chinese industry has risen by more than 25% in 2005.

However, the combination of a twenty four per cent rise in the Yuan against the dollar and an increase of 21% in Chinese units of labor costs relate to America have and account for the steep appreciation presented in the chart. The Chinese Yuan may still be undervalued but according to economist’s estimation Americans should have no fear from competition from Chinese as in the last five years. This is due to the fact that Chinese unit labors have grown much faster as compared to that of America. Employees in Chinese industries have also suffered labor shortages and strikes as compared to America’s worker who have survived recession due to strong productivity (Chou, 1998).

Generally, China and America do not only trade with one another but China’s big surpluses and America’s huge deficits solely depend on the real exchange rates between the two countries and their trading partners. But definitely calculating that will need estimates of unit labor cost for trading partners of China. And that may appear to be a bit laborious.

By 2008, PBoc effectively moved back to dollar peg as a result of its monetary crisis as well as the turmoil in the currency market. With US stimulus in place and the US Fed pumping trillions of dollars led to a slid of other currencies to increase but contrary to this euro began to depreciate against the dollar. This was caused by flight to safety in US dollar as a result of brewing euro zones crisis that turned out and spread to other destinations. This also led to sovereign debt defaults to begin looming in the horizon and made it not possible to jungle the currency market (Zhaoyong, 153). 

China’s withdrawal to the dollar peg was mysterious but it had to adopt the course from 2008 and this was the time when Renminbi changed the direction. In case Chinese were willing to lose basket policy in 2007 instead of switching dollar peg in 2008, then the value of Renminbi could have gone low and therefore dollar based producers could have realized an increased competitive advantage.

Which Companies are likely to benefit from Yuan Appreciation?

i)  Companies that may not suffer as a result of Yuan appreciation is the US manufacturer of capital equipment such as: Deere (DE) and Caterpillar (CAT) since such clients are usually price sensitive and not only driven by brand name.

ii)  Wholesale food exporters such as: Chiquita Brand International (CQB) Archer-Daniels-Midland Company (ADM) and the DANONE.

iii)  Another one is the western commodity manufacturers such as the steel companies.

iv) The Chinese airlines may also benefit such as China Southern Airline that pay less in Yuan for airlines and aviation fuels.

Companies that may suffer due to Yuan Appreciation

i)  Mass market retailers also are bound to suffer such as the Wall Mart Stores and Target Stores.

ii) Electronics manufacturers such as Dell (DELL) Motorola (MOT) and Nokia who built their firms in China. Generally this is due to the fact that the revaluation of the currency is likely to make the price of Chinese imports to the United Staes to rise.

iii) Investors with a lot of treasury bills or the USD denominated bonds are likely to suffer.

The Managed Float

The Renmnibi (RMB) is currently being moved to a managed floating exchange rate that is based on the demand and supply in reference to a basket of foreign currencies. The daily trading price of the USD against the RMB in the inter-bank foreign exchange market is likely going to be allowed to float with a narrow band of 0.3 per cent around the central parity as noted by the People’s Bank of China (PBC). In a later announcement that was published in 2007, the band was extended by a difference of 0.2 per cent compared to the previous one (Chou, 1998). The PBC thus have noted that the bank has been dominated by the USD, euro, Japanese Yen, and South Korean Won, accompanied by the same proportion made up of the British pound, Thai baht, Australian Dollar, Canadian Dollar, Singapore Dollar and Russian ruble.

On April 10th 2008, the Chinese currency traded at 6.9920 Yuan per USD, which has been seen for the first time in a period of not less than a decade. This implies that a dollar was bound to be bought at less than 7 Yuan and 11.03630 Yuan per Euro. Beginning of January 2010, Chinese and those who are not citizens of China have an annual quota to change a maximum of 50,000 USD.

Such exchange can only take effect when the applicant appears in person at the bank and presents his passport or Chinese Identification Card because such deals are usually centrally registered and that is what is going on in China at the moment. The maximum withdrawal is estimated at 10,000USD in a day, the maximum purchase quota of 500USD per day (Williamson, 1991).

            The stringent management of the currency leads to a bottled-up demand for exchange in both directions. It is looked at as the main tool in keeping the currency peg, preventing inflows of hot money. A shift of Chinese reserves into the currencies of other trading partners has led to the shift of such nations to opt for more reserves in dollars and that has really contributed to change in the value of RMB against the USD.

Drivers: Sources of Pressure on the China’s Yuan Exchange Rate

There are forces behind the China’s decision to raise the value of the RMB relative to the USD which include the following:

i) US congressional leader that have proposed tariffs on China if it does not stop subsidizing the RMB through the congressmen.

ii) High level US officials such as Treasury Secretary Paulson and the Federal Reserve Chairman Bernanke who have made effort to visit China in order to urge revaluation of the China’s currency in the light of China’s foreign exchange surplus (Zhang, 2001).

iii) The international Monetary Fund (IMF) which has the mandate to give advice to member countries on their currencies and exchange rate policies.

iv) Definitely, a dispute may also be filed against China before the World Trade Organization (WTO) which is a dispute resolution body. 

Indicators of the Exchange Rate Misalignment

Below are some of the indicators of misalignment such as over and under valuation of the currency that are realized as a result of DARER concept. The first indicator is the debt misalignment index which seeks to identify the currency misalignment through existence of debt. The second indicator is the trend misalignment index which seeks to apply the concept of Hodrick-Prescott (HP) filter, or rather filter method that can applied in determining trend misalignment. The third indicator is the total misalignment index that combines two concepts in order to express a broader perspective of information concerning over/undervaluation of the exchange rate (Zhaoyong, 143).

Further Reform the RMB Exchange Rate Regime and Enhance the RMB Exchange Rate Elasticity

In relation to the recent economic situations and financial market developments abroad and at home, balance of payments (BOP) situation in China, the People’s bank of China has decided to proceed further with its reform that is aimed at RMB exchange rate regime and enhancing the RMB exchange rate flexibility. Since 2005, China began the move of managing floating exchange rate regime. Since the regime was put in play, the Chinese exchange rate has gone higher and is experiencing a positive outcome.

During the moment when there was an international financial crisis got to its worst, the exchange rate of various sovereign currencies to the USD experienced depreciation of varying margins. This is certifying that the stability of the RMB has been of great importance in the process of mitigating the crisis. This impact created by the positive progress of the RMB has greatly contributed to the significant global recovery to Asia. This has also indicated China’s effort towards rebalancing of the exchange rate in the global market (IMF, 1998).

It is true that China’s efforts have clearly contributed to the gradual recovery of the global market. The recovery and the upturn of the Chinese economy have also become more solid in the sense that it has enhanced the economic stability of China. It is therefore desirable to continue with the reform even further in order to establish a stable market standard. The exchange rate floating bands are expected to remain at a constant rate as it had been announced in the inter-bank foreign market exchange (John and Huang, 2001).

Generally, the external market of China is steadily growing and becoming a bit balanced. Since the beginning of 2010 China has been experiencing a surplus in the ratio of the current account to GPD as a result of notable reduction. With the BOP account is moving closer to equilibrium and base of large scale appreciation of the RMB exchange rate does not exist. The efforts made by the People’s Bank of China are likely to create a stronger step towards allocation of resources in order to balance BOP accounts and in turn maintaining RMB exchange rates. This effort China is likely to attain basically stable point of equilibrium and be adaptive and achieve the macroeconomic and monetary stability in China (Prascad, 2009)

Conclusion

The prospect of positive reception of the Chinese currency in real terms is a long run phenomenon that will only be realized in prices of non-traded goods accompanying more balanced growth. As a result of the inherent pitfalls in the efforts to reform the domestic monetary system and China will need to rightly open its capita accounts with great care. It is therefore recommended that China needs to consider changing the peg to float as soon as possible in order to discuss the higher flexibility which must be introduced to the Chinese exchange rate policy which in turn could also lead to an increased degree of undervaluation.

According to (Wall Street Journal, 2004), it is clear that the value of Yuan could be a biggest shift in financial policy after decades of fluctuations. Such a shift is likely to be on the way for the China Currency exchange market. Against the expectation of the greater strengthening of Chinese Yuan accompanied by flexible exchange rates, China stands a chance of losing the peg by approximately 3-6 percent according to (The New York Times, 2004).       Generally it is vital for developing nations to adopt exchange rate fluctuations on serious grounds as compared to industrialized countries. It would be unfortunate for countries such as China to be affected by a fragile banking system, and a market that embrace floating system. The economists have recently noted that the developing countries’ economic institutions may really matter as compared to a mere exchange rate regime (Kaminski, 1997).

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