China__Is_the_Chinese_Currency_Undervalued

Part C: Undervalued Exchange Rates A. It is often said that a currency is undervalued. What does that mean' A currency can be described as “undervalued” if that currency costs less to buy with another currency than its worth in goods (or is priced “too low" relative to the currency of another country). Therefore, the value of the currency on the exchange market is lower than is believed to be sustainable in a sense that its officially fixed value and/or nominal exchange rate is less than its fundamental value and/or real exchange rate. This may be due to a pegged or managed rate that is below the market-clearing rate, or, under a floating rate, it may be due to speculative capital outflows (also see our Book, page 67xx). The monetary fund regards a currency as substantially undervalued if it is more than 20 percent below its fair market value (according to Keith Bradsher, “Spotlight Complicates China's Currency Stance” in New York Times, published March 14, 2010) B. What are the consequences for trade between two countries if a currency is undervalued' An undervalued currency in general facilitates one country’s exports into another country which, in turn, makes a trade surplus in the exporting country more likely while reducing unemployment there, at the same time possibly increasing a trade deficit as well as unemployment in the importing country. For this reason, countries following the approach of holding their exchange rates artificially low are often accused of stealing jobs and causing their trade partners to run huge trade deficits (according to “China economy review and analysis”, March 24th, 2010 in StockMarketsreview). For example, if one country A is undervaluing its currency relative to its trade partner country B, this usually results in more sales of country A into country B since any exchange rate induced discount represents a very attractive opportunity for the buyers of country B. However, it is doubtful if country A benefits from such an undervaluation of its currency in the long run: At first, exporting companies of country A obviously would benefit, as more employees, infrastructure etc. are required to handle the larger export demand. But it is also clear that undervaluing its currency will cost country A on net as it subsidizes country B’s consumption: the undervalued currency could possibly even enable the buyers in country B to acquire valuable goods below country A’s cost of supplying them. Therefore, artificially stimulating country A’s exports of goods by undervaluing its currency is no path to long-run and widespread prosperity in country A. This way of fixing its currency possibly also destabilizes the financial system of country A as a sound banking system requires an independent monetary policy, which uses adequate interest rates rather than fixed directives to sensibly guide credit. C. The Americans often claim that the Chinese currency renminbi is undervalued. Do some research and evaluate this claim. At first glance, it seems quite obvious to concede that those critics are right that accuse China of keeping the value of its currency artificially low so that its exports remain cheap compared with other nations’ products. That, in turn, obviously further boosts China’s economy, but possibly at the expense of other trading partners, which leads to even otherwise moderate economists demanding to revalue China’s currency by 20% (also compare Gregory C. Chow in“Globalization and China’s Economic and Financial Development”, Princeton University 08.05.2005 as well as statement of Federal Reserve Chairman Ben Bernanke during testimony to the Joint Economic Committee on April 14th, 201o quoted from Market News International), more U.S. biased experts arguing that it is undervalued by 40% or more (for example Bryan Rich, “Chinese Yuan the Most Undervalued Currency in the World”, Marketoracle.com Oct 31, 2009). China, in the meantime, merely describes its currency strategy as “stimulus”, not agreeing at all that the currency is undervalued (according to Alan Beattie in “ IMF to China: RMB revaluation made painless” in Financial Times, 14.10.2010). Chinese economists rather point out that the greater the outside pressure, the more difficult it is for the Chinese government to raise the exchange rate, and the more difficult it is for the Chinese people to accept a revaluation of the Chinese currency. According to those experts, “China is an underdeveloped nation that will need a century or more to reach advanced status” (according to Michael Wines in “Chinese Leader Defends Currency and Policies”, New York Times, published March 14th, 2010) Facts seem to underline the critic’s perspective: The Chinese currency’s gradual appreciation stopped in July 2008, and ever since, China has kept it tightly pegged to the dollar irrespective of the U.S. currency’s constant decline (also see “China2s Currency: a summary of the economic issues” by Wayne M. Morrison, Congressional Research Service, published 07.12.2009). [pic] Since then it has risen by only 8% against the Dollar even though the Dollar itself has weakened significantly. (according to Ian Welsh, “The American Eagle Trap: Why a weak dollar won’t save America”, published 31th of August on ianwelch.net, also see the following graph taken from www.globalfinancialdata.com) [pic] That is why voices as prominent as that of Alain Trichet, President of the ECB, already some time ago very openly stated that "the ECB is also of the view ... that the currencies of a number of Asian emerging countries are undervalued against major international currencies, in particular the Euro and the Dollar. This is the case of the Chinese currency but not only the Chinese currency, but as I said, of a number of emerging Asia currencies" (according to AFP in May, 2005). One of the other countries Trichet is blaming with anti-market moves for sure is Japan, which intervened in 2004 to devalue its local currency and boost its exports. First Japan and later China have long relied on the export model and an undervalued currency to build their economies. At the same time China keeps defending its economic policies describing its currency as “basically stable” and at most as a tool to “maximise export employment” (according to the article “China's currency: Bending, not bowing”, published Apr 8th 2010, The Economist print edition). The country’s exports are soaring while most other major economies struggle to recover from the recent recession – quite some evidence leading to the conclusion that the Chinese are skillfully playing inconsistencies in international trade rules to spur their own commercial interests at the expense of others. In its quest to maintain export dominance, China instrumentalizes several means, sharply fighting the protectionism of other trade partners (according to Henry C K Liu, “China and a new world economic order, Asia Times, published January 12, 2010) and in parallel holding down the value of its own currency by buying dollars and other foreign currencies, selling more of its own currency which then depresses its value, helping Chinese export to surge thanks to this severe intervention. Also, and unlike extra government spending in the U.S. and other countries, China’s currency intervention does not expand global demand, but merely shifts it from other countries to China. Again, evidence therefore points into the direction of the critics: - China, coming from only 1% of GDP in 2001, reached a GDP of 9%, or a 250 billion Dollar trade surplus with the rest of the world last year, its exports to the U.S. outnumbering imports from that country into China by more than four to one (according to Xinhua News Agency January 22, 2009); - in parallel, China is filing more cases with the W.T.O.’s trade tribunals than any other country complaining about trade practices of several states in the recent 12 months – this is in sharp contrast to the first seven years of China’s membership in the W.T.O., during which it merely filed three cases (according to Keith Bradsher in “China Uses Rules on Global Trade to Its Advantage”, New York Times published Published: March 14, 2010) - The level of foreign reserves China holds has hugely increased - from the end of the second quarter of 2008, through to the end of 2009, those reserves rose by 590 billion Dollars (data taken von “China and the Dollar”, http://www.kerford.co.uk/images/nl/nl20090731/newsletter.asp, some more graphs are available there). China is also reported to be the biggest buyer of treasury bonds at a time when the U.S. suffer from record budget deficits and need China to keep buying those bonds to finance American debt (according to “China still biggest foreign buyer of US debt, Chinapost, published 27.02.2010) However, it is not clear how to establish the correct value for the Chinese currency - purchasing-power parity (PPP) (As defined in class slides) does not seem to be the ideal method to determine the optimal exchange rate, as there are vast differences in income between the US and China and of course, prices in a country with lower salaries are also lower. Considering those significant differences in income and the different nature of the respective domestic industries, even a considerable rise in the value of the Chinese currency would most probably do little to reduce America's trade deficit as the overlap between American and Chinese production now is neglectable - American products would mostly be no subsidiaries to cheap Chinese imports. Instead, other Asian countries would probably fill the void left by the Chinese goods. (Also see Michael Mandel, “The Real Cost Of Offshoring”, Businessweek, published June 18th 2007). Also, and besides Chinas possible manipulation of its currency, there are of course many other factors that contribute to Chinas recent strength and success - looking at Asia’s changing supply chain, there are many goods that are now assembled in China which in earlier days were delivered by other Asian countries like Japan, South Korea and Taiwan. China has cleverly found a way of importing key components from these countries, assembling them cheaper and then exporting the finished product with great success (further described by Walid Mougayar, Small Screen, Smaller World, YaleGlobal , 11 October 2002). Since a large part of Chinese goods therefore contain many components from other Asian countries, a rise in the Chinese currency would reduce the cost of such imported components even further, keeping the overall costs for the to be exported final product rather stable. Under these conditions, there are also no grounds on which to blame China for job losses in the US since the unemployment rate still is at a rather low rate (also see “unemployment rate holds steady”, pbs.org, published March 10th, 2010). One could therefore even assume that trade with China aids the U.S. rather than harm its economy (Similar conclusion: Will Hutton, “If the US declares economic war on China, we should all tremble”, The Observer, published Sunday 28 March 2010). Thanks to imports from China subsidizing American consumers, prices are lower and real incomes are higher in the US. Same thing is true for China's extensive purchases of Treasury bonds and maintenance of huge Dollar reserves because these help to sustain low interest rates, making it attractive for U.S. consumers to take up loans for homes, cars etc. and to consume in general, thereby keeping the economic system running. Without the Chinese investment in U.S. government debt, the consumption boom in the U.S. would not have taken place (Ambrose Evans-Pritchard “China alarmed by US money printing”, The Telegraph, published September 6th, 2009). It was, of course, Chinese self-interest to finance American consumers to buy goods made in China because this helped China’s double-digit growth rate. If the Chinese currency would appreciate or be revalued, these low interest rates would instantly rise and take prices for consumers with them as China needs to invest less into US currency to keep its own currency artificially undervalued. So while a stronger Chinese currency would for surely lead to less Chinese exports to the US, the US deficit most likely would remain at a high level as these inexpensive Chinese imports could not be replace by domestic goods, but by those from other cheap exporting countries. For all other imports that could be replaced, a stronger Chinese currency would act more like a tax on U.S. consumers (similar conclusion: “The return of the "get tough" approach to China”, The Economist, published Mar 15th 2010). Combining these findings with the claims that Chinese excess saving contributes to global trade imbalances about the same as excess spending of the U.S., there is quite some evidence to assume that it would be in China’s very own interest to let its currency rise without further pegging it to the Dollar, avoiding overheating of its domestic economy in the process (as opposed to Ronald McKinnon, “Why China Should Keep its Exchange Rate Pegged to the Dollar: A Historical Perspective from Japan”, Stanford University, published October, 2006). Also, this would counter fears that the vast budget deficits in the U.S. will lead to inflation that effectively devalues the Dollar, and thus the value of China’s huge foreign-currency reserves. After the credit crunch, it is clear that neither the U.S. nor China can afford to continue to rely on a relationship that involves one partner overconsuming and the other oversaving (also in favour: Michael Pettis, “the Asian savings glut hypothesis, and why it matters”, published in August 2009). Also, China's excess liquidity leads to very low domestic interest rates, which, in turn is a very unattractive incentive to invest. A revaluation would provide a strong sign regarding China’s way forward, away from a pure exports policy that has reached its limits, more towards increased consumption courtesy of strengthened purchasing power, keeping in mind that out of the world’s top 10 largest banks by market capitalization, at least three are Chinese (CBC, China Construction Bank, and Bank of China). Sooner or later, China as the third largest economy will have to adopt a more open capital account and greater integration with the international financial markets anyways since currently, the Chinese currency is still intentively shielded from the other major markets and thereby inconvertible under capital account transactions which does not match the openness of the Chinese economy to international trade, the accumulation of huge foreign exchange reserves nor the growing desire of Chinese companies to invest in non-domestic markets (also in favour: By Keith Bradsher, “In Step to Enhance Currency, China Allows Its Use in Some Foreign Payments”, The New York Times, published: July 6, 2009). Not to forget the fact that China desperately needs an adequate social safety net for its citizens to help prevent further financial imbalances (also in favor: Nina Hachigian, “Clinton goes to China”, The Guardian, published 16 February 2009). As for the U.S., in the long term, they have to solve their huge deficit and save more as the real cause of the crisis is that the U.S. spend too much and save too little which means that even now, the U.S. has to import surplus savings from abroad. To summarize the discussion, critics are right in demanding a revaluation of China’s currency, but for mostly the wrong reasons: China cannot be held responsible for the failures of the U.S. economy. Likewise, with an economy as unbalanced as that of China, the Chinese leaders are in no position to criticize the U.S..