By Mritunjai Singh, MBA Capital Markets, NMIMS
On June 21, People’s bank of China came out with an announcement that it is going to remove the peg on its currency, Renminbi (RMB). The value of RMB with respect to dollar was fixed at 6.83 Yuan per dollar. Now, this currency maintenance by China has been a long standing feature of its economy. This is easily visible, if we look at the history of exchange rates of RMB with respect to US dollar.
Historically, RMB was pegged at 2.46 Yuan per dollar. In 1980s it appreciated to 1.50 per dollar. Then, due to the opening up of China’s economy, the RMB was devalued to improve the competitiveness of Chinese exports. Thus, the official RMB/USD exchange rate declined from 1.50 Yuan to 8.62 Yuan by 1994 (lowest ever on record). Chinese government maintained a peg of 8.27 Yuan per USD from 1997 to 2005. As of August 6, 2010, the Yuan is valued at 6.775 Yuan per dollar.
ADVANTAGES OF A DEVALUED CURRENCY FOR CHINA
Now, let us look at the advantages that China had because of devalued currency:
• The economy was immune to any effects of changes in the value currency. Also, a stable currency played an important part in keeping China away from the global economic crisis. In absence of stability in the currency, China’s exports would have been damaged.
• Floating the currency could have sparked an economic crisis in China and would especially have been damaging to its export industries at a time when painful economic reforms (such as shutting down inefficient state owned enterprises) were being implemented.
• China’s undervalued currency provided a boost to China’s export industry. Eliminating exchange rate risk also increased the attractiveness of China as a destination for foreign investment in export oriented production facilities.
THE ‘SIDE-EFFECTS’
However, an undervalued currency also made import more expensive, hurting Chinese consumers and Chinese firms that import parts, machinery and raw materials. Such a policy benefitted Chinese exporting firms at the expense of Chinese non-exporting firms, especially those that rely on imported goods. This impeded the most efficient allocation of resources in Chinese economy.
Another problem that arose due to currency intervention is that the Chinese government had to expand the money supply in order to keep purchasing dollars, which promoted the banks to adopt easy credit policies. In addition, in the past ‘hot money’ had poured into China from investors speculating that China will continue to appreciate the RMB. These factors helped fuel inflation, overinvestment in various sectors and expansion of non-performing loan by banks- each of which could have threatened future economic growth.
EFFECTS OF DEPRECIATED VALUE OF RMB
On US economy: The feeling among the US policymakers was that the highly depreciated value of RMB with respect to dollar made Chinese exports to United States much cheaper, and US exports to China more expensive. This increased trade deficit with China, hurt production and employment in several US manufacturing sectors. Further, they also felt that it encouraged other East-Asian economies to keep their currencies weak in order to compete with cheap Chinese goods.
But if we look at the facts logically, the following effects can be noticed:
• US exports and production of US goods and services that competed with Chinese imports, reduced in the short run. This caused trade deficit to rise and reduced aggregate demand in the short run.
• Undervalued RMB increased the purchasing power of US consumers.US producers also import capital equipment and inputs to final products from China. An undervalued RMB lowered the price of these US products, increasing their output, and thus making such firms more internationally competitive.
• Capital investment increased which increased aggregate spending in short run and also increased the size of economy in the long run by increasing the capital stock.
• In the medium run, an undervalued RMB neither increased nor decreased, aggregate demand in United States. Rather it lead to a compositional shift in US production, away from US exporters and import-competing firms towards the firms that benefit from Chinese capital flows. Thus, it is expected to have no medium or long run effect on aggregate US employment or unemployment.
On ASEAN countries: There seems to be a growing complexity in the economic relationship between ASEAN and China. It can be urged that China is a major competitor to the ASEAN both as an investment destination as well as a major producer of labor intensive manufactures. But on the other hand, China’s maintenance of RMB during the height of the Asian crisis was a major reason why the crisis did not precipitate an even more devastating meltdown in the region. China’s maintenance of the value of RMB has served as a regional anchor preventing hat could possibly have been successive rounds of competitive devaluations.
EFFECTS OF APPRECIATION OF RMB
On US economy:
• Due to correction in prices of goods as a result of appreciation, the wide gap between cost of Chinese goods and US goods will decrease. This will increase the US trade balance.
• But, there is bad news for US manufactures who depend on intermediate goods imported from China. Appreciation of RMB will increase the costs of these Chinese goods which in turn will increase the cost of production of the US firms. Now, as a cost cutting measure these firms might cut down on jobs, thus the number of jobs in US will decline.
On ASEAN economies:
• The competition from cheap Chinese goods eases on these countries. This will bring down the local interest rates. As a result there might be a spur in capital inflow to these countries.
• Appreciation of RMB creates an accommodative monetary environment and yields substantial wealth effects from a surging stock market when economic and corporate profit growths are still robust
On Indian economy:
• Trade balance will improve due to increase in costs of Chinese goods.
• Output in primary and manufacturing sector will increase but production in service industry and investment will decline resulting in decline in overall GDP production.
CONCLUSION
• Logically speaking, the concerns raised by US and other countries over highly devalued RMB seem to be misplaced. So, appreciation is not going to make their lives any better in the long run.
• Same can be said with respect to other economies also. The governments all over the world might have to review some of their policies to overcome whatsoever minor challenges that may rise due to appreciation of RMB.
Nearly one month has passed since China lifted the peg and signs definitely are not good for US economy. Interestingly, the exchange rates of USD with respect to RMB stood at 1 USD=6.79 Yuan. The trade deficit for US has further increased and the unemployment stood at 10 percent. So, definitely US has to look for better reasons for these problems instead of blaming China. Recently, there were calls from some quarters in US to officially declare China as a “Currency Manipulator”. Such an act would have allowed US to charge tariffs from imported Chinese products, thus, increasing their costs. But, such calls are merely a tool for local politicians to fool the citizens at a time when elections are approaching. As we have seen in our analysis, situation is not going to improve for US until it does something to change the fundamentals of its manufacturing industry.
About The Author
Mritunjai Singh is a 1st year MBA student at NMIMS, Mumbai. He holds a bachelor’s degree in Electronics and Communication Engineering from U.P Technical University Lucknow and can be reached at mritunjai6985@gmail.com.
