Why China wants RMB currency undervalued - Essay Example

?Your Why China wants RMB currency undervalued China's has been under contentious debateover the issues and implications of undervaluation of its currency, the Renminbi (RMB). Regardless of continuous international pressures to appreciate RMB, Chinese government strongly resisted large change at a time (Yang, Wei, and Simla v). China has adopted a policy of intervention to control the appreciation of its currency, the renminbi (RMB), against the dollar and other currencies. This policy measure is heavily criticized by most of its trading partners, especially the United States (Morrison and Marc 1).China's policy of pegging its currency against the U.S. dollar has resulted in severe devaluation of RMB. This undervaluation gives RMB an unfair advantage over competitors in exports. Critics argue that this policy has resulted in China's huge current account surplus, and global trading imbalance (Chen and Mai 4).Some analysts argue that China makes a deliberate effort to manipulate its currency in order to get an unfair trade advantage over other trading partners (Morrison and Marc 1).U.S. claims that RMB's undervaluation is leading to U.S. manufacturing job loss and trade deficit. On the other hand, China strongly condemns such allegations and asserts that international pressure is a form of protectionism and interference in China's domestic economic policy. This research paper explores the reasons behind Chinese currency's undervaluation and implications of appreciating it. Renminbi (RMB) is the official name of Chinese currency, and it is divided in the Yuan units, RMB and Yuan are used interchangeably. China has been under extreme criticism and international political pressure to revalue its currency. The pressure is primarily led by the United States of America who asserts that competitive undervaluation of the Chinese RMB and other Asian currencies have significant influences on the U.S. economy (Bergsten). According to Cline and Williamson's estimate, RMB's 25-40 appreciation would lead to reduction of annual U.S. current account deficit by $100 billion to $150 billion. On the other hand, proponents believe that currency appreciation is the solution to China's own problems as it can work as a tool to curb high inflation, lower import price, and dampen the demand for exports(Goldstein and Lardy 2006; Bergsten 2010; Tyers et al. 2008; Tung and Baker 2004 qtd. in Yang, Wei, and Simla 1). Nevertheless, there are widespread concerns about a major RMB appreciation. Within China, it is believed that a major currency appreciation would lead to slow economic growth and leave adverse employment influences on labor-intensive export sectors (Xu et al. 2011; Tang 2011; Lin 2011; Duan 2011 qtd. in Yang, Wei, and Simla 1). Background on China's Currency Policy Recent empirical studies reveal that undervalued currency leads to faster economic growth. It is because exports rate grow relatively faster than import rates. Therefore, the producing country generates more foreign exchange and enhances its production capacity (Abola qtd. in Joyce). When a country's currency is undervalued, exports grow more than imports because it will provide cheaper goods as compared to their competing trading countries (Joyce). In past, currency valuation has been used by countries who intend to promote their exports, such as, Japan and South Korea, and now China (Diokno qtd. in Joyce). Until 1994, China practiced a dual exchange rate system. It included an official fixed exchange rate system used by government, and comparatively market-based exchange rate system used by exporters and importers in "swap markets". China restricted access to foreign exchange in order to limit imports which resulted in large black market for foreign exchange.There was significant difference in the two exchange rates. In 1993, official exchange rate with dollar was 5.77 Yuan while 8.70 Yuan in the swap markets. United States criticized China's dual exchange rate system due to the limitations it placed on foreign imports (Morrison and Marc 1). In 1994, Chinese government integrated both exchange rate systems at an initial rate of 8.70 Yuan with dollar. The rate was allowed to increase to 8.28 by 1997 and was kept relatively stable until July 2005. The RMB was largely convertible on current account (trade) basis, but it was the opposite on capital account basis. It implies that Yuan could not be obtained for investment purposes. During 1994 to July 2005, China implemented a policy of pegging the RMB to the U.S. dollar at an exchange rate of around 8.28 Yuan. The objective behind this peg was to promote comparatively stable foreign trade and investment environment in China. Many developing countries implement this policy in their initial development stages because it prevents large fluctuation in exchange rates. Chinese central bank sustained this peg by buying or selling all the possible (needed) dollar-denominated assets in exchange of newly printed Yuan in order to reduce excess demand (supply) of Yuan. Consequently, irrespective of changing economic factors (which would have caused appreciation or depreciation of the Yuan relative to the dollar), exchange rate of RMB and dollar remained same. In a floating exchange rate system, exchange rate of the RMB to the dollar is established by relative demand for these countries' products and assets (Morrison and Marc 2). China's Stance over RMB's Undervaluation China strongly confronts external pressures on its currency policy by attributing it to a form of protectionism and interference in China's domestic economic policy (Morrison and Marc 4).China asserts that her currency policies are intended to promote economic stability rather than having negative impact on her trading partners. From July 2005-2008, China allowed the Renminbi to steadily appreciate against the dollar. After the impacts of global economic crisis became evident, China ceased appreciation of RMB and fixed the exchange rate with dollar at 6.83 yuan. China's major trading partners, including United States and European Union criticized this policy. China defended its position by calling the increasing international pressure on China to appreciate its currency "protectionism"(Morrison and Marc 1). RMB Development and Policy In June 2010, People's Bank of China decided to proceed with reforms of the RMB exchange rate regime for better exchange rate flexibility. It rejected any large revaluation at a time since they find it crucial for preventing massive fluctuation in RMB exchange rate. Their partial objective was to facilitate Chinese corporations in order to make easy adjustments for appreciation of currency through process like upgrading. However, the slow pace of RMB's appreciation has been under criticism since the announcement. Since 2005 reforms, the largest one-time rise happened on June 22, 2010 when RMB appreciated by 0.43% against dollar to 6.80 Yuan. However, it depreciated to 6.81 Yuan the very next day (Morrison and Marc 1-4). U.S. Concerns over Undervaluation Many U.S. policymakers, business and labor representative argue that Chinese government manipulates its currency in order to keep it undervalued in comparison to the U.S. dollar. The reason behind this policy is to make Chinese exports to the U.S. substantially cheaper, and U.S. exports to the Chinese markets more expensive as compared to the point where exchange rates are determined by market forces. They observe that pegged currency may have been justified during early stages of China's economic development; however, it is completely unjustified when we consider the size of Chinese economy and trade flows and global influences of China's economic policy (Morrison and Marc 5). Critics also believe that undervalued currency is the primary factor that led to the escalating U.S. trade deficit with China, which increased from $10 billion in 1990 to $266 billion in 2008. Some other factors are also considered as an evidence of Chinese currency manipulation by some of the critics. These factors include: China's massive growth of foreign exchange reserves as they increased from $403 billion in 2003 to $ 2,454 billion in June 2010, and huge annual current account surpluses as it increased from $46 billion in 2003 to $ 426 billion in 2008 (Morrison and Marc 6). According to the IMF's Economic Outlook (2010) China's current account surplus will decrease from $297 billion to $270nbillion in 2012.However, it is expected to reach $235 billion in 2011 and $778 billion by 2015(qtd. in Morrison and Marc 6).Some analysts stress that there is a direct association between the U.S. trade deficit and job losses, particularly in manufacturing sector (Morrison and Marc 6).For instance, a research study conducted by the Economic Policy Institute asserts that the U.S. trade deficit with China has caused loss or displacement of 2.4 million jobs in manufacturing sector during 2001 and 2008(Scott 2).Recent surge in unemployment rates in the U.S. has intensified concerns about the threats associated with the economic influences of China's currency policy. Moreover, some analysts assert that China's policy urges other East Asian economies to intervene in currency markets and keep their currencies undervalued in order to compete with Chinese products. Experts believe that it will prevent further depreciation of the dollar to Asian currencies and reduce U.S. exports in Asia (Morrison and Marc 6). Fred Bergsten from the Peterson Institute for International Economics states: Based on the assumption that China's currency is undervalued by at least 40% against the dollar and 25% on a trade weighted basis…a market-based Chinese currency would result in a large appreciation of the RMB and other Asian currencies against the dollar (or in other words a depreciation of the dollar to Asian currencies), which would boost U.S. exports and generate an additional 600,000 to 1.2 million jobs in the United States. (qtd. in Morrison and Marc 6) U.S. economist Paul Kurgan asserts that undervalued RMB proved to be a substantial drag on global economic recovery. It has lowered global GDP by 1.4% and negatively influenced poor countries (qtd. in Morrison and Marc 6). However, claims about negative influences of Chinese exchange rate on U.S. trade and employment are often discussed with China's exceptional economic growth (10.4% per year) during 2007-2009 as compared to any other advanced economy (IMF qtd. in Morrison and Marc 6).It led to the perceptions that China's exchange rate peg can be attributed to a 'beggar thy neighbor" policy. It means that China is promoting its economic development at the expense of others in global economic crisis (Morrison and Marc 6). The Extent of RMB undervaluation Morrison and Marc state: Given the rapid increase of China's exports and FDI inflows from 1994 (when they dollar peg was established) through the present time, one would have expected China's currency to have appreciated against the currencies of its major economic and trading partners, including the United States, had the RMB exchange rate been determined solely by market forces.(12) In order to avoid appreciation, China has built up official foreign reserves equivalent to $2.5 trillion. For past few years, IMF has entitled RMB as undervalued, but in early 2010, IMF declared that RMB was significantly undervalued from a medium-term standpoint (qtd. in Morrison and Marc 12). There are varying estimates of the RMB's devaluation against the dollar because of different methodologies and various assumptions used (Morrison and Marc 12). Recent estimates represent RMB's undervaluation as: 12 % (Helmut December 2009) for Organization of Economic Cooperation and Development; 25% (Dani December 2009) of Harvard University; 30% (Arvind April 2010) of Peterson Institute for International Economics; 40.2% (Cline and John January 2010); 24.4 % (Cline and John January 2010) of Peterson Institute for International Economics; and 50% (Niall October 2009) of Harvard University and Mortiz Schularick of Free University of Berlin. RMB Appreciation and its Implications If China will allow RMB to float, its value would be determined by free market on the basis of supply and demand of Chinese products and assets relative to U.S. assets and products. As a result, if RMB appreciated, it will increase U.S. exports and U.S. production that competes with Chinese goods. It is likely that U.S. bilateral trade deficit will decline, but it will not vanish. Chinese central bank will stop buying or selling U.S. assets to sustain the peg. In U.S., interest rate will increase since all U.S. borrowers (and federal government) will explore new investors. It will decrease spending on interest-sensitive purchases, for instance, housing investment, capital investment, and consumer durables. The reduced investment spending would reduce long-run size of U.S. capital stock, and thus the U.S. economy. In recent scenario of large budget deficit, some economists express concerns that abrupt decline in Chinese demand for U.S. assets would lead to a devaluation of the dollar that could potentially destabilize the U.S. economy. In case of falling demand for Chinese good and assets, the floating exchange rate would depreciate; therefore, influences will be reversed. Floating exchange rates change quite frequently and significantly in terms of their value (Morrison and Marc 24). Morrison and Marc further state: A move to a floating exchange rate is typically accompanied by the elimination of capital controls that limit a country's private citizens from freely purchasing and selling foreign currency. The Chinese government maintains capital controls (and arguably one of the major reasons China opposes a floating exchange rate) because it fears large private capital outflow would result if such controls were removed...If the capital flow were large enough, a banking crisis in China could result and could cause the floating exchange rate to depreciate rather than appreciate. (25) In the case mentioned above, U.S. exports and import competing firms would reduce in their output as compared to the prevailing level, and the U.S. bilateral trade deficit is likely to expand. It implies that United States would keep borrowing from China quite heavily. However, now private citizens will buy U.S. goods or assets rather than Chinese central bank. China could try to float its exchange rate while keeping its capital controls, at least in the short term. In this scenario, chances of currency depreciation would eliminate due to a private capital outflow. It would not be a direct solution, but it might be possible (Morrison and Marc 25). Yang, Wei, and Simla identified that most of Chinese macroeconomics indicator would have negative influences by RMB appreciation. However, it excludes the real wage of labour and the GDP deflator. Moreover, these influences will stay for short term. In particular, exports, real GDP, investment, and employment are expected to decline. Overall, Chinese economy would significantly reduce in short term. In addition, production will have negative influences which are estimated to distribute across all sectors. According to the study, Chinese imports from other countries will not increase as expected. Moreover, Chinese trade surplus would be reduced significantly (13). RMB appreciation would lead to improvements in trade balance in many countries and regions; however, it won't be the case with United States. U.S. trade balance with China is considered to decline by $8.2 billion due to 5% increase in Chinese nominal ER since U.S. imports would increase as compared to exports due to higher GDP and more demand (Yang, Wei, and Simla 13). In their research study, Yang, Wei, and Simla identified that the ER adjustments of surplus countries is not the solution to global trade balance issues. In particular, changes in Chinese ER in pursuit of improved U.S. trade balance would not only be useless, but also counterproductive. Moreover, any such policy would be costly for Chinese economy and consumers. Consequently, Yang, Wei, and Simla suggest that an effective solution to global trade imbalance should be based on a combination of policies which include: promoting China's domestic consumption, boosting rate saving among American consumers, and decreasing U.S. domestic consumption (13). In their research study, Chen and Mai (2011) also identify strong negative influences of RMB's appreciation in tradable and non-tradable sectors of Chinese economy. Real exchange rate influence employment in tradable industry through export demand and import input channel, however, both of these partially equalize each other. Surprisingly, real appreciation influences employment in tertiary industry even in regions with high export share. If RMB's revaluation would lead to appreciation, as a result, employment contraction would spread across all sectors. Therefore, it would be difficult to expect increase in domestic demand. It is evident that rebalancing service sector would consume time. Furthermore, a real appreciation must be supported by macroeconomic policy measures which sustain domestic demand and structural reforms (23-24). Experts argue that Chinese currency's undervaluation is the major cause of large annual U.S. trade deficits with China and loss of millions of U.S. manufacturing jobs. The situation becomes even critical when we consider unemployment rate in America (Morrison and Marc 1). Economists hold varying perceptions about the extent of the RMB's undervaluation against the dollar, and its implications on China's trading partners. Most often, they argue for both negative and positive impacts. Most of economists believe that currency flexibility can play a critical role in reducing global imbalances that has created the global financial crisis and economic slowdown. They assert that China's long-term economic interest lies in currency reform. On the other hand, many economists argue that RMB's appreciation will contribute little to reduce trade imbalance between U.S. and China unless it includes changes in U.S. and China's macroeconomic practices. Such as, China will be required to save less and consume more, and United States will save more and consume less. It will boost China's overall import (including from China) and reduce overall U.S. imports (including from China) Moreover, some argue that Chinese industrial policies pose greater challenge to United State's economic interest as compared to undervalued currency(Morrison and Marc 1). If RMB appreciated, it will increase U.S. exports and U.S. production that competes with Chinese goods. It is likely that U.S. bilateral trade deficit will decline, but it will not vanish. Chinese macroeconomics indicator would have negative influences by RMB appreciation. However, it excludes the real wage of labour and the GDP deflator. 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