Macro Economics Concepts

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    Macroeconomics An Overview of Important Concepts

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    Key Identities

    Gross Domestic Product or Output (Y)Y = C + I + G + X MC= Consumption

    I= investmentG= Government ExpenditureX-M= Net exports (Exports Imports)

    Disposable Income (YD)YD = Y + TR TATR = Transfer Payments

    TA = TaxesYD = C + SC = ConsumptionS = Saving

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    Aggregate Demand & Supply

    Aggregate DemandEffect of

    Govt. Spending Income Tax

    Similar to micro economic equilibriumOutput represents aggregatePrice level is overall price level in economyMultiplier Effect

    AS

    ADFull

    employmentlevel

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    Fiscal & Monetary Policy

    Fiscal PolicyGovernment Spending/Taxation/SubsidiesRise in Interest Rates (Quantity of Money is same)Crowding Out Effect

    Govt gets the major share of the savings, thus reducing the amount available toother participantsFiscal Deficit

    Monetary PolicyCentral Bank.Some available tools are1. Repo/Reverse repo2. SLR and CRR requirements3. Capital Exposure norms for banks (This is used for targetting specific segments in

    order to reduce speculation in tht segment)

    Two aims: Growth Lower Interest Rates Inflation - Increase Interest Rates

    We do not follow an inflation target mechanism in which the Central Bank ismandated to keep the inflation arnd a fixed value

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    Market Interest rates and Govt Borrowing

    During the pre lib phase government never borrowed at a market determined rate. Itforced banks to buy its paper through policies such as SLR requirements. This footingof government expenditure at a low cost by the banks led to them charging a higherrate for other borrowers. Thus the general interest rates in the economy were veryhigh. Moreover the secondary market for the government papers was non existent.

    During the late 90s and early 2000,structural changes were carried out to remove thisanamoly.Some of these changes were1. No more compulsory buying of govt securities by RBI2. Central Government would borrow at the market determined rates (effective from april

    1 2006)3. A anonymous trading system was developed to increase the trade volumes and hence

    liquidity4. (Spreads in the secondary market for govt sec., is arnd 3 bps)5. Autonomy to RBI to set the SLR limits rather than having a min 25% SLR6. Increased participation by players such as MFs,Pension funds etc.,7. Fiscal Responsibility Act to reduce Govt deficit.

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    International Linkages

    Balance of Payments Forex

    Increase: +

    Decrease: - Current Account Goods & Services

    Exports: + (Credit)

    Imports: - (Debit) Capital Account Foreign financial assets & liabilities

    Assets -/Liabilities +: + (Credit)

    Assets +/Liabilities -: - (Debit) Reserves

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    Exchange Rates

    Fixed The Central bank takes part in selling or buy currencies to keep the exchange

    rate constantFloating

    The Market determines the rates.Most developing economies follow a mechanism of keeping the exchange rate

    within a bandCurrency Appreciation & Depreciation

    Effect on Imports & ExportsA currency appreciation leads makes exports costly and this might hurtexports. Hence SE Asian (pre crisis) had a fixed exchange rate.A currency depreciation on the other hand might make imports costly andlead to inflation in case it is a good such as Oil.

    Effect of Interest Rates: Capital Mobility The quantity of money that flows from a low interest rate country to high interest

    rate one depends on the capital controls,FDI regulations, economies(high int.,country)future growth.

    Ex: Japans low interest rate leading to capital flows out of the country toemerging markets

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    Indian Economy

    Indias economic growth in last 3 years Low rates: Consumption growth (Demand Side), Lower borrowing costs forcompanies (Corporate profits Market Boom), Low interest on govt. debt(deficit under control)

    Inflow of foreign capital huge (Increased by annual average of Rs.100,000crores in last 3 years) high liquidity in system interest rates remainlow(as supply of money increased)

    Allowed government to raise on an average Rs.75000 crores

    annually No crowding out Now, trade surplus is giving way to trade deficit Currency

    depreciates foreign investors become wary liquidity crunch insystem interest rates go up

    Risk of Inflation adds to worries Monetary tightening by RBI Impact ongrowth?

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    Indian Economy

    Split Agriculture: 22% (Population involved- 60%)

    Issues: Opening of agriculture sector (food processing,contract farming), Doha round of negotiations, microcredit,public investment

    Manufacturing: 26%Issues: Labor laws, FDI, IPRs, Infrastructure

    Services: 52%Recent Highlights

    RBI warns of higher inflation

    Correction in Sensex Reverse Repo rate increased by 25 bp WTO says slowdown in world trade growth likely

    Rupee depreciating steadily

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    Money Supply

    Money (M) = Currency (C) + Deposit (D)

    Money created through credit creation

    Principal Players Central Bank (RBI) Commercial Banks (SBI) Public

    Fractional Reserve system

    The amount of money which the bank lends is more than what it has in its reservesEx : 100 deposited in a bank bank lends 70 and keeps 30 out of the 70,the borrowermight keep 30 in the bank bank again lends 21 and keeps 7 and this cycle continuesThus the bank has reserves of 37+ whereas it has lent more than 91.

    High powered money H = C (held with public) + R ( reserves with RBI) One rupee of R with RBI worth more than one rupee of D with commercial banks Why are reserves held ? CRR , Excess reserves Reserves are used to cover daily demands for money by the depositors

    Instruments of monetary policy with RBI CRR Bank Rate Repo and Reverse Rate

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    Inflation, Interest Rate, Money SupplyIncrease money supply (liquidity) interestrate decreases , Price level increases, inflationincreases (this is due to increased spending)

    To control inflation, one mechanism is to reducethe demand for money for buying goods. This isdone by increasing interest rates. Which detersborrowers and also provides an incentive tosave more thus reducing demand for goods andreducing prices and inflation.

    Affecting the money supply by raising themonetary base

    OPEN MARKET OPERATIONS FOREX TRANSACTIONS : Foreign

    exchange market activity by which monetaryauthorities insulate their domestic moneysupplies from the foreign exchangetransactions with offsetting sales orpurchases of domestic assets.

    This is called as Sterilisation DEFICIT MONETIZATION

    RBI prints more money and gives to govtto cover deficit.

    Other ways Tinker with the repo and reverse repo rates Tinker with the bank rate Tinker with the reserve requirement ratio

    Figure 2 The Effects of Monetary Injection

    Copyright 2004 South-Western

    Quantity ofMoney

    Value ofMoney, 1/P

    PriceLevel, P

    Moneydemand

    0

    1

    (Low)

    (High)

    (High)

    (Low)

    1 / 2

    1 / 4

    3 / 4

    1

    1.33

    2

    4

    M 1

    MS 1

    M 2

    MS 2

    2. . . . decreasesthe value ofmoney . . . 3. . . . and

    increasesthe pricelevel.

    1. An increasein the moneysupply . . .

    A

    B

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    Open Economy

    Y = C + G + I + NX, NX = Net export = Export Import

    Twin Deficit Formula : YD = Y + TR TA (YD C) + (TA-TR G) NX = IPrivate Savings + Govt. savings + Foreign Savings =

    InvestmentExchange rate determined by supply and demand of domestic / foreign currency in theinternational marketSupply and Demand of domestic currency determined by

    Export / Import Capital inflow / outflowExport goes up ? Import goes up ? Interest rate goes up ?Export goes up ,then the exchange rate appreciates thus making imports cheaper andthe imports increase. An increase in exports shifts the IS curve outward leading to anincrease in interest rates (i.e exposts increase income increases..aggregate demandincreases..thus the intrest rates increase if the money supply is not changed).

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    East Asian Crisis, 1997 : Build-upUnusually successful economic performance of the Asian Tigers rapid growth in capital inflows

    Outward orientation of growth strategies, export led growth

    Standard macroeconomic indicators good inflation moderate, fiscal health good

    Decline in asset yields in the industrial economies Substantial short-term capital inflow to SE countries

    Export competitiveness lost due to substantial appreciation of dollars from 1995 onwards

    Overheating of the economy : Signs of asset price inflation in real estate and equity markets Lots of speculative short term capital inflow into the banking sector leading to credit boom for the

    private sector and increasing foreign liabilities of commercial banks Short maturity funds used to finance long duration projects.

    Lack of transparency and prudent regulation in financial sectors, bad debts, NPAs, corruption

    In 1997, loss of confidence, speculative attacks on the currencies, panic , flight of capitalThai bhat faced a speculative attack the central bank sold dollars in order to keep the exchange ratefixed it drew down in forex reserves and was forced to devalueThis led to a chain reaction as most of the other countries were put in the same club by foreign investors asfar as risk perception went,and the signs of trouble in one lead to the investrs pulling out thr money in othercountries also

    This is an example of the negative effects of fixed exchange rate system

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    Global Economy of the 21 st Century:Issues and Trends

    Deficits and the Dollar: How is USA managing its economy

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    Global Economy of the 21 st Century:Issues and Trends

    The US Current Account Deficit

    The US current account deficit stood at $835 bn, asat the end of Q1, 06

    Imports = $2.1 trillionExports = $1.3 trillion

    Imports > Exports by 55%; to keep the trade deficitfrom widening further, exports must grow 55% fasterthan importsThe loan-able funds theory at work:

    Y = C + I + G + NX => I S = CADA lot of concern from all sectors of the economy,earlier expressed only by economists. Now echoedby market participants also.

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    Global Economy of the 21 st Century:Issues and Trends

    Components of the US Current Account

    Deficit

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    Global Economy of the 21 st Century:Issues and Trends

    Financing the Deficit

    Over half of all dollar bills in circulation held outside America'sborders

    Central banks over the world, particularly in Asia, financingthe US deficitAlmost half of America's Treasury bonds held as reserves by foreigncentral banks

    Oil-exporting countries also putting extra revenues into dollar-denominated assets, including treasuriesWill the funding continue forever Misplaced optimism?Private investors already turning away from dollar assets: thereturns on investments in America have recently been lowerthan in Europe or Japan

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    Global Economy of the 21 st Century:Issues and Trends

    How has the $ maintained its levelsEmerging economies hold so many dollars that they fear the capital lossthat they would incur if they encouraged the dollar to drop. Hence, the dollarhas held up as foreign investors have been keen to buy dollar assets

    Emerging economies also want to keep the value of their currencies downto help their exports.Vicious Cycle? The longer emerging market economies continue to pileup dollars, the bigger the eventual losses

    If the US economy slows more sharply than expected, their enthusiasm forthe dollar will shrink.Cyclical factors only partly explain why the dollar has been strong; itsattractiveness is based also on structural factors or on an illusion aboutstructural differences between the American and European economies

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    Global Economy of the 21 st Century:Issues and Trends

    Will the funding continue forever ?Removal of a temporary prop : Till recently, American companies wereallowed a lower tax rate on profits repatriated from abroad. Now that has beentaken away, reducing support for the external deficit and the dollarInternational differences in interest rates : Dollar helped by the Federal

    Reserve's policy of raising interest rates (a quarter of a percentage point at 16consecutive meetings after June 2004) at a time when the Europeans heldsteady.Now the markets are worried that the Fed will stop at 5%, while the EuropeanCentral Bank is raising interest rates and might soon be joined by the Bank ofJapan; recent increases in rates in BritainChange in beliefs about how economies are faring the pace of America'seconomy is expected to slacken, while the slower-growing Euro area and Japanare thought to be picking up; evident in confidence surveysFears of inflation worries that Ben Bernanke will not be able to tackleinflation with sufficient vigorForeign central banks have been reducing their purchases of AmericanTreasuries: official holdings of these rose by only $2 billion in the first sevenmonths of 2005, against $295 billion in 2004 and $175 billion in 2003.

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    Global Economy of the 21 st Century:Issues and Trends

    The Dollar and its Decline

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    Global Economy of the 21 st Century:Issues and Trends

    The Dollar and its Decline: A Growth

    ExplanationIn 2006, the American economy was forecasted to grow by 3.6% in 06 and 3.1% in07; later modified downwards to 3.3% in 06 and 2.4% in 07.The prices of federal-funds futures suggest that investors think short-term interestrates are likely to decline within a few months.For the euro area, the forecasts were raised from 2.2% in 06 and 2.1% in 07 to2.6% and 2.2% respectively: its fastest pace for six years. There were positivesignals emanating from the most influential economy within EU Germany.Although EU GDP growth was modest by American standards, it was largelybecause of its slower population growth. Official figures of productivity growth, which

    should in theory be an important factor driving economic growth, exaggerateAmerica's lead.If the two are measured on a comparable basis, productivity growth over the pastdecade has been almost the same in the euro area as it has in America. Even moreimportant, the latest figures suggest that, whereas productivity growth is now slowingin America, it is accelerating in the euro zone.America's growth has been driven by consumer spending. That spending, supportedby dwindling saving and increased borrowing, is clearly unsustainable.That lifted the Euro. This coupled with rapid monetary growth in the euro area,suggests that the ECB will raise rates, making Euro an even more attractive optionfor central banks to hold larger Euro reserves.

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    Global Economy of the 21 st Century:Issues and Trends

    Implications of the DeficitLarge purchases of US treasury bonds depressing bond yields,encouraging households in the United States to take out biggermortgages and spend the cashIncreasing housing prices has encouraged the US population tospend more, resulting in abysmally low levels of savings. The USeconomy is primarily consumption-led. However, long runproductivity gains from non-residential investments

    US Housing market: An accident waiting to happen?New-home sales fell by 3.2% in October 2006, and the stock ofunsold new properties continued to riseSales of existing homes have picked up slightly, but here too theunsold stock has now increased to 7.4 months' supply

    Greater number of retirees in the developed countries + high

    capital to labor ratios. With low capital to labor ratios in developingcountries, industrial countries should be running current accountsurpluses and lending on net to the developing worldGrowth in export oriented sectors has been has been restricted bythe trade imbalance

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    Global Economy of the 21 st Century:Issues and Trends

    Implications of the DeficitGlobal Liquidity Gush

    Build-up of foreign-exchange reservesby countries with external surplusespumping vast quantities of dollars intothe financial system

    A large chunk of Asia's reserves and oilexporters' petrodollars have been usedto buy American Treasury securities,thereby reducing bond yields.In turn, low bond-market returns haveencouraged bigger inflows into higheryielding emerging-market bonds,equities and property, especially in Asia.This gush of global liquidity has notpushed up inflation. Instead it hasflowed into share prices and houses

    around the world, inflating a series ofasset-price bubbles. (Share prices inemerging economies have risen by243% on average from their trough in2003).

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    Global Economy of the 21 st Century:Issues and Trends

    Petro DollarsAlthough prices have recently dipped,most analysts expect the tightness ofoil supplies to keep the average priceclose to $60 a barrelthree times theaverage level in the 1990s.Biggest counterpart to America's deficitis the combined surpluses of the oil-exporting emerging economiesExpected to run a total current-accountsurplus of some $500 billion this year,dwarfing China's surplus of $200 billion

    Relative to their economies, the oilproducers' external surpluses look evenbigger: Saudi Arabia, the UAE andKuwait have an average surplus ofaround 30% of GDP, compared toChina's 8%

    The cumulative surpluses of oilexporters could amount to $1.7 trillionin the coming years, swamping China'slikely surplus of $700 billion.

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    Global Economy of the 21 st Century:Issues and Trends

    Increasing IndebtednessRising health-care and Social Security spending could create a "vicious cycle" of rising debt and interest payments and an eventual fiscal crisis Ben BernankeThis discretionary spending currentlyamounts to almost half of federalnon-interest spending and 9% ofGDP.The Congressional Budget Office(CBO), projects that health carespending will rise to 75% of spendingand 19% of GDP by 2050.The debt, would reach almost 100%of GDP by 2030 according to theCBO, a level previously reached onlyduring World War II. The annualinterest on that debt would be 4.6%of GDP, triple the current level.

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    Global Economy of the 21 st Century:Issues and Trends

    US Profligacy: ConsequencesAmerica's challenge is not just to reduce its current-account deficitto a level which foreigners are happy to finance by buying moredollar assets, but also to persuade existing foreign creditors to hangon to their vast stock of dollar assets.A fall in the dollar sufficient to close the current-account deficit mightdestroy its safe-haven status. If the dollar falls by another 30%, itwould amount to the biggest default in history, wiping trillions off thevalue of foreigners' dollar assets.

    Final Solution!

    The world economy might benefit from a gradual slide in the dollarRER (real exchange rate). It would help to reduce global current-account imbalances and, by shifting production into America'stradable sector and would cushion the United States' economy.

    A weaker dollar will hurt exporters in Europe and Asia. But theimpact on those economies could be offset if central banks holdinterest rates lower than they otherwise would, thereby boostingdomestic demand. This in turn will aid the global rebalancingprocess.

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    Global Economy of the 21 st Century:Issues and Trends

    Sidebar: Is the $s status as the globalreserve currency under threat ?

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    Global Economy of the 21 st Century:Issues and Trends

    History of the Global Reserve Currency Requirements of a Reserve CurrencyReserve currencies need to have a home economy with a large share of global

    output, trade and finance.The financial market of the reserve currency country must be deep, open and welldeveloped.

    Confidence in the value of the currency is also an important requirement.Single true example of a reserve currency shift: British Pound (Global ReserveCurrency in the Gold Standard Era)But after 1914, after the two wars and two episodes of currency devaluation, Britainswitched from net creditor to net debtor, and by the 1920s the dollar was the onlycurrency convertible to gold.In the past 30 years, the dollar has had four bouts of marked depreciation. During themost recent, which began in 2002, it has fallen by 28% against the euro and by 14%against a broad basket of currencies.Yet, 66% of the world's official foreign-exchange holdings are still in dollars,compared with 25% in euros, 4% in yen and 3% in pounds.

    During America's boom, demand for American assets helped keep the dollar strong.It remained so during America's recession the Japanese downturn kept the yendown, and the euro remained weak.In early 2002, the dollar began to fall, helped along by America's yawning current-account and budget deficits.

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    Global Economy of the 21 st Century:Issues and Trends

    Can the Dollar lose its Reserve Currency

    Status ?Barry Eichengreen, of the University of California at Berkeley, argues in a recentpaper that whether the dollar retains its reserve-currency role depends mostlyon America's own policies.

    If America allows its large current-account deficit to persist and its net foreignliabilities to rise, foreigners will become less willing to hold more dollars.The dollar would depreciate, creating inflationary pressure in America andmaking dollar reserves less attractive still, even if the Federal Reserve raisedinterest rates.

    In another recent study, Menzie Chinn, of the University of Wisconsin, andJeffrey Frankel, of Harvard, estimate the importance of these factors indetermining the shares of different currencies in the world's total reserves.They take network externalities into account: the tendency of each monetaryauthority to favor the dominant currency because all others do.

    Suppose, the dollar loses 3.6% a year against a basket of other currencies,while the euro gains 4.6% a yearthe same rates as in 2001-04. Then, theyreckon, the euro could become the top currency by 2024.If in addition Britain, Sweden, Denmark and all the central and easternEuropean countries that joined the European Union last year adopted the euro,it would supersede the dollar by 2019.

    US Yi ld C I i

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    US Yield Curve InversionWhat is a yield curve ?

    It is the yield curve is the relation between the interest rate (or cost of borrowing) and the time to maturity of thedebt for a given borrower in a given currenc y

    What does an inverted yield curve signify? According to

    Expectation theory :People are expecting the forward rates to fall in the future might imply they arepredicting a slower growth in the future hence lowering of interest rates by central bankLiquidity Preference : People are giving a higher preference to liquidity in the short might imply they areseeing a downturn in the near future(eg., bubble burst),safer to keep the money in hand rather than invest

    Inverted Yield Curves have preceeded recessions previously.Inverted yield curves are short term and have reversed themselvesThis reversal is not linked to a return to a growth phase the reversal might preceed the growth period few monthsbeforeThe current inversion on back of a string of fed funds rate hikesInverted yield curve also might be due to increased confidence in the Central banks capability to reign inflation andkeep it stable in the long run

    Short term raises in interest rates in such a scenario effect the short term interest rates only and not the long termones..And a stable long term inflation no premium against inflation risk,hence lower long term yields.Thus ,this might not necessarily mean a recession in the making.

    http://en.wikipedia.org/wiki/Interest_ratehttp://en.wikipedia.org/wiki/Maturity_%28finance%29http://en.wikipedia.org/wiki/Currencyhttp://en.wikipedia.org/wiki/Currencyhttp://en.wikipedia.org/wiki/Maturity_%28finance%29http://en.wikipedia.org/wiki/Interest_rate
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    Revaluation of Yuan

    Chi P li

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    Chinas currency Policy

    Kept it pegged at 8.28 to a dollar till nowOn July 21 05, China re-valued the Yuan by 2.1 % to USD/Yuan 8.11.The Yuan is now pegged to a basket of currencies and not to theUSD alone, and is allowed to float within a band of plus or minus 3%of the previous day's closing against non-dollar currencies and 0.3%against the dollar.

    Reasons for fixed Exchange Rate previously Chinese economy is heavily dependent upon external demand

    (exports) and external funding (FDI).

    Since intro of economic reform: growing much faster

    Causes of Chinas Economic growth

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    Causes of China s Economic growth

    2 main factors:

    large-scale capital investment (financed by large domestic savings and foreign investment)

    Rapid productivity growth.High domestic savings: 42% (profits of SOEs)Productivity gains (i.e., increases in efficiency in which inputs are used)

    Opened up to competitive forcesTrade as a growth engine

    Exports rose from $14 billion in 1979 to $593 billion in 2004, while imports over this period grewfrom $16 billion to $561 billion

    In 2004, China surpassed Japan as the worlds third-largest trading economy (after the UnitedStates and Germany)

    Past 11 years, China -- trade surpluses;In 2004 that surplus was $32 billion.Merchandise trade surpluses and large-scale foreign investment have enabled China toaccumulate the worlds second-largest foreign exchange (after Japan), which reached $610billion at the end of 2004.

    Then why revalue?

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    Then, why revalue?

    Before revaluation, the USD/Yuan rate was $1 to 8.28 Chinese Yuan,maintained by PBC bank since 1994

    The revaluation has two initial components: A 2% revaluation, changing the official value of the Yuan so that $1

    would buy 8.11 Chinese Yuan. Bank's announcement that it would allow the Yuans value to

    fluctuate slightly -- a kind of "managed float :0.3% - $3% - Others

    Why was U S pushing?

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    Why was U.S pushing?

    Most often cited reason : In order to make exports more costly thusreducing the deficit

    Unlikely to have significant impact on the U.S. trade deficit in near

    term.

    In 2004, the US ran a $600 billion trade deficit, of which $162 billionwas with China. Chinas share is a small proportion of the entiredeficit.

    To have any significant effect, the Yuan would have to increase invalue by as much as 20% or 30% against the dollar -- much largerthan the 2% shift -- to have a material impact on the trade deficit.

    Policy move or Political Rhetoric

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    Policy move or Political Rhetoric

    Limited Impact on trade deficit (U.S)

    Chinese officials have time and again emphasized their intention to

    liberalize their exchange rate regime only gradually

    Between July and October this year, the Yuan has appreciated onlyabout 0.3 percent, standing at under 8.09 Yuan to $1 now, slightlybelow 8.11 Yuan immediately on revaluation.

    Seems like a temporary political move

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    Negative Effects:

    Hard Landing Stops Growth Sudden appreciation might hit theexport sector

    Increases Value Of Non-Performing Loans In Banking SectorChinese government has massive amounts of US dollar assets,which they used to peg the Yuan. These assets will lose value inproportion with the revaluation of the yuan.

    Impact on U.S:

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    p

    Trade BalanceThe small size of revaluation: 8.3 4.4

    Since the initial revaluation was only 2.1% and future revaluations areexpected to be limited, the effect of currency revaluation on the tradeimbalance will be extremely smallSince America does not produce most of the goods imported fromChina, there would not be a decrease in the current account deficit.

    U.S Interest Rates China holds huge amt of Treasury Securities An appreciation might lead to chinese by less of securities If the Chinese

    government reduces the amount of dollars it holds in reserve or slows thepace at which it buys dollars the revaluation could put upward pressure onU.S. interest rates.

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    Some current issues

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    Oil price rose to $78 a barrel in july , since then fallen to around $ 60 - very volatile

    Oil price rise was fuelled by : Demand from China, America Hurricanes, cold winter

    Political unrest in oil supplying countries

    Fall being attributed to Autumn period between summer and winter Placid hurricane season Reduced fears of disruption in Iran American slowdown Chinese slowdown

    However, cheaper oil may mean that the slowdown may not happen to the extent imagined

    Amaranth Advisors Hedge Fund with $ 9.2 bn assets lost $ 6.5 bn in less than a month

    Issues to check up on

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    pHousing market boom in US : why? Is it over ?

    Bond Maths

    Yuan revaluation

    US Current account deficit

    India : Capital Account Convertibility

    Japan : Deflation