The relationship between China and western economies

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The economic relationship between the Chinese and American has been a hot spot in the recent years. Chinese was blamed for the losing jobs in Western countries. Due to its cheap production costs undervalued currency, and tremendous export, the United States and Europe has faced the increase of unemployment rate. Trade deficit in these countries to China was also increased along the rise of importing Chinese goods. To minimize negative affection to the Western economies, US and other European countries had asked the Chinese to revalue its currency - yuan. However, the Chinese also recognized that revalue of the yuan will have strong impact to its own national economy, therefore, it took a while for the Chinese government to actually decide to revalue the yuan. The US was stressing China to appreciate its currency by threatening and applying quota and tariffs to Chinese exported goods if the Chinese still remain stubborn, which consequently, Chinese will have its export limited and leading to low GNI.

However, if China raise its currency value, there are several issues will occur. One of the most critical issues is the unemployment in China will rise. A nation with over 13 billion population rely on export to fund its national income. China have to create15 - 20 million new jobs per year to balance with its population growth. Based on economy analysis, (high) unemployment will create ciaos if the government do not settle the unemployed well. In general observation, China generate trade surplus, which mean China earned money and the Chinese become richer and richer. However, China is a country where the geographic is huge and crowded in population, using the national income divided to number of Chinese population, the amount of money for each capita is much more lower than the money that Western have. Furthermore, the balance between the wealth and the poor in China are still in far distance, thus, a rise in unemployment will not only strongly affect its economy and society, but also raise the risks in managing the country.

Chinese is taking a hard position to balance its trade to the international market and its internal financial and society management. According to the text book, to appreciate one nation's currency in a most effective way, there are four options to evaluate, which will be included throughout this essay. Furthermore, we will have a look at the historical data of the Chinese yuan and analysis the pros and corns of its appreciation by taking a critical position as a Chinese exporter.

OPTIONS EVALUATION:

In order to solve the pressures of U.S and E.U on revaluation the yuan Chinese government had several options to choose.

Maintaining a fixed exchange rate:

There are two main advantages (for China) to keep the fixed exchange rate against the dollars:

To maintain the unemployment condition:

Up to 2005, China needed to create at least 1.25 million new job per month. The solution for the unemployment lied on the export sector. Once the yuan revalued, China exported goods would be more expensive and lose its competitiveness eventually. As a result, the export industry would be strongly impacted; and China could have both political and social chaos (Daniels, 2007, p.342).

To protect the return on Dollar assets:

In order to manage the fixed exchange rate, China had significantly increased their foreign exchange reserves since 1995. Started with $75.4 billion in 1995, the reserves raised to $1,068.5 billion (Morrison $ Labonte, 2008, p.10). Moreover, up to 2005, China invested $600 billion of its foreign reserves to U.S Treasury Bill (Daniels, 2007, p.342); hence, if the yuan was appreciated, China would lose huge amount of returns on dollar assets.

However, maintaining the fixed exchange rate against dollar was no longer a good strategy, as China was put under great political and economic pressures.

Tariff and quota pressures:

To force the Chinese government to switch to the floating exchange rate regime, United States and Europe continuously expressed their plan to impose new tariff and quota. For example, U.S's new tariff would be 27.5%, and quota level would be above 7.5% (http://factsanddetails.com/china.php?itemid=1047&catid=9&subcatid=62, http://www.nytimes.com/2005/05/14/business/worldbusiness/14textiles.html). Either the raise in penalty tariff or the change in quota level would cause China's loss of market share and result in the increase in unemployment.

Inflationary pressure, and dollar reserves situation:

In anticipant of a revaluation of the yuan, many people had been moving currency to China, and created high inflation during 2003-2004. To control the inflation, Chinese government forced to sell yuan and buy dollar, which resulted in the expansion of dollar reservation (Daniels, 2007, p.341). Yet, it is risky and unprofitable when keeping huge foreign exchange reserves. According to the McKinsey Global Institute, the People's Bank of China is losing 1.9% of gross income annually (based on 2006 gross income) by not investing the excess currency. This was a tremendous loss, as China's gross income in 2006 was $1.017 billion

(http://www.newsneconomics.com/2007/12/economic-reasons-that-yuan-must.html).

In short, nowadays, fixed exchange rate has short-term positive impacts on the health of a nation's economy. To achieve long term healthy economic growth, Chinese government should seek for new system, such as those will be discussed below.

Switching to floating rate regimes:

The main advantage of this option was help to ease the hot political relationships between China and U.S and E.U. Another advantage of allowing the rate to freely float would help the government to more efficiently and effectively manage the economy by both monetary and fiscal policies. Besides, the exceed currencies would be productively invested into profitable projects.

Yet, there were many risks accompanying with the floating exchange rate. The biggest risk was the lack of knowing how much the yuan-dollar rates would be changed. As a big investor in the world market, China might suffer huge losses due to the yuan appreciation (i.e. the returns on dollar assets would be shrinked). Besides, if the yuan appreciated too fast, it could cause negative shock to China export industry, especially those that had narrow profit margin. Moreover, some Chinese economists worried that the fast appreciation in yuan would wipe off the profits of China's labor-intensive manufacturing sector, while the foreign investors would gain large benefits from the back of low-cost labor in China and become a dominant factor in the Chinese economy. Even more, the persistent anticipation might lead China to the trap of attracting more liquidity for its relatively low interest rates

(http://www.chinadaily.com.cn/business/2007-07/25/content_6002020.htm)

As Chinese's characteristics were future oriented and risk avoided, the government would not immediately apply the floating rate regimes.

Widening the trading band against the dollar:

The main advantage of widening the trading band was to ease the U.S and E.U's pressure while keep the export industry from dramatically shock. In 2002, the yuan was floating with a band of 0.3%. In case China wanted to switch to floating rate regimes, the trading band would be widened within 5% (Daniels, 2007, p.343). The question was whether the widened trading brand would ease the pressure of U.S and E.U. The answer was sadly "No", as many U.S economist believed that to solve U.S trade deficit, Yuan should appreciate 40%

(http://money.butjazz.com/controversy-chinese-yuan-valuation/).

Pegging to a basket of currencies

The advantage of a basket of currencies was to reduce the negative impact of the fluctuation in the dominant currency. If dollar suffered downward, for example, Chinese economy would still be secured as the move would be offset by other currencies doing better

(http://www.bloomberg.com/apps/news?pid=newsarchive&sid=a04ESaRrTpcU).

Furthermore, when pegging the yuan to the basket of currencies, China increased its ability in adjusting to the foreign investment inflows that have been pouring into the country

(http://www.washingtonpost.com/wp-dyn/content/article/2005/07/21/

AR2005072100351_2.html).

In summary, based on the presented pros and cons of each option, pegging the yuan to a basket of currencies proved its effectiveness in managing the capital account as well as ease the relationship between China and other's trading partners, not only U.S and E.U.

Actually, in 2005, the State Administration of Foreign Exchange in china (SAFE) allowed banks in Shanghai to trade with the currencies basket of U.S dollar, euro, yen, and South Korean won. Besides, China was thinking of adding British pound in to the basket (Daniels, 2007, p.343).

YUAN APPRECIATION SINCE 2005

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The historical data showed above is the exchange rate between USD and Chinese yuan for the year 2005. As the graph show, there was a significant change in yuan for the first-half year and the second-half year in 2005. From the first to the second quarter of the year, yuan stayed firmly at the rate of 8.27650 to one US dollar. It was due to the reason that the Chinese was still applying the fixed dollar-yuan peg. However, on July 21st, the Chinese announced that it going to appreciate its currency and abandon the decade-old fixed exchange rate to the U.S. dollar. Thus, in a distance of one night, the yuan appreciated from 8.27650 fall to 8.11110, and ended the year with 8.07020 yuan per USD.

On the other hand, the yuan was not fortunate to have a stable rate with the Euro in comparison to USD. It has a fluctuation records with the Euro ever since the Euro opened to the market. On May 31st, 2005, the rate was at 10.2206 yuan per Euro, and the yuan was gradually appreciating until the rate of 9.96987 on July 20th. However, the yuan was depreciated on the next day at the rate of 10.0253 per Euro, and the following day, the Yuan strengthen its currency at 9.79740 to an Euro.

untitled2.bmp

As mentioned above, the Chinese had removed its currency reliance on the USD since July 21st, 2005. Instead, it announced that the Yuan Would be pegged along currencies' baskets. Independent from the US would help the Chinese loosen its reliance on the dollar, forces and limitation from the US policies. In other words, China will have better chances in controlling its own currency, as well as its economy.

However, over the past 5 years, the Chinese Yuan has continuously appreciated its currency with forces from the Western countries. China was blamed for its remanding on cheap currency that took away jobs in Western Countries. Textile is one of the examples that was bring into the economist argument. Due to cheap labor, materials costs with high quality productivities provide, majority of the Western countries shifted their production to China, whereas US focused on improving its nation's living standard through service economy, and leaving all the heavy industries to developing countries, which started in the past two decades.

The economy crisis in 2008 pushed the Chinese Yuan to further appreciation. From 7.30400 in December 2007, yuan appreciated to 6.70216 in September 2010 in against to one USD. Due to the tremendous down turn in the US economy, as well as Euro economies that could hardly recover in short period of time, they were forcing Chinese Yuan to speed up the appreciation rate in the hope of reaching 5 Yuan to 1 USD. However, even though Chinese kept appreciate its currency, and US and other Western countries might increase their export, but in short term, Western countries still needed to rely on Chinese production to supply its national demand. High labor and materials costs in the Western countries were still the main issue that led their nations purchasing imported goods.

Yuan revaluation challenged the Chinese Garment and Textile Exporters:

The yuan appreciation would contribute to the difficulties and constraints facing to the Chinese Garment and Textile export industries.

For many years, these two industries' competitive advantages relied on the low labor costs and the narrow profit margin. According to the analysts, if the yuan appreciated by 1%, the growth rate of textiles export would be decrease by 1.5% (http://www.china.org.cn/english/BAT/169530.htm). Moreover, for each 5% appreciated in yuan value, the profit of China -based textile felt 5 - 10% (http://www.time.com/time/magazine/article/0,9171,1086198,00.html).

The situation was worse for the textile exporters as the labor cost had been increased since 2004 in both coastal region (11.8%) and in inland (14.6%)

(http://www.just-style.com/comment/chinese-apparel-industry-repositioning-for-growth_id103206.aspx).

Even more, once yuan appreciated, China would be no longer the lowest cost producer in the zone; and the neighborhoods such as Vietnam, Laos, and India would take the opportunity to "steal" its market share. In 2007, Vietnamese textile industry grew 33.4%, and became the USA's second largest foreign suppliers of textiles and clothing in 2008

(http://www.bizcommunity.com/Article/196/160/31706.html).

CHINA'S EXPORT SINCE 2005;

Once the yuan started to appreciate in 2005, many exported worried about the upcoming loss caused by losing the competitive advantage in price. Noticeably, the truth was totally opposite to the common sense. As being shown in the following figure and tables, China export industries actually rose despite of the appreciating yuan.

China-Inflation-Rate-Chart-1png.png

(Source:

http://www.tradingeconomics.com/Economics/Inflation-CPI.aspx?Symbol=CNY)

(Source: http://www.uschina.org/statistics/tradetable.html)

The first reason was the abandon of tariff and quota (by U.S and E.U) on the imported goods from China. This would allow exporter to increase the volume of goods sold in these markets.

Secondly, the appreciation of yuan helped to reduce the costs of imported goods and materials. China relied on imported energies and raw materials for years. For example, in 2008, China imported $159.5 billion of oil (under various forms), $130.6 of electronic integrated circuits, and $60.7 billion of iron ores

(http://comtrade.un.org/pb/CountryPagesNew.aspx?y=2009).

The lower input costs allowed the producers to install new technologies to support the productions, and create more added values for the China's exported goods. As a consequence, the export trend was still favored for China.

The third reason was China was one of the largest exporter in the world. Although the prices of Chinese goods increase due to the yuan appreciation, there was no substitute for them; thus, the world still relied on China's export. Let have a look at the U.S textile market. One year after the yuan began to appreciate, China was continuously the largest textile supplier to U.S (29.1%), followed by Mexico (7.4%), India (5.3%), Indonesia (4.4%), and Bangladesh (3.5%) (Martin 2007, p.12).

LONG TERM ADJUSTMENT:

Although the yuan revaluation caused many challenges for the exporters, especially those in garment and textile industries, there were chances for them to survive.

It had been years since the government relied on the garment and textile export industry to solve the unemployment problems. In the modern economies, the Chinese government should switch the employment pressure to new industries such as services and free the garment and textile companies to pursue modern costs saving method. By doing so, the textile companies could apply new technologies in production, and become more capital - intensive production.

Besides, the companies should reallocate the production to new location where the operation costs were cheaper. However, there were some arguments related to the new level of wages in China recently. To some analysts, even the total wages increased by 25% annually, the compensation in China's manufacturing industry would still less than 15% of that elsewhere in East Asia and Mexico

(http://www.economist.com/blogs/freeexchange/2010/07/china).

To be more secured, the exporters should make more innovation in production, add more values and quality to the goods, and change from low - end to high - end manufacturing.

Retarget the market was also a good strategy for the garment and textile industries. Instead of heavily depending on the U.S and E.U markets, the producers should aim at serving the huge domestic demands as well as seeking for new markets such as Asia, Australia and Africa.

CONCLUSION:

Since China has strong influence on the imbalance of the world's trading, U.S and E.U pressured China to free the exchange rate from the tight control. There were several options for China regarding to manage the exchange rate. According to the facts, China pegged the yuan to the basket of currencies finally.

The appreciation of yuan has caused many challenges and threats to the export industry, while benefit the import one. Noticeably, as China was one of the largest export countries in the world, and there has been no substitute for it, the export rate has been still increased up to now. However, to sustain in the long run, Chinese exporters should adopt more effective strategies to deal with the free floating yuan in the future.

REFERENCES LISTS:

Website:

http://factsanddetails.com/china.php?itemid=1047&catid=9&subcatid=62,

http://www.nytimes.com/2005/05/14/business/worldbusiness/14textiles.html\

http://www.newsneconomics.com/2007/12/economic-reasons-that-yuan-must.html

http://www.chinadaily.com.cn/business/2007-07/25/content_6002020.htm

http://money.butjazz.com/controversy-chinese-yuan-valuation/

http://www.washingtonpost.com/wp-dyn/content/article/2005/07/21/AR2005072100351_2.html

http://www.bloomberg.com/apps/news?pid=newsarchive&sid=a04ESaRrTpcU

http://currate.com/historical-exchange-rates.php

http://money.cnn.com/2005/05/05/news/economy/yuan_revaluation/

http://www.china.org.cn/english/BAT/169530.htm

http://www.time.com/time/magazine/article/0,9171,1086198,00.html

http://www.bizcommunity.com/Article/196/160/31706.html

http://www.tradingeconomics.com/Economics/Inflation-CPI.aspx?Symbol=CNY

http://www.uschina.org/statistics/tradetable.html

http://comtrade.un.org/pb/CountryPagesNew.aspx?y=2009

http://www.economist.com/blogs/freeexchange/2010/07/china

Book:

Daniels J. D., Radebaugh L. H., & Sullivan D.P., International Business - Environments and Operations, 11th edn, 2007, Pearson Education, Inc., p. 77 - 80.

Article:

Martin F. M., CRS Report for Congress, U.S Clothing and Textile Trade with China and the World: Trends since the end of Quotas, 2007, Congressional Reserve Service.

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