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CHINA’s RENMINBI: “OUR CURRENCY, YOUR PROBLEM”?

----------------------------------SUMMARY---------------------------------- In the year 2006, a controversy arises with respect to China’s Renminbi. Many countries all

over the world believed the china had undervalued its currency and was not in line with the

market forces. Due to this, countries like US, and European country were running in a huge

trade deficit and they wanted china to revalue their currency and threatened china of

imposing high tariff rates. To this, China told the trade deficit was only partly attributable of

the undervaluation of the currency and the countries should concentrate on the weakness of

its own economy that generated this deficit. Till 1993, Reninmbi was undervalued but in

1994, the official rate was adjusted to the market rate. Further, Renminmbi had many

restrictions compared to other currencies. For operations on the current account and for

Chinese citizens to travel abroad, renminbi could be converted to other currencies but for

capital account restricitons were imposed like Chinese citizens could not invest/save abroad.

But inflows did not have much restriction as FDI was coming into the country as china had

become world’s primary destination for FDI. To limit the amount of foreign currency, china

has made much legislation. Firstly, the revenues are receiving from exports, companies has to

deposit the currencies in central bank. CFETS comprise 350 institutions that were organized

to do foreign transaction. These are monitored by China’ Central Bank and PBoC. On a daily

basis, each member bank had to maintain the ratios of foreign reserve with that of total

reserve. Once, the amount is deposited, these funds are re-invested in US Treasury Bonds.

By the end of March 2007, they were having foreign reserves of USD 1.2 trillion. To remove

the excessive Renminbi in the system, Govt Bonds were sold to commercial banks or tighter

liquidity ratios were imposed on banks to slowdown lending activities by the PBoC as the

inflation was high. After prolonged pressure on china in 2005, china reformed its exchange

rate regime. The peg to US dollar ratio was replaced by Peg to basket of currencies where

reninmbi was allowed to fluctuate within 0-3% band against the US dollar each day. Later in

May 2007, less than a year into revaluation, the Chinese central bank announced a widening

of the renminbi’s daily fluctuation band against dollar from 0.3% to 0.5% in order to appease

the US for the summit trade talks between the two nations. Many countries who were china’s

trade partners were unhappy with the undervalued Renminbi. USA proposed of imposing

27.5% tariff on Chinese imports if china did not revalue its currency. It was claimed that

PBoC manipulated the exchange rate to lower the prices of exports. Because of which,

American factories had been forced to bankruptcy. The most worried were the developing

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Asian countries about the china’s economic rise as these countries competed with china, the

same categories of products and china’s prices were impossible to match. In response to the

arguments made by countries, Chinese government said that the currency was not

significantly undervalued and its economic growth had nothing to do with manipulation of

currency. China argued that an analysis focussing on Chinese exports and the US-CHINA

trade deficit was misleading. It also said, that the US also had a trade deficit with Japan and

other Asian countries because these countries including China bought large amount of US

Treasury bonds. Even multi-national companies supported china as they were benefitted from

its low operating cost. China said that its reserves were growing because of the large inflow

of funds brought by the speculators. China had learned lessons from its neighbours on

devaluation of currency and the impact that happened. First was the appreciation of Yen,

despite of appreciation of their currency, the country devaluate its currency and Japanese

markets was closed for US imports. Due to that effect Accord Plaza committee was formed

by five major economies for USD currency. The USD depreciates its currency against yen

and Deutsche Mark. Due to this US trade deficit was reduced with Europe. With that effect

Japan plunged into deflation as they heavily rely on trade and appreciation of Yen was

affected. Other was Asian crisis, most of the Asian countries had their countries pegged to

US dollar. During Year 1995-97 USD had appreciated due to this many East Asian country’s

current account deficit increased as their economic productivity was not fast enough, because

of this investors withdrew their capital from these countries. Governments abandoned the peg

to the dollar and result was their currency collapse and deep recession followed. China had to

make important decisions as they were facing with lot of external pressures. The

accumulation of US dollars posed a risk in long term as the US dollar could weaken because

of US trade deficit forcing china to partially write-off its foreign currency reserves. As

china’s economy relied completely on trade, it cannot revalue its currency as revaluation may

bring down their exports affecting the stability of the economy. Also, lifting capital controls

where banks systems are not stable, people will start investing the savings to banks overseas.

So, China brought alternatives to revaluation like “GO ABROAD “policy and voluntary

export tax. In 2005, a mild revaluation was done to ease tensions between china and its

partners and the issue was still extremely controversial through mid 2007.

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1) Why are Japan, the newly industrialised economies (“NIEs”) and

developing Asian countries less vocal than the US on the valuation of

the renminbi?

Japan and other newly industrialized economies (NIE) were less vocal than US because

they were strengthening their economic ties with china.

These countries produced the parts in their own countries and assembled the complete

product in china because of the availability of the cheap labour. Major part of the export

and import of these countries (including china) was by processing trade. This type of

trade was mutually beneficial for both the countries.

2) How do the exchange rate of a currency and its volatility have a

direct impact on the economy?

Currency fluctuations are a natural outcome of the floating exchange rate system that

is the norm for most major economies. The exchange rate of one currency versus the other is

influenced by numerous fundamental and technical factors. These include relative supply and

demand of the two currencies, economic performance, outlook for inflation, interest rate

differentials, capital flows, technical support and resistance levels, and so on. As these factors

are generally in a state of perpetual flux, currency values fluctuate from one moment to the

next. But although a currency’s level is largely supposed to be determined by the underlying

economy, the tables are often turned, as huge movements in a currency can dictate the

economy’s fortunes.

Exchange rate of a currency and have a direct impact on the economy as the exchange rate of

one currency with respect to other currency is influenced by the supply and demand of the

two currencies, capital inflows, economic performance of the country, inflation, interest rate.

A currency’s level has a direct impact on the following aspects of the economy.

Merchandise Trade: - This refers to a nation’s export and imports. A weaker

currency will stimulate exports and make imports more expensive, thereby

decreasing a nation’s trade deficit. Conversely, a significantly stronger currency

can reduce export competitiveness and make imports cheaper, which can cause the

trade deficit to widen further, eventually weakening the currency in a self-

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adjusting mechanism. But before this happens, industry sectors that are highly

export-oriented can be decimated by an unduly strong currency.

Economic growth: The basic formula for an economy’s GDP is C + I + G + (X –

M) where:

C = Consumption or consumer spending, the biggest component of an economy

I = Capital investment by businesses and households

G = Government spending

(X – M) = Exports minus imports, or net exports.

From this equation, it is clear that the higher the value of net exports, the higher a

nation’s GDP. As discussed earlier, net exports have an inverse correlation with

the strength of the domestic currency.

Capital flows – A nation needs to have a relatively stable currency to attract

investment capital from foreign capital from foreign investors. Capitals flows can

be done through FDI, FII.

Interest rate: - the exchange rate level is a key consideration for most central

banks when setting monetary policy. For example, former Bank of Canada

Governor Mark Carney said in a September 2012 speech that the bank takes the

exchange rate of the Canadian dollar into account in setting monetary policy.

Carney said that the persistent strength of the Canadian dollar was one of the

reasons why Canada’s monetary policy had been “exceptionally accommodative”

for so long.

Inflation: A devalued currency can result in “imported” inflation for countries that

are substantial importers. A sudden decline of 20% in the domestic currency may

result in imported products costing 25% more since a 20% decline means a 25%

increase to get back to the original starting point.

Currency moves can have a wide-ranging impact not just on a domestic economy, but also on

the global one. Investors can use such moves to their advantage by investing overseas or in

U.S. multinationals when the greenback is weak. Because currency moves can be a potent

risk when one has a large forex exposure, it may be best to hedge this risk through the many

hedging instruments available.

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3) Analyse the different components of the Chinese Balance of Payment.

Current account analysis

Here it can be seen that components. Current account balance is increasing positively from

the year 2002-06 (U.S 35,422 $ million to 249,866 $ million) means that their export is more

than their import that is creating a positive impact on the BOP. The reasons for the

continuous increase in the surplus of the current account balance is as follows-

Trade balance is one of the component of current account of balance of payment which

generally talks the trade between china and rest of the world in terms of tangible goods shows

a positive increase from the period 2002 to 2006 (44,167 US million dollar to 21,7746 $

million).

Deficit Service balance amount is continuously increasing from 2002 to 2005 and at the end

of 2006 it has a slight decrease in the deficit of services balance from (-6,783 to -8,832 U.S

million dollar). Income balance – received – paid. In terms of income balance it can be easily

seen that china is having deficit from the year 2002 – 2004 from (-14,946 to-3,523 U.S $

million) but it is a decrease in deficit at the same time. After 2004 there is a tremendous

surplus increase can be seen from 2004 – 2006 (10,635 to 11,755 dollar). Current transfer

balance – the balance is showing a continuous surplus increase from 2002- 2006 from (12,

9842 to 29199 dollar). The entire mechanism of the component of current account

contributing to the continuous increasing in the surplus balance of the current account.

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Capital account balance:

Gross financing requirement of the company shows deficit from the period 2002-04 (-45,593

to 49,674 dollar), but after that there is a surplus of gross financing requirement from the

period 04-06 that shows increasing trend (24,200 to 81,368 dollar).

The entire mechanism of gross financing requirement is been contributed by the various

components of capital account balance, it can be seen that there is a continuous increase in

the surplus balance of inward direct investment from the period 2002-06 (49,308 to 78,095

dollar) and at the same time outward direct investment shows the increase in the deficit from

the period 2002-06 (-2518 to – 17,830). So the net direct investment flow of the country is

having a positive and surplus balance and continuous increase from the period 2002-06

(46,792 to 62,265).

Countries balance of payment in terms of inward portfolio investment shows a positive

increase in surplus from the period 2002-06 and at the same time company outward portfolio

investment shows deficit in the year 2002 but 2003-04 in shows surplus which shows that

investment fund is coming back to china, but finally there is an increase in deficit from the

year 2005-06 (-12,095 to -11,0419 dollar), that creates almost a deficit net portfolio

investment flow from 2002-06 increasing trend (-10,533 to -68,208 dollar)

-50000

0

50000

100000

150000

200000

250000

300000

2002 2003 2004 2005 2006

US

$ M

illio

n

Years

Current Account Balance

current account balance

Trade balance Service balance

Income balance current transfer balance

Linear (current account balance)

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China is having continuous increase in deficit in other capital flows from 2002-06 (1102 to -

29,721 dollar) and at the same time there is an increase in the forex reserve of china in the

year 2002-06 (291,128 to 106, 8490 dollar).

4) Why does Chinese government want to keep its currency at an

artificially low level against US dollar?

China’s central bank has devalued the Yuan against the US dollar to boost exports by

offering their products at cheaper rates and also to make it as an official reserve currency.

Chinese businesses compete with regional rivals to supply the world with everything from

raw steel to fridges, and a cheaper Yuan will make Chinese exports less expensive,

potentially boosting the overseas sales that have been among the main drivers of growth.

Another reason is that china also want huge investment from other countries in their

economy and at the same time they want to retain the existing investment in their

economy because they want other economy to operate at lower cost of resources that will

give them a competitive advantage with respect to the rest of the world.

5) Exchanging all of China’s US dollars for renminbi can lead to

inflationary pressure. How does China avoid this risk?

-200000

0

200000

400000

600000

800000

1000000

1200000

2002 2003 2004 2005 2006

US$

mill

ion

s

Years

Capital Account Balance

Gross financing requirement Net direct investment Net portfolio investment

Forex reserve Linear (Forex reserve)

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China had number of legislations to limit the amount of foreign currency in circulation.

After they received the revenues from exports, companies had to immediately sell their

foreign currency to designated banks as the Renminbi could only be traded on an inter-

bank centralised electronic market. The absorption of US dollar meant that the PBoC had

put into circulation around 8 Renminbi for each US dollar that was bought from

commercial banks. Due to this, domestic supply money automatically increased creating

a risk of inflation in the country. To reduce the inflationary trend, the PBoC removed the

excessive Renminbi in the system by using various mechanisms like Government Bonds

were sold to commercial banks and tighter liquidity ratios were imposed on banks to

slowdown lending activities.

6) Why despite the huge US trade deficit, has the US dollar not fallen?

Do you think there is a risk of this happening?

US ran in a huge trade deficit because few of their trading partners undervalued their

currency. In the years 1950-1971, countries like Japan had undervalued its currency.

Japan exported much of its goods to the United States due to which it experienced high

growth with exports as an important driver of their economy. They also had restricted

imports from the US due to which US was full of Japanese products. The US government

blamed the undervaluation of the Yen and threatened to block Japanese imports if the Yen

were not revalued and if the Japanese market were not open to US imports. Following

this, in 1985, the five largest economies (the US, Japan, West Germany, UK and France)

agreed in the plaza accord to led to US dollar depreciate against the Yen.

The plaza accord partly sold the US problem by reducing the trade deficit with the Euro.

During 2006, US also faced the same problem of high trade deficit with China as they

believed China’s currency was undervalued. To force china to revalue their currency, US

threatened to impose high tariff of 27.5% on Chinese import. This is the reason the USD

did not fell.

Yes, there is a risk of happening as United States has a high trade deficit not only with

china but also with other countries which may lead to fall of the US dollar.

7) If China adopted a major revaluation of its currency. Should the

revaluation be a one-off or progressive reform?

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The revaluation of the Renminbi should be progressive because if they revalue their

currency at one-off, the US dollar could weaken because of US trade and budget deficits,

forcing china to partially write-off its foreign currency reserves. Also, if the currency is

revaluated and capital controls are lifted at one-off, the banking sector of china may

collapse as banks were plagued with the mountain of non-performing loans as the

country’s excessive liquidity encourage banks to lend more. If capital controls are lifted

and revaluation is done many Chinese would send their savings to safer banks overseas

threatening the stability of the financing system.

8) Are there alternative solutions to the revaluation that would reduce

trade tensions between China and Western countries?

Western pressure has been mounting on China to revalue the renminbi, from

hardening rhetoric in the US Congress to recent calls by the Group of Seven leading

industrialised nations for more flexibility from China.

Yes, there are alternative solutions to the revaluation like the Chinese government

launched a “GO ABROAD” policy encouraging Chinese companies to invest abroad where

China wanted to develop large internal groups and grants, outward FDI was also aimed to

reduce foreign currency reserves. Another possible reform was to impose a voluntary export

tax. A tax would not affect the value of foreign currency reserve like revaluation, but doing

so, would give Chinese government much needed tax revenues.

If China were to contemplate a revaluation, it should consider as an alternative the

imposition of a tax on its exports. Export taxes are generally permitted under WTO rules.

Indeed, China has already moved in a limited way in this direction on textiles. There are

several reasons voluntary imposition of a tax on its exports may be preferable to a renminbi

revaluation. Both would have similar effects on Chinese exports - they would make them

appear more expensive to the rest of the world. Because of this similarity, an export tax

would provide an empirical answer to the question of whether a revaluation would work. But

it would do this without some of the significant costs attendant on revaluation.