Question

a. Outline the differences in the exchange rate regimes in China and in the US. [6 MARKS] b. China recently devalued the Yuan. Explain why the Chinese government adopted this policy. What do you expect would happen to China's balance of payments? [6 MARKS]

Answer 1

A cornerstone of China’s economic policy is managing the yuan exchange rate to benefit its exports. China does not have a floating exchange rate that is determined by market forces, as is the case with most advanced economies. Instead it pegs its currency, the yuan (or renminbi), to the U.S. dollar. The yuan was pegged to the greenback at 8.28 to the dollar for more than a decade starting in 1994. It was only in July 2005, because of pressure from China’s major trading partners, that the yuan was permitted to appreciate by 2.1% against the dollar, and was also moved to a “managed float” system against a basket of major currencies that included the U.S. dollar. Over the next three years, the yuan was allowed to appreciate by about 21% to a level of 6.83 to the dollar. In July 2008, China halted the yuan’s appreciation as worldwide demand for Chinese products slumped due to the global financial crisis . In June 2010, China resumed its policy of gradually moving the yuan up, and by December 2013, the currency had cumulatively appreciated by about 12% to 6.11.

The true value of the yuan is difficult to ascertain, and although various studies over the years suggest a wide range of undervaluation - from as low as 3% to as high as 50% - the general agreement is that the currency is substantially undervalued. By keeping the yuan at artificially low levels, China makes its exports more competitive in the global marketplace. China achieves this by pegging the yuan to the U.S. dollar at a daily reference rate set by the People’s Bank of China (PBOC) and allowing the currency to fluctuate within a fixed band (set at 1% as of January 2014) on either side of the reference rate. Because the yuan would appreciate significantly against the greenback if it were allowed to float freely, China caps its rise by buying dollars and selling yuan. This relentless dollar accumulation led to China’s foreign exchange reserves growing to a record $3.82 trillion by the fourth quarter of 2013.

Implications of Yuan Revaluation

Overall, the effects of China’s currency policy are quite complex. On the one hand, the undervalued yuan is akin to an export subsidy that gives U.S. consumers access to cheap and abundant manufactured goods, thereby lowering their expenses and cost of living. As well, China recycles its huge dollar surpluses into purchases of U.S. Treasuries, which helps the U.S. government fund its budget deficits and keeps bond yields low. China was the world’s biggest holder of U.S. Treasuries as of November 2013, holding $1.317 trillion or about 23% of the total issued. On the other hand, the low yuan makes U.S. exports into China relatively expensive, which limits U.S. export growth and will therefore widen the trade deficit. As noted earlier, the undervalued yuan has also led to the permanent transfer of hundreds of thousands of manufacturing jobs out of the U.S.

A substantial and abrupt revaluation in the yuan, while unlikely, would render Chinese exports uncompetitive. Although the flood of cheap imports into the U.S. would slow down, improving its trade deficit with China, U.S. consumers would have to source many of their manufactured goods - such as computer and communications equipment, toys and games, apparel and footwear - from elsewhere. Yuan revaluation may do little to stem the exodus of U.S. manufacturing jobs, however, as these may merely move from China to other lower-cost jurisdictions.