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Custom Currency and Trade Conflict Essay

The issue of China’s currency policy is not a newfound debate among the largest economies in the world, like the USA, Japan, Germany, and other countries. The debate has even become hotter after China ranked as the second largest and the fastest growing economy worldwide. China’s strategy to limit its currency’s rate of appreciation through intervening in exchange markets, especially in regard to undervalued Chinese Renminbi (RMB) versus the US dollar, has raised concern and instability in the global economy. Some critics claim that China deliberately undervalues its currency, the Renminbi (RMB), to obtain unfair trade advantage over other countries in the world. The currency policy of China has been criticised for making its exports significantly cheap and, on the other hand, making its imports extremely costly; however, to the extent that would not have occurred should the RMB be exchanged as a free-traded currency. They argue that the RMB is considerably underrated versus the dollar, and this factor has significantly contributed to the US and other leading economies incur increased annual trade deficits in their trade with China, leading to relative loss of the US trade-related jobs in recent years.

Krugman claimed that if China pursues with its present course, eventually, this will lead to some serious conflict pertaining to currency and trade policy worldwide. To evaluate this argument, firstly, it is necessary to highlight the proofs that China has undervalued its RMB against the US dollar and the European euro, the Japanese yen and other crucial currencies in the world. Next to this, it is essential to identify the negative impact and possible benefits of China’s currency policy for China, as well as other leading economies in the world.

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This paper attempts to pick up a discussion with Krugman and other critics on the extent of global economic harm that has been caused by China’s currency policy in view of its defensive reasons to implement the policy. In order to carry out a relevant analysis, this paper will tend to concentrate on the effect of the RMB devaluation on the U.S, as China’s main trading partner.

China’s Currency Policy

Although China is one of the major economies in the world, its currency policy is different from other advanced economies, like the U.S. The Chinese government does not maintain a floating market-based exchange rate. China pegged its currency, the yuan, or the RMB at 8.28 yuan per dollar. However, in 2005, the Chinese authorities allowed the RMB appreciate to the dollar by around 2.1% in order to manage key floating world currencies. To maintain the required exchange rate with the US dollar and other main currencies, China has established control and restrictions over capital and currency transactions and has been purchasing U.S assets (dollars) in large quantities.

Following the global financial crisis, the Central Bank of China had adjusted the dollar-RMB exchange rate to appreciate from 8.27 yuan respectively to 6.83 yuan per dollar, which translated in an appreciation at about 21.1%. However, once the economic crisis came to a halt, the Chinese government intervened with into the currency policy by maintaining the exchange rate of yuan at 6.83 yuan per dollar. This policy helped avoid an immense decline in the excessive demand of the Chinese products, in the world market.

Preceding 1994, China had upheld a double exchange scheme on its currency. It comprised of a present swap over rate scheme, which was utilised by the government, as well as a comparatively market-oriented exchange rate structure that the exporters and importers used in exchange markets. However, there was high restriction of accessibility to international exchange with an aim of regulating imports, leading to a wider black market for foreign swap. There was a considerable difference between the two rates of exchange. Officially, the swap rate for the dollar was at 5.77 yuan against 8.70 yuan in the exchange markets. Part of the world economists criticised China’s double swap rate scheme for the limitations it imposed on imports.

The government of China united the two swap rate structures at a starting rate of 8.7 yuan to the dollar. In 1997, the yuan was allowed to go up to 8.28 and was then stabilised until July 2005. Except for capital account basis, the convertibility of RMB enlarged on the basis of current account. This meant that, for purposes of investment, the process of obtaining the yuan was inconsistent. As earlier explained, between 1994 and 2005, China upheld the strategy of attaching the RMB to the US dollar at a swap rate of approximately 8.28 yuan versus the dollar. The attachment seems to have been highly determined to endorse a fair environmental stability for investment and foreign trade in China. Such a strategy was essential in maintaining stable exchange rates as it has been applied by many developing nations during their first development stages.

The Chinese central bank initiated a process of maintaining this peg through either purchasing or selling as many assets, which had the dollar dominance, as required to eradicate the surplus demand-supply for the yuan. Consequently, the swap rate between the dollar and the RMB had a substantial stability, notwithstanding the varying economic aspects which could have triggered the depreciation or appreciation of the yuan compared to the dollar. Under the prevailing swap rate system, the comparative demand for goods and assets between the two countries would establish the swap rate of the dollar versus the RMB.

Some Evidence of Intentional Currency Depreciation by China

The main basis that has been used to prove the claim that China undervalues its currency includes its continued trade deficit with the U.S and other leading economies, its enormous accumulation of national reserves, and currency valuation based on Big Mac prices across different countries. Analysts of the currency peg in China often emphasize the increasing imbalance of trade between China and the U.S. This has been used to indicate that the yuan is considerably underrated, comprising a methodical attempt to attain an unjust upper hand when trading with the U.S.. Nonetheless, the balances of the bilateral trade replicate structural causes and swap rate impacts.

There are other numerous factors to be considered when conducting the analysis of bilateral trade deficit. For example, the rapid increase in the U.S. trade debit with China deflects concentration from the point that, while there has been a swift rise of China’s exports to the U.S., China’s imports from the U.S. have had the same rapid increase. Furthermore, in recent years, there have been considerable improvements in productivity gains in Chinese industries that focus on exports, disregarding the fixed swap rate. For instance, since 1995, the prices of Chinese exports have come up to a 27% cumulative decrease.

There is a strong indication that an important share of the growing intensity of China’s exports to the U.S. has originated in East Asia. Its multinational firms have transferred their facilities of production to China in an attempt to utilize the abundance of cheap labour in the country. The rising level of imports from China is the key cause of the U.S. trade deficit. One third of China’s GDP is contributed by foreign exchange earnings. In particular, China’s economy largely depends on its exports to the USA. Consequently, an increase in value of the Chinese yuan would lead to some changes in its exports to the USA, since the results would mean reduction in price of the imported inputs. Given that, China can be justified in tinkering with the yuan exchange rates, for direct benefits it brings to the country’s balance of trade and national economy.

Impacts of China’s Currency Policy on Other Economies

Many economies have been hurt globally, owing to China’s strategy of currency manipulation. The yuan has undervalued as a result of Chinese government pegging it to the dollar. China’s currency has fallen against other currencies, like the euro or the Brazilian real that have risen against the dollar in the 2009 currency market. Trade deficits between those countries and China have grown tremendously. Nevertheless, most of these countries have too weak economies to be able to retaliate against China’s influence on their own.

For a long time, currency exchange rates and international trade have had a clear linkage. A well-built currency stimulus in a certain country has the capability to enhance export prospects for partnerships in trade, as it increases the private purchasing power and domestic consumption and increases prices of national exports. China, for instance, has proposed that the undervaluation of the RMB should be above 20% versus its real terms and about 40% versus the dollar. The Chinese central bank, in maintaining the synthetically undervalued RMB, resorts to the stimulation of Chinese exports by imposing an unreasonable price advantage on domestic exporters over foreign competitors. When a country runs the current account surplus, natural forces require another country to maintain the resultant deficits.

Analysts have argued that the policy of manipulation of currency is present not only in China but also in Singapore, Malaysia, Taiwan, and Hong Kong with the extent of underrating ranging between 25% and 32%. Similarly, the Japanese yen is underrated by about 14% (Cling and Williamson, 2010: 99). Nevertheless, some analysts argue that the industrial strategies of China, its let-down and reluctance in providing adequate protection for the property rights of the US and its model of unequal economic growth have caused serious economic concerns to the US, as compared to China’s currency strategy.

Impacts of China’s Currency Policy on the USA

Numerous economists have analysed the complex impacts of China’s currency strategy on the U.S. Many argue that, if the RMB is underrated, it may be regarded as oblique export funding, which would cause a synthetic reduction of the U.S. imports prices for Chinese products. In this perspective, this will be in favour of the U.S. firms and consumers who happen to use China-made components and parts. Underrating of the RMB may also have an impact on restricting the scope of U.S. exports to China more than it could have occurred in the case of a floating swap rate structure.

The rise of trade deficit between China and USA eroded the trade-related job market. The initial causes of this crisis were general export subsidies, high-tax and non-tariff import barriers, and the abuse of key standards of labour by China. China’s currency strategy has been criticised that the low yuan value has had a significant impact on the manufacturing sector in USA, resulting in a loss of about 2.7 million jobs in factories since July 2000. However, although there has been this tremendous loss of jobs in the United States’ manufacturing sector, analysts have argued that there is no clear evidence that the job losses are the result of China’s imports (Goldstein, 2009.). Most economic analysts are of the opinion that market forces should dictate the exchange rates, and not monetary policies employed by the government.

Most policymakers predict that if the Chinese government could appreciate the yuan, exports from the U.S. to China would increase, resulting in a decrease of imports from China. The deficit of trade in the U.S. would also gradually decrease overtime. Fred Bergsten argues that a market-based RMB rate would reduce the annual U.S. current account deficit by between $100 and $150 billion.

However, the probable results of the RMB appreciation on the U.S. economy are complicated by the fact that there are short- and long-term implications to it. In addition, exchange rate is just one out of the many factors that affect trade flows. Changing to a floating exchange rate is characteristically followed by the removal of capital controls that prohibit a country’s private citizens from buying and selling foreign currency unreservedly. In addition to opposing a floating exchange rate system, China maintains capital controls, as it fears of a large private capital outflow, which could result, if such controls were to be detached. If China accepts floating currency rate, it would be manipulated private players in the market, since it would base on the supply and demand proposition for the Chinese goods and assets, as opposed to the U.S. goods and assets.

A study, which took place at Yale University, concluded that a 25% RMB appreciation would reduce the Chinese exports to the U.S. and front a large-scale domestic production in the US and increase exports to China. Nevertheless, the study concluded that the advantages to the U.S. economy might be balanced by a lower Chinese economic growth brought about by falling exports, which would reduce its demand for imports. Additionally, appreciation of the RMB would increase the U.S. costs for imported goods from China, and this would lead to an increase short term interest rates, in the U.S..

In the context of this, it would be useful to break down the impacts of China’s currency policy on different aspects of the U.S. economy.

Impact on Exporters and Import Competitors

The exchange rate policies cause the RMB to be cheaper, with supply and demand forces determining its real value. It results in China’s exports being relatively cheap and China’s imports from the U.S. being relatively expensive. This causes depreciation of the the U.S. exports to China, as well as the production of the U.S. goods and services that compete with Chinese imports, in the short run. Since most of the affected firms are in the manufacturing sector, the trade deficit rises and reduces aggregate demand, ceteris paribus. A market-based exchange rate may enhance U.S. exports and offer relief to the U.S. firms that are in direct competition with the prevailing Chinese firms.

Impact on Consumers and Producers

Economic theories suggest that a society’s economic welfare is calculated by how much it can consume and not by how much it can produce. The undervalued RMB that reduces the price of Chinese exports allows the US increase consumption through the expansion, in trade terms. Variations in the spending are, therefore, temporary. In the long run, the fixed effects of the undervalued RMB are to increase the purchasing power of consumers, in the United States. Chinese imports include other goods, rather than consumption goods only. The U.S. also imports capital goods and inputs from China for production purposes. Here, the undervalued RMB reduces the value of these US products, increases the output, thereby making the firms more competitive globally. If the yuan appreciates, then prices for the US would rise.

Impact on Borrowers

U.S. borrowers are also affected by the undervalued RMB. An equal amount of capital flows from China to the USA when the U.S. is in a present account deficit with China. As a result, capital investment increases due to greater demand for the U.S. assets in China. This demand puts downward pressure on the U.S. interest rates, which give an incentive to firms are to make investments that were considered a loss previously. When the U.S. incurs a current account deficit in its trading with China, there would also be a flow of equal amount of capital from China to the U.S., as reflected on balance of payments accounts .

China’s Defence of Its Currency Policy

The Chinese authorities are of the opinion that their policies on currency manipulation and exchange rates are not to encourage exports or depress imports. They argue that China has adopted the currency peg with respect to the U.S. dollar so as to promote economic solidity and investor assurance. The authorities explained that changing the existing currency policies could ignite an economic crisis in the country, which could badly upset the exporting industries, which are the pillars of the Chinese economy.

A reduction in agricultural exports and domestic food prices could be experienced if the currency appreciates, due to the increase in imports, in China. Such a consequence would cause an increase in prices in the overseas markets, which would strain international ties and lower the income of local farmers. Just before the economic crisis began globally, the Chinese authorities had been in the process of adjusting their currency policies. However, the neighbouring East Asian countries had achieved fiercely negative economic impacts as a result of maintaining a floating currency rate. This made China rethink its stand and choose not to change its currency policy, as it was seen to be the reason for its immunity from the global financial crisis. If the policies are to be amended, then a gradual approach is recommended, so that the new, flexible currency can maintain stable development and economic growth.

If a floating exchange rate in China had been maintained, quality changes and productivity may have raised the demand for goods and foreign direct investment. In order to maintain the exchange rate peg, central bank needs to supply or reduce currency when economic situations decrease or reduce, so as to restore supply back to normal at an equilibrium market demand. This is done by increasing or decreasing foreign exchange reserves. China has been accumulating foreign reserves since 2005. This, however, cannot entirely deter the yuan from appreciating against the dollar, as China has not purchased enough foreign reserves. The yuan has continued to appreciate gradually, but quite steadily, as it went up by 2% in 2005 and by 4.6% in 2007. The government appears to manage that through intentional retarding of the appreciation by market intervention tactics. The accumulation of foreign exchange reserves by the Chinese government does not result in the prevention of the yuan from appreciating in the face of International trade financing; together with capital controls this fosters the foreign exchange reserves, and thus, discourages speculations with the currency.

There are claims that, while the undervalued RMB could have distorted world trade to some extent, that is not the main challenge facing the U.S and other leading world economies. The appreciation of China’s currency by itself would arguably not do much to boost main world economies. Some experts even argue that the appreciation of RMB would create a few thousand jobs in the U.S and other leading economies.

Custom Currency and Trade Conflict Essay

Code: Sample20

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