WTO Assignment on China Currency and its Impact on other countries
Sriman Reddy. V
Regd#1226110237
MBA(Ib)-Sec(B) .
Abstract: This paper discusses the pros and cons of appreciating the Chinese currency. The
Governmental stances and views of economists and businessmen both for and against the RMB
appreciation are discussed, followed by the analysis of the fundamental motives of American and
Japanese government and industrialists for pressing China to revaluate RMB. This is followed by
a brief discussion and analysis of what should be done about RMB's value. This paper concludes
that it is not in the interest of China to appreciate RMB at the moment or in the near future.
Before China succeeds in systematic structural reforms and its economy gets strong enough to
withstand risks of RMB appreciation, it should and will maintain the current RMB-dollar
exchange rate.
Introduction:
From 1994 until July 21, 2005, China maintained a policy of pegging its currency (the renminbi
or yuan) to the U.S. dollar at an exchange rate of roughly 8.28 yuan to the dollar. The Chinese
central bank maintained this peg by buying (or selling) as many dollar-denominated assets in
exchange for newly printed yuan as needed to eliminate excess demand (supply) for the yuan.
As a result, the exchange rate between the yuan and the dollar basically stayed the same, despite
changing economic factors which could have otherwise caused the yuan to either appreciate or
depreciate relative to the dollar. Under a floating exchange rate system, the relative demand for
the two countries’ goods and assets would determine the exchange rate of the yuan to the dollar.
Many economists contend that for the first several years of the peg, the fixed value was likely
close to the market value. But in the past few years, economic conditions have changed such
that the yuan would likely have appreciated if it had been floating. The sharp increase in China’s
foreign exchange reserves (which grew from $403 billion at the end of 2003 to $1.5 trillion at the
end of October 2007) and China’s large trade surplus (which totaled $178 billion in 2006 and
may have hit $268 billion in 2007) are indicators that the yuan is significantly undervalued.
Because its currency is not fully convertible in international markets, and because it maintains
tight restrictions and controls over capital transactions, China can maintain the exchange rate
policy and still use monetary policy to pursue domestic goals (such as full employment).
The Chinese government modified its currency policy on July 21, 2005. It announced that the
yuan’s exchange rate would become “adjustable, based on market supply and demand with
reference to exchange rate movements of currencies in a basket,” (it was later announced that the
composition of the basket includes the dollar, the yen, the euro, and a few other currencies), and
that the exchange rate of the U.S. dollar against the yuan would be immediately adjusted from
8.28 to 8.11, an appreciation of about 2.1%. Unlike a true floating exchange rate, the yuan
would (according to the Chinese government) be allowed to fluctuate by 0.3% on a daily basis
against the basket. Since July 2005, China has allowed the yuan to appreciate steadily, but
slowly. It has continued to accumulate foreign reserves at a rapid pace, which suggests that if
the yuan were allowed to freely float it would appreciate much more rapidly. The current
situation might be best described as a “managed float” — market forces are determining the
general direction of the yuan’s movement, but the government is retarding its rate of appreciation
through market intervention. The modest increase in the value of the yuan to date has done little
to ease concerns raised in the United States, but the Chinese, with concerns about their own
economy, have been reluctant to make significant changes to their currency. This paper reviews
the various economic issues raised by China’s present currency policy.
Literature review
This study draws from two strands of literature: the narrative approach to monetary stance and
monetary policy reaction functions. The narrative approach to studying monetary stance is
motivated by difficulties in accurately identifying monetary policy impulses using the
conventional measures such as M2 and a short-term interest rate. As noted by King and Plosser
(1984) and Boschen and Mills (1995) among others, these monetary indicators can fluctuate for
reasons not related to changes in monetary policy. Romer and Romer (2004), Nelson (2000), and
Batini and Nelson (2000) for the Bank of England, Judd and Rudebusch (1998) for the Federal
Reserve, Gerlach and Schnabel (2000) using pre-EMU data, and Faust et al. (2001) for the
European Central Bank. This analysis has also been undertaken for a number of Asian central
banks, such as Shen and Chen (1996) and Huang and Lin (2006) for the Central Bank of China
in Taiwan, and Liu and Zhang (2007) and He and Pauwels (2008) for the PBoC. Central banks’
policy decisions in response to changing economic conditions have been studied from both
descriptive and prescriptive perspectives (Svensson, 2003). A descriptive perspective study
focuses on how to best characterise a central bank’s behaviour, while from a prescriptive
approach, research examines what kind of rules are best at stabilising output and inflation in
different macroeconomic models.
The Dollar: No more international currency!
If the euro’s crisis has a silver lining, it is that it has diverted attention away from risks to the
dollar. It was not that long ago that confident observers were all predicting that the dollar was
about to lose its “exorbitant privilege” as the leading international currency. First there was
financial crisis, born and bred in the US. Then there was the second wave for quantitative easing,
which seemed designed to drive down the dollar on foreign exchange markets. All this made the
dollar’s loss of pre-eminence seem inevitable.
What about the alternatives?
There are of course a variety of smaller economies whose currencies are likely to be attractive to
foreign investors, both public and private, from the Canadian loonie and Australian dollar to the
Brazilian real and Indian rupee. But the bond markets of countries like Canada and Australia are
too small for their currencies to ever play more than a modest role in international portfolios.
Brazilian and Indian markets are potentially larger. But these countries worry about what
significant foreign purchases of their securities would mean for their export competitiveness.
They worry about the implications of foreign capital inflows for inflation and asset bubbles.
India therefore retains capital controls which limit the access of foreign investors to its markets,
in turn limiting the attractiveness of its currency for international use. Brazil meanwhile has
tripled its pre-existing tax on foreign purchases of its securities. Other emerging markets have
moved in the same direction.
China is in the same boat. Ten years from now the renminbi is likely to be a major player in the
international domain. But for now capital controls limit its attractiveness as an investment
vehicle and an international currency. Yet this has not prevented the Malaysian central bank
from adding Chinese bonds to its foreign reserves. Nor has it prevented companies like
McDonald’s and Caterpillar from issuing renminbi-denominated bonds to finance their Chinese
operations. But China will have to move significantly further in opening its financial markets,
enhancing their liquidity, and strengthening rule of law before its currency comes into
widespread international use.
CNY vs. USD Correlation
We first examine the historical correlation of the CNY and US dollar (USD) returns as predicted
by Axioma’s Medium Horizon, Global Fundamental Factor Risk Model. Currency returns, of
course, are measured against a base currency, termed a numeraire. We cannot use either USD or
CNY as the numeraire when computing the CNY/USD correlation since the return of any
currency to itself is, by definition, zero, thus making its correlation to any other currency also
zero.
The historical CNY/USD exchange rate (top) and the CNY vs. USD correlation since July 2007
using three different numeraires: the Euro (EUR -- blue), Pounds Sterling (GBP - red), and
Japanese Yen (JPY -- green). (The CNY was depegged from the USD on July 21, 2005; prior to
that the CNY/USD correlation was 1.0) Notice that the exchange rate levels off in July 2008 and
exhibits essentially no variation from January 2009 through June 2010. Whenever the exchange
rate is constant over a significant period of time, the correlation should rise toward 1.0. This is
exact what happened in Axioma’s risk models. Prior to August 2008, correlations were flat or
falling. In July 2008 China took deliberate steps to respond to the financial crisis. Once the
exchange rate leveled off, the correlation rose steadily in all three numeraires. The correlation
reached a near perfect correlation for the first six months of 2010. Since June 2010, the
correlation has fallen steadily as the exchange rate has dropped.
Several recent dates are indicated on the graph in the top right. It is interesting to see how these
political events closely bracket the highest currency correlations in Axioma’s risk models.
Figure 1. The correlation predicted by Axioma’s Global Risk Model between the US dollar and
the Chinese Yuan Renminbi (CNY) as measured in three different numeraires: the Euro, Pounds
Sterling, and Japanese Yen.The corresponding exchange rate between CNY and USD is shown
in the top graph.
The data indicates that Axioma’s Global Risk Model’s accurately and quickly tracked events and
market news related to the currency crisis. Axioma’s risk models use exponentially weighted
historical data to estimate volatilities and correlation. This explains why the correlations did not
reach 0.999 until December 2009 even though the exchange rate was flat starting in July 2008.
The correlation drops very quickly in June 2010, without any apparent lag. This occurs because
the correlations are so high: when the vast majority of the returns are nearly perfectly correlated,
just a few data points are needed to cause the correlation to drop from values such as 0.999.
A Mao in every pocket
CHINA likes to cover large distances in small steps. Last month it said that a few lucky foreign
banks, including central banks, could invest some of the yuan they hold offshore in local Chinese
bonds. The first to take up the offer was Malaysia’s central bank, the Financial Times reported
this week. With that purchase, another stone was removed in the great wall shielding China’s
currency from the outside world.
Global currencies emerge sporadically—the dollar in the first half of the 20th century, the euro
over the past decade. That China could even have a plausible claim to such a thing is a
remarkable turnaround. Its monetary policy and its mints were often in such wretched shape
before the 1949 revolution that old Mexican silver dollars still circulated. The very word “yuan”
is a contraction of “yang yuan”, or “foreign round coin”. After the revolution the currency
situation got even worse, with ration coupons playing a role in transactions. International deals
went through the creaking hands of the Bank of China or, quietly, black markets. It was only in
1994 that a unified, official exchange rate was established.
After solidifying the role of its currency in its domestic market China resisted the next logical
step. It kept a tight grip on the flow of capital across
its borders. And even as its companies conquered
world markets, they priced their goods in other
people’s money. The limits on conversion allow
China’s authorities to steer the economy and control
business. But this strategy has exposed China’s
companies to potential foreign-exchange risk, one
reason why the authorities are reluctant to let the yuan
move more freely against the dollar. It has also
deprived China of the easy “seigniorage” profits that
come from buying foreign goods and assets in return
for non-interest-bearing pieces of paper adorned with
portraits of Chairman.
The off- and onshore markets are still separated by a
cliff of controls. Companies cannot borrow yuan from the mainland; they must earn them
through trade. Crudely put, yuan flow out of China only if goods or services flow the other way.
And offshore yuan do not easily travel back into China either. A currency represents a claim on a
country’s underlying assets. “The good news is that those assets in China are ever-growing,”
observes Ronald Schramm, a visiting professor at China Europe International Business School in
Shanghai. “The bad news is that with all the restrictions, there are few ways for outsiders
actually to cash in on the claim.”
Last month’s decision to let some banks spend their offshore yuan on local Chinese bonds
creates another link between these otherwise parallel universes. It will allow some offshore yuan
to climb back onshore in exchange for assets rather than goods. These purchases will be subject
to a strict quota but still broaden the menu considerably. The onshore bond market is after all
worth $2.9 trillion, 725 times bigger than its nascent offshore rival.
If global trade in yuan does swell, international banks have a good chance of developing other
fee-generating, predictable businesses, such as handling letters of credit or payments. And since
money on its way from one place to another inevitably pauses, there should be more rises in
deposits, which become the stuff of loans.
Many foreign bankers, and even some government officials, will say these kinds of changes are
necessary and inevitable. Some sort of opening up of capital flows certainly seems to be under
consideration. But given the potential consequences, there may be far more talk than action.
United States – China Strategic & Economic Dialogue
Contemporaneously, this year’s United States – China(S & ED) has taken place against the
backdrop of very rough and patchy US-China relations in the past one year. The mutual
euphoria of a new wave in US-China relations raised by incoming President Obama seems to
have evaporated. So has evaporated the G-2 Concept which was projected as a mechanism to be
used by USA and China, to jointly work on solutions to global political problems concessions
being made by USA to China whether political or strategic, arise from US compulsions to
involve China in a financial bail-out of the United States from its financial mess. The review of
the S & ED 2010 outlined below needs to be viewed from this perspective.
The United States-China Strategic & Economic Dialogue (S & ED) took place in Beijing on May
24-25, 2010. The United States sent a 200 strong high powered delegation for discussion of a
wide-ranging agenda of security and economic issues between the United States and China. The
US side was led by US Secretary of State and the US Secretary of the Treasury.
China should re-evaluate its currency
China should revise the policy of “indigenous innovation”. In essence this Chinese policy aims at
keeping out foreign firms from doing business in China by favouring and giving preference to
Chinese firms. In other words it amounts to ‘Chinese protectionism primarily aimed at the
United States.On both these issues, China refused to budge from the existing positions. Since the
revaluation of the Chinese currency is a recurring theme in all high-level US-China dialogues,
the Chinese President once again asserted that China would consider the issue at its own pace
and time.
Conclusions:
The US and Japanese governments attribute their economic woes to the undervalued Chinese
currency. They are using various political leverages to pressure China to appreciate RMB. Many
western politicians and economists hold that the world economy would be better off with a
substantial appreciation of the RMB and China could also benefit from doing so. The
fundamental truth is that these countries have exhausted the traditional means of economic
recovery and still could not reel their country out of recession. They find China an easy
scapegoat for their incompetent economic policies. RMB-dollar stability at present, more
exchange rate flexibility will be needed in the long run, as China gradually opens the capital
market and becomes a full-fledged member of the international community. The Chinese
government is already considering options such as widening the range of RMB-dollar exchange
rate fluctuation and pegging RMB to a basket of major currencies in the world instead of US
dollar solely. Nevertheless, before China succeeds in its systematic structural reforms and the
Chinese economy gets strong enough to withstand risks of RMB appreciation, it should and will
maintain the current RMB-dollar exchange rate.
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