Change_and_Determination_of_Exchange_Rate

Changes and determinations of exchange rate Changes and determinations of exchange rate Whether Chinese Yuan will or should be appreciate is a question widely speculated in world financial markets and intensively debated in China. Since the Asian financial crisis in 1997, there has been keen interest in the exchange rate policy in China. In this paper, we will first talk about the determinations of the exchange rates in China in details. And then, we will review the exchange rate changes and policies of China during the past several years. Finally, we will talk about the current situations and give some suggestions. Introduction Definition and importance of exchange rates In this section, the paper will briefly describe why we study exchange rate and also look at the definition of this term. Understanding the basic concept of the exchange rate and its importance is the basis for this essay. In finance, the exchange rates between two currencies specify how much one currency is worth in terms of the other. In other words, it is the value of a foreign nation’s currency in terms of the home nation’s currency. It is not an exaggeration to say that the exchange rate is the single most important macroeconomic variable in an open economy, especially in the present environment of financial deregulation and globalization of financial markets. From a microeconomic perspective, the exchange rate is very important. Even if a firm does not deal with the rest of the world, it is also exposed to foreign exchange risk because the fluctuation affects its share in the domestic market. For example, domestic currency appreciation induces foreign firms to enter the domestic market, thereby threatening the market shares of purely domestic firms. From a macroeconomic perspective, exchange rate fluctuations affect output, employment, inflation, the external balance, interest rates, and monetary and fiscal policies. Determinations of changes in exchange rates According to the abundant empirical literature on the determinants of changes in exchange rates, the key variables which drive real exchange rate changes are the following items: GDP levels and productivity (or productivity differentials) GDP reflects a country’s ability to offer goods and services and is the representative figure of a country’s comprehensive national strength. Higher GDP will lead to the public confidence, which will result in increase in the demand of this country’s currency and exchange rate appreciation. Moreover, higher growth of average productivity at home compared to the foreign country is believed to lead unambiguously to real exchange rate appreciation. The real interest rate differentials On one hand, the real interest rate differential is an indicator of attractiveness of domestic currency on international markets; high interest rate will attract foreign funds flow into the domestic market. On the other hand, the real interest rate is also an indicator of the cost of using home currency funds. High domestic interest rate will result in higher cost and will lead to increase in the demand of foreign currency. Both these factors will post at least positive short-term impact on the exchange rate. The term of trade The term of trade reflects the ration of export to import prices. It is implicitly linked with the price component of the real exchange rate. If the terms of trade improve, then relative domestic prices rise, which leads to exchange rate appreciation. Net foreign asset An increase in the net foreign asset position is expected to increase the value of domestic currency and contribute to real exchange rate appreciation. Besides the factors that listed above, there are also other factors that will lead to changes in the exchange rates. The profile of the exchange rate in China The following is a brief look at the behavior of the exchange rate during the past several years in China. Before 1979, China was a central-planned economy country, and because with state monopoly in foreign trade, the exchange rate played no significant role. After economic reform began in 1978, the role of the exchange rate changed. Its official exchange rates were linked to a basket of currencies. China also issued Foreign Exchange Certificate based on the official rates for foreign tourists and foreign residents in China. In 1981, China introduced a dual-exchange-rate system: an official rate for nontrade-related transactions and an internal settlement rate for authorized current account transactions. As foreign trade became decentralized, the overvalued official exchange rate hurt the export incentive. Therefore, the official rate depreciated towards the international settlement rate until 1985. After its establishments of special economic zones, China reintroduced a dual-exchange-rate system in 1986. Foreign and Chinese enterprises in special economic zones were permitted to trade foreign exchange among themselves at negotiated exchange rates in Foreign Exchange Adjustment Centers, the so-called swap centers. On January1.1994, China adopted a new managed float regime. Under the new regime, Chinese Yuan began to appreciate, as a result of China’s current account balance turning from negative to positive in 1994 and steady growth in foreign direct investment to China. Concerned that further appreciation of the currency would undermine export competitiveness, China froze the exchange rate through central bank purchasing excess dollars in the market place. Since the Asian financial crisis, the exchange rate has been maintained to 2004. Since 1994, China had current account surpluses every year and capital account surpluses in all years. At first, reserve increase was smaller than the country’s balance of payments surpluses, but in 2003, as market expected an appreciation of the Chinese Yuan exchange rate, capital flight was reversed and China witnessed a large capital inflow, including hot money, resulting an unprecedented increase in official reserves. In conclusion, the evolution of Chinese Yuan’s exchange rate since the 1970s has been helpful for China’s economy. China has been enjoying high and stable economic growth in the last two decades while maintaining a stable financial system. Pressures for China to appreciate exchange rate There are many pressures for China to revalue Chinese Yuan, including many internal pressures and external pressures. Many professional argue that the real exchange rate of Chinese Yuan is undervalued and this undervaluation is the root cause of China’s current account surpluses. Even in some media, China is blamed for the gloomy economy and the decline of jobs in some of its trading partners. Different countries have different purpose to pressure Chinese Yuan to appreciate: America Bilateral trade flows between China and the US have expanded considerably over the past two decades but the increasingly unbalanced nature of this trade has caused considerable concern in American political circles. It has been widely argued that the imbalance is largely the result of the supposed undervaluation of the Chinese Yuan which has been effectively pegged against the US dollar, giving Chinese manufacturers an “unfair advantage”. Even though the America knows that Chinese Yuan’s appreciation cannot improve the state of international trade, it also pressures the exchange rate to appreciate. The reason for this lies in the following two points: First, the America considers China as its strong competitor and thus spares its no effort to weaken the competitive strength of Chinese goods. Second, pressuring Chinese Yuan appreciation can attract global “hot money” flows into China, which may lead to bubble economy. The European Union Contrast to America, the European Union had held a mild attitude to the Chinese Yuan appreciation issue. But since the beginning of 2007, the European Union has changed its attitude and paid more attention on this problem. The reason for this phenomenon is that although Chinese Yuan is appreciate against US dollar, the US dollar had begun to depreciate against euro dollar which results in that Chinese Yuan largely depreciate against euro dollar. On one hand, this may increase the difficulties of exporting goods to China, on the other hand, this also make easy for domestic goods enter into Europe market. The big global imbalance makes European Union to force the exchange rate of Chinese Yuan appreciation. Japan Different from America and the European Union, the reason for it to pressure Chinese Yuan appreciation is not the trade deficit. Rather, it wants to competitive with China for owning the Asian leadership power. In conclusion, each country tries to pressure the exchange rate of Chinese Yuan to appreciate to benefit itself, which forms a hot focus. Besides the external pressures, there are also internal pressures within China for the revaluation of the Chinese Yuan. The surplus in the overall balance of payments results in an increasing money supply, which may also contribute to a bubble in the capital market. In the long run, it may also result in inflation. The impact of the Chinese Yuan’s appreciation There are several adverse effects of the Chinese Yuan’s appreciation: First, a huge appreciation of Chinese Yuan may suppress the growth of export. The exchange rate appreciation may increase the export cost, which may decrease the profit of the export products and thus decrease the initiatives of the export enterprises. If the export enterprises increase the price of the product to maintain a certain profit, this will lower the competitive strength of the export products and thus pose adverse effect on the market share, especially after the financial crisis explosion. Second, a huge appreciation of Chinese Yuan may heavily impact the Chinese competitive industries. In the current international division structure, contrast to the research and development advantage and advantage of service trade in other countries, China’s advantage is manufacturing labor-intensive products. This trade structure can be easily affected by the violation of exchange rate. Third, a huge appreciation of Chinese Yuan may affect the stability of domestic financial market, especially at current when the domestic financial system is fragile and the capital market is unhealthy. In addition, the work service sector, limited skilled labor workers all indicate that currency exchange rate change will have a major impact. China itself would suffer the greatest loss after appreciation of the Chinese Yuan in terms of output, consumption, and overall welfare. There will be domestic inflation pressures, while both real and nominal interest rates will decline, much as the Japanese economy experienced with appreciation of its yen. In addition, Chinese Yuan appreciation will have a substantial impact on China’s productive mix in terms of both skilled and service sectors of its economy. Design an appropriate exchange rate policy How to set an appropriate exchange rate level has been a highly controversial issue for a long time. There exists an extensive literature that addresses these issues and the present study presents a some what different perspective to the current debate on the Chinese exchange rate policy. Whatever, it is indeed a difficult thing to design an appropriate exchange rate policy. After reading a list of professional essays, when designing an appropriate exchange rate policy, we can consider the following aspects: First, it is the acceptable domestic economic level. Specifically, it means that when making this decision, we must consider the acceptable economic level, including the acceptable growth of GDP, the unemployment rate, the constraint of the resources, etc. Second, we must focus on breaking the expectation of the appreciation of the exchange rate. In recent years, the stability increase of the exchange rate of Chinese Yuan has formed an intensive, forecasted expectation of increase in exchange rate. As a result, the pressure of the hot money inflows has brought big difficulty to the control of stock price and the price of the real estate, which may be a big issue that China has to face to in the future years. As a consequence, find a way to break this expectation is needed. Finally, to guide domestic demand rather than adjustments of exchange rate is an urgent matter for China. This is exactly in accordance with the long-term benefit of China.