1 Name: University: Course: Tutor: Date: The benefits of China can achieve from yuan appreciation and why

the yuan is becoming a regional trade currency. Introduction. The Asian currency crisis of 1997-1998 made China to rethink about the exchange rate system which should be adopted by the economy (Buzan and Foot, 2004). On of the lessons learn from the crisis is that a de facto fixed exchange rate regime causes mismatches of boomand bust-cycles since borrowers in an emerging market will not be interested in the currency risk the same with the lenders in advanced economy which will create a mismatch of the long-term local currency assets and short-term foreign currency liabilities (Goldstein and lardy, 2008). Another important lesson that China learned from the crisis is that the choice of the foreign exchange regime should also be influenced by the foreign exchange regimes which close trading partners have adopted hence Malaysia and Indonesia had similar de facto fixed exchange regimes hence these Asian countries had fair competition in trade since all their currencies were pegged on the dollar (Buzan and Foot, 2004). Though other Asian countries changed their exchange regimes to floating rate regimes, China remained renminbi tightly fixed to the US dollar since 1994 until 2005 when the Peoples Bank of China changed exchange rate regime to a more flexible regime which caused the currency to appreciate by two percent. Since the rate of exchange was pegged to the US dollar, when the dollar declined the yuan which is the national

2 currency of China would also move the same direction making the Chinese goods more competitive hence this would harm other trading partners. The first official complain on the undervalued yuan was made by Japan in 2003 at international financial conference where numerous countries began to worry about the exchange rate system adopted by China and called for China to revalue its currency or face trade sanctions by some countries. US manufacturers were not contented with the undervalued yuan and also internal businesses in China were concerned with the massive inflows of foreign capital. The US has become a key trading partner with China over the last two decades with China been a net exporter to US markets which have made several economists to attribute the expanding US trade deficit to the undervalued yuan (Morrison, Labonte and Sanford, 2006) Some analysts have pointed out that appreciation of the yuan would hurt Chinas economy with workers, manufacturers and consumer in China and other trading countries facing severe economic consequences. In this essay we shall examine the effect of China pegging its currency to the US dollar and the consequences of appreciation of the currency in a floating exchange rate regime where the rate of exchange with relation to other international currencies is determined by the forces of demand and supply of the currency in the foreign exchange market. We shall explore also the possibilities that yuan may be a regional trading currency in the Asian region. This essay shall also explore the value of the Chinas yuan in the foreign exchange market in comparison to the US dollar. According to the Americas treasury secretary, adaptation of a more flexible exchange rate by China would serve Chinas interests and create more economic benefits for the country. Implementation of a more floating exchange rate would liberate the monetary policies which would create more innovativeness in the manufacturing sector leading to more employment creation. China usually pegs the yuan to the US dollar which has made its currency to stay

3 undervalued for sometime. This is a policy of keeping the exchange rate down which many economic analysts have observed that is equivalent to protectionalist policies or export subsidy for the manufacturers in the country. As per last year, China had accumulated more than $ 2, 273 billion dollars in foreign currency reserves due to its net exports which could but despite this the foreign exchange rate is still undervalued. China has distorted the world economy since its the worlds fastest growing country and has the largest current account surplus (DeKrey, 2010). The world economy has failed in numerous times to make a currency exchange rate adjustment which has resulted to different economic growths for some countries at the expense of the others. During the 1930s, the US economy grew faster while in 1960s it was Europe and Japan and know its China which is managing its exchange rate against the dollar hence resulting to more export competitiveness. In July 2005, the peoples bank of China announced a revaluation of the yuan and a reform of the exchange rate regime where the currency would appreciate at 2.1 percent against the dollar with a basket of currencies being the pegging target (McDaniel and Gitman, 2009). The U.S dollar is one of leading currencies in international trade and investment hence when China pegs its yuan to the dollar that helps in facilitating exportation and importation of goods and services between China and its trading partners. External imbalance in China has led to the trade surplus and inflow of foreign direct investments which have left the Peoples Bank of China with no option but to keep the excess reserves (Hall and Lieberman, 2005). China officials argue that the goal of pegging the currency against the US dollar is to foster economic stability through currency stability and not to favor exports over imports (Ferrington, 2007). Chinese workers believe that that the policy aims at attracting foreign direct investments and high exports which create employment. Chinas monetary officials have

4 claimed that international pressure on appreciation of the Chinese yuan interferes with the countrys sovereignty of implementing sound economic policies. China has argued that promotion of rapid economic growth in the country rather than currency appreciation is a significant policy of ensuring global economic recovery. During the first eight months in 2010, imports raised by forty five percent compared to the same period in 2009 while the exports only raised by thirty five percent compared to the same period in the previous year. During the same period, the trade surplus declined by sixteen percent over the same period in the previous year and the worst was a trade deficit in March 2010 which was the first in a period of six years hence Chinese officials believe that currency policy does not promote the local economic growth at the expense of other trading partners. From 2005 to April 2009, the dollar-yuan exchange rate appreciated by 18.9 % from 8.11 to 6.83 % while the price index for U.S imports from China rose by 3 % while the U.S imports from China grew by five percent. During the year 2009, Chinas exports, imports and foreign direct investments declined by 15.9 %, 11.3 % and 2.6% respectively from the volumes which were witnessed in the previous year 2008. China was affected by the global financial crisis which made several firms close laying off millions of migrant workers but the government implemented a $ 586 billion stimulus package revived the economic growth to 9.1 % in 2009. Many economists argue that if China appreciated its currency, the U.S would increase its exports to China and the imports from China would decline thus reducing the trade deficit of the U.S economy (Zhang, 2004). However, other factors are responsible for bilateral trade deficit since when the yuan remained constant between 2001 and 2004, the US imports from China grew by 92 %. Despite the appreciation of the yuan in 2005 to 2008, the US trade deficit with China grew by 30% but the current account deficit declined by six percent. On the Chinas economy, the appreciation of the yuan had little economic effect

5 since trade surplus increased from $ 102 billion to $ 297 billion which was an increase of nearly two hundred percent while the current account surplus and foreign exchange reserves increased by one hundred and fifty percent. The yuan is of significant value in the foreign exchange markets since foreign-invested firms mainly multinationals from the U.S account for about half trade flows in both imports and exports (Yager and Yager, 2005). From the economists point of view, adoption of market based foreign exchange regime will result to more benefits for the Chinas economy since this would lead to efficient allocation of resources in the economy. The Chinas foreign exchange rate is undervalued compared to what would be the situation if it was determined by market forces of demand and supply of the yuan hence this has made the Chinas goods to be relatively inexpensive compared with those of US and other major economies which has resulted to high exports and low imports. From the welfare perspective of the economy, the economic welfare is not measured by the amount of production but the amount of consumer spending hence the undervalued currency of China lowers the prices of imports from China hence increasing the aggregate consumption due to increased purchasing power. Other countries import capital goods from China to produce final goods which hence the lower prices of capital goods will make those countries increase the level of their output. The possible appreciation of the yuan will increase the prices paid by consumers of Chinas imports hence lowering their consumption as well as lowering the production output of the firms making those industries less competitive (Morrison, 2010). The undervalued yuan has serious consequences on the borrowers from other economies like the U.S since some countries have a current account deficit with China, capital flows from China to those other economies will be realized through the balance of payment accounts since more Chinese people will be investing in those other economies. The capital inflows from China

6 (trade deficit) will result to lower interest rates (Chisholm, 2009). The Chinese will have to invest in the US treasury bills which will help the US government to fund its budget deficit. According to the US treasury, the treasury bills which were held by China as at April 2010 was estimated to be worth $ 902 billion which was the largest foreign holder of the securities which represented about twenty three percent. However, if China was to stop buying the US treasury securities especially at a time when the country if faced with high budget deficit, this could disrupt the global financial system where investors will cast doubts about the US governments ability to sustain its macroeconomic policies. The undervalued yuan has several effects on the Chinas economy in comparison to the US dollar since it makes exports cheaper than they would be if they were freely traded (Ahearn, 2011) The pegging system eliminates the foreign rate risk which makes many foreign investors consider the China as an attractive investment destination thus increasing the inflow of foreign direct investments (Carbaugh, 2009). However, the overdependence on only export revenue and foreign direct investments has made the country vulnerable to global financial shocks since net exports account for about 60% of GDP. The rate of gross domestic growth fell from 13 percent to 9 percent in 2009 due to the effects of global recession which reduced the demand of Chinas imports globally. The undervalued yuan has negatively affected the Chinese firms which would like to import machinery and other raw materials which are used in the production process hence this policy benefits only the exporting firms which are mainly foreign multinationals at the expense of non-exporting firms hence this can be viewed as a case of inefficient allocation of resources. Since the undervalued yuan will make Chinese importers to pay more due to the de facto undervalued currency policy, China will not use its entire trade surplus to purchase imports hence will maintain large foreign exchange holding in the US debt securities which earn low

7 returns (Peng, 2009). The pegged regime of the yuan limits the ability of the monetary authorities to control inflation since high interest rates in China would result to high inflow of foreign capital which will lead the government to increase the amount of money supply in order to buy the foreign currency which is enough to maintain the pegged rate of exchange. This makes banks and other financial institutions to lend cheap credit which fuels inflation in the economy (Apte, 2006)

Appreciation of the yuan and adoption of a market based foreign exchange regime where the rate pf exchange is controlled by the forces of demand and supply of the currency would result to some benefits to the Chinas economy. For instance, the country would increase the level of terms of trade by boosting the quantity of imports which could be purchased by the revenues from exports (Finn2007). Another benefit which the economy of China will achieve from a market based regime will be efficient allocation of resources where resources will be channeled to the most competitive and productive sectors of the economy and not only the export-producing firms. Appreciation of the yuan is beneficial to the Chinas consumers and workers since this will lower the prices of imports which will result in fair global competition

8 which results to lower import prices and higher living standards. Chinas export producing firms will be more competitive if the prices of imported raw materials and inputs come down due to the appreciation of the yuan. Market based system will help the government of China to institute macroeconomic policies that will be able to control inflation and alleviated the high income disparities which have existed in the country due to the export-based growth strategy which is a potential risk of future national stability. Appreciation of the currency will reduce the trade tensions which have existed with other countries since many of the claim that China pursues economic growth at the expense of its trading partners through the undervalued yuan which is pegged on the US dollar which is the main trading partner. The recent global financial crisis and the subsequent reduction of the gross domestic product of many trading partners have made them examine the global imbalances in savings and investments. Some countries have little savings relative to their investment levels. Countries where domestic savings exceed the investment have trade surplus while countries where domestic investments exceed savings tend to have a current account deficit (Celone, 2008). Chinas exchange rate policy has hindered the ability of other Asian countries from appreciating their currencies due to fear of losing export market share to China unless the yuan appreciates. Global imbalances are responsible for recent global financial crisis since high saver like China loaned the US in order to keep the rates of market interest rates low which resulted in the housing bubble which went toxic due to sub prime mortgage lending. Resolving this global imbalance could cause short run problems since when low saving countries try to increase their saving rate by cutting the budget deficits this will harm employment creation while the high saving countries do not increase their consumption thus resulting to a global output demand decline and high unemployment in the short run.

9 According to Hu Xiaolian who is the deputy governor of the Peoples Bank of China, the trading settlements between China and the Central Asia countries should be denominated in the yuan since this will help mitigate the exchange rate risk and increase the volume of the regional trade (Krassel, 2011). China wants the yuan to become a regional trade currency since it has expanded direct investments in Central Asian countries and awarded loans worth $ 10 billion to some countries. China has promised to contribute one third of the $ 120 billion economic stimulus package which is aimed at helping some Asian countries reduce their dependence on loans from the International Monetary Fund. China has also pursued this objective through advocating for the formation of the China-ASEAN free trade agreement which came in to effect in January 2010 where the yuan is used as the regional trade currency. The peoples Bank of China has asserted that some of the yuan which have been held in foreign central banks could be invested in the Chinas bond markets. In the two months, the yuan has not appreciated despite adoption a more flexible exchange system with the largest trade surplus being reported since January 2009.

Conclusion.

10 China has always pursued a pegged foreign exchanger rate system where the rate of exchange is pegged to the US dollar. The reason why it pegs its yuan to the dollar is because the dollar is the international currency which is used in global trade settlement. In 2005, China announced that it would be pegging its currency using a basket of currencies. Many of the Chinas trading partners have accused the country of protectionalist foreign exchange policy which is aimed at helping the exports and decreasing the imports. China has a trade surplus in comparison with other major economies and has to buy US treasury bonds in order to keep the interest rates low (Wiggin, 2005). Chinas undervalued yuan policy reduces the terms of trade since fewer imports are able to be financed with the export revenues. Chinese workers believe that appreciation of the yuan will significantly be beneficial since it will make imports less expensive, create fair global competition with the local production which will eventually reduce the prices of goods hence improving the living standards of the population. Undervalued yuan results to inefficient allocation of resources which has led to high income disparities. Market based exchange regime will help China control the rate of inflation and also diversify the economy to other productive activities. The undervalued yuan has caused a lot of global imbalances in savings and investments which resulted to recent global recession and financial crisis. China is aiming at making the yuan a regional trade currency by the formation of the China-ASEAN bilateral trade agreement where currently about the trade settlements are done in yuan. China has loaned several Asian countries and contributed significantly towards helping countries stop depending on IMF. China has launched the first international bond which is dominated in yuan (Murphy Yuan, 2009).

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