15480187 (ECO3AWE)

Asia in the World Economy (ECO3AWE) Essay – Semester 1, 2013

Paul William Shoobridge (Student No. 15480187)

Discuss the debate over the Chinese exchange rate policy, paying attention to the implications of maintaining an ‘undervalued’ exchange rate for the current account. You should critically review the main opposing arguments in regard to the value of the Chinese currency, backed up by empirical evidence. In your view, what is going to happen to the current account balance if China moves to a flexible exchange rate in the future?

Abstract:

This essay presents a discussion of China’s exchange rate policy. In 1994, China fixed its

currency (the RMB) to the US$, until 2005 when it was allowed to gradually appreciate.

Critics identify China’s current account surplus and foreign currency reserves as signs that

it is effectively subsidising its exports and damaging industrialised economies, by

maintaining an ‘undervalued’ RMB. However, the research material provides refutations

which are found sufficiently compelling to discount these criticisms. It is anticipated that

China’s future exchange rate flexibility will be achieved in an environment of strategic

certainty, without significant risk for the current account.

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ECO3AWE Essay: China’s Exchange Rate Policy – PW Shoobridge (15480187)

This essay examines the contention surrounding China’s exchange rate policy; utilising

recently published academic journal articles to inform a discussion which addresses the

criteria of the question. This discussion commences by outlining China’s recent exchange

rate policies, moves on to identify contentious issues and examines economic implications,

before critically analysing the opposing arguments and, finally, speculating on how a future

flexible exchange rate would impact China’s current account. It should be noted that across

the research material there are differing preferences regarding the two terms “Yuan” and

“Renminbi (RMB)”. To avoid confusion, this essay will consistently refer to China’s currency

as the RMB.

In the 1990’s, China commenced an export focussed development strategy, which delivered

a period of significant economic growth and development. In 1994, the official RMB

exchange rate was combined with the domestic settlement rate and set to a fixed rate of

8.68 RMB per US Dollar, which was considered be an approximate equilibrium. China’s

exchange rate remained fixed until 2005, with the RMB ‘pegged’ to the US Dollar. In June

2005, China abandoned the RMB’s peg to the US Dollar, allowing an immediate 2.1%

appreciation. The RMB was then linked to a basket of 11 currencies from across Asia and the

industrialised world, with unrevealed flexibility and weightings. Between July 2005 and April

2012, the RMB was allowed to gradually appreciate from 8.27 to 6.39 RMB per US Dollar.

(Cao, Cao, Prasad & Chen, 2011; Wang, Krause & Tong, 2012; Highfill & Wojcikewych, 2012;

Frankel, 2009)

Since before the reforms in 2005, China has attracted continual criticism for its exchange

rate policies, with claims that China’s substantial current account surplus and foreign

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currency reserves are indications of a deliberately undervalued currency which gives China’s

exports an ‘unfair’ advantage in global markets, and compromises industrialised economies.

The magnitude of these indicators are undeniable, China’s current account surplus totalled

US$ 300 billion in 2009, and by 2010 China had accumulated foreign currency reserves

valued at US$ 2.8473 trillion. These foreign currency reserves equated to approximately

50% of China’s GDP, rising dramatically from only 15.6% in 1999. (Cao et. al, 2011; Xing,

2010; Highfill & Wojcikewych, 2012; Wang et. al, 2012)

China has been accused of achieving its current account surplus through a form of

‘mercantilism’, effectively subsidising its exports with low interest government loans and

suppressed exchange rates. China’s critics contend that the strength of its current account

creates equivalent trade deficits for its trading partners, increasing their reliance on foreign

capital and their national debt. It is further proposed that China is damaging the global

economy by holding a large stockpile of US Dollars outside of circulation and that, to avoid

causing further damage, China’s foreign currency reserves should be invested in the United

States’ financial assets market or used to bail out the Eurozone. (Cao et. al, 2011; Highfill &

Wojcikewych, 2012)

In essence, the criticisms are based on an assumption that China’s current account surplus

and foreign currency reserves provide evidence of the effective subsidisation of China’s

exports derived from an undervalued currency. This assumption is an extension of the

broadly accepted idea that for developing countries, an undervalued currency or the

significant depreciation of a country’s exchange rate, can act as a driver for export growth.

This idea is frequently demonstrated across the research material, through a variety of

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theoretical proofs and economic models designed to support China’s critics. (Cao et. al,

2011; Xing, 2010; Highfill & Wojcikewych, 2012; Chen, Rau & Chiou, 2011; Chit & Judge,

2011; Chen, 2011; Xiang, Zhan & Liu, 2011).

However, these proofs and models face considerable criticism themselves. Particularly

compelling is the observation that extending the uncontroversial concept that the value of a

country’s currency influences the value of its exports, to justify the contentious concept that

controlling exchange rates is precisely equivalent to imposing a scheme of import tariffs and

export subsidies, is “highly misleading” (Staiger & Sykes, 2010:616). A similar criticism, made

in slightly stronger terms, judges the proposition that an undervalued RMB is the

determining factor in the United States’ trade deficit with China, as having “more to do with

dogmatic ideology than sound economics” (Moosa, 2011:89).

Moosa (2011) supports this somewhat damning statement with considerable evidence,

offering China’s high rate of domestic savings, low interest foreign investment, and

comparatively low capital and labour costs, combined with the United States’ pattern of

consumption beyond its income, as factors of greater significance than China’s exchange

rates. The use of China’s trade surplus with the United States as evidence of an undervalued

RMB or of a global trade imbalance is also strongly questioned, as it represents only 3% of

China’s GDP and 7% of the United States’ trade deficit. It is observed that Singapore, whose

trade surplus with the United States is 31% of its GDP, and Germany, which accounts for

20% of the United States’ trade deficit, have avoided similar ‘accusations’. Another

compelling observation is that an appreciation of the RMB by 24%, between 2005 and 2011,

did not reduce the United States’ trade deficit with China. (Moosa, 2011)

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Across the research material, several articles offer further findings that contradict the claims

of China’s critics. An important example considers the assumption that appreciation of a

country’s currency will reduce its exports, which is challenged in the case of Chinese

exports, especially into the United States. According to Wu (2010), the nature of American

demand for Chinese products means a major appreciation of the RMB would have little, if

any, effect on the trade imbalance. Similarly, Li & Xu (2011) find that after adjustments of

supply and prices, China’s trade surplus from processed goods would grow. Their rationale

is, as the world’s leading low cost producer of processed goods, China would be best placed

to respond to new market conditions and its market share would increase. (Wu, 2010; Li &

Xu, 2011)

Two factors which further complicate this issue are third party currency movements and

Foreign Direct Investment (FDI). Chen, Rau & Chiou (2011) find that China’s capacity to

influence its balance of trade through RMB exchange rates is significantly limited by the

impacts of other currencies. Third party currency movements affect intermediary goods

coming into China and create substitution and complement effects upon China’s products

within common export markets. Similarly, FDI into China has a complicating impact on trade,

influenced by the country of origin. FDI from Japan tends to stimulate China’s exports back

into Japan, while FDI from the United States suppresses China’s exports into the United

States. FDI from a third party stimulates exports into the United States more than into

Japan. (Chen et. al, 2011)

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While the critics mainly focus on international implications, there is also concern that

sustained undervaluation of the RMB could contribute to imbalances within China’s

domestic economy; through high levels of foreign investment and household savings,

outweighing consumption. These factors contribute to the current account, but restrict

domestic growth. However, the gradual nature of the RMB’s controlled appreciation has

also benefitted China’s domestic economy by allowing it to avoid the dangers of radical

currency appreciation. These dangers include downward pressure on interest rates and the

associated risk of liquidity traps; rampant inflation, waves of unemployment and the

resulting likelihood of social unrest; and the loss of momentum for economic growth and

development. (Wang, 2010; Cao et. al, 2011; Wang et. al, 2012; Mehrota & Sanchez-Fung,

2010)

In my view, this balancing of the potent forces in China’s domestic economy is the most

important consideration for the future of China’s exchange rate policy and its current

account. It seems clear to me that the purpose of China’s exchange rate policies has always

been to advance the nation’s welfare and improve its people’s standards of living. I see

absolutely no evidence of ill will from China towards its trading partners, or any attempt to

get a free ride from the rest of the world, but rather, a strategically sophisticated and

extremely careful determination to develop into its economic potential. I expect China’s

progress towards a more flexible exchange rate to continue gradually, with delicate and

undisclosed adjustments to flexibility and weightings, as required.

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For this reason, I expect that rather than RMB flexibility having a major impact on the

current account, it is more likely that the condition of the current account will determine

the future flexibility of the currency. I envision this happening in either of two ways. Firstly,

as China’s domestic consumption emerges as being economically comparable to its

manufacturing exports, and increasing demand for imports shifts the current account

towards becoming balanced, it may become prudent to float the RMB to allow greater

control over monetary policy. Alternatively, as China’s current account continues to

strengthen, with growth in manufacturing fully accommodating domestic consumption

growth, China’s importance to the global economy will create pressure for the RMB to

become a global currency. At this point, the sheer volume of trade pushing the RMB

towards equilibrium would make it impractical, and counterproductive, to control it through

market intervention.

Beyond these scenarios, I find it unlikely that China would float the RMB without enjoying a

position of extreme certainty regarding its current account. I expect China to progressively

extend the RMB’s flexibility range before officially releasing it, which may require activating

its foreign currency reserves to keep the RMB from depreciating at some stage, but I am

certain that China will not relinquish exchange rate control recklessly or prematurely. It

wouldn’t surprise me if the precise point at which the RMB achieves effective flexibility

requires historical hindsight to identify, which reinforces my view that a future move to full

flexibility of China’s exchange rates will probably have an essentially undefinable impact on

its current account.

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References

Cao, E.Y., Cao, Y., Prasad, R. & Chen, Z. 2011, ‘U.S.-China Exchange Rate Negotiation:

Stakeholders’ participation and strategy deployment’, Business and Politics, vol.(13), no.(3),

Article 6.

Chen, L. 2011, ‘The Effect of China’s RMB Exchange Rate Movement on its Agricultural

Export: A case study of export to Japan’, China Economic Agricultural Review, vol.(3), no.(1),

pp.(26-41).

Chen, K., Rau, H. & Chiou, R. 2011, ‘Determinants of China’s Exports to the United States

and Japan’, The Chinese Economy, vol.(44), no.(4), pp.(19-41).

Chit, M.M. & Judge, A. 2011, ‘Non-linear Effect of Exchange Rate Volatility on Exports: The

role of financial sector development in East Asian economies’, International review of

Applied Economics, vol.(25), no.(1), pp.(107-119).

Frankel, J.A. 2009, ‘New Estimation of China’s Exchange Rate Regime’, Pacific Economic

Review, vol.(14), no.(3), pp.(346-360).

Highfill, J. & Wojcikewych, R. 2012, ‘A Note on Teaching the Yuan-Dollar Market vis-à-vis

China’s Dollar Holdings’, Global Economy Journal, vol.(12), no.(1), Article 8.

Li, X. & Xu, D. 2011, ‘Impact of RMB Appreciation on Trade and Labor Markets of China and

the USA: A multi-country comparative general equilibrium model’, China & World Economy,

vol.(19), no.(2), pp.(19-39).

Mehrota, A. & Sanchez-Fung, J.R. 2010, ‘China’s Monetary Policy and the Exchange Rate’,

Comparative Economic Studies, vol.(52), no.(1), pp.(497-514).

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Moosa, I. 2011, ‘On the U.S.-China Trade Dispute’, Journal of Post Keynesian Economics, vol.

(34), no.(1), pp.(85-111).

Staiger, R.W. & Sykes, A.O. 2010, ‘‘Currency Manipulation’ and World Trade’, World Trade

Review, vol.(9), no.(4), pp.(583-627).

Wang, Y. 2010, ‘The Internal and External Equilibrium Exchange Rate of RMB: 1982-2010’,

Frontier of Economics in China, vol.(5), no.(2), pp.(210-231).

Wang, X., Krause, A. & Tong, C.S.P. 2012, ‘Foreign Exchange Reserve Accumulation,

Domestic Stability, and Foreign Exchange Policy: The case of China (2001-2010)’,

International Journal of Economics and Finance, vol.(4), no.(12), pp.(39-50).

Wu, Y. 2010, ‘Exchange Rates and Prices under Processing Trade: A macroeconomic

analysis’, Atlantic Economic Journal, vol.(38), no.(1), pp.(345-357).

Xiang, H., Zhan, Z. & Liu, M. 2011, ‘The Trade Destruction Effect and Trade Diversion Effect

of RMB Appreciation’, Frontiers of Economics in China, vol.(6), no.(3), pp.(479-493).

Xing, Y. 2010, ‘The Yuan’s Exchange Rates and Pass-through Effects on Prices of Japanese

and the US Imports’, Comparative Economics Studies, vol.(52), no.(1), pp.(531-548).

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15480187 (ECO3AWE)