The Inflation Rate and Exchange Rate of the Chinese Yuan and the US Dollar - Research Paper Example

number: International Financial Management Introduction International financial management is concerned with the international monetary issues like comparison of exchange and inflation rates of two or more different countries. The annual change in percentage of the consumer prices against that of the previous year is inflation whilst exchange rate is the equivalence of the value of one currency with the other. The most significant concept applied here is the purchasing power parity (PPP) between two international economies. This aids in establishing the amount of money required to obtain similar commodities from different countries hence using that to determine foreign exchange rates. Foreign investors rely on foreign and exchange rates tools of trade to make wise decisions along the economic situations in the international markets. Inflation and stock markets are related because an increase in inflation results to subsequent decrease in the value of the stock market. The focus of the report is to evaluate the relationship of Chinese Yuan against the US dollar as far as the inflation rates and exchange rates are concerned. Aims and objectives of this report The overall objective in this report is to study the relationship between the inflation rate and exchange rate of the Chinese Yuan and the US dollar. The aims are to examine whether inflation has considerable influence and relationship to exchange rate of the nation in short or long run for China and USA. This report aims at determining the economic forces of China and the US by focusing majorly on the historical rates of both countries for a minimum period of 40 months. China and the US are countries boosting of super economies with the main economic drivers being investment on technological advancement of industries and economic systems. The aim of the report is to find out what are the causes of the inflation rate and the base commodities of the two states. This is vital information because the US economy uses the bread as a base commodity while the Chinese like to use Rice. This causes disparity when evaluating the purchasing power parity because the citizens spend enormous amounts of their money on different commodities (Hutcheon 340). The US dollar being a stable currency, many countries have opted to use it as their preferred reserve money. It is used in this case as the base currency to compare its strength against the Yuan. The economy of US had never experienced inflation before unlike in China where the inflation was high as a result of the winter storms that affected the operations of the industries. The monetary and fiscal policies adopted by the federal bank of USA plays a pivotal role against the dripping of the currency or consumer goods price increase. The objective of this report is to show that inflation is not uniform in all countries or does not occur to affected countries at the same rates. A small increase in the prices of consumer goods cannot lead to high inflation rates instantly (Jerome 30). Data HISTORIC INFLATION RATES OF CHINA AND USA FROM JANUARY 2009 TO DATE Historic Exchange Rates of China and US from January 2009 To date (C) 2012 Prof. Werner Antweiler, UBC The list below indicates the exchange rate of the Yuan to US dollar for the last 40 periods. Historical Chinese Yuan Rate to US dollar Year CNY/USD 1981 1982 1983 1984 1985 1986 1987 1988 1989 1.71 1.90 1.98 2.33 2.94 3.46 3.73 3.73 3.77 1990 1991 1992 1993 1994 1995 1996 1997 1998 4.80 5.33 5.53 5.78 8.64 8.37 8.34 8.32 8.30 1999 2000 2001 2002 2003 2004 2005 2006 2007 8.28 8.28 8.28 8.28 8.28 8.28 8.19 7.97 7.61 6.95 6.83 6.77 6.46 The changes of the Yuan and Dollar exchange rates Since, 2006 to 2011 the Yuan has been mostly traded under de facto fixed peg to united State dollar regime. In 2005 china announced 12.1 percent revaluation of the Yuan to Dollar exchange rate. Meanwhile, there was a change in Yuan exchange rate arrangement to enable the value of Yuan to fluctuate based on the market demand and supply. This was done to allow a greater role for market forces in determining the Yuan exchange rate and they have to liberalize and develop china’s foreign exchange markets. During the 60-day credit period, the exchange rate for Yuan rises to 0.12 dollars and it means that a single Yuan now costs 12 cents dollar to purchase. T-test and hypothesis The china central bank set the parity rate of 6.2879 Yuan per US dollar that means the Yuan was allowed to trade in a range of 6.2564 to 6.3193 per dollar. On the 2012 February, the Yuan recorded an increase of 6.2884 per dollar and it is expected that the Yuan will perform better than the dollar in the foreign exchange market. According to the results of central Bank of China estimation , the Chinese Yuan shows the strongest pegging against the Dollar with a value of mean at 0.996, and standard deviation of 0.003 and t-value(hypothesis b3=0) of the estimated coefficient of 332. Thus, the t-test indicates that the Yuan is different from the United State dollar, and it shows Yuan is currently stronger than US dollar. Methodology The secondary data used in this report consists of monthly time series data from January 2009 to the current date of the inflation rates and exchange rates. The prediction of the changes in the currency value will be conducted through the purchasing power parity. This is achieved by using the price index of goods and services that people use in the US and China. The measures used in the data above are consumer price index, gross development products deflator. Changes in the inflation rates of Yuan do affect the exchange rates because relatively high inflation rates will lead to decline in currency value. Loss of monetary value will affect investments of the dollar in the Chinese economy but not the Yuan. The returns of the dollar will be lower in the stock market than in the actual returns because more dollars will only trade in few shares. The relationship between inflation and exchange rate is that a high inflation currency is likely to depreciate against a low inflation currency. This means that as an investor in the Chinese economy gets the same returns denominated in Yuan then he cannot buy the much stuff with the Yuan he is getting because of the inflation (Trahan, Francois, and Katherine 454). Inflation changes The current inflation rate of china is reported at 3.6% this is an improvement from the normal average rate of 4.25%. In October, the rates slowed to 5.5% compared to the same time a year ago which is down from 6.1%. In that month food, prices moderated as the price index moved up 11.9%. That change was an increase in September, food prices fell by 0.2% from September and the overall price index rose by o.1% from the previous month an improvement of 0.5% from August. The CPI rose by 6.5% in July, the highest since June 2008 when it reached 7.1%. Food prices accounted for this rate as it amounted to one-third of spending of 14.8% in July. The PPI for July was up 7.5% from 7.1% in June. Food prices being an indicator of price index, it is assumed that it led to the sudden increase in rate from 5.3% in April exceeding the March’s rate of 5.4%. This was the fastest increase in price since July 2008 when the rate was 6.3%. China’s inflation rose in May to 3.1% from April’s 2.8%. May’s inflation went down due to an increase in food prices. The inflation rate in recorded last in the US was 2.7% as at March 2012. There has been standard annual average rate of 3.38% in the last couple of months. The entire items index rose 2.7% over the last 12 months, a decline from last month’s 2.9%. Inflation adjusted trade weighted stock market of Yuan based on a number of economies appreciated by 8.9% from July 2008 to May 2010. A notable decline in the exchange rate in 2009 is observed in the data due it started to rise in 2010 because of the debt crisis effects in the Euro zone countries. In 2010, January to September, the value of Yuan increased by an impressive 5.2%. The yearly comparison of the two countries, in the inflation table, shows that US is two times better in curbing the causes at earlier stages before it goes out of hand than China. A slight improvement, however, is noticed in the year 2009 when a change of 50% in the economy of China. Between the year 2009 and 2010, the inflation of China reached its record high presumably because of the winter storms that hit the region leading to economic loss of money and time. The massive supply of money to the Chinese between 2009 and 2011 led to the historic high rate of all time. This was influenced by the introduction of monetary policies of lowering the interest rate to encourage borrow of loans in empowering the citizens. This affected the performance of dollar in the stock market as the exported goods could not yield the expected returns. Pleas by the US government about China has so far aided the dollar and restored its value to the usual worth (Hong 5). The prediction for the next period is that changes in the consumer basket of goods are soon changing due to the prevailing increase in the price of the domestic foods. The US recorded a better index in the latest month of February as all items index showed a slight change in the spending power of the people. The law of PPP will only be true and helpful if the exchange rate, of Yuan and US, is in equilibrium when their domestic powers of purchasing are the same at that exchange rate. PPP holds that 100Yuan note in China, can obtain similar goods in the US $100 can in America in which case they are now identical. With the prevailing increase in the consumer prices many will opt to purchase stuffs locally than abroad, this will improve the exchange rate because it is affordable amount to get a rather expensive item at home. In the early 2008, inflation rose to the high as there was a weeklong lunar New Year celebration that influenced spending thus disrupting supply of food. Oil and metal prices failed because of weaker demands due to the economic slump. The food prices that account for almost 39% of the CPI also toned down. The use of PPP holds in predicting the future of a country, but it faces a lot of technicalities like determining the common consumer goods between different countries. Countries use different consumer goods where money is spent on daily (Sexton, Robert 272). In 2009, the growth was largely a result of injection in the economy of 4 trillion Yuan which was taken to improve infrastructure and lending. China has been maintaining the currency’s value against the dollar at relatively low levels. The US inflation improved towards the 2011, because the prices were stripped in food and gas the energy prices went up by 4.6% whilst food gained 3.3% over that period. Prices for medical care, clothing, fares, vehicles both used and new were some of the commodities that led to the decline in March. Later in the year 2011, overall annual inflation rate peaked at 3.9%. The other 2.9% gained was an indication that inflation was under control (Mundell, Robert 226). Food prices in an economy that the average monthly salary is just about 3500 Yuan is the driver of unrestricted consumer spending, of which the policy makers strive to rebalance economy towards to protect against risk of dripping demand from the US. Annual food inflation hit a high of 14.8% in July 2011 driving consumer prices. Cooling of china’s import and export growth cause problems to the other parties like Beijing this led to the under performance in the stock market in the last quarter of 2011. Conclusion Inflation has many consequences, positive and negative; introducing a lot of money at once into an economy during a slowdown may reduce job losses, boost confidence and stimulate growth, and also create excess capacity and boost imperfection across the financial system. An Increase in inflation causes a decline in foreign exchange; this is because of the fact that the amount of goods in the local market only helps the local currency. As more products are imported in the country, the expected returns cannot be attained considering all factors constant because the value of the local currency can not meet the expectations. The purchasing power policy is a crucial tool that facilitates calculation of stock market rates, making it easy to compare foreign rates and income of different countries. The prices of the consumer goods should not be left in the hands of scrupulous businessmen who have selfish interests. They will hoard and increase prices of goods to make massive profits at the expense of the innocent consumers. Too much of this, causes a negative impact on the economy and the government should take the initiative to advice on price control mechanisms. There is a correlation between the interest rate and inflation. If the interest rate is too low many people will be encouraged to borrow, thus so much is released in the economy circulating. The supply of money in the economy should be managed so that people work hard for it, the fewer the supply, the stable the economy. This affected the economy of China when it lowered its interest rate to empower the citizens, to borrow more money for; investment not knowing that it would lead to inflation. However, inflation has its better sides too. Inflation helps the labor market to reach its equilibrium faster. This is because considering pay increase to all employees is not a better business decision and can affect the operations of the company in offloading the recurrent expenditures. The causes of inflation are numerous and if identified in a reasonable time like the US did van be a beneficial remedy to the economic implications. The common modes of controlling inflation include; the monetary and fiscal policies where the latter involves measures like taxation and subsidies while the former includes measures like high interest rates. Adequate balance of the interest, foreign and inflation rates are the only ways towards economic prosperity. Works Cited Corsi, Jerome R. America for sale: fighting the new world order, surviving a global depression, and preserving U.S.A. sovereignty. New York: Threshold Editions, 2009. Print. Hong, Tu. Foreign Exchange Control in China. The Hague: Kluwer Law International, 2005. Print. Hutcheon, Robin. China Yellow. Hong Kong: Chinese Univ. Press, 2006. Print. Mundell, Robert A. Monetary theory; inflation, interest, and growth in the world economy. Pacific Palisades, Calif.: Goodyear Pub. Co. 2008. Print. Sexton, Robert L. Exploring Macroeconomics. Mason, Ohio: South-Western Cengage Learning, 2011. Print. Trahan, Francois, and Katherine Krantz. The Era of Uncertainty: Global Investment Strategies for Inflation, Deflation, and the Middle Ground. Hoboken, N.J: J. Wiley, 2011. Print. Read More