The Depreciation of the RMB against the USD

By: Hasnaa Taih Course: ECN 450
Date: 28/03/2011

China has a high level of policy intervention in the depreciation of the Renminbi (RMB) or (CNY). The depreciation of the RMB against the United States of America’s Dollar (USD) puts the USA’s firms and factories at a massive competitive disadvantage (China Currency Overview, 2010). There are two economists’ viewpoints when it comes to the undervaluation or overvaluation of the RMB against the USD and against other world currencies. There are economists that argue that the RMB is overvalued against some world currencies beside the Euro and the USD (Yuan is Overvalued, not Undervalued: report, 2010). Other economists argue that the RMB is undervalued against the USD, and this would be the major focus of this research paper.
The RMB’s depreciation allows China to unfairly gain trade advantages over other trading nations. Economists views varies on the level at which the RMB’s undervaluation affect other Chinese trading partners. But most economists agree that currency flexibility would be of great help to decrease global imbalances (China Currency Overview, 2010). This research paper will discuss the different component of the Chinese protectionism policy for its exchange rate, and its effects on other nations such as the USA. The focus will be in showing the advantages and disadvantage for the USA and China in the trading balance.
Historical background of the RMB: Preceding year 1994, China had a dual exchange rate system. The dual exchange rate system was practiced in two different ways, which are the official fixed exchange rate system and the moderately market-based exchange rate systems (China Currency Overview, 2010). The government used the fixed exchange rate system, but the exporters and the importers used the market-based exchange rate (China Currency Overview, 2010). At this period of time the government was restricting the access to foreign currencies in order to limit the amount of imported goods by the Chinese, which lead to a large black market for foreign currencies (China Currency Overview, 2010). In 1993 the official exchange rate to the USD was 5.77 RMB where the market-based exchange rate was 8.70; this was highly criticized by the U.S.A, because of the restrictions that were put on imports by China (China Currency Overview, 2010). In year 1994, the official and the market exchange rate systems were combined into an initial rate of 8.70 RMB to the USD (Gang, 2011). After the unification the following happened: “The RMB became largely convertible on a current account (trade) basis, but not on a capital account basis, meaning that Yuan are not regularly obtainable for investment purposes” (China Currency Overview, 2010). Also, before 1994 80% of the foreign trading exchange was made in the market-based currency prices, and only 20% at official exchange rates (Gang, 2011).
The RMB/USD peg and affect: From1994 to year 2005 the RMB’s peg to USD was maintained at a 8.28 RMB to USD, in order to obtain a sustainable environment for foreign direct investment (FDI) and trading (China Currency Overview, 2010). The Chinese Government in year 2005 declared the RMB’s exchange rate would be “adjustable, based on market supply and demand with reference to exchange rate movements of currencies in a basket” (China Currency Overview, 2010). The Chinese Central Bank maintained the peg by “buying or selling as many dollar-dominated assets in exchange for newly printed yuan as needed to eliminate excess demand (supply) for the yuan” (China Currency Overview, 2010). Because of the peg the Chinese currency maintained a stable rate, which other wise could of caused the depreciation or appreciation of the currency because of the changing economic factors.

Past and current CNY/USD exchange rates: Historical Chinese Yuan Rate (CNY) Year CNY/USD | Year CNY/USD | Year CNY/USD | 1981 1.71 | 1991 5.33 | 2001 8.28 | 1982 1.80 | 1992 5.53 | 2002 8.28 | 1983 1.98 | 1993 5.78 | 2003 8.28 | 1984 2.33 | 1994 8.64 | 2004 8.28 | 1985 2.94 | 1995 8.37 | 2005 8.19 | 1986 3.46 | 1996 8.34 | 2006 7.97 | 1987 3.73 | 1997 8.32 | 2007 7.61 | 1988 3.73 | 1998 8.30 | 2008 6.95 | 1989 3.77 | 1999 8.28 | 2009 6.83 | 1990 4.80 | 2000 8.28 | 2010 6.77 | Average annual currency exchange rate for the Chinese Yuan (Yuan per U.S. dollar) is shown in this table: 1981 to 2010 |
Source: (Chinese Yuan Rate Forecast, 2011)
HISTORICAL EXCHANGE RATE SUMMARY: CNY/USD
“Average (Last 12 Months) 6.73 Average (Last 10 Years) 7.71 High (Last 12 Months) 6.83 (May, 2010) Low (Last 12 Months) 6.58 (February, 2011) High (Since January, 1981) 8.73 (April, 1994) Low (Since January, 1981) 1.55 (January, 1981)” (Chinese Yuan Rate Forecast, 2011).

The table above shows that the CNY/USD exchange rate had been stable for six consecutive years from 1999 to 2004 at a rate of 8.28 Yuan to the USD. Also, the table shows that the CNY/USD exchange rate had been declining since 1994. February 2011, data show that the exchange rate is at 6.58 CNY to USD, which is the lowest it reached since the start of the peg in 1994 (Chinese Yuan Rate Forecast, 2011).
Exchange rate theories:
Purchasing Power Parity (PPP) Approach:

The Purchasing Power Parity (PPP) approach is established in the bases of the one price law. The law states that the “exchange rates should change in response to the price differentials that exist between countries” (Theory of exchange rate determination, 2011). The problem with the PPP is that it doesn’t hold true in the short-term period to determine the exchange rate, but it is more applicable in the long-term. In the case of China the RMB’s exchange rate doesn’t reflect the precise strength of China’s economy, and this can be seen in the enormous difference from its PPP (Exchanging Blows, 2010).

The Big Mac Index:

Source: (Exchanging Blows, 2010).

The Economist a weekly news magazine created an informal index called the “Big Mac Index”, where the purchasing power parity of many countries is measured by the price of a Big Mac in every country in US Dollars (Exchanging Blows, 2010). This index shows if the currency of a country is over valued or undervalued. As shown in the graph above the Chinese currency is undervalued by about 48% to the USD currency for the price of a Big Mac.

Source: (Big Mac Index, 2009).

Also, the table above shows the measurement of the Big Mac Index in greater details. The “hamburger standard” table above shows that the Big Mac price in the U.S.A is $3.54, where in China is $1.83. In the local price the burger is sold for 12 RMB or Yuan. Also, the chart shows that implied PPP of the dollar is $3.53. The RMB/USD exchange rate is 6.84 RMB for every USD. This means that the Chinese currency is undervalued by 48% (Big Mac Index, 2009). True that this index doesn’t take into consideration other components of living in China such as rent, but the index can be used, as an example of how much is the Chinese currency is under evaluated. The Big Mac index emphasis the opinions of economist that say that the RMB is undervalued against the USD (Big Mac Index, 2009).

Balance of Payments (BOP) Approach:

The balance of payment approach establishes the exchange rate where the domestic and external economy reaches equilibrium (Theory of exchange rate determination, 2011). The BOP approach project the exchange rate by taking into consideration current account balances, portfolio investment, foreign direct investment (FDI), exchange regimes and official monetary reserves to determine the direction of the exchange rate” (Balance of Payments Approach, 2011). A payment to other countries enters the Balance of Payments as a debit transaction. Payments received from other nations enter the Balance of Payments as a credit transaction.

The Balance of Payments account is presented in two main categories, which are the current account and the capital or financial account. Current account includes: goods trade, Services trade, Investment income, and current transfers. The capital or financial account record transactions that include the purchase and sale of assets. Also, the financial account includes the following subdivisions, which are direct investment, portfolio investment, and other assets such as currency deposits. FDI in China

Source: (World Development Indicators, 2011).

Foreign direct investment, net inflows (BoP, current US$) Year | 2005 | 2006 | 2007 | 2008 | 2009 | FDI in USD Billions | 79,126,731,413 | 78,094,665,751 | 138,413,185,203 | 147,791,603,822 | 78,192,727,413 |

Source: (World Development Indicators, 2011).

The table above shows that FDI had increased in a large scale in year 2007 and 2008. Also, it shows that FDI decreased in year 2009.

Source: (High Investment Supported by High savings, 2006).

The graph above shows that the Chinese not only consume less than the USA but they also save much more than the USA. These large amounts of savings prevent the occurrence of an account deficit, because people are consuming less so the nation wouldn’t need to import as much as the USA.

Source: (China Inflation Rate, 2011).

China has an inflation rate of 4.9%. The consumer price index has rose by 4.9%, and the producer price index rose by about 7% in 2011 (China Inflation Rate, 2011).

Exchange rate can be defined in the following two ways:

In general terms a change in national income will affect the current and capital accounts, which allow for the prediction of the exchange rate reactions and this can be shown as follow:
“Saving – Investment = Income – Expenditure = Exports – Imports” (Balance of Payments Approach, 2011).

Fixed exchange rate: In the situation of a fixed exchange rate and a pegged exchange rate, the government is unwilling to deal with the floating of the currency. The government in this case state the currency’s exchange rate level at which it should be exchanged in the world market (Balance of Payments Approach, 2011).
Floating exchange rate: In the floating exchange rate market the change in the price of the currency by the free market is determined by supply and demand (Fixed Versus Floating Exchange Rate, 2007). China’s currency had been pegged to the USD since year 1994. Now-a-day the USA requests that China should stop controlling its currency and let it fluctuate according to the market demand and supply. The USD is a floating currency, where the RMB is a pegged exchange rate currency to the USD.

Rise in China’s Balance of Payments Surplus and Foreign Exchange Reserves

Source: (China’s Transition to a Freely Floating Exchange Rate System, 2008).
The graph above shows that China is increasing its foreign exchange reserves. Also, it shows that there is an increasing current account more than the capital account. Taking into consideration that these three components have been recognizably raising since year 2001.
Mechanism of Increasingly Foreign Exchange Reserves

Source: (China’s Transition to a Freely Floating Exchange Rate System, 2008)
The model above shows the increase in the purchase of USD by the Chinese government. Taking into consideration that a strong Dollar will create a weak RMB, which would give China trading advantages over the USA.

China Vs. USA Balance of Trade:
A positive balance of trade means that the country exports more than it imports, and it results in a trade surplus. A negative balance of trade means that the country imports more than it exports, and it results on a trade deficit. In general the Balance of Trade shows the difference between the monetary value of exports and imports for a specific period of time (China Balance of Trade, 2011).

Source: (China Balance of Trade, 2011).
The graph above shows that China had repeatedly earned a Balance of Trade surplus. Taking into consideration that the graph above shows data from year 2000 to present. Since year 2005 China started gaining large amounts of trading surpluses until year 2010, and only in February 2011 where it lost less than $10 Billions that was shown as a trade deficit in its Balance of Trade.

Source: (United States Balance of Trade, 2011).
The graph above shows that the USA has a Balance of Trade deficit repeatedly since year 2000 until present. This means that the USA imports more than it exports. There are three arguments that can be discussed behind the reason of the USA’s deficit. The first argument would be that the USA’s consumption is higher than that of China. Taking into consideration that the Chinese population is larger than the American population one may start to wonder why the Chinese have a large surplus. One of the reasons for the Chinese surplus would be that the Chinese people consume less and save more, while the Americans do the opposite. The second argument would show that America is the largest export partner to China, which means that China gains more from the USA than many other nations. Also, the Chinese Currency is depreciated, which means that importers would tend to import from China than importing from the USA.
Conclusion:
The Chinese currency RMB is depreciated against the USD, which give the Chinese an unfair trading advantage over the USA and other nations. The undervaluation of the RMB can be seen in the country’s Purchase Power Parity, which is undervalued by 48% against the USD as shown in the Big Mac index. The balance of trade surplus for China and the balance of trade deficit for the USA show that China has trade advantages over the USA. One of the reasons that allowed China to gain these trade advantages is its, undervalued currency, high savings, and lower consumption. By looking at all the previously stated economic factors one can see clearly that China depreciate its currency in order to gain trade advantages over other trading partners such as the USA.

Bibliography
Balance of Payment Approach. (2011). Available: http://forex.blorc.com/forex/balance-of-payments-approach/. Last accessed 20th Mar 2011.
Big Mac Index. (2009). Available: http://www.economist.com/node/13055650?story_id=E1_TPDVVGVD. Last accessed 20th Mar 2011.
China Balance of Trade. (2011).Available: http://www.tradingeconomics.com/economics/balance-of-trade.aspx?symbol=usd. Last accessed 25th Mar 2011.
China Currency Overview.(2010). Available: http://web.ebscohost.com/ehost/detail?vid=4&hid=7&sid=bda1cb35-1061-43fc-9815-846cc7e31f5c%40sessionmgr13&bdata=JnNpdGU9ZWhvc3QtbGl2ZQ%3d%3d#db=aph&AN=55371213. Last accessed 20th Mar 2011.
China Inflation Rate.(2011). Available: http://www.tradingeconomics.com/Economics/Inflation-CPI.aspx?symbol=CNY. Last accessed 20th Mar 2011.
China's Transition to a Freely Floating Exchange Rate System. (2008). Available: http://www.rieti.go.jp/en/china/08082601.html. Last accessed 20th Mar 2011.
Chinese Yuan Rate Forecast. (2011). Available: http://forecastchart.com/usd-chinese-yuan.html. Last accessed 20th Mar 2011.
Exchanging Blows.(2010). Available: http://www.economist.com/node/15715184?story_id=E1_TVSTVTRQ. Last accessed 20th Mar 2011.
Fixed Versus Floating Exchange Rate. (2007). Available: http://www.articlesbase.com/finance-articles/fixed-versus-floating-exchange-rate-229803.html. Last accessed 20th Mar 2011.
Gang, Y. (2008). Renminbi exchange rates and relevant institutional factors. Available: http://findarticles.com/p/articles/mi_go2835/is_2_28/ai_n31444966/?tag=content;col1. Last accessed 20th Mar 2011.
High Investment Supported by High Savings - Doubts over the Sustainability of the Relationship. (2006). Available: http://www.rieti.go.jp/en/china/06122702.html. Last accessed 20th Mar 2011.
Theory of Exchange Rate Determination. (2011). Available: http://www.economywatch.com/exchange-rate/theory-of-determination.html. Last accessed 20th Mar 2011.
United States Balance of Trade .(2011). Available: http://www.tradingeconomics.com/economics/balance-of-trade.aspx?symbol=usd. Last accessed 25th Mar 2011.
World Developing Indicators. (2011). Available: http://data.worldbank.org/indicator/BX.KLT.DINV.CD.WD. Last accessed 20th Mar 2011.
Yuan is overvalued, not undervalued: report. (2010). Available: http://www.chinadaily.com.cn/bizchina/2010-06/17/content_9985152.htm. Last accessed 20th Mar 2011.