Transcript Revaluation of Chinese Yuan and Its Impact on US Economy

Revaluation of Chinese Yuan and Its Impact on US
Economy
Term Paper, ECO6226, Summer 2006
Fan Zhang
China’s currency exchange system
 Pegged exchange system
 Overvalued prior to 1994
 Pegged to US dollar at a constant ratio of 8.3 since 1994
 The pegging is believed to play a positive role in 1997-
1998 Asian financial crisis.
 Significantly undervalued for the last several years
 Pegging is achieved through foreign exchange
intervention
 Policy change in 2005
How much is Yuan undervalued?
Like everything else, the exchange rate is determined by
supply and demand in a floating exchange system.
Demand for Yuan: purchase of Chinese goods, services
and assets by other countries.
Supply of Yuan: purchase of foreign goods, services and
Value of Yuan
assets by China.
YS
YD
Y
How much is Yuan undervalued?
PPP based methods
 Price level in any two countries should be same after
converting prices to a common currency (one dollar buys
the same goods)
 Use of “basket” of goods
 Big Mac Index
 Starbucks tall-latte index
(Source The Economist, January, 2004))
Country
Australia
Britain
Canada
China
Euro area
Hong Kong
Jpan
Malasia
Mexico
New Zealand
Singapore
South Korea
Switzerland
Taiwan
Thailand
Turkey
Starbucks
tall-latte index
-4
17
-16
-1
33
15
13
-25
-15
-12
2
6
62
-5
-31
6
McDonald
Big Mac index
-17
23
-16
-56
24
-45
-12
-53
-21
-4
-31
0
82
-21
-46
5
How much is Yuan undervalued?
PPP indicators, 2000
(USA = 100, Source: Pakko and Pollard
Observation:
It is not unusual for
countries to have
significant deviation
from 100
Country
Argentina
Australia
(2003))Brazil
Britain
Canada
Chile
China
Columbia
Czeck Republic
Denmark
France
Germany
Greece
Hong Kong
Hungary
Indonisia
Israel
Italy
Jpan
Malasia
Mexico
New Zealand
Phlippines
Poland
Russia
Singapore
South Africa
South Korea
Spain
Sweden
Switzerland
Thailand
Turkey
PWT
66
75
45
98
79
45
23
33
33
107
91
95
69
86
42
18
92
81
145
41
61
66
25
42
17
80
37
65
74
105
118
30
40
Big Mac
100
61
66
120
77
98
48
91
55
123
104
94
83
52
48
73
143
86
111
47
88
67
56
51
55
75
53
108
83
108
138
58
50
How much is Yuan undervalued?
Trend in PPP indicators:
Developing countries
typically has undervalued
currencies.
(Source: Rogoff(1996))
Country
United States
Canada
Germany
Jpan
France
United Kingdom
Italy
Spain
Taiwan
Venezuala
Mexico
Brazil
Poland
Turkey
Thailand
Argentina
Columbia
South Africa
Algeria
China
Peru
Morocco
Indonisia
Phlippines
Egypt
Pakistan
Bangladesh
India
Sudan
Kenya
Nigeria
Per Capita GDP Relative
to the United States
100
95.9
84.0
82.5
77.3
71.3
69.8
54.0
47.1
30.2
29.3
21.3
21.0
20.4
19.3
19.0
17.3
17.2
13.0
12.5
11.2
11.1
10.3
9.6
9.4
7.4
6.5
5.8
5.2
5.0
3.9
Price Level Relative to
the United States
100
103.9
132.3
133.9
126.5
110.5
125.6
108.2
74.9
37.5
43.7
68.6
36.8
43.9
34.4
79.8
34.0
76.0
74.7
11.9
70.0
41.9
27.0
34.3
33.5
22.4
15.4
26.7
30.1
33.6
36.7
How much is Yuan undervalued?
Trend in PPP indicators:Developing countries typically has undervalued
currencies.
Price Level = 1.0762 x (GDP Per Capita) + 27.924
(0.12)
(5.09)
160
140
y = 1.0762x + 27.924
Price Level Relative to US (US=100)
120
100
80
60
40
20
0
0
20
40
60
Per Capita GDP Relative to US (US=100)
(data source: Rogoff(1996))
80
100
120
How much is Yuan undervalued?
Price Level = 1.0762 x (GDP Per Capita) + 27.924
(0.12)
(5.09)
 China’s Per Capita GDP in 2005 is 16% of that of the US.
 The above equation shows that we should expect an
undervaluation of 55% for Yuan.
 This value is in line of the Economist published Big Mac
index that shows Yuan is 58% undervalued. This is probably
just a coincidence.
How much is Yuan undervalued?
Why PPP fails?
 PPP only applies to tradable goods. It does not apply to
non-tradable goods or services, such as rents and salaries.
 If Big Mac were merely the sum of its ingredients, the Big
Mac index would be more reliable for currency valuation.
 Only 6% of Big Mac’s price is for ingredients
 Big Mac based PPP can only explain a small portion of the
total price difference and the equilibrium exchange rate
determined from it could be well biased.
 The price of Big Mac or Starbucks also reflect the market
conditions and pricing strategy in different countries.
How much is Yuan undervalued?
Payment of balance based methods
 The equilibrium rate is determined by having a equilibrium in the
country’s balance of payments, which means that the net capital flows
is equal to the current account.
 Goldstein (2004) estimated that there was $50 billion surplus in
China’s balance of payment in 2004, equivalent to 4% of China’s
GDP for the year. 15-30% revaluation of Yuan will offset this surplus.
 O’Neil and Wilson (2003) calculated that Chinese Yuan is 9.5 – 15
percent undervalued. Their estimate was based on the export
elasticity that China’s export would fall 0.2% and import would
increase by 0.5% for each percent of revaluation of Yuan.
How much is Yuan undervalued?
Summary on methods to determine equilibrium exchange rate
 There exist various methods to determine the level of
undervaluation of Yuan. No method is clearly better than others.
 Results varies significantly from one method to another. However,
most method showed that Chinese Yuan is undervalued to some
extent.
 China’s economy has achieved nearly double digit annual GDP
growth every year for the last 12 years, its exchange rate has kept a
constant against US dollar. Based on this evidence, it is safe to
draw the conclusion that Chinese Yuan is indeed undervalued.
How much is Yuan undervalued?
 Most economists believe that China should take a gradual
process in adjusting its exchange rate so as not to cause disruptive
effect on the economy in China and the that of the other countries.
 Goldstein and Lardy (2003) proposed a “two stage” currency
reform:
 Stage 1:
•
switch from a unitary peg to dollar to a currency basket
•
a medium size (15 to 25 percent) revaluation of the Yuan
•
widening of the currency band
 Stage two:
a managed float system
Effect of a revaluated Yuan on US Economy
Trade deficit with China
Trade Deficit with China
250,000.00
200,000.00
(million$)
150,000.00
100,000.00
50,000.00
0.00
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
Effect of a revaluated Yuan on US Economy
 A nation’s trade balance can be viewed as the difference between
the nation’s total goods production and total expenditure.
 Revaluation of Yuan can reduce the overall US trade deficit only if
it increases US domestic production of goods or it reduces the
amount of US domestic expenditure.
 Less import from China; more export to China and other countries.
 Misperception: $1 reduction in bilateral deficit with China means
$1 reduction in overall trade deficit.
 Could reduce the expenditure through interest rate channel
 Conclusion: reduction of trade deficit, But, is it a good thing?
Effect of a revaluated Yuan on US Economy
In the testimony to the Senate Finance Committee on June 23,
2005, then Federal Reserve Chairman Greenspan made this
statement:
“Some observer mistakenly believe that a marked
increase in the exchange value of the Chinese Renminbi
[Yuan], the so-called RMB, relative to the US dollar, would
significantly increase manufacturing activity and jobs in
the United States. I am aware of no credible evidence that
supports such a conclusion.”
Conclusions
 There are various methods to estimate the equilibrium
exchange rate of Yuan.
 All the methods are based on certain assumptions.
 The level of undervaluation estimated from these methods
vary significantly.
 Yuan is undervalued.
 A marked revaluation of Yuan will have a mixed effect on
US economy.
 Some industry sectors will benefit from a revaluated Yuan
and others may suffer.
 Reduction US trade deficit.
References
Pakko, Michael and Patricia Pollard (2003), ‘Burgernomics: A Big Mac Guide to Purchasing Power Parity’,
Review, Federal Reserve Bank of St. Louis, Vol. 85, No. 6, page 9, Nov/Dec.
Funke, Michael and Jorg Rahn (2005), ‘Just How Undervalued is the Chinese Renminbi?’, The World
Economy, Vol. 28, No.4, Page 465, April.
Rogoff, Kenneth (1996), ‘The Purchasing Power Puzzle’, Journal of Economic Literature, Vol.34, No. 2, 647668.
Ong, Li (1997), ‘Burgernomics: The Economics of the Big Mac Standard’, Journal of International Money and
Finance, Vol.16, No.6, p.865, December.
Goldstein, Morris (2004), ‘Adjusting China’s Exchange Rate Policies’, Revised paper presented at the IMF
Seminar on China’s foreign exchange system, Dalian, China, May 26-27.
O’Neill, Jim and Dominic Wilson (2003), ‘How China Can Help the World’, Goldman Sachs Economics
Paper 97, September 17
Morrison, Wayne and Marc Labonte (2005), ‘China’s Exchange Rate Peg: Economic Issues and Options for
US Trade Policy’, CRS Report for Congress, May 10
Goldstein, Morris and Nicholas Lardy(2003), ‘Two-stage Currency Reform for China’, The Asian Wall Street
Journal, September 12.
Bown, Chad, et al (2005), ‘The U.S. Trade Deficit: Made in China?’, Economic Perspective, 4Q/2005. Dfgdsf