Us-China Exchange Rate Review Example

The objective of the report is to analyze the trade relationship between US and China as the issue regarding US blaming China’s undervalued currency arise due to US which incur trade deficit. In addition, the report would like to examine the factors that lead into the US-China trading problems. Therefore, first section in the report discusses the background of US-China trading. The next section explains the dynamics of exchange rate mechanism works and how it set upon. Then, fourth section elaborates the factors that lead to distortions in trade between two countries due to unfair trade.

The fifth section clarifies about China’s exchange rate policy and its impact on the global financial and economic market while subsequent section analyze about the factors behind the trade deficit with China. Lastly, the section examines the measures that can be taken by international financial bodies in ensuring the exchange rate mechanism works. 2. 0BACKGROUND OF US-CHINA TRADING US-China trade rose rapidly after the two nations established diplomatic relations in January 1979, signed a bilateral trade agreement on July 1979, and provided mutual most favoured-nation (MFN) treatment beginning in 1980.

Total trade (exports plus imports) between the two nations rose from about $5 billion in 1980 to $366 billion in 2009 (Table 1); China is now the third-largest US trading partner. Over the past few years, US trade with China has grown at a faster pace than that of any other major US trading partner (Morrison, W. M. , 2005). Throughout the years, even their trading keep continuing, both countries faced difficulties in managing their trading relations. Therefore, it is crucial to analyze how the exchange rate mechanism influenced US-China trading as they involve foreign market. [pic]

The above table describe the relationship between China and US trading. As we can see, the total of US exports and imports are keep increasing with there is significant changes in US imports. 3. 0 EXCHANGE RATE MECHANISM Exchange rate is defined as a rate at which one currency can be exchanged into another currency. In other words, it is a value of one currency in terms of other when the countries involves in foreign exchange market. The exchange rate mechanism (ERM) is a methodology to determine the currency exchange rates within an agreed-upon range with respect to other countries.

The entire world’s economic system depends on the exchange rate. It is very important because it determine the competitive advantage among businesses globally. For example, if China can buy the same product from Germany that it can from the US, thus China more likely will buy from Germany and then US will lost their competitive advantage. Or else, regarding a travel to other country, the travellers should think about the exchange rate as a means to have reasonable vacation. The mechanism itself is market forces which determine the foreign exchange rate.

On the ground that banks do most of actual trading through over-the-counter market, it purpose is to satisfying its currency needs. For example, foreign exchange (Forex) trader trades with broker and then broker trades with banks or else, businesses directly communicate with banks for exchanging the currency. There are a lot of factors influencing the exchange rate. However, the basis is about supply and demand for the currency. In order to indicate how dynamic the ER mechanism works, the Figure 1 summarising its flows towards the determination of ER, taken Renmimbi Yuan (RMB) as an example (Spaulding, W. C. , 2005-2008).

According to Figure 1, the main currency of China is the RMB and as an international bank, the bank also deals with other currencies in Forex market. By taking the US dollars as an example for exchanging the currency, some customers will want to exchange Yuan for dollars, and some will want dollars for Yuan. Since an international bank needs different currencies to operates, they will keep some of the dollars that it gets from customers so that it can give other customers the dollars that they demand.

But when bank having too many dollars due to the bank’s customers’ demand, they tend to reduce the price of the dollar in terms of Yuan. Mean that, bank will pay lower number of Yuan for each dollar, thus, lower the exchange rate of dollars for Yuan. In addition, other banks might need dollars while to some extent the multinational companies needs to trade dollars for franc. Same goes to policy of lowering the ER of the Yuan against dollars in order to promote exports and reduce imports as Central Bank of China will buy dollar for Yuan.

Therefore, in these form of microeconomic view, ER ultimately depends on demand on both customers and other banks that the bank trades with (Nikolas, A. , 2008). If there are excess of supply over demand from customers, then those banks will buy dollars from particular bank until its rates become equal. In other words, banks simply equalize this supply and demand whole over the world by trading with each other, and given that the process is basically the same for the other countries which involves in foreign exchange market. 3.

1Types of exchange rate mechanism The exchange rates affect the trading nature among the global businesses since it involved export and import thus it influenced the income earn by the country as a whole. ERM comprises two types of mechanism which are fixed ER and floating ER. Basically, a fixed ER means the amount of currency received is set in advance or fixed at some value. Under a fixed ER, the supply and demand for currency may vary but the exchange rate remains which cause the economic activity progress according to the exchange rate.

The government or monetary authorities for those countries which adopted fixed ER functioning to ensure the rate does not change in line with their monetary policy. Fixed ER mechanism promotes stability and predictability as it allows the global businesses plans for their activities with certainty on the value of money. Until 1971, governments with the major currencies in the world maintained fixed exchange rates. The rates were originally based upon the price of gold, and then the value of the US dollar.

After 1971, governments with major currencies, such as US and European countries, could no longer control the exchange rate and the rate was allowed to float. In many developing countries governments continued to use a fixed exchange rate for their currency (Alley, R. ). While, floating (flexible) ER mechanism indicate the moving rate which dependable on the time of exchange. The value of a nation’s currency was allowed to float down or up due to market condition which determine the rate. The market force consists of supply and demand that value the nation’s currency.

For instance, when the US dollar is considered strong it will take more Euros, the currency of most European countries and vice versa. 3. 2Factors influencing the exchange rates The important factor which influences the ER which interrelates with supply and demand is the strength of the economy itself. When the economy is fast-growth and strong, it will attract foreign currency. Thus, the inflow of foreign currency will be greater than the outflow of own currency, thereby strengthening its currency. Next, political stability is believed to lead for stable rates.

For example, India’s foreign exchange rating was downgraded because of political instability. The balance of payments (BOP) also affects the setting of exchange rates. If the balance of payments is positive and foreign exchange reserves are increasing, the home currency will become stronger. In contrast, trade deficit occurred when a country imports more than it exports, as BOP imbalances affect the demands for different currencies in foreign exchange. (Nikolas, A. , 2008). US incurred continuous trade deficit due to higher imports from China instead of exports.

Inflation also reflects the supply and demand for currency. High inflation rate reduces a country’s competitiveness as their ability to sell in foreign market was decreasing. This is because demand for home country reducing while demand for foreign currency increasing (Bryant, B. J. ). Government intervention through monetary and fiscal policies affects international trade. Governments control monetary supply and central bank function to intervene either by buying or selling foreign currency in order to maintain stability and economic growth. 3. 3Determination of exchange rates

The change in supply and demand is a complex issue, thus it is important to indicate the approaches for exchange rate determination. First, using purchasing power parity (PPP), the common assumption is that the amount of currency needed to purchase a specified basket of goods should be equal to any other currency needed to buy that same basket of goods. For example, if the US price level rose 10 percent and the Japanese price level rose 5 percent, the US dollar would depreciate 5 percent, offsetting the higher US inflation and leaving the relative purchasing power of the two currencies unchanged.

However, this is an unrealistic assumption since there are no transportation costs, information gaps, taxes, tariffs, or restrictions of trade taken into consideration which lost its competitive advantage. Secondly, determination of exchange rate can use fundamental equilibrium exchange rate (FEER), based on sustainable current-account balance in which a country cannot continue accumulating more currency unless it is actively intervening. This is because to ensure the currency keep low. For example, China is continuously having growth in current-account surplus of US dollars as Yuan is seriously undervalued.

In addition, large current-account surplus is subject to a lot of investment in foreign countries, or because of the country has a low interest rate (Economic Concepts). The behaviour of a country’s exchange rate mechanism is crucially depends on whether its currency using fixed or floating rate. However, for China, they use a modified fixed rate in which the rate was set but then allow to be floating within certain limits. The limits are actually small, which later on the small allowable changes determine the rate to be around previous set rate after the changes was up or down.

This is the way China put small amount of free market in foreign currency at the same time maintaining their government control (Alley, R. ). Therefore, the supply and demand for Yuan currency is depends on its policies in determine the exchange rates. As far as US-China exchange rates are concern, the trading among the two countries had increased China’s trade and financial integration which promote towards a more flexible exchange rate (Nikolas, A,. 2008). 4. 0 CENTRAL BANK OF CHINA’S ROLE The central bank of the People’s Republic of China is the People Bank of China (PBOC or PBC).

Its have power to control monetary policy and regulate financial institutions in China. PBOC replaced the Central Bank of China in 1950 and gradually took over private banks. It’s also issues the currency, control circulation and plays an important role in disbursing budgetary expenditures. Not only that, it’s also responsible for international trade and other overseas transactions. The POBC conduct by the top management consists of governor and deputy of governors. The President of the People’s Republic of China is a person who responsible to appoint or removed the governor from the institution.

The Premier of the State Council nominated the candidate for that position and will be approved by the National People’s Congress. Based on information in Wikipedia, Zhou Xiaochuan is the current governor for China. The POBC is unique because it has its own printing technology research division that research new techniques for creating banknotes. The RMB or Yuan on the other hand, which is China’s legal currency is issued and controlled solely by the POBC. RMB exchange rates are decided by POBC and issued by the State Administration of Foreign Exchange.

In December 1948, the first series of RMB banknotes was introduced. This was about a year before the establishment of the People’s Republic of China. China’s exchange rate policy received many criticisms from many countries. The issues of undervalued and unfair trade are being talked by one to another. Mostly they blame China and this is unfair to China itself. Does this because of personal interest or something related to their economy? American politicians for an example, has tendency to blame China’s currency policy for the large current account deficits and high unemployment rate of their country.

Chinese Premier (also referred to Prime Minister informally) have said that he can understand when some countries told China to revalue the Yuan in order to raise exports, but what he do not understand is the protectionism where they willing to depreciate one’s own currency and attempt to pressure others to appreciate for the purpose of increasing exports. It is sound unreasonable and totally ridiculous. The policy statement of POBC during the past few years have repeatedly emphasized the need to improve the exchange rate formation mechanism and keep the exchange rate at the rational and balanced levels as reported by English News.

Traditionally, China not focuses on short term policy which does not give growth implication to country but now it’s already change. China also takes into consideration the short term policy as it will impact long term potential growth. China’s exchange rate is not a main factor that cause trade imbalance between China and US. Any attempt to change this rate actually will not affect China’s economy but will disrupt regional and even global stability. This imbalance can be described as a structural in nature that reflects the changing trade pattern and a high degree of balancing and harmonizing between the two countries.

China’s currency exchange rate was not to be blame for the US trade deficit as said by Ma Kai, China’s Minister in charge of the State Development and Reform Commission. On December 2007, Zhou, the governor of POBC hold a news conference during the annual sessions of the National People’s Congress. Zhou says that China will push forward the reforms of the China’s banking that year including financial restructuring. This reform will improve support to the development of country-level economies and the effort to develop and improve rural areas.

He also adds that POBC will further expand Yuan business in Hong Kong specifically referring to issuing Yuan denominated bonds there. 6 billion Yuan that worth of government bonds in Hong Kong is a major step to internationalize China’s currency was said by the Chinese Ministry of Finance. The Yuan bond issue is equal with $879 million that will promote the Yuan in many countries and improve the Yuan’s international status. Even the bond issue is represent a step towards making Yuan a global currency but the size of the sale is small compare to US Treasury securities and it will take time to establish the Yuan internationally.

Mr. Shi, the Bank of China analyst adds that to develop this market, it may take at least three to five years. 5. 0 CHINA’S EXCHANGE RATE POLICY AND IMPACT ON THE GLOBAL FINANCIAL AND ECONOMIC MARKET Exchange rate can be defined as price of one country’s money in relation to another’s. It can be fixed or flexible depending on countries policy. When two countries agree to maintain a fixed rate through the use of monetary policy, fixed exchange rate has been used while exchange rate is flexible when two countries agree to let international market forces determine the rate through supply and demand.

The fixed exchange rate system tends to invite mismatches since the borrowers in emerging market and the lenders in advanced countries fail to see the currency risk because of the peg. But, due to the currency crisis, most of the Asian countries shifted from fixed exchange rate to managed float system except China, Hong Kong and Malaysia. China had held Renminbi tightly fixed to the US dollar, mean China has maintained until now, a fixed exchange rate against the US dollar and recognize it as their exchange rate policy.

A country with a fixed exchange rate and a strong (weak) external position like China typically would be reluctant to revalue (devalue) during a period of weak (strong) aggregate demand since revaluation (devaluation) would increase (decrease) the demand for imports and reduce (increase) the demand for exports. That is the reason of why China in their exchange rate policy unenthusiastic to revalue its currency. Eventually, China currency remains undervalued and it directly makes their account surplus sharply increased over the past two years. For example, there was a rising from $17 billion or 1.

5% of GDP in 2001 to $46 billion or 3. 2% of GDP in 2003. And in 2004, China ran a trade surplus of $32 billion. Since China is largely depends on the peg of the Yuan to the dollar, the real trade-weighted value of Chinese currency has declined when the US dollar reached a peak in the beginning of 2002. It gives a positive feedback from this depreciation on the trade balance whereby make the current account will strengthen further. As reported, China has run surplus on it capital account for every single year because of the Asian financial crisis.

The unwillingness of China to adjust the exchange rate is because Chinese defends that stability of maintaining the fixed nominal exchange rate will introduce more flexibility. But, stability on what sense? Their assumption is confusing on two matters. First, China has practices fixed nominal exchange rate for almost nine years and this rate is a guarantee that the Yuan on a trade-weighted basis will be quite volatile. For example, it happens when the dollar depreciates against the Japanese yen so does the Yuan.

Seconds, Chinese have made many major adjustments in the exchange rate since 1978 which is the year where economic reform began where increased economic growth and have made China one of the largest economies in the world. In 1981, value of Yuan is 2. 8 Yuan to the dollar after being cut by half of the trade transactions while the official rate remained 1. 5. In that year, authorities tend to depreciate the official rate until it reached 2. 8 by demolished the internal settlement rate. From the year onwards the authorities continued to gradually devalue the official rate, putting the

rate at 3. 7 to the US dollar. In the era of 1990’s the rate reaching at 8. 28 Yuan to the dollar and the rate has been pegged for the entire period. Thus, as the dollar has appreciated or depreciated in value relative to other currencies, such as the Euro, the Yuan has appreciated or depreciated by the same amount relative to these other countries. Even though the rate has remained fixed, the value of the Yuan on a real trade-weighted basis has been anything but stable. The central bank of China has place huge effort in order to maintain this fixed exchange rate.

When demand for the Yuan increase, the Yuan is sell in exchange for dollar denominated assets and buy the Yuan with dollar denominated assets when demand has decrease. Central bank also has heavily got involved in the market just to ensure Yuan are preventing from appreciation. The existing of the strong internal policy environment in China can better explain the fixed nominal exchange rate practicing by them. When Ju Hianto, the new president come into place, the monetary target is fixed at a relatively high 16 percent and RMB 1.

8 trillion in 2003 as compared to the prior year where target growth and the expansion of domestic currency loan is 13% and RMB 1. 3 trillion. Table 2: Panel DOLS Estimates of China’s Labor-Intensive Manufacturing Exports *1 [pic] An appreciation of the RMB would cause a large drop in the export of labour-intensive goods. As shown in the above table, it indicates that 10% appreciation would reduce labour- intensive export from China by about 18%. Plus, appreciation among countries competing with China in third market would cause China’s labour-intensive export dramatically increased.

From the outcome, 10% appreciation among other leading exporters of labour-intensive goods would increase China’s export by 9%. Other than that, recent study has shown China exchange rate policy is not only relevant for the China’s major export destination such US and Europe but also for the countries who have linked to China trough the global production chains. Other East Asian countries will definitely affected by a Renminbi appreciation if they wish to export parts and components to China. Its mean, the complementarities of exports from East Asian to Chinese product is larger than the competition between these countries in final’s market.

China exchange rate policy also give huge impact to the economy of US Study conducted by US House of Representatives in 2003 shows more than 9 million Americans are without jobs. Since 2001, the number of unemployed Americas has raise by 3. 2 billion. Not counting of number of Americans experiencing long term unemployment. For example, the national unemployment rate is high rate in New York City. This situation would focus on a country that utilizes an artificial peg to maintain exchange rate with the US dollar. Many economists believe Chinese currency peg maintains a set of exchange rate with the US dollar.

Other economists believe that Chinese currency peg remained undervalued will benefits China in term of their exports since it directly making difficult for domestic textiles, furniture and other manufactured goods to compete. Lower price consumer goods and lower interest rate in U. S are the reasons of undervalued Chinese currency as pointed out by the economists. The trade deficit with China is not the main reason of exchange rate mismatch. But, in fact that, many import from China are the goods from other Asian economies which are processed in China before shipping to the U.

S. By this way, China will be able to grasp trade deficit number that would spread out to the region. Moreover, there are some countries in Asian that are purposefully fixing the currency. It is means that the rules of free trade are no longer applied. When Asian countries fix the currency that is the equivalent of a 15 to 40 percent price advantage over U. S. manufacturers. Subsequently make US have to incur an additional 40 percent tax on their exports to China and a price break of 40 percent for Asian imports into the U. S.

If this situation is continue, it will make US facing $140 billion lost in exports. It cost at least a half-million workers lose their jobs. What make this situation become worse is, Chinese argue that pegged Yuan to US dollar is not show their kindness since China is one of the countries that buy U. S treasury bills and notes. If US wish to change their rules on currency, China put on pressure by saying that they will not going to buy anymore and rate of inflation will go up since Chinese pretends that they control not only inflation but as well as US lending rate.

In 2002, statistic shows that, China was the US’s seventh largest export market while US was China’s second largest export market. Study has shown that an appreciation on Yuan relative to the dollar make US export to China less expensive and directly make US import from China more expensive. Since, some of the portions of export from China are produced in China make the price of Chinese good in US would not change as much as the change in the exchange rate.

China is expected to take a good step in enforcing US property and market access especially in service sector if this relationship is continue to grow by these two countries. The reason why China able to make trade surplus while US facing trade deficit is because U. S current trade policy has failed to well-functioned in foreign market. US and other East Asian countries that have trade dealing with China are inspired to have a free-floating currency rather than fixed. By having that, it will help them to be more competitive, as well as bring the trade deficit in line.

What US are dealing with today is whether or not they should put pressure on China to change the valuation of Yuan. Therefore, it can reduce the unemployment rate of Americans. 6. 0 FACTORS OF DISTORTIONS IN TRADING US-China trade rose rapidly after the two nations reestablished diplomatic relations (in January 1979) US, and beginning in 1980 they provided mutual most-favored-nation (MFN) treatment. Before china’s reforms began, total US-China trade (exports plus import) in 1978 was $1 billion; China ranked as the 32nd-largest US export market and its 57th-largest sources of US import.

Bilateral trade between US-China in 2009 reached $366 billion (down from $409 billion in 2008 because of the global economic slowdown). In 2009, China was the second-largest US trading partner after Canada, the third-largest US export market after Canada and Mexico, and US largest sources of imports. China has been one of the fastest-growing US export markets in recent years and the importance of this market is expected to grow even further, given the pace of China’s economic growth, and as Chinese living standard continue to improve and a sizable Chinese middle class emerges.

In addition US have made significant gains from its economic and trade relations with China. Low- priced and good-quality goods and services imported from China have raised the consumer surplus and eased the inflation pressure in the US. Trade with China in 2004 alone saved America consumers $100 billion and created 4 million new jobs, according to a Morgan Stanley report. Second, China’s imports from the US have added new momentum to the US economy. China has been the fastest growing market of American exports for five consecutive years.

And US exports to China increased more than 350 percent over the past decade which is about six times the growth of US exports to other regions. In 1995, china was the 13th largest export market for US products, and it is now the US ‘fourth largest market. Third, US investments in China have yielded high returns. As of November 2007, US investors had poured in a total of $56 billion into 51,555 enterprises in China. These investments have obtained high returns and shared China’s economic success.

A study by the US-China Chamber of Commerce showed that 70 percent of American companies operating in China profited from their local businesses, and 42 percent of them reported profit margins in China higher than their global average. According to the US Bureau of Economic Analysis, since 1990 the remittance of investment proceeds generated in China by US companies, not including retained earnings and reinvestments, has totaled $ 20. 8 billion, which is about 8 percent of their global total ($270 billion) over the same period.

Fourth, China’s large-scale purchase of US dollar-denominated assets has helped lower US long-term interest rates, thereby providing cheaper capital for supporting US economic growth. Though enjoying a rapid and sustained growth, the economic and trade relations between the two countries are not free of problems or frictions, among which the most notable is the trade imbalance. 6. 1Trade Imbalance between US and China Figure 2: U. S. Exports, Imports, and Balance of Trade with China, 1983-2005 As shown in Figure 2 and Appendix Table A1, China runs a trade surplus with the United States by either looking at Chinese or U.

S. data. Although US report it at $201 billion, the Chinese figures show it at only $114 billion in 2005. According to People’s Republic of China (PRC) data, China has run a trade surplus with the United States since 1993. While according to U. S. data, the United States has incurred trade deficits with China since 1983. Trade imbalance between United States and China is continuing up till now where in 2010 the projection of United States trade deficits is $229. 2 billion. The U. S. -China trades deficits widen in recent years are affected by many factors.

The two main factors are macroeconomic forces in the United States and China moving in opposite directions, lead to their overall trade balance to move in opposite direction; and currency manipulation. 6. 1. 1Macroeconomic forces in opposite direction A Saving-Investment Imbalance The trade deficit widen as the economy expands, not because of trade barriers abroad, not because of foreign dumping of exports, and not because of any inherent inferiority of the U. S. goods on the world market, but because of underlying macroeconomic spending and saving behavior at home and abroad.

As shown in Figure 3, the United States has a lower national saving rate than any of the regional grouping in the world especially China. The United States’ saving rate is less than half the rate of some regions and less than one-third rate of China. Moreover, unlike most other region, the United States (along with Other Emerging Markets region) has a negative public saving rate as personal consumption increased reduces the overall national saving rate. Although US investments are lower than the rates of other regions, the gap is smaller among saving rates.

As shown in Table 3, United States was the only country whose investment rate significantly exceeded its national saving rate in 2004: as a result, large foreign capital inflows (which come to the country in form of a current account deficit) are needed to bridge the gap. Table 3: World Saving, Investment, and Current Account Balances as a Percentage of GDP, 2004 In US-China trade, the bilateral trade balance swung from a surplus of $3 billion in 1980 to a deficit of $201 billion in 2005. This reversal of the bilateral trade balance is in line with the opposite movements in the overall trade balance of the two countries.

US households spent more than they earned and increasingly so. By 2005 their deficit equalled 6% of GDP and almost 9% of household disposable income. It is hence quite natural that of the 25 largest US trade partners, 18 of them ran surpluses in their trade with the US in 1996 compared to only 8 countries in 1980. Just as US saving-investment behaviour was widening the US overall trade deficit, macroeconomic forces within China were reducing China’s overall trade deficit. In 2005 china has incurred trade surplus with for $201 billion as compared to $ 1. 5 billion trade deficit in 1984.

Hence lay the first important determinant of the bilateral trade balance: the opposite movements of macroeconomic forces in the two countries, reinforced by demographic trends and by China’s reforms. To a first approximation, the widening bilateral trade deficit reflected the saving slow down in the US (that has been pulling in fo