Essay Title - Should China change its exchange rate policy?

An examination of social, political, market and economic factors affecting domestic and international trade

Abstract

This paper discusses all aspects of one of the most heated debates in international economics - the present and future actions of China in regards to the valuation of its currency and any changes that it should make to its exchange rate policy in order to more closely align with what its trading partners desire from their relationship with China. To better understand the complexities of the issue, the exchange rate of China is examined throughout its various phases of evolution as well as analysed in terms of both the Chinese and US perspective.

It would seem that much of the debate really has to do with many of China’s actions that the US deems as unethical and threatening to its own economic stance on the world stage, so it has taken its complaints to the WTO in hopes of convincing the organisation that China is manipulating its currency and creating excessive trade imbalances that are upsetting the growth patterns of all trade partners with China. Despite all of these claims, the paper will provide an extensive amount of empirical evidence from a comprehensive list of secondary source information, including academic journals, economic surveys, and international economists.

The information gathered suggests that there is so much more to this issue that involves domestic social, political, and macroeconomic factors for China that also greatly influence how its currency is valued within the global exchange market. Although still inhibited by its state-controlled Communist ideologies, China is attempting to evolve its exchange rate into a more flexible policy despite concerns about domestic economic health that could be detrimentally affected by rapid valuation of its currency and too much freedom in the capital markets and domestic investment.

Introduction

Of all the world economies, none seem more closely watched or scrutinised as China’s emerging economy and its exchange rate policy. Now that the country has become a member of the World Trade Organisation (WTO) and has gained a larger influence over the state of global trade, understanding the effect of any changes to its exchange policy goes a long way to tracking or estimating issues that may impact other countries involved in trade or financial markets with China. Economists have agreed that China’s currency presents one of the most difficult situations for declaring it either undervalued or overvalued. Hence, the conclusion on whether the currency should be flexible or fixed has become one of the most problematic economic issues in recent years. According to certain economists, “how a country selects an optimal exchange rate regime is one of the most important questions in international economics” (Yi 2008: 2).

After all, the exchange rate affects trade disputes as well as the country’s “ongoing macro management efforts” (China Daily 2004: 1). The recent surge in investment in China has also called attention to the debate over whether or not the revaluation of the Chinese renminbi currency would really stimulate growth and development for the country as well as benefit its trading partners (Lian 2003: 1). While the IMF Articles of Agreement forbid any country from manipulating its currency, the US has continually put China in the line of fire by accusing it of manipulating its currency to keep it substantially undervalued (Frankel and Wei 2007: 2). Additionally, there is also a gap between an exchange rate policy put forth by a government and how it actually operates within that regime, adding to the complexity of this issue (Yi 2008: 3).

This dissertation will cover all aspects and issues related to the Chinese exchange rate policy and any need to make changes to its current strategy. These issues include the impact of China’s exchange rate from both the perspective of the United States and China; the imbalance in global trade due to the undervaluation of the renminbi; the impact of its current exchange rate policy on China’s WTO commitments; and how the country is somewhat handicapped by its current undervalued currency and fixed rate exchange policy. Also addressed are some of the arguments about the true degree of undervaluation that the currency now has as well as whether or not a rapid, large-scale appreciation would hurt China’s growth, development and stability (Goldstein and Weatherstone 2005: 1).

Literature Review

Historical Context

In order to understand the decisions that have been made by China in terms of its currency, it is important to obtain a historical context on where the currency has come from in terms of its value and presence within the global marketplace. Three phases of changes have occurred to the Chinese exchange rate system.

Prior to the 1980s, the exchange rate was artificially fixed and was not a vital part of the Chinese economy (Chinability 2007: 1). Changes began to occur as early as 1979 in terms of reforming and opening up the exchange, leading to a single official rate (China Daily 2004: 1). From 1979 to 1993, the exchange rate was only used as a “tool for financial planning” and was considerably overvalued (China Daily 2004: 1). As part of the reform movement, the exchange rate experienced a number of devaluations that pushed it as far down as 73 per cent against the US dollar as part of a plan for economic reform and growth (China Daily 2004: 1-2). There are certain advantages to having a fixed exchange rate to which the Chinese central bank and government were aware of:

“First is the provision of a nominal anchor to prevent inflationary monetary policies and expectations thereof. But there are other possible alternate candidates for nominal anchor, including nominal GDP, the CPI, and an export price index. Second is facilitation with those countries that use the dollar, or at least are pegged to the dollar. Other advantages of fixed rates include facilitating financial integration, forestalling competitive appreciation or depreciation, and preventing the sort of speculative bubbles that seem occasionally to afflict floating exchange rates” (Frankel 2004: 4).

From there, a dual-track system was developed that provided one official rate and one rate that was for foreign trade, which also experienced drops of between 68 per cent and 76 per cent (China Daily 2004: 2).

As China started to be considered a more viable economic power in the 1990s, the currency started to appreciate and stabilise, which encouraged authorities to consider loosening up the current “rigidly-controlled exchange rate” (Chinability 2007: 1). During the second phase, which occurred from 1994-1997, further changes occurred. Primarily, China resorted to a “market-based, managed floating rate system” and the official and foreign exchange swap market rates were integrated (China Daily 2004: 2). This action stopped the devaluation process in its tracks, leading to a stronger renminbi. The Asian financial crisis of 1997 again led government officials to think about reforming the exchange rate once more (China Daily 2006: 1).

The third phase started in 1998 and continued into 2004. This phase started out with the continued effects of the Asian financial crisis, causing crippled capital outflows and a return to the devaluation process until the Chinese government stepped in to stop any more reductions in the value of the local currency (China Daily 2004: 2). This action was thought to have assisted in halting the financial crisis and returning a certain level of stability to both Asia and the world markets that were reacting to the issues (China Daily 2004: 2). It was at this point that the Chinese currency became one of the strongest emerging market currencies (China Daily 2004: 3). However, recovery was short-lived as the world again reeled financially from the effects of the 9/11 terrorist attacks, causing global recession (China Daily 2004: 3).

In 2005, China moved to build more flexibility into its exchange rate system because of a large amount of foreign exchange reserves (McGregor 2005: 1). This was the first time in eleven years that the central bank had decided to revalue its currency and the decision was also made to set the exchange rate on a daily basis, moving the value based on circumstances in the domestic and international markets (Kalish 2005: 1). The promise by China at that time was that it would implement an adjustable currency rate based on market supply and demand (Morrison and Labonte 2008: 1).

There are other far-reaching implications connected to this decision based on the fact that China has so much invested in the US treasury market (McGregor 2005: 1). Part of this was connected to Chinese companies that were gambling on a revaluation, so they borrowed money through offshore US dollar credit transactions and converted the money into renminbi currency at home (McGregor 2005: 1). During this time, there were continued “robust” capital inflows as well (McGregor 2005: 1). It was during this time that China decided to move from a pegged system to a “managed exchange-rate system” (Higgins and Humpage 2005: 1).

In tracing this historical perspective of the exchange rate, there are a number of conclusions that can be drawn, according to Guo Shuqing, director of the State Administration of Foreign Exchange and deputy governor of the People’s Bank of China. The first is that the evolution of the exchange rate has been driven by the market rather than completely influenced by external factors (China Daily 2004: 4). While the exchange rate became devalued during the earliest attempts at reform, it then rebounded up until 2004 and showed a “stable uptrend” (China Daily 2004: 4). However, compared to the currency exchange rates of the country’s trading partners, China shows a lot more fluctuation (China Daily 2004: 5), which could indicate stability but it was this movement that also helped Asia’s financial markets rebound after a crisis.

Compared to its past, China has come a long way forward through its ability to create a “hybrid economic system, with market mechanisms and the private sector playing an ever-increasing role in resource allocation as well as price determination” (Liang 2003: 2). In addition, the Chinese economy has become intertwined within the global economic and trade landscape that has developed within the last ten to fifteen years (Liang 2003: 2).

Understanding Fixed and Flexible Exchange Rate Policies

China’s fixed rate policy allowed the Chinese central bank to buy and sell “as much currency as was needed to keep the yuan-dollar exchange rate constant” (Morrison and Labonte 2008: 7). There are a number of reasons why a fixed exchange rate is a good option for a country:

Then there is the flexible exchange rate policy, which has “fundamentally changed the nature of the global financial architecture” (Dorn 2006: 426). In contrast, the US and Euro exchange rate system is a flexible, or floating, rate. Based on the economic theory of supply and demand, the flexible rate system revolves around the idea that “the relative demand for the two countries’ goods and assets determines the exchange rate of the Euro to the dollar” (Morrison and Labonte 2008: 8). These currencies are “traded on a global market, which means their relative value is constantly shifting in response to economic conditions” (Martel 2003: 2).

In terms of defining the positive and negative factors of each system, “empirical studies have shown that fixed or relatively rigid exchange rate regimes have indeed provided some benefits in terms of macroeconomic stability, especially to low-income countries where financial market development is limited and the capital is closed” (Prasad, Rumbaugh, and Wang 2005: 11). However, the downside is that this type of system “can often mask underlying policy and institutional weaknesses and result in the build up of various sorts of imbalances (Prasad, Rumbaugh, and Wang 2005: 11). In contrast, a flexible system provides much more transparency and allowances for development and access to capital.

The US seems to define a flexible exchange rate as one that it appreciates and does so on a rapid basis, especially if it is being quizzed over China’s currency valuation (Keidel 2007: 12). In looking at the idea of appreciation and artificially causing it to happen, there are certain economists that believe that when China does completely move to a flexible exchange rate system, appreciation will occur on its own accord (Morrison and Labonte 2008: 8). This would happen because productivity and quality improvements would increase the global demand for Chinese goods (Morrison and Labonte 2008: 8).

As such, the central bank would then be able to supply or remove currency in order to maintain a balance that aligns with market demand, thereby pushing the currency rate up or down (Morrison and Labonte 2008: 8). In looking at the US, Euro, and Chinese exchange rate systems, it is clear that there are “differences in institutional design and accountability within each system” which lead to various “consequences for policy outcomes” (Henning 2007: 785). These differences will become even more apparent later on in this research paper and will serve as the basis for understanding why the Chinese exchange rate policy has become such a critical issue within global trade.

Current Status of Exchange Rate Policy

In looking at China’s exchange rate and its monetary policy, these tend to be one in the same since the “exchange rate is identically equal to the nation’s inflation rate, minus the average (trade-weighted) foreign inflation rate and plus the rate of change of the real exchange rate” (McCallum 2004: 2-3). Since 2005, the value of currency has been gradually appreciating in the range of 2-4 per cent based on decisions by the Chinese government to float its rate based on a tie to “a basket of currencies” rather than to just simply peg it to the dollar (Goldstein and Lardy 2006: 1).

In 2007, China decided to widen the daily trade bands connected to the exchange rate as part of a plan to control the country’s growth, which has experienced some rapid expansion that may be too much, too fast (Bryson 2007: 1). The recent actions also maintain some control over inflationary pressures set against lower import prices while sending the message to other economies that the country is addressing the speed at which it has been suggested that they appreciate the country’s currency value (Bryson 2007: 1). However, China has yet to live up to its promise of a flexible exchange rate. Currently, the actions of China’s policy have been described as a “managed float” where “market forces are determining the general direction of the yuan’s movement, but the government is retarding its rate of appreciation through market intervention” (Morrison and Labonte 2008: 2).

In looking at what is to come, many who are following the upward movement of the currency exchange rate predict that 2008 will bring an increase in value of nearly 8 per cent (Bryson 2007: 2). Some financial experts are even predicting a 10 per cent increase in the currency’s value (McGregor 2008: 1). The country is currently seeing a strong investment demand while there is a weaker consumer demand as the trade surplus is expected to stay at its current enormous size (McGregor 2008: 1). Recent movements in the renminbi - including a 2.3 per cent growth in the last two months - indicate that such a strong increase can be possible (Wood 2008: 1). In fact, China reported as recently as January 2008 that there has been a total of 11.6 per cent appreciation in its currency since its announced a change to its policy in July 2005 (Morrison and Labonte 2008: 4).

After all that has been accomplished with China’s attempts to modernise and evolve its economy and exchange rate, US economists continue to insist that the Chinese currency is undervalued by between fifteen and forty per cent (Primosch 2006: 5). In fact, of all China’s trading partners, no voice seems louder in protest to China’s exchange rate policy than that of the US (Morrison and Labonte 2008: 1). In a May 2006 report, US Treasury Secretary Snow said:

“We are extremely dissatisfied with the slow and disappointing pace of reform of the Chinese exchange rate regime….it is a matter or extreme urgency that China act immediately to increase the flexibility of its exchange rate regime before real harm is done to its own economy, to its Asian neighbors, and to the global financial system” (Primosch 2006: 5).

However, these comments may present another side of what the US intention is in pushing for China to change. It might have more to do with political posturing than be about the reality of the aforementioned claim.

Exchange Rates and International Trade: A Complex Relationship

Based on the components of economic theory, it seems as though exchange rates tend to be one of the first segments of a country’s economy that gets scrutinised when trade imbalances occur (Keidel 2007: 1). An undervalued currency can send both positive and negative signals to economic and trade markets in various countries involved in trade with that country, resulting in imbalances, labour issues, and a swing in the cost to produce, buy, and sell goods.

The upcoming sections of this dissertation illustrate how the US is being the blame game with China in regards to trade imbalances and currency undervaluation. However, trade and exchange rates cannot be compartmentalised by creating an easy explanation. This is a complex issue with various factors and forces that are working against each other across the global business spectrum.

The Chinese Perspective

China prides itself in the fact that it has never purposely manipulated its currency, which would have helped them “benefit from improved price competitiveness in export commodities” if they had implemented such a strategy. There were a number of reasons that have been proposed as the reasons behind the decision to revalue the currency in 2005. One of the primary reasons related to the perspective that it would result in a beneficial economic interest for China. One economist provides the reasoning on why the Chinese held this perspective and have maintained that that there is a positive aspect to raising the value of its currency:

“Holding down the value of the renminbi has required that the People’s Bank of China (PBC) purchase the excess supply of dollars coming into China. To do this, they have had to print renminbi. That created excessive money supply growth, inflationary pressures, a property price bubble, and an overheated economy….they did it to shift the preponderance of economic growth away from exports and toward domestic demand. That is, a higher currency will make imports into China cheaper. This will effectively increase the purchasing power of China’s consumers, thereby increasing domestic demand. In addition, lower import prices will create more competition for China’s domestic companies, forcing them to become more efficient and more competitive”(Kalish 2005: 1).

Despite this realistic perspective of the Chinese in terms of how they see themselves within the global market, the next section will provide the US interpretation of how they see the country’s currency policy, which tends to take a 180-degree view difference on the type of policy that China should adopt.

Currently, China, among many countries, prohibits “foreign access to their currency and on-shore markets,” making if very difficult for US investors to hedge in the local markets (Higgins and Humpage 2005: 1). The concern is that there could be a situation where a country invests too much money as a means of gaining more power over that country. Additionally, the fear is that opening up this area to foreigners would give them the “ability to transfer local currencies to non-residents, encourages speculative financial movements, greater exchange-rate volatility, and ultimately some loss of monetary control” (Higgins and Humpage 2005: 1-2).

Part of the reason that the current exchange rate policy has not been altered to realise greater appreciation in a shorter period of time is a real concern in that it could adversely affect China’s domestic growth, development, and financial stability. There are a number of arguments that have been presented around this concern:

“Some opponents of renminbi revaluation emphasize the large-scale and continuing migration out of agriculture, the sizeable employment losses in state-owned industries, and the large annual flow of university graduates looking for work. Taken together, these labor force trends are said to create irresistible social pressures for rapid economic growth that can only be accommodated with the high export growth emanating from a highly undervalued exchange rate” (Goldstein and Weatherstone 2005: 4).

Other economic researchers believe that the undervaluation of the renminbi and its link to the US dollar serve as “an essential pillar of China’s domestic financial stability and as a way of encouraging large inflows of foreign direct investment that can compensate for the weaknesses of China’s domestic banking system” (Goldstein and Weatherstone 2005: 4).

To counter these opinions, there are those that have pointed out the benefits to the Chinese economy if there was to be a rapid appreciation of the currency and movement to a floating exchange rate. These arguments are comprised of three specific points. The first counterpoint is that appreciation of the currency cannot really be tied to slow growth nor can it be assumed that exports are the main driver’s of China’s growth (Goldstein and Weatherstone 2005: 4). The researchers back up this claim with some significant data:

“Between 1994 and early 2002 the real, trade-weighted exchange rate of the renminbi appreciated by almost 30 percent…, yet the Chinese economy grew at an average annual rate of 9 percent, and growth never dipped below 7 percent growth in any single year….this large real appreciation of the renminbi did not come all at once, but there were individual years in which the appreciation was 8 percent or more (13 percent in 1997 and 8 percent in 2000). Also the record over this 8-year period demonstrates that the Chinese economy is capable of growing at a robust pace when the real exchange rate is following strong trend appreciation” (Goldstein and Weatherstone 2005: 6).

The second counterpoint is that the exchange rate is not the only factor that influences and determines what comes of a country’s macroeconomic policy because there are other issues, such as demand growth, inflation, trade surpluses and the like, that determine the positive or negative status (Goldstein and Weatherstone 2005: 6). This is not a suggestion that revaluation be put aside but it is merely a different tact that could be taken to deal with the dilemma faced by China as is demonstrated in the section that covers empirical evidence related to this topic.

The third counterpoint revolves around the concern about the effect that revaluation will have and the protectionist response that it will illicit from other economies involved in trade and export markets with China, which could have a detrimental effect on China’s growth (Goldstein and Weatherstone 2005: 7). In explaining this crucial area of concern, one economic analyst had this to say:

“If China’s rapidly rising current account surplus, huge accumulation of reserves, and limited appreciation of the renminbi persuade legislators and policymakers in the major industrial countries that China is blocking effective balance of payments adjustment and running afoul of IMF exchange rate manipulation guidelines, China may well find its access to these markets constrained by new protectionist barriers. That could be a serious dent in China’s exports as well as damage the global economy….” (Goldstein and Weatherstone 2005: 8).

This is somewhat evident in the current trade disputes and tension with the US, which will be discussed in greater detail in the next section.

Lastly, in addressing the idea that it is beneficial that the link between the renminbi and the dollar is beneficial, others within the Chinese perspective would counter with the point that it this connection has actually taken away its “monetary policy independence” (Goldstein and Weatherstone 2005: 9).

The US Perspective

It is clear from what is provided in the available secondary research that the US does not have a positive outlook about China’s exchange rate policy and has continually pushed for faster appreciation of the currency (Bryson 2007: 1). Its current attack on China closely mirrors what it had done to Japan and the yen nearly thirty years prior when it pushed to accelerate that country’s currency rate (McKinnon 2005: 1).

Before explaining why the US has such a negative outlook, there are some benefits to an undervalued Chinese currency. Imported Chinese goods are cheaper, allowing US consumers to receive cheaper goods while US manufacturers have access to cheaper parts in their production processes (Morrison and Labonte 2008: 1). The benefits extend further in that this undervalue of currency offers lesser inflationary pressures for the US and a better competitive edge over other countries (Morrison and Labonte 2008: 1).

Despite these benefits, the US -- along with other nations -- feels strongly that China wants to ensure that its currency remains undervalued because it can then maintain and “attract large amounts of incoming foreign direct investment (FDI) and that such large FDI inflows, in turn, permit Chinese firms to circumvent the weakness of the domestic banking system” (Goldstein and Weatherstone 2005: 9). The US Treasury contends that “trading behaviour since the reforms strongly suggested that the new mechanisms remain, in practice, a tightly managed currency peg against the dollar” despite claims by the China that its exchange rate is now based on market supply and demand (Morrison and Labonte 2008: 5).

What it really boils down to is the fact that the US is concerned because it is heavily indebted to China and is concerned that the country will call on its loans. This deficit is at the highest rate ever and the US realises that the dollar will further depreciate against all of the world’s currencies (Goldstein and Lardy 2006: 1). Strengthening the Chinese currency would help the US get its trade deficit under better control (Wood 2008: 1), so it has been pushing for an upward movement. Additionally, it would increase the price of Chinese exports, making them less competitive and providing leverage for more growth among US producers (Kalish 2005: 2).

There are other concerns that the rise in the renminbi currency could also affect the non-deliverable forward (NDF) markets in which currencies are bought for the purpose of future deliver at a known rate at the point of purchase (Higgins and Humpage 2005: 1). Recently, there have been a lot of attention given to these markets as speculators have decided to jump into the currency market that are interested in gambling and hedging their bets on what China will deliver (Green 2006: 2). There are major issues to be addressed. If the Chinese currency appreciates too quickly, firms that have invested would find that their dollar costs associated with that purchase would rapidly increase, thereby wiping out any possibility of profits (Higgins and Humpage 2005: 1). Rather than being able to hedge the risk, the risk involved is experienced as a head-on collision if the currency exchange rate was to increase rapidly.

The situation with the US has also been problematic due to becoming second on the list after the European Union (EU) in terms of exports to China due to the fact that the value of EU exports was near to double that of the US driven by a demand for shoes, textiles, electronics, and steel (McGregor 2008: 1). The US wants to China to loosen its monetary policy rather than tighten it and end up exacerbating capital inflows, reducing demand, lowering imports, and increasing the balance of payments surplus (Econbrowser Blog 2007: 3). Overall, the US says that it does not expect an overnight move to a floating currency system that would result in rapid appreciation but that it just wants further reform measures from China as well as signs that there is a forward momentum toward a flexible exchange rate policy (Morrison and Labonte 2008: 7).

Summarising the Two Perspectives

After detailing both the perspective of the US and of China, it is clear that it does not make sense to so tightly link the US dollar and the renminbi because of the extreme policy differences between the two nations. A clear example of the dramatic depth in differences between the US and China in terms of its policy is the example of the US Federal Reserve which reduced short-term policy interest rates in 2003 to maintain stability in the local economy while the Chinese policy took the exact opposite action to deal with the “overheating of the Chinese economy” during the same period (Goldstein and Weatherstone 2005: 9). They may have decided not to raise their interest rate in China out of concern that it might make any issues with large capital inflows worse due to the tight linkage to the US dollar (Goldstein and Weatherstone 2005: 10). The Chinese business cycle is “not synchronized with that of the U.S. (Liang 2003: 1), further exacerbating the situation.

While the US policy papers do touch on important issues outside of their push for Chinese currency appreciation, the Chinese do not see the purpose of revaluation as “necessary for promoting fairness in the bilateral commercial relationship” (Keidel 2007: 2). For China, there is also no value in rapid appreciation of their currency and could only result in domestic problems for a country that is focused on becoming a primary force in the world’s economy (Keidel 2007: 3). Overall, it would seem that this relationship between currencies and trading partners is the best alternative for changing the monetary exchange rate within China. Despite having said that, the maximum benefit would be achieved if and when the US and China reach a crossroads that then puts them on parallel policy paths that yield improvements in global payments adjustment that opens markets and supports mutual growth (Goldstein and Weatherstone 2005: 12). The US has gone so far as to suggest that it uses “access to the US market as leverage to persuade China to stop engaging in predatory trade” (Ellis 2006: 2).

It really is a misplaced judgement on the part of the US to focus so closely on China’s currency rate as the focal point of any economic crisis within any country and craft political documents around the argument that China’s exchange rate policy is the sole reason for any trade imbalances. As the empirical evidence later on in this dissertation will show, there are really so many more factors involved in the dynamics of China’s market as well as within the world’s integration of its economies, financial markets, and trade markets.

A Review of China’s WTO Commitments

This tension between political and economic policies of various trade partners with China leads to a discussion on how well the WTO and its member nations believe in the extent to which the country is fulfilling its commitments as a member.

China joined the WTO in 2001, signalling that the country was ready to reform its social, political and economic structure to achieve greater growth through trade partnerships with other world powers (China Daily 2006: 1). Since becoming a member of the WTO, China has become the third largest trading nation. Participating in the organisation has sped up China’s modernisation processes of its infrastructure and manufacturing industries (Primosch 2006: 1). Many firms within the US National Association of Manufacturers have viewed China’s membership as a way to grow their own industries. Many have “invested in manufacturing facilities to sell their products there and source inputs for their global supply chains. At last calculation in 2004, there were 19,000 small- and medium-sized US manufacturing firms that were exporting to China (Primosch 2006: 2).

While the WTO praised China in an April 2006 report for the number of reforms made to reduce the number of people living in poverty in the country and substantially raise GDP (China Daily 2006: 1), there are other commitments that many of the member nations believe are not being met. Beyond the issue of China’s currency exchange rate policy, other commitments pinpointed in the report that the WTO believed were not being met had to do with a disregard for intellectual property rights and “slow liberalization of key service sectors such as banking and telecommunications” (China Daily 2006: 1).

The primary purpose of the WTO is to create a standardised process for agreeing on trade practices between countries (Primosch 2006: 1). However, the past few years have seen escalating trade hostilities between the US and China. American manufacturers within various industries have claimed that China is purposely keeping its currency “undervalued by as much as 40 percent” so that Chinese goods for American consumers are cheaper while US products are more expensive in China (China Daily 2006: 2). From the perspective of US manufacturers who have done business with China, there is concern that China’s current currency exchange rate is putting US firms at a disadvantage, especially those within the metal-making and fabricating segments (Primosch 2006: 2). This would include segments, such as steel making, auto parts, machinery, hand tools, coat hangers, and metal fixtures, which has occurred because China has been rapidly developing its own competitive steel industry from money that it has received from foreign investors. As such, the relationship between US firms and China has developed into a complex relationship that is both opportunistic and threatening. While there are “new trade opportunities in a rapidly growing market,” there is also “more intensive competition from Chinese-made products” (Primosch 2006: 2). At the same time, however, the US has been able to use China as an effective outsource location to leverage “lower manufacturing costs” (Primosch 2006: 2).

In 2007, a bill was introduced in the US Senate that proposed that the Treasury Department take complaints about countries that purposely “misalign” their currencies to the WTO by filing a complaint that addresses a lack of commitment by China in terms of trade issues rather than monetary manipulation (Econbrowser Blog 2007: 1). By describing China’s actions this way, the US government hopes to gain greater attention by the WTO to investigate any unethical action by the country. In an attempt to maintain a neutral stance, the WTO has encouraged China to move to a flexible currency exchange rate based on the advantages that it would give the country to further fulfil the other commitments where progress has not been made.

Realistically, it is truly hard to gauge whether or not China is living up to its WTO commitments although there are some issues that are problematic outside of the area of currency exchange. However, it is important to point out some of the reasons why there are a lot of grey areas in terms of China’s fulfilment. For example, consider the following points:

In summary, one of the most important factors within the entire discussion of exchange rates and trade is the need for China to continue delivering on its WTO commitments, especially those relating to their “open markets” with their trade partners (Keidel 2007: 2). Interestingly enough, the WTO has, to this point, declined any petition by the US to investigate China on the grounds that it is manipulating its currency (Morrison and Labonte 2008: 4).

Problematic Behaviour and Questionable Business Practices

While this research is primarily concerned with the exchange rate in China, it is important to briefly touch on other areas where China has become a concern in terms of its problematic behaviour and questionable business practices. While the US may be off base in terms of the exchange rate, there have been some valid cases of unethical actions on the part of China that should be explored in order to provide a well-rounded discussion of this global economic dilemma.

For example, there seems to be significant situations just within the US National Association of Manufacturers that have uncovered “large-scale trademark counterfeiting and copyright piracy” in terms of “media products, computer software and luxury goods” as well as “consumer and industrial products” (Primosch 2006: 6). There have been specific instances where a US manufacturer has discovered “substandard Chinese knockoffs” in other countries, such as the UAE and Saudi Arabia (Primosch 2006: 6). Other activities involve the application and payment of Value-Added Tax (VAT) in China and whether or not the local Chinese businesses are following payment schedules since there is no tracking system or transparency that would make it easy to identify any abuse (Primosch 2006: 7).

Another concern involves subsidies received by China that provide them with a competitive advantage over US firms (Primosch 2006: 8-9). The Chinese government apparently has been providing approximately 70 different “export and local-content subsidies” in the form of “tax breaks, exemptions from some tariffs and employee benefits payments, and preferential lending terms (US-China Business Council 2007: 3). China also tends to fall behind on its WTO commitments to maintain excellent compliance in the areas of “technical standards, technical regulation and conformity assessment” (Primosch 2006: 9). Just in 2007 alone, major events involved the lead paint scandal in thousands of toys sent to the US as well as the fatal pet food products that killed numerous pets. These two examples clearly indicate a lack of quality concern in the manufacturing process within China, which is in complete disregard for WTO trade standards.

Taking all of these issues together, organisations like the US National Association of Manufacturers carries the argument forward that if China is practicing questionable standards and falling behind on other WTO commitments, then the possibility exists that they could also be manipulating their currency. Whether this is truly the case still has yet to be discovered, but it does present a formidable question that China must answer.

Methodology

Before moving into a discussion about the empirical evidence that has been gathered concerning the topic of Chinese exchange rate policy, it is important to detail what type of methodology has been used to formulate this dissertation.

All the methodology in this paper is based on data collected from secondary sources, including books, economist and financial newspapers, academic journals, economic analysis and surveys, and research reports. The information within this paper has been gathered from US, UK, Chinese, and international source material. This methodology has been used due to the extensive availability of information and data connected to the subject of China’s exchange rate policy. With a subject of this nature and the difficulties in language barriers, time zones, and accessibility of the appropriate personnel for interviews and questionnaires, it is extremely difficult to gather primary source data that could be analysed for this topic.

Various articles and research has been collected from all of the aforementioned sources and studied to disseminate the information that is most essential for understanding the topic related to deciding whether or not China should, once again, change its exchange rate policy. Once all of the data was accumulated and studied, the current evidence available within these secondary sources was then grouped according to thematic issues that were part of the dissertation’s main question of the exchange rate policy strategy.

Empirical Evidence

The next section provides a significant amount of empirical evidence gathered from a comprehensive array of secondary sources that have conducted primary research and analysed data related to the prospects of changing the Chinese exchange rate policy and the various implications and benefits in implementing these changes on both a domestic and international scale. As the empirical evidence discussed below suggests, China’s monetary actions do have ripple effects across its own economy and that of its trade partners. However, beyond just trade imbalances, the decision to appreciate or devalue the valuation of the currency in China also can be inhibited by other economic barriers.

Effects on Local and International Economies

A country like China wants to achieve both an internal (macroeconomic) and external (trade) balance. This balance would involve “output equal to potential output, or as employment equal to the natural rate of employment” (Frankel 2004: 7). Its economy was considered “overheated” when output was above potential and there was an excess demand for goods (Frankel 2004: 7). The choice then becomes does China raise its interest rate to stem inflation or does it appreciate the value of its currency?

The decisions in the past few years have led to a number of issues for both the local Chinese economy as well as those on the international front. In terms of the domestic problems, a lack of flexibility in the exchange rate mechanisms “limits the independence of China’s monetary policy and thus hampers macroeconomic stability” (Goldstein and Lardy 2006: 1). The current state of China’s financial system is considered repressed and has been given the title of “most restricted capital market in Asia” (Dorn 2006: 430). Interest rate and exchange rate suppression as well as non-privatised financial markets have greatly restricted capital freedom and creates inefficient capital markets, inhibiting some of the growth potential of China (Dorn 2006: 430). If China were to become more liberalised in terms of its capital markets “through deregulation, proper implementation of the rule of law, the encouragement of private markets and extensive private ownerships” of businesses, China’s “balance of payments” would be more in aligned to its other trade partners (Dorn 2006: 435).

On the international front, other countries like the US are pushing for a more rapid increase in the exchange rate. It is hoped that the eventual rise in value of the Chinese currency will help reduce the US trade deficit (Kalish 2005: 2). There will be an impact on other global markets. Various calculations indicate that any revaluation would not impact the US as much as is being claimed by the country. According to Business Monitor International, “a 5% revaluation of the Chinese currency would reduce the US current account deficit by just 0.03% of GDP by 2007, while a 20% revaluation would reduce the deficit by only 0.13% over the same period” (BMI 2005: 35). So, despite all the clamouring by the US government about appreciating the Chinese currency, there is not much difference made in terms of the trade deficit. First, is because China only accounted for ten per cent of total US trade in 2005 (BMI 2005: 35). Second, this example indicates that the “pass-through from the exchange rate to US import prices to be relatively low, attesting to the willingness of foreign producers to absorb adverse currency movements into their profit margins rather than lose footing in the US export market” (BMI 2005: 35).

The US also points to other foreign exchange markets as proof that China should revalue its currency, including other Asian markets, such as Japan, Taiwan, and South Korea, that have also “intervened to prevent their currencies from appreciating” (UCESRC 2005: 3). While the European Union (EU) would favour a revaluation of the Chinese currency so that its exports are more competitively priced within China (Kalish 2005: 2), there is concern if the valuation were to rapidly accelerate. Jean-Pierre Jouyet, France’s European affairs minister said, “[Europe] is exerting growing pressure on Chinese authorities, together with its G7 partners, to obtain an accelerated appreciation of the yuan, whose administered management has more and more negative economic consequences for Europe, as well as for China” (Wood 2008: 1).

Currently, the US trade deficit with China stands at $260 billion, according to 2007 calculations (Morrison and Labonte 2008: 1). This major deficit has the positive effect of pushing China to invest in more US treasury securities, which, in turn, lowers US interest rates and increases US spending (Morrison and Labonte 2008: 1). It would seem that it is rather a symbiotic relationship between the economies of these two nations.

In fact, there is always a flipside to every economic relationship. For example, the lower priced goods from China can also hurt US industries that are trying to provide the same products as China but they cannot do so at a competitive price. Therefore, consumers and manufacturers will choose to buy the cheaper Chinese products even if there is lead paint in the toys or chemicals in the pet food. When these scandals do break and people stop buying these products, suddenly the more expensive US products are more attractive to consumers but upset the margins of global retail firms, such as Wal-Mart. The other side of the coin is that US exports to China also become more expensive, which reduces production and then adversely affects employment (Morrison and Labonte 2008: 1).

Trade Imbalance and Undervaluation of the Renminbi

One of the major questions associated with the entire discussion of China’s exchange rate policy is whether or not the global imbalances in trade are tied to this policy. The answer is yes and no. If a country may want a high surplus, it can do this by “intervening in the foreign exchange market, then sterilising the domestic consequences, and supplementing this with some kind of ‘internal balance strategy,’” but it can also obtain the same results without intervention (Corden 2007: 6). As such, the follow section illustrates how there can be a connection and lack of influence by exchange rate policies on trade imbalances.

In looking at all the empirical evidence available, it is important to consider what is known as the Balassa-Samuelson effect, which is described as follows:

“There is abundant empirical evidence, along both the cross-section and time-series dimensions, that prices of non-traded goods, and thereby of general price levels, rise with levels of productivity, real wages and real income. This robust empirical regularity is called the Balassa-Samuelson effect, and is most often explained by the assumption that productivity growth is more rapid in traded goods than non-traded goods” (Frankel 2004: 13).

In utilising this concept to determine the benefit of rapid revaluation in a short-period of time, economists would point to a number of reasons why this could be detrimental to the overall economy in China as well as further exacerbate any existing trade imbalances. It would seem then that appreciating the currency’s value over time is essential to “curtail excessive build-up of reserves through the current balance of payments, and the dangers of excessive monetary expansion, overheating, and inflation” (Frankel 2004: 16). In looking at the relationship between valuation and trade, one economist concluded that “China’s rapid productivity growth and increased trade integration mean that levels of the nominal exchange rate that might have been consistent with long-run equilibrium in the past have now become undervalued” (Frankel 2004: 16).

In 2005, the state of China’s exchange policy changed and there was a narrow band for the exchange rate of around Rmb8.11:US$1, which represented “a far smaller appreciation than had been called for by the United States and other trading partners” (Chinability 2007: 1). As of 2007, the renminbi seems to be appreciating more rapidly against the US dollar than that of any other world currency (Chinability 2007: 1). The charts below show its valuation against the pound, Euro, yen, and dollar.

Sources: State Administration of Foreign Exchange of the People's Republic of China.

China does not want the value of its currency to appreciate too rapidly because this would impose a slowdown on export growth, which would cause a ripple effect that would negatively impact GDP and the unemployment rate (Bryson 2007: 1).

Related to this is what has happened in recent years where trade imbalances have become more apparent as China has experienced portfolio capital inflows and excessive trade surpluses (Goldstein and Lardy 2006: 1). For example, 2007 trade surpluses set a new record of $262 billion even though “import growth exceeded export growth in each of the final three months of the year” (McGregor 2008: 1). The trade imbalance issue extends beyond the domestic market and affects many global markets due to “China’s prolonged, large-scale intervention in foreign exchange markets (Goldstein and Lardy 2006: 1). As the currency continues to appreciate, the effect will start to limit the surplus “by making imports cheaper” but it will not impact the export aspect of the market (McGregor 2008: 1).

While trade imbalance does play a role in the valuation of currency, there are so many other factors involved in improving valuation or creating further barriers to exchange rate improvements. Beyond trade balance, there is a macroeconomic policy that needs to be addressed, including interest rate targets, and other factors that involve an internal balance for a country’s economy (Frankel 2004: 7).

What it comes down to is being able to understand the difference between the real exchange rate and the nominal exchange rate. Herein lays the true consequences of valuation and trade. One economist presented this example:

“China’s currency could rise in value relative to the U.S. dollar, but if China’s yuan prices are rising more slowly than the dollar prices of US goods, China’s goods could end up selling at lower prices in the US than US goods do….If the yuan were undervalued and fixed, as critics claim that it has been, it would be expected to appreciate in real terms through faster inflation in China than in the US…The responses to an undervalued yuan would lead to a rise in Chinese prices relative to US prices pushing up the real exchange rate for the yuan, given the nominal exchange rate. This has not occurred to any large degree over the past 13 years” (Tatom 2007: 3-5).

This type of empirical evidence calls all of the US claims into doubt in regards to manipulation by China of its own currency.

China’s Trade Surplus

Many economists have looked closely at China and its trade surplus in order to understand whether or not its current exchange rate policy is really affecting domestic and international trade. There are a number of key empirical data points that support the idea that China’s policy is really not the only factor and that the issues the US has with China is more political than economic (Keidel 2007: 7).

China’s global trade surplus is only eight per cent of America’s trade deficit (Keidel 2007: 6). China’s joining the WTO had everything to do with a “dramatic reduction of trade barriers in all directions” (Keidel 2007: 7). The result has been a rather quick response on the export side but problematic on the import side related to the fact that “reductions in non-tariff barriers and fluctuations in domestic trade…have not supported import growth fast enough to keep up with exports, although imports too are growing very fast” (Keidel 2007: 7).

It was only about two years ago that China’s door opened to international retail chains and there is still a cap of forty locations put on global retail companies (Keidel 2007: 7). Tied to this new tolerance for foreign competition, China’s trade surplus jumped from eight per cent to seventeen per cent (Keidel 2007: 8). Taken on its own, this data might be shocking and provide solid evidence for what the US has been claiming, but when this quantitative figure is measured against other countries it is more realistic. For example, although this is a considerable jump for China, it is still less than other countries, such as Germany, Japan and Singapore, that have higher double-digit trade surpluses (Keidel 2007: 8).

During the same time in which trade surpluses more than doubled for China, there were no real movements in the valuation of its currency, proving that trade is not the only factor that alters the dynamics of a country’s economic foundation - that being its currency exchange rate. When looking at the trade surplus situation in China, it would seem that implementing short-term forced appreciation of the currency would create more challenges due the very nature of a global trade environment that is in constant flux (Keidel 2007: 9). The conclusion, then, would be that it is the rapid and varied nature of the forces within global business that are affecting trade levels rather than China’s currency valuation.

A Closer Look at the US Accusation of Currency Manipulation

On paper, the US looks at China’s $1.5 trillion foreign reserves and account surplus of about twelve per cent of its GDP and believes that this is the proof they need for their accusation of currency manipulation (Goodfriend and Prasad 2008: 84).The US Treasury Report on Currency Manipulation seems to have skewed its findings to push for the increase in the renminbi valuation by claiming that “China has a growing dependency on exports to drive its economic growth” (Keidel 2007: 9). The conclusion of the report leads the reader to assume a connection between exports, currency valuation and growth (Keidel 2007: 9). And although the US believes that China’s stockpile of foreign reserves is part of its plan to manipulate its own currency, the Treasury Report’s calculations actually prove otherwise and show reasonable rates as well as lower ratios than any other economies within the WTO (Keidel 2007: 13).

According to one global economic researcher, one only has to look at China’s GDP growth history to realise just how unrealistic this claim is by the US:

“In the latter 1990s, when the US economy was booming because of hi-tech expansion, China’s economy was in a growth slump caused by domestic policy developments. Conversely, as the United States went into recession in 2002 - causing serious trouble for many Asian economies - China’s economy had already come out of its growth slump and had accelerated GDP growth past 9 percent….unlike other East Asian economies, China didn’t follow the ups and downs of U.S. demand - quite the reverse” (Keidel 2007: 10).

At this point in the review of available empirical evidence, it would seem that there must be other factors that influence, inhibit, and alter the state of both China’s domestic economy and that of the other global economies that partner with the country.

The US needs to see China as a “legitimate competitor” (Keidel 2007: 15) as opposed to a threat that needs to be controlled. Perhaps it would be beneficial to all of China’s trade partners if they allowed China to flex its economic prowess and grow into its role as a serious participant on the world stage. Currently, the US actions seem to be about keeping China on a leash out of its own inability to strengthen its own “fundamental competitiveness” with China (Keidel 2007: 15). Protectionists are really afraid of the “large shifts of business and employment to China” so the solution becomes a push for China to raise the prices of its goods so people will buy less from China and more from the US (Tatom 2007: 3). What many economists have concluded is that there is “fundamental misalignment between US and China currencies, which detrimentally affects trade relations (US-China Business Council 2007: 2).

China’s Evolving Policies

Despite all the debate, it does appear to make sense that China’s exchange rate “operates in an environment where short-term capital flows are heavily regulated” (Keidel 2007: 11). And since this regulation has been in place for so long, there are no empirical decisions that could be put forth on what might occur to the exchange rate if the “capital account restrictions were lifted at the same time that the currency was allowed to float freely” (Keidel 2007: 11). Currently, as Richard McGregor of the Financial Times sees it, there are only certain audiences that are benefiting from China’s current exchange rate policy:

“Chinese leaders publicly stress the priority of employment creation, but economic incentives continue to favour capital intensive industries, not the job-generating service sector. The huge profits these industries have made in recent years have flowed back to the state investors and officials, not the workforce. The other winners have been foreign multinationals, often in local joint ventures, using China as an export base” (Setser 2007: 3).

The conclusion by a majority of economists is that an exchange rate must be flexible in order to enable the simultaneous existence of “an open short-term capital account and domestic independence in setting monetary policy” (Keidel 2007: 11). However, economic theory does acknowledge the ability of a country to maintain its fixed rate policy and manage its monetary policy on an independent basis, but it must be able to “control short-term capital flows adequately” (Keidel 2007: 11).

China has already acknowledged that it needs and will benefit from implementing a more flexible exchange rate, but it is hesitating due to the inability to completely control these short-term capital flows because this was one of the factors that led to the Asian financial crisis of 1997 (Keidel 2007: 12). Besides this issue, there are a number of other key barriers that China is carefully investigating before it takes any dramatic action.

China’s Exchange Rate Evolution Concerns

To China, there is very little reason why they should allow their currency to appreciate when they are enjoying substantial economic growth as well as transforming themselves into a formidable economic power (Goodfriend and Prasad 2008: 84). In providing evidence from both sides of the economic argument, China has some valid reasons for why it could be concerned with rapidly appreciating its currency as well as moving to a completely flexible exchange rate policy. Its concerns are as follows:

Barriers to Exchange Rate Improvements

In order for this growth in value to happen, it would seem that China will have to address a number of critical issues. One of these problems is the fact that its fragile banking system is inhibiting any more flexibility to the exchange rate policy (Goldstein and Lardy 2006: 2). As previously mentioned, the Asian financial crisis had a detrimental effect because international reserves pushed bank credit to expand too quickly, leading to poor loan decisions and fiscal consequences (Goldstein and Weatherstone 2005: 8). This definition of what defines a financial crisis is very similar to what recently happen. Stability was only regained over the Asian financial crisis when strict controls were implements on bank lending and investment practices (Goldstein and Weatherstone 2005: 9). Therefore, working in partnership with tactics that will improve the valuation of the currency, “better credit decisions based on an objective, forward-looking assessment of the borrower’s creditworthiness” will strengthen this unstable banking system (Goldstein and Weatherstone 2005: 8).

Additionally, there is consensus that the undervaluation level is so substantial that the incremental appreciation approach that has been attempted is never going to solve the currency imbalance (Goldstein and Lardy 2006: 2). The aforementioned movement in bandwidth around the daily fluctuation limit to the currency exchange rate is a definite step in the right direction. Additionally, a greater rate of appreciation would also push up the value while creating more balance on the trade front. Fiscal expansion will help offset some of the reverberations in the markets after a rapid currency appreciation occurs. Lastly, keeping a grip on capital controls will be useful in improving balance at least until the banks are stronger and can regain this responsibility It would be at this point that China could then float the currency rate and remove the last of the capital controls it has in place (Goldstein and Lardy 2006: 2).

There are other aspects to the market outside of just the currency that affect the economic prospects of China as well as its trade partners, including higher wages as well as “more expensive environmental and land costs” (McGregor 2008: 1). As such, it is important to consider maintaining a revaluation of the Chinese currency while, at the same time, the country should consider re-evaluating its fiscal policy to take on social needs that tend to come into play when revaluation increases the “contractionary effect of revaluation on aggregate demand” (Goldstein and Weatherstone 2005: 7). Another suggestion is to make revaluation into a two-part process that implements at various times related to “when domestic demand growth is more buoyant” (Goldstein and Weatherstone 2005: 7).

Another barrier to changing the current policy is strictly political because it would provide a more liberalised approach to living within China, which the current Communist regime may not be comfortable with accepting. As one economist pointed out:

Adjustment requires that China not only allow greater flexibility to the change rate but also allow the Chinese people to freely convert the RMB into whatever currencies or assets they choose. Capital freedom is an important human right and would help undermine the Chinese Communist Party’s monopoly on power by strengthening private property rights (Dorn 2006: 428).

The government would remain a barrier to complete freedom and flexibility as long as it is ruled by Communism. Again, this example illustrates just how tightly economic factors are tied to political, market, and social factors,

Helping China as the Optimal Solution to Global Trade Imbalance

Rather than taking the time to push for WTO investigations into China’s actions, it might be better to focus on finding solutions that help China because the benefits will reverberate to the other trade partners. For example, the US Treasury Department’s “Strategic Economic Dialogue (SED)” with China will create a win-win-win situation for the US, China, and the other international partners, according to this list of benefits proposed by one economic expert:

One analyst has calculated strong growth from China’s economy that is moving so quickly that it will outpace Japan by 2025 and the United States by 2040 even though its standard of living will remain below those two countries (Thomas 2007: 1). It would benefit the US and other trade partners to help an economy, such as China, that holds so much potential.

Predictions on Future Appreciation and Monetary Exchange Rate Policy

As a “transitional economy,” any decisions that China makes about its exchange rate policy must align with its economic development, including “macroeconomic, financial and institutional conditions” (Yi 2008: 19). Recent reports that change is already in the works. Since the Chinese currency rose 6.86 per cent in 2007, future predictions indicate faster appreciation in 2008 and beyond t while “authorities seek to redress mounting domestic imbalances” (EmergingMarketsMonitor.com 2008: 1). What really happens remains to be seen.

Conclusion

As with everything related to economics, there are both good and bad factors and it seems as though most of these are interrelated and work off of and against each other to create complex dynamics. Within the challenging and ambiguous issue of China and the evolution of its currency exchange policy and valuation, there are also various political and social issues and opinions that come into play because various countries are competing with each other but, at the same time, benefiting from a relationship with each other.

In looking at the various country perspectives, economist opinions presented here and empirical evidence, it would seem that the only blame that could be placed is on the decision to move to a global trade process where each other’s economies become interrelated and affected. However, there are really just as many benefits and opportunities as challenges and threats. Also, China is a prime example of how a global trade environment can help modernise and grow countries that were once considered third-world nations.

Despite all the controversy, China has made great strides in bringing its economy into the modern global age of trade. Although some of its behaviours and practices are not reflective of what its trade partners are doing, China is making improvements given the circumstances of being engrossed in a state-controlled Communist economy and exchange rate regime for so long. While many of the accusations of other countries are unfounded, there is the possibility that other economic superpowers may be undone by this emerging economic force in the near future if they do not learn to work with China to produce more favourable trade agreements and exchange rate policies. Despite all the complex weights and measures associated with international economics, it appears that China will emerge with a stronger, more highly valued currency that could become the global currency in the near future if the country continues its strong and rapid growth strategy.

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