Us-China Exchange Rate Paper 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.