USD/CNY: Exchange Rates - Essay Example

?Running Head: USD/CNY USD/CNY: Exchange Rates Part A: Background Infromation: Initially China followed a policy of keeping its exchange rate extremely low. However, it soon realized the adverse affects of its policy and started appreciating its currency. From the period of 2004 to March 3, 2012, Yuan appreciated by more than 23% and fluctuated between 8.2800 to 6.3039. The following graph shows us that condition of Yuan between 2004 and 2012. Figure 1: China’s exchange rate appreciation and Dollar’s Depreciation Source: Google Finance, 2012 The fluctuation can be divided into the following important periods: Figure 2: Important USD/CNY Fluctuation Date Source: Google Finance, 2012 China follows the policy of managed exchange rates. In other words, Chinese Yuan is not allowed to change its exchange rate according to the forces of demand and supply instead Chinese Government intervenes in the exchange rate market to set the rate it desires. Many experts argue against this policy. They believe that if Chinese government allows the currency market and forces of demand and supply to control the market, the USD/CNY exchange rate will be much higher. Although many economic theorists question the viability of such policy, but it has been proven that the policy has been pretty successful as China is lead the global economy. So much so that even President Obama stated that the Chinese policy of keeping their currency undervalued results in competitive disadvantage for American firms. We can look at the above scenario from the economic theory of fixed exchange rates. Figure 3: Chinese Government Intervention in Exchange Rate Market Source: Sloman, 2004 pp. 235 Figure 1 above shows the how Chinese government keeps it exchange rates at level lower that what it should be. This strategy helps the economy of People’s Republic of China. Chinese firms are more competitive when the exchange rate is lower than when it is higher. It makes Chinese products cheaper and raises the demand of Chinese products. Coming back to figure 1, we can see that the market forces of demand and supply leads to higher exchange rate than the current exchange rate of CNY. However, the government intervenes in the market and increases the supply of Yuan in the market. This makes sure that the exchange goes down to a level that is determined by the Chinese government. This leads to more exports and improving balance of payment scenario as higher prices of imports discourage people to buy imported goods. Hence, the Chinese government is at an advantage by keeping exchange rates in control. This policy makes Chinese firms more competitive in the international market and leads to more exports and at the same times it discourages imports because imported goods become expensive in local currency. The figure 2 above shows the change in China’s policy after 2005. The Chinese government decided to increase the role of market forces in determining the exchange rate after 2005. In the first stage, the government appreciated the currency from 8.28 to 8.11. This was an appreciation of 2.1%. It was also announced that the exchange rate of USD/CNY will be allowed to fluctuate around 0.5% daily. After this the government appreciated the USD/CNY exchange rate slowly but steadily. In 3 years time from July 2005 to July 2008, the USD/CNY exchange rate moved up from 8.11 to 6.53. The current system can be called as managed floating exchange rate. In this system, market forces are allowed to operate until certain limit (in this case 5%) after which the government starts intervening the market in order to maintain exchange rate stability. Figure 3: China use of “Managed Floating Rate” Source: Lipsey and Chrystal, 2003 pp. 243-248 Figure 4: Chinese Exchange Rate New System Source: Sloman, 2004 pp. 235 Figure 4 above shows how the new Chinese Exchange rate system works. The government allows the market forces to operate until the exchange rate is under certain limit (represented by red region). However, as soon as the exchange rate crosses the limit, the exchange rate system reverts to managed exchange rate. Government intervenes in the market when the exchange rate reaches the green region and pushes the exchange rate back to the red region. This is done to promote stability in the market. Figure 5: More Exchange Rate Appreciation Source: Williamson and Labonte, 2012 pp. 12-13 The Chinese Government further revalued its currency from 2010 onward citing the global economic conditions. The exchange rate moved from 6.83 to 6.35. This was a movement of around 7.6% in the exchange USD/CNY exchange rate market. There are number of factors that can be attributed to the changes in the USD/CNY exchange rate market. These movements do not occur only because the government wanted to change the way it operated the currency market, but these changes occurred due to a lot of economic factors such as Balance of Payment, Inflation in the economy and to provide relief to the people of China. The first reason why the Chinese authorities allowed the USD/CNY to appreciate is because of the going inflation rate in China. In China, inflation was growing at a rate which is twice the rate of inflation in the United States of America. This meant that the traded goods should have increased in value by around 10%, whereas in terms of exchange rates, the increase was only 7.6%. Hence, in order to provide fairer picture of the parity between the economic indicators of the two countries, the Chinese government allowed the exchange rates to appreciate. Chinese currency is pegged against US dollars. In other words any appreciation in the US dollar ultimately increases the value of Chinese Yuan in the global currency market. Hence, this resulted in disturbing results in Trade Weighted Index with China unwilling to move its currency either ways. Another reason for the Yuan’s appreciation was the concerns by US officials against Chinese currency undervaluation and its impact on balance of payment deficit and unemployment in the USA. They argued that China is playing an unfair game with the USA. Keeping it currency undervalued means that Chinese exports are cheaper to American people, whereas American exports are expensive to Chinese people. This is giving an unfair advantage to the Chinese companies and deteriorating balance of payments and current account balance of the USA. Many companies that are unable to do well in the Chinese markets as a result of this policy have to close down their business that leads to unemployment. Hence, this policy of China has direct relationship with unemployment in the United States of America. Hence, the officials in the USA called for China to abolish its policy of keeping exchange rate undervalued. Figure 6: China’s Current Account Balance and FX Reserves Source: Williamson and Labonte, 2012 pp. 8 IMF also warned China that it is wounding the world economic system through its policies. By accumulating such large amount of FX reserves it is deteriorating the current account balance of its trading partners. These partners are facing large amount of trade deficits as a result of China’s polices. US alone is suffering a lot from China’s policies. As a result of China’s policies the trade gap between China and USA has grown from $10 Billion in China’s favor to $270 Billion in China’s favor. China has also been able to accumulate $2.75 trillion foreign reserves and it can beat any country or currency in the foreign exchange market. Hence, China should change its policies for the betterment of the global economic system. Economists also argued that these practices of China are forcing other economies in East Asian to follow the same policies. This has further worsened the situation in the United States of America, where around 1.2 million people have lost their jobs. (Sloman, 2004 pp. 143-154). Foreign investment also has a bearing on the exchange rates. There are two types of foreign investment. One type of investment is portfolio investment and other type of investment is direct investment. Direct investment is in physical assets such as factories and production assets. A portfolio investment is in shares and other financial instruments. Foreign direct investment is long term and more stable whereas portfolio investment leads to fluctuation in the exchange rates. All of these factors were not only a concern for the United States of America, but they were a concern for the global economic system. As a result, China was pressurized to abolish its practices of manipulating its leveraged position in the currency market. Several bills were passed in the US congress against the China’s stance of manipulating the exchange rate market constantly. These bills talked about reducing the unfair imbalance in international trade through unfair practices and forced China to abolish its system of managed exchange rate. Among these bills, these common ones were S.1619, S.1130, and HR.639/S. 328. Even President Obama stated that making China address its currency policy will be his top priority. Obama tried to address the issue by making two forums. The purpose of these forums was to force China to adopt market based foreign exchange system. These forums were S&ED and JCCT. (Reuters, 2012) As a result of all these reforms and actions taken by the US officials and multilateral trade organizations, the Chinese government allowed its exchange rate to fluctuate and the USD/CNY exchange rate fell from somewhere in the mid 8s to 6.29. It was done to protect the future of the USA and the future of global economic system. However, it must be remember that China did not suddenly move its exchange rate. Instead it moved its exchange rate slowly in the region of around 0.5 to 2 percent in order to make sure that economic stability in China does not get a hit or does not suffer in any way. This shows the shrewd thinking and planning of the Chinese system and the result of this superior planning is that China is ruling the economic system of the world through its trade policies and growth oriented stance and no wonder, we can see that in future China is going to beat the United States of America in the future if it persisted with its out-of-the-box economic and business friendly policies. (Lipsey, 2004 pp. 235-240) Part B: In the short-run, this devaluation of currency will hit the United States of America in an adverse way. This will be because of the J Curve effect. Figure 7: The J-Curve Effect Source: Welker, 2012 The above diagram shows that the US economy will not immediately recover after the appreciation of Chinese currency and there will be some time before the US currency will rally against the Chinese Yuan. In the long-run however, the imbalances caused due to the artificially managed Chinese Yuan will disappear and US currency will devalue (Usd.fxexchangerate.com, 2012). This will be a good sign for the US economy and forex markets because it will make other countries more competitive against China. Some of the reserves that the Chinese government has accumulated over the years will also come down and imbalances will start to disappear. In other words, it is about time that we see that Yuan value will rise and it will be a good sign for the global economic system. (Forecasts.com, 2012) This will start a cycle of appreciation of Chinese currency and there will come a point when USD/CNY will equate. This is possible because it is China that is funding the United States of America and has the largest portfolio of US treasury bills. As a result of this Chinese currency will become dearer as more and more financial institutions will start buying the Chinese currency in order to prevent them from any credit risk and from any sovereign debt crises if China loses its interest in US treasury bills. Hence, I can foresee that within few years USD/CNY will become equal. This will bring USA and China at par in terms of economic affair and will create a better global economic system. This will eradicate any trade imbalance in the region and in the global scenario. This will improve the balance of payment situation in the United States of America and will create more jobs. (Online.Wsj.com, 2012) Conclusion: In the end, it can be concluded from that paper that China has done more harm than good by maintaining its exchange rate lower than what they should be. It has not created trade imbalance between the United States of America and People’s Republic of China, but it has played it part in creating trade imbalance in the global economic system. Many countries are now thanking President Obama and the US congress for making China realize that it is harming the world through its unfair currency policy. The Chinese government is also good enough to respond to the concerns by slowly appreciating its currency to fair level. However, still the currency needs to go up in order to eradicate all the unfair advantage and to create advantage for countries other than China in international trade for the development of global economic system. References Forecasts.org (2012) Chinese Yuan to U.S. Dollar Currency Exchange Rate Forecast. [online] Available at: http://www.forecasts.org/yuan.htm [Accessed: 28 Mar 2012]. Google.com (2012) US Dollar: CURRENCY:USD quotes & news - Google Finance. [online] Available at: http://www.google.com/finance?q=USDCNY [Accessed: 31 Mar 2012]. Lipsey, R. and Chrystal, A. (2004) Economics. 3rd ed. Oxford: OUP, p.233-240. Morrison, W. and Labonte, M. (2012) China's Currency Policy: An Analysis of the Economic Issues . [online] Available at: http://www.fas.org/sgp/crs/row/RS21625.pdf. Online.wsj.com (2012) Beijing Hints Yuan Has Room to Rise - WSJ.com. [online] Available at: http://online.wsj.com/article/SB10001424052702304450004577276410346641148.html [Accessed: 28 Mar 2012]. Reuters.com (2012) Top Republican: bill on China yuan dangerous| Reuters. [online] Available at: http://www.reuters.com/article/2011/10/04/us-usa-china-currency-idUSTRE7911TD20111004 [Accessed: 28 Mar 2012]. Reuters.com (2012) China to let yuan rise faster to ease prices: paper| Reuters. [online] Available at: http://www.reuters.com/article/2011/04/19/us-china-economy-yuan-idUSTRE73I0BI20110419 [Accessed: 28 Mar 2012]. Sloman, J. (2004) Economics. London: Prentice, p.143-154. Usd.fxexchangerate.com (2012) United States Dollar(USD) To Chinese Yuan(CNY) Exchange Rates Today - FX Exchange Rate. [online] Available at: http://usd.fxexchangerate.com/cny/ [Accessed: 28 Mar 2012]. Viet-studies.info (2011) The Future of the Yuan. [online] Available at: http://viet-studies.info/kinhte/FA_Future_of_Yuan.htm [Accessed: 28 Mar 2012]. Welker, J. (2008) The Marshall-Lerner Condition, the J-curve, and the US trade deficit | Economics in Plain English. [online] Available at: http://welkerswikinomics.com/blog/2008/12/12/the-marshall-lerner-condition-the-j-curve-and-the-us-trade-deficit/ [Accessed: 28 Mar 2012]. Read More