Evaluation of Chinese Yuan - Coursework Example

Evaluation of Chinese Yuan Student’s Name Course Number State and City Date Introduction Over the last ten years, Yuan (CNY), the Chinese currency has experienced a high inflation rate, and the compounded annual inflation rate is about 22 percent compared to the U.S compounded annual inflation rate of about 3%, which has led Chinese policymakers to continuously come up with policies for tackling the decade-high inflation period to no avail. The current round of inflation began in 1994 and was associated with the rise in the prices of food products. Control of inflation and stabilization of market prices have become China highest priorities. Since 1994, the Yuan has been “pegged” to the U.S. dollar initially with a value of more than 8.6 Yuan for a dollar (Tatom 2007). The stabilized value was 8.27 to 8.28 for one dollar between 1998 to July 2005; there was an utmost day-by-day rise and fall to around a mean value of 0.3%. The currency value of any country is dependent on the productivity, economic growth, foreign investment, foreign exchange surplus, interest rate, and political stability. A currency normally appreciates when there is economic growth, increased productivity and foreign direct investment inflow, increase in exports as well as building of reserves in Central Bank (Madura 2011). Almost all of these factors have been helpful in China for the last ten years. When China partly floated Chinese Yuan between 2005 and 2008, there was an appreciation from 8.276Yuan/USD to 6.827Yuan/USD. United States 2000 2005 2007 2008 GDP (Current US $ 9,764.80 12,376.10 13,751.40 14,204.32 GDP growth (annual %) 3.7 3.1 2 1.1 China 2000 2005 2007 2008 GDP (Current US $ 1,198.48 2,235.91 3,382.27 4326.19 GDP growth (annual %) 8.4 10.4 13 9 Source: World Bank, World Development Indicators 2009 The table above shows that China Gross Domestic Product increased to USD 4.3 trillion in 2008 from USD 1.2 trillion in 2000, this was almost 300% growth. At the same time, the US Gross Domestic Product increased to USD 4.3 trillion in 2008 from USD 1.2 trillion in 2000, which was a 45% increase. The trade tensions, political pressure, and market pressures instigated the alterations in the Chinese currency policy. China reinitiated the direct peg of the Yuan to the US Dollar in 2008 and this happened as China experienced a 25.7% decrease in export and a considerably higher number of unemployed workers. As the US depreciated with other currencies, the prices of goods bought by China continued to increase and this acted as the driving force of the Yuan inflation (Stanford 2005). Controlling inflation is a key priority in China, and a Yuan appreciation would curb the inflation. US-China Trade The bilateral trade amid the U.S. and China has been particularly high and this has benefitted both countries. In 2000, the exports by China to the U.S. amounted to US$52.1 billion and increased to US$ 162.9 billion in 2005 (a 212-percentage increase) (China Customs statistics 2005). According to the custom statistics in the US, in 2000, the exports by US to China amounted to US$ 16.2 billion; however, they increased by 157% to reach a high of US$ 41.8 billion in 2005. US exports to China are relatively high than most of the other US trade partners. In 2000, China was ranked fourth in terms of import trade partners and eleventh in export trader, though by 2005, China was ranked third among U.S. leading trade partners, the fourth leading trade export partner, the second major import trader compared to Japan, Mexico as well as Canada (Morrison 2011) . By 2005, China was US strategic trade partner. China’s exports to US was US$243.5 billion and accounted for 32% of China, US$762 billion overall exports as well as 14.6% of U.S. overall imports. The two countries also boasted remarkable achievements in financial c-operation with China holding US$ 254.4billion in U.S. treasury bonds as well as a significant sum of U.S. private securities and business stocks in 2005. At the start of 2006, the foreign reserves in China increased to over US$810 billion with 60% being U.S. capital (Morrison 2011). This shows that the US and China were big markets for each other in this period. However, after this period, the trade and economic relationship between US and China encountered numerous problems marked by increasing frictions and conflicts. This has made trade and economic relationship between the two countries to face numerous challenges, for instance in trade balance, RMB exchange rate, intellectual property rights, textile trade as well as market access in the services area(Morrison 2011). The two countries have managed to solve some of the disputes. In 2009, the total amount of goods and services that U.S. traded with China amounted to $ 390 billion. Imports totalled $ 305 billion whereas exports totalled $85 billion. The US trade deficit with China was $219 billion. Currently China is US second largest trading partner with $ 457 billion in total trade. In 2010, the goods exports were $92 billion whereas imports were $365 billion and a trade deficit of $273 billion (this was a 20.4% increase from 2009). The U.S FDI in China was $49.4 billion in 2009 led by the banking and manufacturing sectors. During the same period, China FDI in the US stock was $791 mostly in the wholesale trade sector. Both the FDI decreased from 2008. Effect of Exchange Rate, Inflation Rate, and Interest Rate on Trading China upholds a fixed rate exchange rate with the U.S. The Chinese central bank sells or purchases as much currency as is required to maintain the Yuan-dollar exchange rates steady at 8.3 Yuan per dollar (Madura 2011). The main alternative to this exchange rate is a floating exchange rate, which is comparable to the one United States uses within the Euro area, where demand and supply in the market is the basis of continuous fluctuation of euro-dollar exchange rates. In a afloat system of exchange rate, the comparative demand for a country’s assets and goods would establish the exchange rate of the dollar to the Yuan (Madura 2011). In case demand for China’s assets or goods rose, added Yuan would be required to buy those assets and goods and the Yuan value would rise if the supply of Yuan were kept constant by the Central Bank to restore equilibrium. The Central Bank of China would not need to take any action to maintain its currency peg to the US dollar if the fixed rate and the rate that would prevail in the market were equal if the Yuan were floating. Nonetheless, in due course there is a change in the economic conditions and with them the country’s currency relative demand change. If China were to maintain a floating exchange rate, there would be an appreciation over a few years because the quality and productivity improvements in China would increase the relative demand for foreign direct investment and Chinese products. Effect of Real and Nominal Value on Inflation The real (inflation adjusted) exchange rate determines a country’s economic activities, counting the amount of exports and imports and not the nominal exchange rate. The U.S and China have had approximately comparable rises in the general price levels over the past ten years (24% in the US and 29% in China); the disparity between the nominal and real rates has been small. Nevertheless, China has experienced increased inflation rates than the US during this period, so the nominal and real exchange rates have deviated significantly throughout this period. From China’s perspective, there was an appreciation of real exchange rate, which made their exports more costly and made U.S. imports low-priced. In view of this fact, the nominal and real exchange rates have diverged for the reason that inflation in China has been higher than that of the U.S. Over a long period of time, real (inflation-adjusted) exchange rates go back to their market price regardless of whether they are nominally floating or fixed (Madura 2011). If the demand for goods and services from China were to increase with the Yuan floating, the Yuan would appreciate. It would keep on appreciating until the surplus demand for goods and assets from China is exhausted and at this point, the trade balance would go back to its equilibrium point. The real exchange rate goes back to its market value with a fixed exchange rate because of price adjustment instead, although it takes time (Tatom 2007). If the rate of exchange was set below the level, which would prevail in the marketplace, Chinese exports would be relatively low-priced and U.S. imports would be moderately costly. If this situation prevailed, the trade surplus with the US would keep on. The trade surplus added to the net remittances equals the capital flowing to the US from China. Strong Versus weak Currency Both a strong and weak currency has its advantages and disadvantages. A weak currency had advantages, such as increased exports and foreign investment. The competitiveness of a country’s goods increases with a weaker currency. This boosts foreign demand while simultaneously maintaining consumer demand in the local market. Over the medium term, the also benefits companies which eventually translate into more jobs and increased consumer spending and reduces trade deficit. A weak currency also attracts foreign investors who buy companied with sound fundamentals and which are less vulnerable to an economic slowdown, encouraging value hunting in the equity markets. The profitability for multinational companies with high revenues also increases, as their foreign currency revenue is higher when repatriated. The disadvantages of a weak currency include increased costs for foreign goods, inflation and reduce profitability for importers. The increased costs for foreign products bring about inflation, which is why a weak currency is regarded as inflationary. Inflation pushes the central bank to retract monetary stimulus. A weak currency hurts companies that import many goods or those that have considerable expenses in foreign currencies. On the other hand, a strong currency has its advantages and disadvantages. The advantages include curbing inflation and reduced costs of imports. A strong currency reduces the imports costs and as a result increases consumers’ spending power. The competition of imported goods helps to keep inflation down. Increased imports also assist in boosting foreign economies, which help to produce friendly relations with other countries. It also constricts monetary conditions reducing inflation and paving way for low interest rates. The currency also expands aggregate supply because foreign input goods are cheaper and this lowers business costs. The disadvantage of a strong currency is that it increases the trade deficit because of increased imports while exports decrease because they become more costly for foreigners. A strong currency decreases the buying power of foreign consumers because their currency is not as strong. It also contracts aggregate demand as more wealth leaves for imports and this slows down the economy. CHINESE YUAN I. China’s Currency strategy The subject of China managing its own currency dominated meetings between the Chinese and U.S. officers for most of 2010. The Chinese government let its currency to appreciate by twenty-one percent when compared to the US dollar from 2005 to 2008; however, China had gotten involved in currency markets to maintain its currency exchange rate at a point which most scholars consider to be considerably undervalued compared to other world currencies (Bergsten 2010). The undervalued currency causes the country exports to other parts of the world unnaturally low-priced and its imports from these countries including the US, unnaturally costly for Chinese customers. China’s treasury suggests that considerable appreciation of the Yuan could come in handy in curtailing of outsourcing of United States jobs and creating more competition for goods and services internationally. Chinese officers refute that China’s currency practices are a large basis of the imbalance of global trade. In June 2010, China’s Central bank made known plans for improving the flexibility of the currency exchange rate (People’s Bank of China 2010). However, in November 2010 President Obama argued that China’s currency was still rated too low at the G-20 summit in Seoul. Obama recommended that the country transition to a market-based system gradually for evaluating the Yuan’s value, to ensure that everyone gains from trading (White House Office of the Press Secretary 2012). Analysts have noted that in case the Yuan appreciates considerably, the U.S. customers will deal with increased costs for the wide range of products that the US imports from China, and U.S. companies will probably experience increased costs for inputs from China. The Chinese government is trailing in the inflation fight as shown in the figure below. The measures that the Chinese government has so far adopted to curb inflation include raising interest rates, increasing the bank-reserve ratio to lend out lesser amounts of money, as well as imposing price controls on various goods; have apparently been ineffective in reducing inflation. In April 2011, the consumer price index (CPI) rose to 5.3%. The inflation numbers hovered around 5% per annum, which is particularly high in China’s past standard because the standard inflation rate for each year was 4.3 % between 1994 and 2010. There are numerous policies fuelling price increases in China. Primarily, the interest rates are very low and in the face of the recent raises, the annual lending rate is at 6.31% every year, which is just a percentage above the rate of inflation. In October and September inflation rates were officially 4.4% and 3.6% respectively, however the Chinese economists believe that there is a hidden inflation rate, which is higher than the official figures with currency issuance generating a compounded inflation rate of more than 30%. II. Yuan Exchange Policy and the necessity for improvement Over the last 10 years, the Yuan exchange rate has gone from Y8.3/$1 to Y6.3/$1. China has adopted the de facto peg to the dollar exchange policy for its currency since 1994. It maintains a fixed exchange rate to the dollar, which facilitates exporting, and importing between Chinese and foreign economy entities by reducing the risk from foreign currency exchange (Stanford 2005). This has marked a tremendous amount of change in China’s economy coupled with rising inflation rate and product price index and consumer price index revering from negative to positive. There is need to improve Yuan’s exchange policy (Stanford 2005). To prevent China’s economy bubble through currency exchange rate policy: exchange rate is a price variable and it is closely linked to price and economy growth. The price usually shifts when the exchange rate is fixed. An exchange rate reflects the relative price between a nation’s trade and non-trade goods. Non-trade goods include services, real estate, and other non-tradable goods. With economic development, the prices of non-trade goods and trade goods increase, it is not reflected through the exchange rate, and it has to reflect itself in price increase in real estate and services. This is evident in China and can explain the change in the exchange rate. The Chinese government is attempting to prevent the raise of housing market price and the economic bubble. To adjust the economic structure through currency exchange rate policy, appreciation would help China to develop a balanced economy (Sinnakkannu & Nassir 2006). In 2010, China put structural adjustments as its priority. The US economy crisis had a huge impact on Chinese economy because of its export oriented economy model. The decrease in number of exports in China from 2008 to 2009 rendered China extremely vulnerable to external environment change (Lo 2010). China’s is extremely dependent on external demand and Yuan appreciation can reduce this dependency on external demand. The inflation in China keeps raising because of the carryover effects over the last ten years. A study by academy of Social Science suggests that there will not be large unemployment in the Yuan appreciates. Thus from inflation, global trade, and economy structure, the benefits of appreciation exceeds the costs. Effect of Yuan inflation on McDonalds McDonalds has over 1,000 branches in China. The inflation has led the company to raise prices of its products. The increase in material prices has led the company to adjust the menu prices accordingly. In November 2010, the company raised menu prices by 0.5 yuan to 1 yuan for every product to tackle the rising costs of material costs as China struggled with accelerating food prices (Kwok 2010). Inflation has made business too expensive and has led the company to make steps such as issuing debt dominated in the Chinese currency in August 2010. This step paved way for establishment of the Chinese currency to compete with the U.S dollar (Lo 2010). According to Purchasing Power Parity (PPP) concept, when a country’s inflation rate rises, the demand for its currency declines as its exports decline due to higher prices. The companies and consumers in the country also tend to increase their importing and these forces place downward pressure on the high inflation country’s currency. Inflation has negatively affected McDonald operations and causing reduced profits. Inflation overstates McDonald’s financials as the earnings and revenue rise with the rate of inflation in addition to any benefit that the company generates. Inflation rates and interest rates have a significant impact on exchange rates and therefore influence the value of McDonald’s. The exchange rate exposure generated from transaction risk is evident in the reduced operating profits of the company. The operating and transaction risks affect the net cash flow and the profiting capability of the company in a comprehensive way and this is reflected by fluctuations of stock prices in the market. According to (Kwok 2010), McDonald’s shares were underperforming closing at 2.09 percent in one of the trading sessions. McDonald’s food rising prices are resulting from the pressure of rising food and rental costs caused by inflation. By doing this, the company is attempting to deal with inflationary cost increases in an effective manner. The fast inventory turnover, capacity to regulate menu prices, considerable property holdings and cost controls, most of which are at set costs and partially funded by debt which have been made cheaper by inflation – have come in handy for McDonald in dealing with the inflation. McDonald can counteract the inflation rates by using transfer pricing and costing. The company can value goods and services that pass between its branches. It can use a cost-plus method, whereby they take actual costs of production and add a fixed monetary percentage or amount. Alternatively, it can use the market price, less a certain percentage discount. Under arm’s length pricing, they can charge same prices to affiliates. The cost-based transfer has the advantage of providing the firm with flexibility. MNC and Exchange Rate Risk One of the major risks faced by MNC is an exchange rate risk. Since exchange rate movements can affect a multinational cash flow, they affect the MNC value and performance (Madura 2011). The risk of the foreign exchange rate arises from doing international business denominated in currencies other than the domestic currency. Higher fluctuations like in the current Yuan case causes high risk of gain or loss. An MNC can reduce foreign international risk through international transfer prices. Transfer pricing is rated as one of the best strategies of minimizing foreign exchange losses from currency fluctuation or to shift the losses to another subsidiary by moving assets from one country to another under a floating exchange rate system. A MNC can change the transfer price to take advantage of expected movements in the exchange rate; this enables it to charge high transfer prices when the currency is expected to decline. By doing this, an MNC like McDonalds maintains the gross profit margins in terms of U.S. dollars. To reduce exchange-rate risk, MNCs diversify operations, hedge in foreign exchange markets, and borrowing in the currency used while investing. Using financial tools such as currency and options swaps to hedge currency price risks is of great importance in reducing exchange rate risk. Conclusion The Yuan inflation has put an upward pressure on prices of products and real estate and on the local interest rates. The currency is weak because of the forces from the purchasing power parity. A decline in the exchange rate and a decline in a country's purchasing power usually go hand-in-hand. The high inflation rates and interest rates influence a considerable effect on the exchange rates and influenced the value of Multinationals such as McDonald. China’s should change its current exchange rate system to a floating exchange rate. If it changed to a floating exchange rate system, the relative demand for its goods and services would establish the exchange rate of the Yuan to the dollar. In case demand for its assets or goods increased, there would be a demand for more Yuan to purchase the assets and goods and this would make the Yuan to rise in value, given that the government instructs central bank to keep the supply of Yuan fixed to re-establish equilibrium. Reference List Bergsten, C 2010, We can fight fire with fire on the renminbi, Financial Times. Kwok, D 2010, McDonald's price rise points to inflation pressure, Available at: http://www.reuters.com/article/2010/11/17/us-mcdonald-china [accessed 18 April 2012] Lo, C 2010, The myth of the internalization of the Chinese Yuan, The International Economy, pp. 30-33. Madura, J 2011, International financial management, 11ed, South-Western College Pub, Mason, OH. Morrison, W 2011, China-U.S. Trade Issues, Congressional Research Service. 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