Ethiopia: Undervalued yuan, currency wars and their implications
By Seid Hassan,
Part I. Undervaluation and stylized facts
Introduction
As a result of my recently published article dealing with the devaluation of the birr (Ethiopian currency), some friends of mine and students wondered if the controversy surrounding the undervalued Chinese currency, the yuan renminbi, is similar to devaluation or have the same effect as a devalued currency.
Even though both an undervalued currency and one that is being devalued have two common characteristics, specifically their direction of change (their current values being lower than their previous ones) and both being members of a family of fixed (managed) exchange rate systems, there are significant differences between them. An undervalued currency, just like the Chinese yuan, is one whose value is kept lower than where it should be and its value could rise absent of manipulation. To keep a domestic currency below its market value, the central bank needs to intervene in the exchange rate market more often than devaluation would require.
A devalued currency is one whose value is suddenly downwardly altered (and usually its value never to come back up to its previous position) from its official value by the relevant authorities (the central bank of the country with consultation of political leaders.) Currency devaluation is less frequent and such a measure is taken only when the economic fundamentals of a country are in serious trouble. As a result, the economic and political effects of a devalued and an undervalued currency are also drastically different.
The second reason which prompted me to write this article is the acrimonious debate over the undervalued yuan which escalated after the U.S. House of Representatives voted last September threatening to levy tariffs on Chinese imports unless China allows its currency to appreciate. By delving into this acrimonious debate, I briefly present the methods used to keep the yuan undervalued, the pros and cons of an undervalued currency and its economic implications to its trading partners, particularly the U.S. I am sure that readers will find this issue in particular, and the concept of exchange rates, in general, being interesting and applicable to real life situations.
To briefly represent the recriminations over currencies between China on the one hand, and the U.S. and Europe on the other hand, the latter have been claiming that China intentionally kept the value of its currency undervalued in order to sell more goods at the expense of its trading partners. On the other hand, China claims that U.S. policymakers have no moral superiority regarding the handling of exchange rates since it irresponsibly let its unsustainable boom in housing prices and mortgage lending practices corrupt the balance sheets of the world's financial institutions. China also claims that the Federal Reserve's "irresponsible," loose monetary policy is destabilizing world capital markets. What is the truth and why is the undervaluation issue reverberating without an end in sight?
Some stylized facts about the Chinese exchange rate system:
Before 1994, China had followed different versions of fixed (semi-fixed) exchange rate system. Since the beginning of 1994, the Chinese government decided to peg its currency to the U.S. dollar with an exchange rate of 8.28 yuan to the dollar. The pegging remained until July 2005, the time that the Chinese central bank decided to peg the yuan to a basket of currencies- the U.S. dollar, the euro and the Japanese yen being some of the currencies included in the basket. As announced then, the central bank of China was allowing the value of its currency to be partially determined by supply and demand. The value of the Chinese currency has been rising since then (to about 6.65 yuan per dollar today), even though the appreciation is not enough in the eyes of its competitors such as the U.S. and Europe. For some of the reasons I provide below, this appreciation of the yuan is indeed lower than what it could have been. The pegged yuan is now on a “managed float” system in which the central bank of China intervenes in order to change the direction of its value. China’s competitors and some analysts think that China’s intervention is too manipulative arguing that the managed float is a little too dirty.
Is the yuan really undervalued?
There several things that indicate the yuan has been and continues to be undervalued. For one thing, China has been raking record level of trade surpluses against its major trading partners such as the U.S. Since traders must buy the Chinese currency whenever they want to buy Chinese products, the demand for the Chinese currency must rise, thereby boosting its value. Second, China’s trade surpluses have resulted in a rapidly growing currency reserves for the country. Among other things, large foreign exchange reserves signal financial strength which boosts international confidence for the yuan. Third, China’s economy has been growing at a more rapid rate, with annual GDP growth rates ranging between 8% and 11% per year than those of the U.S., Japan and Europe. This growth should boost investors’ confidence for it currency as well. However, the value of the Chinese currency is lower than what the above fundamentals would indicate, mainly due to the interventions of the central bank of China in the exchange rate market. We turn next to the tools that China uses to keeps its currency undervalued. What are some of the mechanisms that China keeps the yuan undervalued?
There are many ways that a country can keep its currency undervalued, depending on the situation at hand, but some of the options and tools available to China and the ones it is known to have implemented include:
a. Buying dollars using the yuan in the open market in order to keep the demand for dollars high and raise the dollar price upwards relative to its own currency. This increased supply of the Chinese yuan effectively decreases its value. According to economist Peter Navarro, China first sells its bonds at about 4% and uses the revenue to buy U.S. Treasury bonds at about 2%. He says: “China is willing to endure these losses because it views them as a small price to pay for creating new jobs in Chinese export industries, albeit at the expense of American workers.” [ ]
b. Increasing the money supply in order to keep domestic interest rates lower than what they would otherwise be. Lower interest rates increase domestic investment spending while at the same time being less attractive to foreigners who could have wanted to make many by putting their assets in Chinese banks.
c. Preventing Chinese citizens from taking their investments abroad or putting a cap on the amount of foreign assets Chinese citizens could invest abroad. This latter action has the potential to decrease the demand for the dollar (thereby making it cheaper relative to the yuan) while at the same time maintaining or increasing domestic spending. All of these actions depress the value of the yuan while at the same time (artificially) increasing the prices of foreign currencies and/or foreign currency-denominated assets. The effectiveness of such policies depend from country to country but given that the Chinese economy is relatively large and the country sits on huge amounts of foreign currency reserves and surpluses, the effectiveness of the policy could be dramatic.
Many policymakers such as the members of the U.S. Congress also complain about China’s managed (fixed) exchange rate system which they claim to have given Chinese exporters undue advantages. They say that China’s use of a fixed (pegged) exchange-rate system allows it to keep the yuan within narrow trading band while at the same time the values of its competitor’s currencies such as the dollar, euro and yen are being determined in free exchange rate market with minimal or no interventions (or are at the mercy of the free market system).
Part II: The real and potential costs and benefits of an undervalued yuan to Americans
[For an extensive discussion and analyses, the reader can refer to the following one of two studies to the U.S. Congress: or ]
To summarize some of the points made below, even though the Chinese currency is undervalued and the complaints about this undervaluation are valid, the undervalued currency is not the main culprit behind our growing bilateral trade imbalance with China. Rather, it is China’s ability to produce certain products at lower comparative costs than its competitors. The reader will also understand why the complaints made by American and European policymakers about the undervalued Chinese currency have not succeeded so far. For those who may not know, the 1988 U.S. law requires the Treasury to identify and submit to Congress, twice a year, if a major trading partner is manipulating its currency in trying to boost its exports and if a retaliatory measure is warranted. But neither the Bush nor the Obama administration have been hardly successful in ascertaining the negative effects of the currency manipulation on the U.S. In fact, and to the contrary, the Treasury’s Semi-Annual Report presented to the Congress in July 2010 and earlier suggest that China is not a currency manipulator, indicating only that the yuan is undervalued. These studies (reports) are contrary to the political posturing made by U.S. and European authorizes, which in turn should indicate to us that the issue is more complex than what meets the eye. Our trade deficit may indeed be unsustainable and something must be done to rectify the problem, but jumping on the China-bashing bandwagon, just like we did it against Japan in the past, will not solve the problem unless we address the real culprits. It is also important to understand that resolving the bilateral imbalance does not mean that our overall trade deficit will find a solution, for the same trade deficit could be maintained as long as we continue to buy more goods from the rest of the world than we sell to them.
Economic Effects of an Undervalued Currency to Different Group of Americans: in Brief
Consumers: The groups of Americans who benefit the most from an undervalued yuan are the consumers. The undervalued Chinese currency allows American consumers for their dollar to buy more goods than would be otherwise, effectively raising their purchasing power and standard of living. American consumers also benefit from the increased variety brought to the market.
Exporters and Import-Competitors: An undervalued currency has the potential to make China’s exports cheaper and imports into China more expensive than they would be under free market conditions. By giving China a competitive edge, the undervalued dollar puts pressure on American exporters and import-competitors and creates job losses. One should not forget, however, that most of the goods that America imports, such as textiles, toys, furniture, shoes etc, are highly labor intensive products and require fewer skills. China has more abundant unskilled labor, which has become increasingly scarce in America. It is also important to remember that most of the stuff that is being imported from China was already being imported from other countries such as South Korea, Taiwan, Singapore and other countries. On the other hand, the undervalued yuan also has the potential to force American import-competing and exporting firms to work harder and be more innovative and creative, which in the end helps them to be more viable and competitive than they would be otherwise.
Domestic (American) manufacturers, particularly those importing capital (intermediate) goods also benefit from the undervalued yuan. By lowering the cost of their inputs, the undervalued yuan helps American producers to be more competitive in world markets than they would otherwise be.
U.S. Government and the U.S. as a whole – The undervalued yuan also has an effect on U.S. government and the U.S. economy as a whole. America benefits when China uses the surplus of funds that it accumulates and buys U.S. Treasury notes, which have the effect of lowering U.S. interest rates. Since the major cost of investment capital is the interest rate, lower domestic interest rates allow American borrowers, businesses and consumers alike, to increase their spending, which in the end increase the size of the U.S. economy. America also benefits from the flow of capital from China when China and/or its citizens buy our assets.
Finally, it is important to understand that a strong and stable Chinese economy is in the national interest of the U.S. in the same way that a strong and stable American economy is in the best interest of China. Since these two economies have become increasingly interdependent, the destruction one implies the destruction of the other – an important and pragmatic principle well-known in the military circles as MAD (mutually assured destruction.) Jumping on the China-bashing bandwagon and trying to make China a beggar of the world nations is not only counter-productive, it could also be downright dangerous. Emphasizing the point I made earlier, my fellow Americans should note that, unless we understand and recognize the real culprits behind our bilateral or multilateral trade deficits, such as our reckless overconsumption and increasing appetite for cheap products, and the increasing dependence on foreign financial resources to finance our debts, our overall trade deficits would stay the same even though those goods that we currently import from China may not come from that country.
I admit that China (and many other countries) has become too dependent on U.S. consumers. The undervaluation of the yuan could be construed this way, even though it is not the major culprit behind U.S. ills. It is, therefore, in the interest of China to let its currency float. A floating yuan would also ease the inflationary pressure which builds up as a result of China’s economic expansion and increased demand for its products from abroad. On the political side of the issue, China has to understand that the mounting domestic political pressure arising from high unemployment and lackluster economic recovery is making U.S. lawmakers increasingly jittery, forcing them to look for a scapegoat. China’s attempt to flex its muscle by restricting its shipment of crucial minerals to the United States, Europe and Japan shows that the country still in its old militaristic (communist) mentality. China has to understand that its remarkable growth hugely aided by international trade and investments made by its trading partners. China’s bizarre acts (embargoes) show that, unfortunately, the economic benefits of trade to a nation are only fully understood by industrial (grown-ups) countries. It is time for China to act one. Given the consequences, industrial nations need to be careful not to lead us towards a trade war.
Seid Hassan is a Professor of Economics at Murray State University
Source EthioGuardian.com
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