Why China Is in a Position to Threaten the US Currency - Assignment Example

?Foreign Currency Business May 24, Examining the Debate That China is subsidizing and threatening the U.S. currency. The debate that China is practically subsidizing the U.S. currency makes sense because China has been the largest trading partner of the United States. It is the second leading economy in the world, next only to the United States. I n 2010, China is the second world’s largest economy, producing $10.9 trillion (based on the purchasing power parity. It comes next to the United States that has $14.6 trillion . It is even predicted by the IMF that it will overtake the US economy by 2016(Economy Watch, June 2, 2010) In November 2011, U.S. debt to China amounts to $1.13 trillion. This is 25% of the total $4.6 trillion of US debts. In 2011, China exported $1.58 trillion worth of production, 18% of which is exported to the US, while it has imported $333.9 billion from US, creating a trade deficit of $295.5 billion.(Kimberly, Amadeo). This massive surplus is the effect of China’s monetary policy of keeping their Remnibi lower than the equilibrium rate. This monetary policy is the subject of debate of IMF, the World bank, the government ,and other financing bodies. However, despite its robust economy, its GDP per capita income has remained relatively low as compared to United States. China’s GDP per capita is $4,428 while US has $47,153.(The World Bank) In effect, China is not subsidizing US economy because both countries benefit from the deal. The proceeds of the US debts are spent on federal programs while payments of interests of loan is spent by China to propel its economic growth. US debts also kept interest rates low. It is threatening because by holding too much ownership of U.S debts, China can use it as an economic weapon and shift the economic balance in its favor. Being second greatest in the world’s economy, China can use this power as leverage for imposing demands. For instance, in 2009, China proposed for a new global currency to replace the dollar because it was alarmed of the drop of dollar rate, and was afraid that its investments would deteriorate (Macdonald, Joe. 24, Mar. 2009). China has been reported to feel uneasy about relying on the dollar to store its reserves. It has also pressed for changes to give developing countries more influence on the IMF, the World Bank and other financing institutions. To reduce its complete reliance to dollars, China now swaps currency with G-20 trading partners like Hong Kong and Argentina. G-20 is a group of finance ministers and central bank governors from 20 economies and was formed to discuss the international financial system. To date, there is no report on the success of this proposition. What is its impact to the U.S. economy? The reduction of China’s demand for dollars leads to a domino effect – increase of interest rates that would hamper revival of the economy. Threatening to pull out all of its holding from the US will create havoc because if China calls its debts all at once; demand for dollars would be increasingly high, causing a dollar collapse that would disrupt international markets. This would trigger another financial crisis wherein everybody suffers including China (Kimberly). This is more unlikely to happen because it will reflect of China’s competitiveness. When China raises its export prices, US consumers will think twice and buy US products instead. As a policy, China keeps its currency Remnibi, lower than the dollar, a strategy that works for its advantage because it makes product imported from China lower than the U.S. products, and in the final analysis, be able to create more jobs for the Chinese, and be able to fund the growth of its economy. The US is trying to persuade China to revise its policy of having an undervalued Remnibi. The Remnibi is said to be 40 percent below it real value thus making its products excessively low and the US exports comparatively high, but whether this will be heeded by the Chinese government remains to be seen in the light of recent economic developments, The recent macro-economic developments come as a big surprise because according to Kenneth, Rogoff, a Chief Economist of The International Monetary Fund, there is a sharp drop in the account surplus of China. The IMF is forecasting a 2012 surplus of only 2.3%, down from its peak of 10.1 in 2007 because of the decline in China’s trade surplus – meaning there is still an excess of the value of exports than its imports. In view of this decline there is a question on whether the US, IMF and other governing bodies should continue to persuade China to consider changing its monetary policy of keeping its Remnibi low. The answer should be no because China’s economy is still filled with imbalances. Professor Rogoff argues that the logic of linking the exchange rate with the current account is weak because there are other factors that caused the decline of China’s balance of account. First, is the rise in the cost of imported raw materials that could not be passed on as entire added cost. Second, is the slow growth in the advanced economies as an effect of financial crisis. While China is experiencing a stunning growth, other economies are going down, thus, exports are relatively affected by decline, it has nowhere to go but down. Third, is that the China’s exchange rate has appreciated by 14% since 2008 as per IMF estimates. As per report, China’s inflation is higher than the average of its trading partners, but is now declining. It was at its peak of 6 percent in 2008 and now down to almost zero in 2011and that its Remnibi is gradually strengthening. According to Market Watch, IMF cuts its forecasts of China’s growth due to the threat of weakening of China’s exports and uncertain global conditions. However, despite this slow down, IMF believes that China has “room for counter veiling fiscal response” and will use this to “provide more stimulus to the domestic economy”(Market Watch) . Thus, IMF expects China will grow by 8.75% next year, lower than its initial projection of 9.0%. IMF predicts that, as the global condition normalizes, China’s current-account imbalances will again return to its previous conditions. Due to the appreciation of the Remnibi by 6% in real terms in 2011, upward pressure on this currency has diminished. Report said that the pace of China’s reserve accumulation has slowed down due to ” smaller trade surplus, higher global risk aversion, and valuation effects associated with a stronger dollar” (IMF) This particular decline of China’s exports simply points out that their trade balances has no relations with exchange rate and current account balances because as Prof. Kenneth Rogoff argues, “capital flow pressures can exert pressure on their own exchange rate, independent of trade”. Thus, as observed, China is in a position to threaten the US currency because of its leverage due to its accumulated debt holdings. Any threat of withdrawal can trigger pressure on the demand for dollar and an increase of exchange rate. It cannot be called as subsidizing because both countries are benefitted by the transactions. U.S. pays a fixed interest rate on its debt securities, meanwhile China uses this income to fund its growth. IMF’s projections that when the global condition normalizes which is due over a period of time, the Remnibi will seek its own level and will not be a threat. References International Monetary Fund. Feb. 6, 2012. China Economic Outlook. China. (Economy Watch, http://www.economywatch.com/economies-in-top/?page=full 02 June 2010 MacDonald Joe. 24 March 2009. China calls for a new global currency. currency. ABC News. http://abcnews.go.com/International/story?id=7156932&page=1 Rogoff, Kenneth. Why a Flexible Remnibi Still Matters. 02 May 2012. Project Syndicate. http://www.project-syndicate.org/commentary/why-a-more-flexible-renminbi-still-matters Shen Hong. IMF cuts China 2012 growth Forecasts to 8.25%. 23 May 2012. Market watch. The Wall Street Journal. http://www.marketwatch.com/story/imf-cuts-china-2012-growth-forecast-to-825-2012-02-06 The World Bank. GDP per capita (current US $) http://data.worldbank.org/indicator/NY.GDP.PCAP.CD Read More