Question 1

Part 1
In recent years, there have been several misconceptions, debate and accusations from different parties around the world aimed at Chinas Renmibi being undervalued for a long time. Many believe that China is manipulating their currency hence maintaining their low exchange rate in order to make their goods cheaper for trade. This significantly reduces the international trade competitiveness as Chinas low exchange rate makes them the worlds largest exporter to date.

Therefore, in order to examine the claims made regarding the RMB being undervalued, the relative purchasing power parity (PPP) is used to find the real exchange rate of the RMB against the USD, JPY and EURO. The data that were provided to calculate the relative PPP were the RMBs nominal rate and the level of CPI of China, Japan and US from the period January 2005 to December 2012. Since the RMB de-pegged itself form the USD in July 2005, we can see that the RMB has been constantly appreciating till today with its value showing an increase from 8.287 RMB/USD in January 2005 to 6.2866 RMB/USD in December 2012, as much as an appreciation of 31.8%.

RMB/USD Nominal vs Real

8.500 Nominal rate Real exchange rate

8.000 Exchange rate

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6.000 JAN JAN JAN JAN JAN JAN JAN JAN SEP SEP SEP SEP SEPT SEPT SEPT MAY MAY MAY MAY MAY MAY MAY MAY SEP

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Figure 1: RMB/USD Nominal vs Real exchange rate

Based on the graph in figure 1, we can see that the RMB gradually appreciates after it de-pegged from the USD in 2005. From the graph above, it is worth nothing that the RMB gradually appreciated post-depegging in 2005. Howeever, it appreciated sharply in 2008, which was when the global financial crisis occurred. This is sharp appreciation occurred due to the RMB re-pegging itself to the US dollar. This repegging was reversed in sometime during 2010 and 2011 when china re-pegged itself to an undisclosed basket of currencies. Following this, we can see that the repegging of its currency led to a higher rate of appreciation, albeit, slower than in 2008. However, despite the appreciation of RMB after its depegging in 2005, the real exchange rate, based on Figure 1 can be seen to fluctuate with periods where it's above the nominal rate and periods where it's below the nominal rate. A lower real exchange rate indicates that the USD is able to purchase more RMB than what it should be in real terms. This indicates that the RMB is undervalued. Analyzing the RMB/JPY exchange rates however shows that the RMB initially appreciated against the JPY reaching it's highest value in July 2007, after which it steadily depreciated against the JPY.

RMB/JPY Nominal vs Real

0.090 0.085 Exchange rate 0.080 0.075 0.070 Nominal rate 0.065 0.060 JAN JAN JAN JAN JAN JAN JAN JAN SEP SEP SEP SEP SEPT SEPT SEPT Real exchange rate

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Figure 2: RMB/JPY Nominal vs Real exchange rate

Looking at figure 2 however shows us that despite the fluctuation of RMB's value against the JPY, its real exchange rate is constantly higher than the nominal rate. This indicates that the RMB is continually overvalued against the JPY. Analysing the RMB/EURO exchange rate however shows us that the RMB has not appreciated much against the Yen from January 2005.. Unlike the RMB's appreciation against the USD, we notice that the Yen stedily appreciates against the RMB post 2008-global financial crisis. Generally, this is indicative of Japans strong economy. One of the explanations for this rise in the value of the Yen is

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due to an increase in productivity in Japan. An increase in exports and a simultaneous decrease in imports had led Japan to a current account surplus thus prompting an appreciation of the yen.

RMB/EUR Nominal vs Real

12.000 11.000 Exchange rate 10.000 9.000 8.000 7.000 6.000 Nominal rate Real exchange rate

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Figure 3: RMB/EURO Nominal vs Real exchange rate

We can also see from Figure 3 that the real exchange rate is constantly higher than the nominal rate indicating that the RMB is overvalued against the EURO. The sharpest appreciation of the RMB also occurs here in 2008. Again, this is most probably due to the re-pegging of the RMB to the USD. Looking at the graphs below, it seems as if the RMB is not as undervalued as many seem to believe.

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Under/Over Valuation of RMB

10.0000% Percentage Over/Under valuation 8.0000% 6.0000% 4.0000% 2.0000% 0.0000% JAN JAN JAN JAN JAN JAN JAN JAN SEP SEP SEP SEP SEPT SEPT SEPT MAY MAY MAY MAY MAY MAY MAY -2.0000% -4.0000% MAY SEP RMB/US$ RMB/JPY RMB/EURO

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Figure 4:Over/under valuation of RMB

Figure 4 above shows the percentage over and under valuation of the RMB for the period examined. Looking at the graph, we can see that the RMB is mostly overvalued against all three currencies. Worth noticing is the fact that the highest overvaluation occurs in the months leading to the global financial crisis with the currency falling closer to its actual value after re-pegging itself to the USD. As the graph is unclear as to whether the RMB is mostly undervalued or overvalued, especially for the RMB/JPY and RMB/EURO pais, the average under/overvaluation is tabulated to better understand the actual value of the RMB.

H1/05 H2/05 2006 2007 2008 2009 2010 2011 2012

RMB/USD RMB/JPY RMB/EURO -0.7062% 2.4554% 0.1633% -2.3277% 1.7571% -0.9765% -1.6769% 1.2392% -0.6265% 2.2574% 5.0503% 2.8579% 1.4895% 4.0118% 2.2041% -0.2993% 0.8296% -0.9226% 1.9386% 4.2762% 1.8504% 2.1627% 5.6121% 2.5800% 0.3607% 2.5176% -0.0002% 0.3554% 3.0833% 0.7922%

Table 1: Average over/under valuation of RMB

Looking at the table, we find that the RMB is only slightly overvalued against USD and EURO with its overvaluation being less than 1% and is 3% overvalued against the JPY. Against the USD, it can be seen that the RMB was initially undervalued against the USD, however, post-depegging, it's value

has constantly appreciated and is no longer undervalued against the USD. Despite the results indicating that the RMB is not undervalued, more research has to be done into understanding why it is being accused of being undervalued, especially in understanding the factors that constribute to China's booming exports and the factors that affect its exchange rates.

Part 2
China is now the worlds second biggest economy and is set to surpass the US by 2016 in real terms and by 2020 in absolute terms. But despite the growing economic and financial international role of China, its currency, the renminbi (RMB), remains a highly debated topic throughout mass media and among politicians around the world. (Saidi, 2012) In 2005, after much pressure from several parties especially the U.S. who blamed the RMB for creating unfair trade competitiveness of China products, China had unpegged its RMB from the USD. (Das, 2010) After the RMB had been unpegged, from July 2005 to July 2008, Chinas central bank allowed the RMB to appreciate against the dollar by about 21%. However, once the effects of the 2008 global economic crisis became apparent worldwide, China chose to halt appreciation of their RMB in an effort to help their domestic industries dependent on trade. Therefore, from July 2008 to about mid-June 2010, the exchange rate of Chinas RMB had been kept relatively constant at 6.83 RMB/USD. Then on 19 June 2010, China resumed appreciation of the RMB, and since then, China has allowed the RMB/USD exchange rate to rise by 7.6% (to 6.35 RMB/USD) through November 30, 2011.

However, many U.S. analysts have criticized this pace as being too slow, especially given Chinas strong economic growth over the past few years, including its trade sector, and its rising level of foreign exchange reserves. (Morrison & Labonte, 2011) Many U.S. citizens generally assume that the pegging of the renminbi (RMB) to the U.S. dollar (USD) causes Chinese employment and exports to boom at the expense of the U.S. export industry and its workers. (Jackson, 2012). Global accusations by other countries even include China being involved in unfair trade competitiveness as they manipulate their currency in order for them to maintain as one of the dominant leaders of the worlds export market.

Today, the fact that the Chinas RMB is undervalued is widely known. However how much is the RMB actually undervalued has been widely debate upon with several different parties and analyst claiming differently. Some reports by Big Mac Index had claimed that the RMB is undervalued by as much as 58% based on the purchasing power parity (PPP). Another index known as the Starbucks Tall Latte Index had claim that the RMB isundervalued by only 1% in 2004. However, these indexes were considered to be facetious and far-fetch as they are based on merely one product and different

models uses different time-horizons and measurements. Therefore, based on recent econometric estimates, the undervaluation of the RMB can range from modest undervaluation to a high of 45%. (Das, 2010).

The purpose of this report is to recommend if the RMB should be further appreciated. Prior to any recommendation, this report firstly examines the impact of appreciating the RMB against other major currencies such as the USD, YEN and EURO. Firstly, we look at the impact of appreciating the RMB on Chinas stock market. Secondly, we examine how the levels of foreign reserves maintained by China helps in improving US budget deficits. Next, China's trade competitiveness is examined. The macroeconomic impact of appreciating the RMB are also examined, namely, the impact china's trade balance as well as its trading partners, the impact on China's GDP as well as the impact on employment in terms of the employment rate.

Should the RMB continue to appreciate, we would see the domestic stock market in China to rise significantly. This is due to international speculators, or carry traders who purchase Chinese assets to profit from the strengthening of the RMB. As the expected appreciation of the RMB against the USD increases, carry traders will find that borrowing USD denominated assets and investing in RMB denominated assets to be more attractive as they can take advantage of interest rate differentials. (Jackson, 2012) Therefore, in an attempt to control the rates of appreciation of the China currency, it is likely to expect the domestic central bank, which is the Peoples Bank of China (PBoC), to accumulate reserves to mitigate the effects of rapid inflation due to hot money inflows.

Moreover should the RMB continue to appreciate, it will have an impact on Chinas foreign reserves as well as US trade imbalance. We will continue to expect and observe Chinas attempt to prevent the appreciation of its currency by purchasing larger quantities of foreign reserves mainly the USD and using the reserves to purchase US treasury securities. By maintaining large amount of foreign reserves, China is able to maintain their exchange rate at a low level, or reduce the pace of the appreciation of the RMB. To date, China has accumulated official foreign reserves equalling to $2.5 trillion. (Morrison & Labonte, 2011). Besides that, by using foreign reserves to purchase US debts, this aids the US government in funding their budget deficit and this in turn helps to keep U.S. interest rates relatively low.

In terms of trade competitiveness and addressing the impact on the trade balance, should the RMB appreciate, this would cause China to lose its dollar value of exports. According to (Das, 2010), a 20 per cent appreciation of the RMB was estimated to cause an overall loss of 3 per cent in the dollar value of Chinas export. Globally however, this would pose mixed effect on other countries, depending on their current trade relationship with China. Firstly, the exporters to China are likely to be better off but the countries competing with China in the world market are expected to lose. Furthermore, an undervalued RMB might also have the effect of limiting the level of U.S. exports to

China than might occur under a floating exchange rate system hence ensuring Chinas trade surplus position. In addition, many analysts predicted that if China significantly appreciated its currency, U.S. exports to China would rise, while imports from China would fall, and the U.S. trade deficit would decline within a relatively short period of time.

For example, according to (Morrison & Labonte, 2011), appreciating the RMB would lower the annual U.S. current account deficit by $100 billion to $150 billion. But the issue of the possible effects of an RMB appreciation on the U.S. economy is determined by not only exchange rates but other factors that affect trade flows. For instance, the effect of the 21% RMB appreciation of the RMB to the dollar from July 2005 to July 2008 on U.S.-China trade flows shows on the one hand, during this period U.S.imports from China increased by 39%, compared to a 92% increase from 2001 to 2004 (when the exchange rate remained constant. On the other hand, U.S. exports to China during the 2005-2008 period did not grow as fast as during the 2001-2004 period (71% versus 81%). Despite the RMBs appreciation from 2005 to 2008, the U.S. trade deficit with China still rose by 30.1% (although the overall U.S. current account deficit declined by nearly 6%).68 The appreciation of the RMB appears to have had little effect on Chinas overall trade balance from 2005 to 2008. During this time, Chinas merchandise trade surplus increased from $102 billion to $297 billion, an increase of 191%, and Chinas current account surplus and accumulation of foreign exchange reserves both increased by 165% over this period. The current high rate of unemployment in the United States appears to have intensified concerns over the perceived impact of Chinas currency policy on the U.S. economy, especially employment. Many have argued that RMB appreciation would boost the level of U.S. jobs (Morrison & Labonte, 2011).

1 Claims about the negative effect of Chinas exchange rate on U.S. employment and trade are often contrasted with the observation that Chinas economy has grown rapidly over the past thee years (real GDP grew at an average annual rate of nearly 10% from 2008 to 2010), while other countries experienced negative or stagnant growth. This has led some commentators to argue that Chinas exchange rate peg represents a beggar thy neighbor policy (i.e., meant to promote Chinese economic development at the expense of other countries) at a time of global economic crisis

Numerous bills have been introduced in the US Congress over the past several years that have sought after China to reform its currency policy or to address the perceived undervaluation of their RMB according to several parties. The objective of various recent currency bills is aimed at creating a process whereby the US Treasury Department would identify countries with currencies that were estimated to be misaligned and to identify countries that intentionally manipulate their currency. In addition, some supporters of these laws aimed at China hope that the introduction of such bills will induce China to appreciate its currency more rapidly. Opponents of the bill contend that such legislation could antagonize China and induce it to slow the rate of RMB appreciation. Furthermore, there is a risk that China might also retaliate against U.S. exports to China or U.S.-invested firms in China if such legislation became law.

Works Cited
Das, D. (2010). The Renminbi Yuan and its Accelerating Global Clout. Journal of Asia Business Studies, 109-116. Jackson, L. (2012). An Analysis of the Appreciation of the Chinese Renminbi Through the Lens of the the Nixon Shock, the Plaza Accord, and the Japanese Yen. Department of Economics. California: Stanford University. Morrison, W., & Labonte, M. (2011). China's Currency Policy: An Analysis of The Economic Issues. Washington: Congressional Research Service. Saidi, N. &. (March, 2012). The debate: Is the yuan on the verge of becoming an international reserve currency? Kansas: Vision. Retrieved from The debate: Is the yuan on the verge of becoming an international reserve currency?: http://vision.ae/en/special_report/articles/the_debate_yuan

Question 2

Given the international setting in which many multinational corporations operate in, managing foreign exchange risk constitutes an integral part of all major corporate decisions. However, despite the repercussions of not managing foreign exchange risk, some companies are choosing to not actively hedge and manage their foreign exchange risk. In order to better understand the mindset of these companies, the risks that they're leaving themselves open to have to be first understood. Companies with international business exposures typically encounter three main forms of exposures, namely, transaction exposure, translation exposure and economic exposure. Transaction exposure involves gains/losses arising from transactions that require settlement in a foreign currency (Jain, 2007). Translation exposure is a result of translating the foreign currency assets/liabilities into local currency at the time of finalising accounts. Economic exposure on the other hand is defined as a change in the value of a company due to an unexpected change in exchange rates(Jain, 2007). These exposures arise from various sources such as through imports and exports, capital expenditure denominated in foreign currency, revenue received in foreign currencies, foreign currency loans, as well as through the companies offshore assets such as operations or subsidiaries that are valued in a foreign currency, or foreign currency deposits(CPA Australia, 2009). As such, there are various impacts of not managing currency risk. Unmanaged foreign exchange exposure can cause significant fluctuations in the earnings and market value of the firm (Goel, Gupta & Goel, 2001). Foreign exchange exposures not only affect a firms financial position but also its competitive position in the market and in some instances can paralyze the financial position of the company and could even lead a company to bankruptcy. For example, in 1978, Laker Airways, a British company, expanded their business by purchasing more airplanes and financing them through a USD denominated debt despite their revenues being primarily denominated in GBP. In 1981, the USD started to gain against the European currencies, as such, Laker's expenses increases while their revenues decreased. Laker Airways was forced to declare bankruptcy in 1982, in no small part due to the foreign exchange losses they experienced due to their USD denominated debt. Besides that, during the Asian financial crisis, Thailand devalued it's currency by 18% leading Siam City, Thailands second largest cement producer, to loss THB 5,870 million (USD 146 million), giving a net deficit for the nine-month period of 1997 of THB 5,380 million. This is despite Siam City Cement reporting a net profit of THB 817 million during the first nine months of 1996. It is believed that the massive loss was due to foreign exchange losses on a USD590 million foreign debt it had incurred. These incidents are a direct result of not managing foreign currency risk and occurred at a time when the usage of derivatives was not common. However, despite the massive potential losses, some multinational corporations still choose to not manage their currency exposures or use derivative. Although this might seem foolish, the corporations do have legitimate reasons for not managing their exposures. The first is due to the company's focus on natural hedges. For example, when managing foreign exchange debts, multinational corporations may use a decentralized debt denomination model instead of centralizing their debts. Companies borrow in countries and currencies where the subsidiaries operate or to which it exports to (textbook). This is an example of a balance sheet hedge with the idea being that the debt service payments are denominated in the currency in which the subsidiaries operating profits are generated. Through this, any risk of the foreign currency

depreciating (which decreases the asset value) is balanced by an equal liability denominated in that foreign currency. An example of such a transaction can be found in Appendix 1. The second reason the company may have abandoned hedging their currency exposures is due to the costs of derivatives which can sometimes do more harm than good. The usual method of hedging is through the use of financial instruments such as options, swaps and forwards contracts. In theory, these instruments allow corporations to lock in exchange rates or create a price ceiling or floor hence reducing the fluctuations in earnings. However, some argue that even the most superbly designed and executed hedging programmes are not able to reduce cashflow volatility significantly for most firms (Copeland & Joshi, 1996). Since the financial crisis of 2008, companies around the world sharply reduced their hedging due to the increased volatility of exchange rates making hedging more difficult and costly (Schoenbenger, 2011). According to Gail Sullivan, the treasurer of The Gilette Compay, hedging everything can lead to costs greater than unhedged exposures. Besides that, accounting regulations in certain countries make it rather unprofitable to hedge currency exposures. For example, in America, FAS 133 requires financial instruments to be marked to market instead of reported at their historical cost. Gains and losses on financial instruments should also be included in earnings when they can't effectively hedge and exposure. As such, the company would have to incur further costs to determine the hedge effectiveness. Inaccurate forecast could also lead to massive losses for a company. For example, Air Asia, like many airline companies, practiced hedging its fuel costs to curb rising costs due to rising fuel prices. Towards the end of fuel crisis of 2007-2008 when oil prices started falling from the July 2008 high of $147/barrel to a December 2008 low of $32/barrel, AirAsia made a significant loss as it had hedged for fuel prices of US$90/barrel and as a result AirAsia recorded its first ever full year loss of RM471.7 million for the year ended 31st December 2008, despite achieving a growth of 36.6% in revenue. This led to the removal of all hedges on fuel prices and AirAisa declared itself as completely un hedged. As such, proper forecasting has to be done to prevent such incidents which can cripple a company. However, this requires skilled personnel and causes a company to incur higher costs, and even then, hedging is still a risky affair. As such, it is understandable for MNC's to not rely as much on derivatives to manage its foreign exchange risks Therefore, multinational corporations with a significant presence overseas, can, and do, use natural hedges to greatly reduce their transaction risk which is the impact of currency fluctuations on cash flows. However, this leaves companies vulnerable to translation risk, the impact of variations in exchange rates on a multinational's reported earnings and shareholders' equity. Gilette for example, saw its shareholder equity falling 54% with 20% of the loss a direct result of foreign-currency translation. Arrow electronics as well lost $98.8 million in 2001 due to currency translations loss that year. As such, despite the disadvantages of not using derivatives and the fact that natural hedges cant fully insulate a company's exposures, to some the benefits of actively hedging exposures aren't worth the cost (Fink, 2003). It was also found can be seen that it is not wise to completely eliminate managing foreign exchange risks, foreign exchange exposures at the company's cashflow level can, and should be managed, however, hedging individual transactions do not work (Copeland & Joshi, 1996). Therefore, the ability to manage foreign exchange risk without derivatives is very much subjective and highly dependent on the company's geographical spread.