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The exchange-rate determination of any country can be determined using theories such as the purchasing power parity, the balance of payment approach and the monetary and Portfolio Approach. A majority of the countries have now adopted the theory of purchasing power parity as a way of calculating the rate of exchange. The approach assumes that goods of the same value should be priced the same. The theory relates to balance of payment. It stipulates that exchange rates between currencies must compensate for the variations in the price of goods. The theory points out that exchange rate must cater for the difference in inflation rate. On the other hand, this theory has failed to take into account the existing, workforce, taste and technological differences amongst customers and which have the potential to not only alter the national productivity, but also the actual rate of exchange. This theory assumes that the exchange rate maintains both internal and external equilibrium of the economy. Internal equilibrium is assumed to be achieved with the attainment of full employment while external equilibrium is based on the difference between imports and exports. The theory is more reliable than the purchasing power parity as it can explain permanent variations. The approach gives guidance to short-term fluctuations of the currency. The monetary and portfolio approach provides a basis on which the prices of a variety of internal and external assets are determined. In this approach, a portfolio choice of a variety of assets is given, of which may be money or bonds with expected rate of returns from their investments. The investment opportunities occur when the expected loss of value is not unable to compensate the disparity in exchange rates (McKinnon & Gunther 2004. pp. 06-09).
Over the last couple of years, China has increased its investment in US treasury bills through increased buying. It is the second biggest holder after Japan. Due to this fact, the trade relationship between these two countries has increased drastically. Due to low prices of Chinese exported goods to the United States, the United States consumer demand for Chinese goods has greatly increased. With the global financial crisis and the United States stimulus package coupled with loose monetary policies have laid fears in the Chinese government over United States debt. Due to this fear the Chinese monetary authorities have called for the replacement of the dollar as the international reserve currency with the International Monetary Fund. By 2004, China had already established huge trade Surplus against United States. In 2005, its economy was adversely affected by the epidemic of the SARS and it nearly collapsed, The China injected money into the economy to boost production activities. It announced a 2.1 Revaluation of its currency to lower the rate of inflation that threatened to increase due to excess liquidity. The exchange rate of the Chinese currency with other major economies currency and especially the dollar appreciated gradually to reach a manageable float in 2008. After 2008, although not formally announced, it was believed the China government re-pegged its currency against dollar and returned to the fixed exchange rate to protect its export market from collapse due to the global financial crisis. This can be observed from the steady exchange rate of their currency since 2008 (Chou, & Chao, 2001, pp. 19-25).
The republic of China maintained a pegged exchange rate of their currency to the US dollar before 2005. The pegging required the intervention of the authorities to maintain a fixed rate. To avoid currency depreciation or appreciation, the government kept on buying the domestic currency during times of excess supply and sells it during the period of excess demand. By July 2005, China stopped pegging its currency to the US dollar and assumed an economy with a floating exchange rate although the floating rate was highly controlled. Despite the marginal float of the Yuan, its present value is between 20% and 40% lower than the true market value. Since then, the Yuan started appreciating against the dollar. China is one of the countries with the largest forex reserves in the world the large reserve has been due to its high growth record on its exports (Cheung, et-al 2007. pp. 241-244).
The undervaluing of its currency has enabled China to acquire enormous trade advantage in relation to other countries and especially the United States. This has enabled it maintain a high gross domestic growth. Chinas export accounts for the largest share in the world, while United States is a great importer and hence it operates a large current account balance. China uses its large forex reserves to buy United States government securities, a move that helps China to keep its currency undervalued as well as maintaining a low interest rate in the United States. Low interest rates increases consumption in the US, This move increases Chinas exports which are kept cheap by their undervalued currency. Even with the rapid growth of its economy, China cannot allow its currency to appreciate in value as this will have an adverse effect on its export volume. Appreciation of the currency will increase the price of their export produce to their trading partners and this will have an effect of a reduction in consumption which in tern will lower their export income considerably. The growth of the Chinas gross domestic product is mainly dependent on export earnings. The increased pressure from the G8 countries and United States in particular to make China bear a larger share of global adjustments by increasing imports and reducing its exports, the China government accepted to float its currency by a minimal margin. This move resulted to a rise in value of the Yuan at against the dollar at an annual rate of 13%. The appreciation of the Yuan will result into large capital inflows which in turn will increase the country reserve and raise the value of the yuan even higher. The China government sees such a move would distabilise the economy and weaken its monetary policy. Continuous rise in China trade surplus with the United States has brought about a widespread complaints from United States industrial sector over the competitive disadvantages caused by Chinese low import value have led to a series of complaints and a call for a severe measures by the Unite States against restrictive Chinese trade policies that seem to be unfair. This led the Chinese government to appreciate its Yuan by 13% which is only a modesty appreciation compared to its rating with the dollar. They further claimed that China continued manipulating its currency to pose an unfair trade advantage over its competitors (Frankel, Jeffrey, & Shang, 2007 pp. 324-327).
The currency manipulation has led to widespread loss of jobs in the United States. The undervaluing of the Yuan against the dollar makes the Chinese imported goods cheaper than what they could actually be if the value of the Yuan was determined by the market forces. Undervaluing of the Yuan has the effect of lowering the market price for United States consumers a condition that reduces inflationary pressure. The move also lowers the prices of imported inputs such as parts and hence lowering the production costs to the firms in production industry making them more competitive in the international market. The balance of payment between China and United States is very large. This results to capital inflow to United States from China through buying of United States Treasury securities by China. This mandates the United States to lower its treasury securities interest rates and rise its investment spending. The negative effect of currency devaluation is that cheap goods from China competes with similar goods produced locally there by damaging the United States Industries, reducing production and consequently increasing unemployment. Undervaluing of yuan results to increasing the cost of imports in China and hence this reduces the amount of goods the United States exports to China and consequently reduction of jobs in the Unite States industrial sector. The undervaluing of thee Chinese currency is partly responsible for the large trade deficit between China and the United States Most of the Chinese exports are from large foreign companies which have invested in China to take advantage of the large cheap labour force. Over the past few years, China has come to be one of the rapidly growing markets for the United States Exports. United States trade deficit has been partly due to its deficit between saving and investment (Arize, 1994. pp. 1-9).
Despite the ills that undervaluing of the Chinese Yuan has on the economy of United States, there are no serious regulations of exchange rates at the international levels. Due to this factor governments can institute substantial influence on their currency exchange rates through monetary policies and physical interference in financial markets. Monetary authorities however, analyses this policies so as to strike an optimal balance to macro economical issues such as unemployment, Product prices and inflation. The monetary authorities of a country can use monetary tools to keep the value of their currencies lower than the value which would have been set by the market forces. The undervaluing of the Chinese currency acts as an import regulating tool as well as export promotion tool. The cheap Chinese imports have helped keep Americas level of inflation low. This has resulted to too few jobs in America and creation of more jobs in China. China has been saving heavily while America has been consuming a lot. Heavy Chinese savings has helped keep United States inflation level low. Too low interest rates have increased the asset price bubble in the United States. With Chinas revaluation of the Yuan, reduction in Americas consumption level and increased savings, the United States monetary authorities are hoping to reduce the United States deficit with the Chinese and increase export to China. The appreciation of the value of the Chinese Yuan to about 14% in relation to the dollar has been argued to be too low. From July 2008, the value of the Chinese Yuan has been re-pegged to the dollar. This makes the Yuan the only currency from a major economy that lacks floating exchange rate. In 2009, The United States authority announced intentions to put pressure on China to stop pegging their currency on the dollar as exchange rates were putting America on a tight competitive advantage. China enjoys a current account surplus. With its rapidly growing economy, it should have a rise in the value of its currency. This has not been the case, the value of the Yuan has stagnated at a value around 6.83 Yuan to the dollar for almost the last two years (Friedman, 1953, pp. 187-203).
Pegging the Yuan to the dollar made its value to fall with the fall of the value of the dollar in year 2008. This made the yuan loose its value to over 10% to the euro in year 2009. Estimates by economists showed that the value of the yuan had been undervalued to about 40.7 % against the dollar as per December 2009. This late however accelerated in late 2009 since in March 2009, it only required to be appreciated by about 21.2 % against currencies from the major economies. In November 2009 however, the yuan real exchange rate had fallen by 8.4 percent. The peoples republic of China however disputed the claims arguing that the currency had appreciated by over 20 percent within the period 2005 to mid 2008. The Chinese authorities retaliated that it was committed to contributing to global economic rebalancing by contributing 4 trillion yuan towards the fiscal stimulus package. Pegging yuan to the dollar have advantages in some situations. The great demand of the dollar that was as a result of the credit crunch of 2008 and 2009, made the dollar rise as investors were fleeing from the collapse of the financial market. The rise in value of the dollar made the value of other currencies that were pegged to it to rise with it while the value of other currencies fell. By 2009 December, the value of the yuan had raised to acceptable levels a clear indication that it was appreciating gradually. The appreciation of the Chinese Yuan resulted in the fall of Chinas fall in current account without reduction in domestic consumption. It has been argued that a revaluation of the yuan may not yield much. A rise in yuan may result to negative consequences. Under valued exchange rate may spur growth in developing countries since they can act as incentives to increase economic activities in production of commercial products which are basically produced by more productive economic sectors (Taylor, Alan & Mark, 2004, pp. pp.135-148).
A higher rate of appreciation of the yuan would greatly reduce the growth rate of the Chinese economy by appreciating the yuan by 25percent, the growth rate of the Chinese economy would be maintain below 8 percent which is the required minimum to maintain minimal growth rate in the economy. Critics argue that undervaluing of the Chinese currency should not be viewed as a policy to cause global economic imbalances. They point out that the real culprits of economic imbalances are the less developed and emerging economies since they compete at almost the same level with China as opposed to the developed economies like the United States. The American economy does not depend much on export of light commodities and hence it is not directly affected by the trade imbalances. Countries that are main exporters of light goods are the ones that are heavily affected by the undervaluing of the yuan. The threat by the United States on providing trade restrictions to products from China to force it to appreciate the value of the yuan and increase the exchange rate would pose a big challenge to the development of the emerging economies. There is no future hope that the Chinese economy can be driven by domestic consumption. The Chinese economy has invested heavily on export related production and the trend shows that the economy growth of China is increasingly becoming dependent on exports. The Chinese authority therefore can only change the exchange rate if the export market becomes very competitive or if the value of the dollar falls significantly. The low rate of interest rates in the United States of America is as a result of loose monetary policy which has been made to encourage economic growth and boost investment. This scenario presses the emerging economies between the Chinese fixed exchange rates and the United States low interest rates (Pilbeam, 2006, pp. 223-228).
The Americans investors have shifted their investment base from the American economy to the economies of the developing countries where high returns are guaranteed. This in turn raises the value of these countries hence increasing their competitiveness against the dollar and the yuan. The proponents of valuation argue that appreciation of the yuan would prove beneficial to the economy of China as well as the Chinese people. This is probable if China develops a growth model which is capable of balancing investment, export and consumption. This would raise the customers purchasing power. The government of China has developed methodologies to prevent capital inflows in order to prohibit the appreciating of the currency through capital repression. This is made possible through using bank deposits to keep interest rates low. Consequently, the house hold savings would attract higher interest rates representing a considerable amount of income. At international scene, a less devalued yuan would considerably influence global finance. The implications of this exchange rate movements between the Chinese yuan and the US dollar is that it has resulted to expansion of the United states trade deficits with China this in turn has brought about low profits to the United State manufacturers and accelerating unemployment, which stood over 10% in November 2009. This is clear evidence that the yuan is highly undervalued. As a result of undervaluing the yuan, the Chinas foreign exchange reserves sharply raised from 403 billion US dollars in 2003 to 1.5 trillion US dollars in October 2007. The Chinas trade surplus rose to 268 billion US dollars. In order to maintain a highly undervalued currency, China was buying assets worth between 15 billion and 20 billion US dollars per month (Qiao, 2005 pp. 259-262).
The success of the Chinese economy may be attributed to the undervaluation policy of its currency, the Yuan. As a result, the Chinese government have been advocating for currency policies that would gradually maintain global growth. The increase in Chinas dollar reserves has been a threat to the growth and stability of the United States economy. China policy of undervaluing its currency has led to a large degree of dollar overvaluation and the increasing trade deficit. The increasing trade deficits according to the Americans economists may necessitate the United States government to undertake protectionist trade policies. This may be taken through dollar devaluation. The United States, may decide to lower the amount of debts it sells to China. Although these would be disastrous to the United States economy through loss of the favourable rate of interest that the Chinese government offers to finance its debts. The Chinese government has been reluctant to appreciate the value of the yuan as per the demands of the United States for fear that the resultant slow in economic growth below the targeted 8 percent would result to political unrest and instability. The 8 percent growth rate is necessary to keep low level of unemployment especially in rural areas. The United States increasing debt has raised some concerns about holding of the United States treasury bills. This could make international investors and commercial banks of other economies to abandon dollar and invest in more safe investments. The United States devaluation of its dollar could immensely hurt its economy as it would lead to higher interest rates, inflation, increased unemployment as well as low economic growth (Bernanke, 2005, pp. 78-81).
Reference List
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Bernanke, B.,2005. The Global Saving Glut and the U.S Current Account Deficit.[Online]. Web.Â
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Chou, L, & Chao, C., 2001. Are Currency Devaluations Effective? A Panel Unit Root Test. Economics Letters, Vol. 72, pp.1925.
Frankel, J., 2006. On the Yuan: The Choice Between Adjustment Under a Fixed Exchange Rate and Adjustment under a Flexible Rate, in Understanding the Chinese Economy, edited by Gerhard Illing, CESifo Economic Studies, Vol. 52, No. 2, pp. 246-275.
Friedman, M.,1953, The case for flexible exchange rates, in Essays in Positive Economics. Chicago: University of Chicago Press.
McKinnon, R. & Gunther S., 2004. A Return to Exchange Rate Stability in East Asia? Mitigating Conflicted Virtue. International Finance, Vol. 7, No. 2.
Pilbeam, K., 2006, International Finance. (3rd Ed.). Basingstoke: Palgrave Macmillan
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Stanford University, Center for International Development, China Working Paper Series #259 Taylor, A. M. & Mark, P., 2004, The purchasing power parity debate. Journal of Economic Perspectives, Vol. 18, No. 4, pp. 135148
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