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Introduction: In the year 1994, China devalued Renminbi (RMB), also called Yuan, by 30%
and pegged it against USD (United States Dollar) at 8.28 RMB for 1US$ with a narrow band
of +0.3% movement per day. It remained at the same level till 2005 and People’s Bank had
to sell or buy billions of dollars every month to maintain the exchange rate. During 2004
buying US$15 billion per month became the price for People’s Bank to keep the exchange
rate controlled. During that period USD depreciated against Euro because of which RMB
also depreciated. To correct this, RMB was appreciated by 2.1%. In July 2005, Chinese
authorities changed the policy of their currency evaluation from a quasi-fixed exchange rate
to a managed float system and RMB was no longer pegged against USD but against a basket
of currencies of the major trade partners of China with assigned weights. Till mid 2008 RMB
kept on appreciating bit by bit and reached a level of 6.8 RMB for 1US$ which was a 20%
rise against USD. This time China again pegged its currency against US dollar and since then
it is at an almost stable rate for nearly 2 years. (Refer to annexure 1) But the policy followed
was criticized by many countries because Renminbi was significantly undervalued and it
gave the Chinese exporters an undue advantage over the others and thus made Chinese goods
cheaper in market. As a reason China was pressurized by rest of the world to change its
policy. On 19th June, 2010, Saturday, People’s Bank of China announced that Renminbi is
ready to float more freely in the market against a basket of currencies. The article, “The
Long March, published in The Financial Express” raises four main concerns regarding the
decision of Chinese government.
Analysis of the article: An undervalued currency acts as a subsidy to the exports and tax on
the imports. China was also following the similar policy of undervaluing its currency and
subsidizing its exports. Thus China was following the mercantilists approach towards the
international trade which does not lead to the global welfare. By exporting the goods using
an undervalued currency, the country was actually increasing unemployment in US because
the producers there were not able to compete with those of their Chinese counterparts. US
trade balance has been negative for a very long time. It reduced to certain extent during the
economic crisis (Refer to annexure 2) and during crisis the current account surplus of China
was also cut by more than a third as a share of China’s GDP. But in May, 2010, the exports
of China surged because developed countries were emerging from the affect of crisis, once
again leading towards the huge surplus for China from exports.
Thus, from (1) it can be said that a country which exports more will save more and
conversely a country which has huge trade deficits will be more prone to consumption.
Equation 2 states that any foreign exchange earned must be sent on either imports or
exchange for claims. This will lead to a conclusion that deficit in the current account is
exactly equal to the surplus in the financial account. Otherwise, there would be an imbalance
in the foreign exchange market and the exchange rates will fluctuate. If we see the Chinese
investment in US it speaks the same story. China being the largest exporter to US is also the
largest investor in the treasury bonds issued by US govt. (Refer to annexure 4) China holds
23% of the total treasury market of US. Now when imports will fall cheaper to China, it can
also face the similar problem and thus to check the same, China will try to put a control on
the foreign capital flowing in the economy.
Imports to China will be cheaper as its currency is appreciated and it can purchase more by
paying the same amount what it has been paying before. It can raise the trade deficit problem
for the country.
Currently saving rate in China is very high being at around 50% of their GDP. As per the
equation, the economy which has huge current account surplus will have high saving rate.
The author in this article says that China has to put a control on the savings rate to remove
the global imbalance. As the currency appreciates, there will be decrease of exports from
China and increase of imports. Thus automatically the saving rate will be decreased in the
country. Also, the holdings of treasury in US will be reduced as total trade of China with US
will be affected by the decreasing exports by China.
Conclusion: The change of policy by China will have impacts on the GDP of China for sure
but it need to have a check on the exchange rate and not allow it to increase suddenly
because it can have devastating impact on many economies. China is currently the regional
processing center and if Chinese economy suffers, it may have a huge impact on the global
economy. The saving rates in China need to be checked and it will when the currency
appreciates leading to decrease in exports. Though US cannot have immediate impact on its
trade deficit but slowly the condition can turn favorable. China will have to keep a check on
capital inflow in the nation so that it can defer the possibility of heavy imports and also to
cool down the rising inflation in the economy.
Annexure:
Annexure 1: CNY/USD exchange rate
Source: http://www.federalreserve.gov/releases/h10/summary/
Source: http://www.ustreas.gov/tic/mfh.txt