Transcript China Turn Into the Largest Market in the World

International Convention of Asia Scholars
The Controversies over the Chinese Currency Value:
China’s Central Bank’s Responses and the Future of Yuan
Gene Hsin Chang 张欣
University of Toledo
Director of the Asian Studies Institute, Professor of
Economics
August 22, 2005
©
The Issue of the Chinese Currency
Yuan (RMB)
Under the pressure of the market, the
Chinese authority announced the
currency-policy change on July 21, 2005.
“ 2% Solution: China Lets Yuan Rise vs.
Dollar, Easing Trade Tensions Slightly”
---Title of the Report, Wall Street Journal, July 21, 2005
The Issue of the Chinese Currency
Yuan (RMB)
The July 21st Policy Change includes:
2.1 % one-time revaluation, from $1=8.27yuans
to $1=8.11yuans
Move to “managed floating” exchange rate
regime
The exchange rate is decided by an undisclosed
basket of currencies.
The rate will be allowed to float against U.S.
dollar by 3 per thousand each day.
The value of yuan has not really
changed since then
RMB / Dollar Exchange Rate
8.300
8.200
8.150
8.100
8.050
5
/2
00
18
8/
8/
11
/2
00
5
20
05
4/
8/
5
/2
00
28
7/
21
/2
00
5
8.000
7/
Yuans to $1
8.250
The yuan has not really changed
since then
In the past month, the yuan has changed
only 0.065%, from
July 21st: $1 = 8.1100 yuans
to
August 22nd: $1=8.1047 yuans
If this pattern continues …
In the past month, the yuan has changed
only 0.065%. Assume this pattern
continues,
On July 21st, 2006: $1 = 8.046 yuans
which represents
a total of 0.72% additional revaluation
or
Cumulatively, 2.8 percent revaluation from
the original rate before the peg policy
change
This is far from what the market
expects
How much does the yuan
undervalued?
Has China’s Central Bank (The
People’s Bank of China) done a good
job in the exchange rate reform?
What is the future of yuan?
Background: The U.S. Congress
Senate Bill by Charles Schumer (D., N.Y.) and
Lindsey Graham (R., S.C.)
If no RMB revaluation, imports from China can
be subject to 27.5% tariff.
House China Currency Act by Congressmen
Duncan Hunter (R., Calif.) and Tim Ryan (D.,
Ohio)
If no RMB revaluation, trigger an antidumping or
countervailing duty.
Top trade partners of the U.S.
(2004)
Trade Deficit
1
Total Trade
Volume
Canada
2
Mexico
Japan
3
China
Canada
4
Japan
Mexico
5
Germany
Germany
China
US Trade with China
(million dollars)
250,000
200,000
Total
Deficit
150,000
100,000
50,000
19
85
19
87
19
89
19
91
19
93
19
95
19
97
19
99
20
01
20
03
20
05
0
The Bush administration
-- ambivalence
•2003: US Treasury Secretary John Snow told a House of Representatives panel.
"China has pegged its currency to the dollar for 10 years. This administration
has stressed that China needs to move to float its currency as soon as possible”
•The U.S. Treasury angered Congress by stopping short of issuing a formal finding that
the Chinese government manipulated the exchange value of the yuan. It concluded that
such a policy by itself does not meet the statutory definition of currency manipulation.
•May 26, 2005:
The Bush administration stopped demanding that China let its currency, the yuan, float
freely against other major currencies. "I don't think it is in our interest or in their interest
in going immediately to a full float," Treasury Secretary John Snow told the Senate
Banking Committee on Thursday. " Snow refused to say by how much he wanted China
to revalue the yuan.
Federal Reserve:
--- reservation
•March 2005: Federal Reserve Chairman Alan Greenspan warned if
China were to let its currency float immediately, as many in the US want,
it could weaken that country’s banking system and threaten the world
economy
•May 20, 2005 – Greenspan: “American shoppers will pay higher prices
but the U.S. trade deficit with the rest of the world won't fall if China
revalues its yuan currency as the Bush administration wants”.
Debate in the U.S.
Pro
Reducing trade deficit
with China
Preserving more jobs
in the U.S.
Con
Increasing trade deficit in terms
of dollars
Speculative sell of dollars
Pressure on the global dollar
system, dollar and T bonds
U.S. bonds down, interest rate
up
Widening financial resource gap
Inflation
Deterioration of terms of trade
Consumer surplus loss
Debates in China
Con
Reduce competitiveness
Adversely affect exports
Adversely affect
employment
Deflation
Pro
Improve terms of trade
Reduces debt service
burden
Reduces the cost of the
huge foreign reserve
Upgrading economic
structure
Debates among Asian countries
China is the largest export destination for
many Asian regions including Korea and
Taiwan
China and Hong Kong imports more
goods from rest of Asia than Japan
The benefits of revaluation of yuan are
ambivalent for Asian countries
Concern over a floating RMB that may
cause regional economic instability.
Responses by various countries to
the yuan revaluation
The U.S.
Japan
European Union
Rest of Asia
Developing countries
China itself
Summary of the Responses
in the World
Welcome the change
Many are unsatisfied: the change is
symbolic and not enough to respond to the
market condition
The world is evaluating the policy: what
the implication are impact
The world is wondering: what the future of
yuan will be.
Understanding the Yuan Value
Jeffrey Frankel: Yuan 42% undervalued
Lardy and Goldstein: 15%-25%
undervalued
Gene Chang: 19.2% undervalued
Steve Hanke and Michael Connoly: No
undervaluation
Ronald McKinnon
Robert Mundell
Estimation of Equilibrium Value
of Yuan
Determination in the short-run
Determination in the long-run
Purchasing power parity
E = PU.S. / PChina
Relative purchasing power parity
% depreciation in E
= inflation U.S. – inflation China
Problems with using relative PPP to estimate
equilibrium value of yuan
Estimation of Equilibrium Value
of Yuan
Real Exchange Rate (RER)
RER = (E X PChina) / PU.S.
If absolute PPP holds, RER = 1
Fig 1. Relative Pruchasing Power (RPP) of
Currencies of Various Countries
Relative Purchasing Power
10
8
RPP
Fitted line
Linear (Fitted line)
6
4
2
0
0
10000
20000
30000
-2
-4
GDP per capita
40000
50000
Estimation of Equilibrium Value
of Yuan
Why is RER greater than 1 for poor
countries?
The Balassa-Samuelson hypothesis
The Bhagwati-Kravis-Lipsey hypothesis
Estimation of Equilibrium Value
of Yuan
Model with control of the income level:
RER = f (GDP per capita)
Data for RER
Linear or log linear
(ln) RER = a + b X (ln) GDP per capita
Control heteroskedasticity
Estimation of Equilibrium Value
of Yuan
Using the world sample to obtain the
estimates and the prediction equation
Intercept
Coefficients Standard
error
4.28039
0.15922
GDP p.c. -0.13386
0.01320
t -statistics
26.88387
-10.14495
RMB exchange rate
RER actual
20
01
19
99
19
97
19
95
19
93
19
91
19
89
Exchange rate (yuan per $)
19
87
19
85
10
9
8
7
6
5
4
3
2
1
0
RMB Undervaluation Estimation
Year
GDP pc
2001
RER
actual
RER
predicted
Valuation
P-value
1978
703
1.98
4.07
51.3%
0.084
1985
1158
2.68
4.02
33.3%
0.187
1986
1293
3.21
4.00
19.7%
0.299
1987
1509
4.33
3.97
-8.9%
0.406
1991
1757
4.39
3.94
-11.2%
0.384
1994
2484
4.79
3.86
-24.3%
0.263
1995
2788
4.30
3.82
-12.6%
0.372
1996
2987
4.08
3.80
-7.4%
0.424
RMB Undervaluation Estimation
Year
GDP pc
2001
RER
actual
RER
predicted
Valuation
P-value
1997
3145
4.01
3.78
-6.1%
0.437
1998
3308
4.09
3.76
-8.9%
0.409
1999
3522
4.26
3.73
-14.3%
0.357
2000
3829
4.37
3.70
-18.4%
0.319
2001
4020
4.41
3.67
-20.1%
0.304
2002
4309
4.48
3.64
-23.2%
0.278
2003
4618
4.41
3.60
-22.5%
0.286
2004
5024
4.23
3.55
-19.2%
0.315
-1
-1.5
.V
inc
en
-0.5
i
Bo
livi
ta
a
nd
Ec
the
ua
do
Gr
r
en
ad
ine
s
Jam
aic
a
Fij
ub
lic
Le
so
tho
Uk
rai
ne
Gu
yan
a
Ch
ina
Pa
rag
ua
y
Ge
org
Tu
rkm
ia
en
ist
an
Sri
La
nk
a
Mo
roc
Sy
co
ria
Alb
nA
an
rab
ia
Re
pu
Gu blic
ate
ma
la
zR
ep
rgy
Ky
Under / Over –valued currencies
1
0.5
0
China’s Choice of
exchange rate regime
It is claimed to be “Managed floating”
Definition for managed floating– floating with
government intervention, normally allowing
for change within the range of 3-5%.
China’s policy is not a conventional MF
regime.
China’s Choice
It is also claimed to be fluctuate around a central
rate set by the previous transaction day, and
using an undisclosed basket currencies as a
“reference”, but not stick to this basket.
Definition:
Target zone, or band – a margin of fluctuation
around some central rate
Basket peg – fixing not to a single foreign
currency but to a weighted average of other
currencies
China’s policy is not a conventional regime as
defined above.
China’s Choice
Definition of various FEX regimes
Crawling peg – a preannounced policy of
devaluing a bit each week
Adjustable peg – fixing the exchange rate,
but without any open-ended commitment
to resist devaluation or revaluation in the
presence of a large balance of payments
deficit or surplus
China’s Choice
The real nature of China’s Foreign Exchange rate
regime is:
Basically still using the U.S. dollar as a major
anchor rather than a basket of currencies.
In practice allowing changes within only a very
narrow band, much smaller than the announced
0.3% band.
In theory, China’s policy and practice is close to:
“crawling adjustable peg”
Achievements of
China’s New FEX Policy
Diplomatic gain
Right direction to achieve the long
term equilibrium value
Cautious step, move and see.
More flexibility for future changes
Merits of Pegging to dollar
Lower transaction costs including
cost of gaining information
cost of hedging exchange rate fluctuation
cost of negotiation
More than 90% of international transaction is
in dollars. This is extremely true for the
small and medium size Chinese firms
Problems with China’s Policy
Contradiction between what is claimed and
what is actually practiced.
The 2.1% revaluation is too small to ease the
market pressure.
Ambiguous statement of “initial adjustment” ,
and the allowed floating band, leaving too
much room for speculators to guess
Inviting more speculation and more capital
flow.
Problems with China’s Policy
As a result,
The huge capital inflow continues and
show no sign of slow down
2 billion dollars inflow on the first day
after the policy change
Future of the Yuan
The 2.1 percent revaluation is too little to
ease market pressure.
If China’s inflation is under control, yuan is
going to revalue by 20% in coming five
years.
In the coming future …
The current adjustment pace is certainly not
enough.
Hence the foreign capital flow will continue and
even accelerate. By the end of 2005, China’s
foreign reserve will exceed 800 billion U.S.
dollars.
The central bank has to issue more and more
bank notes to sterilize the explosion of the
money base.
It adds tremendous pressure on the money
supply control and price level.
Future of the Yuan
The central bank has to accelerate the
revaluation in the late period of the year
Or, it has to make another one-time
adjustment at a certain stage.
Internationalizing yuan
Advantages
1. More flexibility for an independent
monetary policy
2. Low transaction cost
3. Seigniorage income
But must meet the conditions
1. Good macro fundamentals
2. Greater role in the global market
Feasible only in the long run
Conclusion
China’s change in FEX policy is a
welcome step and in a right direction
But it is too little to correct the
disequilibrium
We expect that China is going to and has
to take more actions to address this
equilibrium issue in near future