Chinese Exchange Rate Policy - Essay Example

Chinese Exchange rate policy This project discusses about the long going debate regarding the exchange rate policy of China. The huge trade surplus and high growth rates of the country have clearly indicated that the exchange rate is undervalued. This has caused trade deficit problems for America, Europe and even the Asian countries. The chief arguments that prevent China from revaluation of its currency have been discussed to understand the stance of China. However, in recent times the country is slowly moving towards a flexible exchange rate system by opening its financial markets. Finally, the future implications once China adopts a flexible exchange rate have been discussed in the last segment. Introduction Throughout the period of 1950s and 60s, China’s exchange rate policy was determined by the nation’s geo-political, security and strategic interests. Economic calculations hardly played any part in it. The currency reforms in China had begun in the period of 1970s and ever since its inception, reforms had undergone a wide number of changes. The early 70s witnessed the delinking of Chinese currency from American dollar and linking Yuan to the Hong Kong dollar and the British pound sterling. Again, in the subsequent years, free-floating Hong Kong dollar and its rapid depreciation had led the authorities to again detach Yuan from Hong Kong dollar and the effective rate of the Yuan was pegged to a trade-weighted basket of 15 currencies. However, these currencies were not identified. In recent years, the country has switched from dollar peg to basket peg and is trying to adapt to a more flexible floating rate (Soofi, 2009). Since 2005, the currency has constantly remained undervalued, which has caused great debates in the academic and business cycles. This paper highlights this debate in details. Debate The Americans blame the Chinese for maintaining an undervalued exchange rate in the country, thereby creating trade imbalances, which favours the Chinese economy only, without helping the US trade. The Chinese, on the other hand, support their stance by arguing that trade imbalances between countries is a mere reflection of the productivity differential between the two nations and has very little to do with the undervalued exchange rate. Higgins and Humpage (2005) argue that even if the renminbi (RMB) appreciates in value, this will only have a temporary positive effect on trade balance of the US (Higgins and Humpage, 2005). McKinnon and Schnabl (2005) argues that if China succumbs to the pressure of US and appreciates its currency, then it might suffer a fate similar to that of Japan (which had appreciated its currency under the pressure from US and Europe and the entire period of 90s was marked by deflation, zero interest rate and liquidity trap) (McKinnon and Schnabl, 2005). Until 2001, the nominal exchange rate of Yuan was close to the real effective exchange rate and RMB appreciated against other currencies, including dollar. Since 2002, high productivity growth of the Chinese export sector and depreciation of the dollar have made the RMB greatly undervalued. This has resulted in immense growth of Chinese exports, with the country scoring high on trade surpluses and foreign exchange reserves. During the global financial crisis, the government had kept the dollar RMB exchange rate artificially low, primarily to boost exports of the country. The impacts of the low exchange rates had materialized in terms of providing robust growth figures in China, when the rest of the world was experiencing extremely weak growth figures. The US government has been heavily complaining about China’s exchange rate policy. This is because the US primarily considers that the undervalued exchange rate is lowering values of China’s exports and causing people in US, Asia and Japan to lose their jobs. The US fears that if China continues to keep its exchange rate undervalued, then it will have adverse effects on all the economies. The US strongly believes that under the name of currency reforms, China is actually playing the role of currency manipulator. Though Europe understands the implications of undervalued exchange rate on its trade sector, yet complaints from the country has been only modest. The concerns of Asian countries, on the exchange rate policy of China, comes from the fact that they believe that the exchange rate policy of China is attracting foreign direct investment from other regions of Asia, which is impeding their development (Funke and Rahn, 2005). China, on the contrary, has a very strong belief that the fixed exchange rate, followed by it, is important for maintaining exchange rate stability, at a time when global financial markets are extremely unstable (Gradziuk, 2010). The Chinese regards this as beneficial for both the economy of China and the world. It is because of this reason that the country has resisted any significant changes in the appreciation of its currency. China does not want to change its exchange rate policy because of any external pressure as the country strongly believes that this will be considered as a sign of weakness of the authority and will throw off the balance of its competitive supremacy. There is a strong agreement in the academic circle that if China continues to keep its exchange rate artificially lowered, then the U.S. or European Union will have no money to buy any goods from China, no matter how competitive the latter’s exchange rate is (Chen, 2010). It is supposed that if China does not appreciate the situation now, then it will slow down the recovery process of the entire global economy, in times of recession. The situation for China is not easy, given that the authority experiences a dilemma in face of the rising external pressure. The main problem with emerging countries is that the capital account liberalization and adaptation to a floating exchange rate must be done in a well-regulated manner; otherwise, this will have adverse consequences on growth of the economy. If capital controls are removed without implementing a robust floating exchange regime, then this may result in speculative capital inflows, thereby driving the inflationary pressure. To improve this situation, the country will have to revalue its currency and this may act as an impediment to the export-led growth of the country. There is empirical evidence that this is exactly what has been happening in China, as the country has been experiencing steady rise in the inflationary pressure. If the capital account controls are removed, then this may respond in capital outflows from the country and under this situation, the Chinese authority will have no other option, but to devalue the currency of the country (Soofi, 2009). The future At present, it appears that China is removing its capital controls and slowly adjusting itself to a flexible exchange rate regime. With recent actions of the People’s Bank of China (which announced major changes in China’s capital account control policy), China Investment Corporation and various other financial institutions of the country, China is headed towards establishing a flexible exchange rate. The opening up of financial institutions can be seen as an indication of adopting a more pliant exchange rate regime. A well-developed currency market and reforms in the banking industry are expected to be the precursors of this desired change. Eswar Prasad argues that even if China changes its RMB, it will not resolve the financial problems of the world economy. The most immediate impact will be improvement of the trade position of U.S., as the latter has consistently been recording trade deficits and China is recording trade surplus, as a consequence of the present policy. The more significant impact of the change of RMB will be the move towards a more conciliatory regime. The desire of the Chinese government to maintain a stable exchange rate, relative to dollar, implies that China will only import the monetary policy from U.S., which can constraint the short-term policies and hamper long-term developments. On the other hand, if the country adopts a flexible exchange system, then monetary policy of the country can act adequately to suit economic conditions of the country. The reforms in the banking sector will lead to a shift in credit flows directed at the private sector and this in turn can create possibility of increasing the number of jobs (Prasad, 2010). Another possible impact of currency appreciation in China is that it can improve the purchasing power of the country. This is because if currency of a county appreciates, then it affects by lowering the price of imports for the country. As a result, the purchasing power of the households can improve (Prasad, 2010). In the recent times of close integration between the economies of countries, cooperation is an integral recipe for wholesome development. So, there is a growing consensus that if China adopts a more flexible regime, then it will hasten the pace of recovery of the entire global economy. Conclusion This project has studied in details about the exchange rate policy of the Chinese economy. In the first section, the paper deals with historic developments of exchange rate in China. The next section establishes the debate over Chinese exchange rate policy by highlighting the implications of the policy. It has been observed that the U.S. is the biggest opponent of the exchange rate policy of China, as trade deficit of U.S. is largely due to the undervalued exchange rate of China. The rationale of China for maintaining its position has been discussed as well. China practically faces a dilemma in removing capital controls and liberalizing its exchange rate. Adjusting capital flows without making proper changes in the exchange rate can either result in speculative capital inflows or outflows. This has been the main reason as to why authorities are being defensive about changing the exchange rate policy. The final section of the project discusses the probable impacts that will materialize, once China adopts a flexible exchange rate system. Reference List Chen, S., 2010. Undervalued Renminbi: Illegal or Inefficient? [pdf] Illinois Business Law Journal. Available at: 5 [Accessed 4 February 2014]. Funke, M. and Rahn, J., 2005. Just How Undervalued is the Chinese Renminbi? The World Economy, [e journal] 28(3). Available at: 4 [Accessed 4 February 2014]. Gradziuk, A., 2010. Problem of an Undervalued Exchange Rate of the Chinese Currency. The Polish Institute of International Affairs, [e journal] 71(147). Avaialble at: [Accessed 4 February 2014]. 3 Higgins, P. and Humpage, O., 2005. The Chinese Renminbi: What’s Real, What’s Not. [pdf] Federal Reserve Bank of Cleveland. Available at: < http://www.clevelandfed.org/research/Commentary/2005/0815.pdf> [Accessed 4 February 2014]. McKinnon, R. and Schnabl, G., 2005. China: A stabilizing or deflationary influence in East Asia? the problem of conflicted virtue. Cambridge: MIT Press. Prasad, E., 2010. What China’s Currency Shift Could Mean. New York Times, [online] 8 April. Available at: [Accessed 4 February 2014]. Soofi, A. S., 2009. China’s exchange rate policy and the United States’ trade deficits. Journal of Economic Studies, 36 (1), pp. 36-65. Read More