The Chinese Exchange Rate and Its Impact On The US Dollar

Since mid 2008 and due to economic crisis China has initiated a soft peg exchange rate regime pegging its currency to US dollar at a rate of about 6.83 RMB per US dollar. This change in policy terminated Chinese managed float exchange regime between 2005 and 2008. There is no time table set for this policy to end.

Chinese currency is about 40% undervalued in compare to major currencies such as USD and Euro, however, this statement is not considered valid by Chinese authorities. China buys about $1 billion a day to keep the exchange rate constant which costs US about 6 to 8 thousands job every day. This is also hurting China's neighbors as they can not compete with in the export market. As world entered the economic crisis and demand for Chinese goods dropped, China has started seeing inflation as it had not seen before.

Inflation is mainly caused by the stimulus package and cheap money available in China. RMB's appreciation at this time not only can help ease the inflation but also can lower the world's trade imbalance especially between the US and China which can stimulus the world economy. China argues its currency is not undervalued and keeps implementing monetary policies to keep the rates low. It is concluded that China is manipulating its currency to keep its export high and to increase its foreign reserve. This can not be sustainable as it increases the trade imbalance and hurts US and China's neighboring countries dramatically. It is highly recommended to pressure China to re-think its exchange rate policy. Chinese change of policy can reduce the trade balance in the world and ends the recession sooner than later. This would eventually help China's economy in the long run. Many factors affect a country's trade balance besides exchange rate and one of those forex master levels factors would be saving rate. As long as American saving rates are as low, appreciation in RMB will not eliminate trade imbalances, although it would narrow it.

Exchange Rate Regimes

There are two extreme exchange rate regimes, floating and fixed. Floating regime (US Dollar and Euro) is a market-driven policy that determines the foreign exchange rate based on the external demand and supply caused by free market forces. In this policy rate does not get intervened by government policies. This regime could be fully independent or managed, where as in independent regime exchange rate is completely a function of free market movements and supply and demand but in the managed regime government may intervene with some monetary policies to prevent sever fluctuation in the rates, if needed. Learn more about the forex wealth strategy system here.

The benefit of such a regime is the automatic adjustment of exchange rate based on supply and demand. This regime will automatically balance the trade of deficit; when deficit increases the foreign currency values go up and therefore reverses the deficit as it makes exports cheaper and imports more expensive. Other benefit is the independence of the domestic inflation from possible inflations in the world economy as the rate floats accordingly. Furthermore, governments will have more freedom choosing their domestic policies (monetary) as those policies will not affect the balance of payment equilibrium.

However, uncertainty and instability in exchange rate is a huge concern in this regime as government will have no control over the rates. This fear is bigger for emerging markets as they carry liabilities in foreign currencies and assets in domestic currencies. Sever fluctuations in exchange rate can adversely affect liabilities and assets on the books which could be substantial for emerging market with weak economies.

Fixed or pegged regime is typically defined by rate fluctuation in a fixed band around a central rate. The rate is usually pegged to a certain currency (typically US Dollar) or a basket of currencies or sometimes gold. Therefore, the government needs to use several policies to keep the rate in that range.

Under this regime, devaluation of the currency will lead to rise in current account balance resulting in artificially cheaper exports and more expensive imports. This will increase the export level while decreasing the import and therefore, higher positive surplus and decrease in deficit. Another advantage of this regime is the certainty in exchange rate that it creates which would result in less risky international investment, especially between two countries with a lot of investments in each other and in countries where external investment and trades make a big portion of their economy.

A problem with this regime is not having the flexibility to adjust quickly to international waves and having less control on inflation caused by changes in international markets. This limits the government power in using monetary policies to affect macroeconomics of the country freely as the monetary policies will affect the exchange rate. The government needs to have a relatively strong foreign currency reserve to be able to buy/sell its own currency or the foreign currency to keep the exchange rate in that window (like China as it will be discussed in the following Sections).

Chinese Exchange Rate

Looking at most recent history of Chinese exchange regime, we see a fixed exchange rate, pegged to US dollar, between about 1995 and 2005, (8.28 RMB per USD). After 2002 following China's accession to the WTO, US trade deficit with China increased dramatically and this put a lot of pressure on China to drop its fixed regime. In 2005 China announced it would let its currency float little by little and peg to a basket of currencies instead of just US dollar. This managed float policy was conservatively implemented and currency appreciated very little, (with highest appreciation in the first half of 2008). Since mid 2008 and amid the financial crisis China has used a soft peg policy (to US dollar), fixing the rate at about 6.83 RMB per Dollar. Although Chinese authorities have emphasized on this temporary soft peg, they have not set a time table to end this policy. Chinese government does not believe in RMB being under-valued. China's argument to resist appreciation is the fear of wrecking China's export and resulting in speculative inflows as it happened to Japan in 90's due to pressures in letting Yen appreciate against US dollar.

The Chinese currency is undervalued by about 25 percent on a trade-weighted average basis and by about 40 percent against dollar. The Chinese government does so by buying about $1 billion and selling their own currency daily to keep the currency undervalued. This policy is being followed by the neighboring countries in order to keep the competitive edge with Chine. These countries including Hong Kong and Singapore peg their currencies to RMB which magnifies the problem. Under-valued Chinese currency increases its exports as it damages exports of other countries, including the neighboring countries.

New and Old Bretton Woods (BW) Systems

Chinese exchange regime resembles similarities to old BW system as it carries differences too. It is similar as RMB is fixed to the US dollar; China keeps the exchange rate low to increase exports as Japan and Europe kept their rates low for the same reason during the old BW system; and the dollar is still the reserve currency in the world. fixed exchange rate for more information.

However, they are different as during the old BW United States had a huge account surplus but now it carries the biggest account deficit in the world. The other difference is that the old BW had a widespread support and world's central banks would hold US debts, however it is unlikely they would continue absorbing US debt these days. And the biggest difference is that not so many countries like China peg to USD as they used to in the old BW system. The other difference is that at that time USD was the only currency to peg whereas now China can easily switch its peg to other currencies such as Euro.

China and Inflation

China's GDP has been growing substantially. However, it has not experienced any notable inflation and its CPI has kept a low profile. This is a familiar pattern (high growth, low inflation) as it was seen in Southeast Asian economies during 50's and 60's and US in the 90's (2.6% average inflation in US between 1991 and 1999 despite high growth). One of the factors contributing to is the simple supply/demand curve. China's high growth has led to supply exceeding demand in the domestic market which has led to downward pressure on prices. Besides, high growth in production, technology advancement, innovation, and higher productivity are adding to the downward pressure too. These factors help reduce costs of production and ultimately lower the prices. Massive investments in China (especially manufacturing) are creating dramatic growth in supply. Historically, in such developing countries massive investment in infrastructure leads to relatively high supply well surpassing demand and keeping the prices low. On top of these, growing competition in China will add to the factors to keep the prices low.

As discussed above, low inflation in China is a direct result of excess supply over domestic demand, which makes the inflation very dependent to external demand or world demand. As the world economy is experiencing one of the biggest recessions China is experiencing first biggest fall in demand for its products in years.

CPI has been growing in the last 11 months in China as it is expected to reach 2.8 percent in April including 5.5% hike in food prices (year to year) led by 32.2% rise in vegetable prices (food accounts for about 30% of the CPI in China). Recent inflation could partially be related to the massive stimulus program and cheap money in the country. As the world economy is going back to normal and Chinese exports going up, higher pressures on inflation is expected especially if China resists appreciation in its currency.

Although, a good effect of rising inflation in China is increase in consumption. Chinese are seeing lesser gain by keeping their money in the bank as prices hike. This creates incentives for them to take out the money out of the banks and invest on other things such as real estate or to increase spending as RMB loses its value. This will reduce savings and helps narrow the surplus-deficit gap in the world.

China and Beggar-Thy-Neighbor Policy

China's policy of undervaluing its currency is being fueled by its government purchasing about $1 billion daily. Chinese's purchase of about $1 billion a day results to about 6 to 8 thousand Americans lose their jobs by depreciating its currency and therefore increasing its exports (600,000 to 1,200,000 jobs every year). However, this is not just hurting Americans and Europeans but is also hurting the neighboring countries like South Korea, Indonesia, and Japan. Devaluation of RMB has made it very hard for American manufacturers or China's neighboring countries to compete and has increased the off shoring substantially.

The Chinese recent soft peg policy in this economic crisis came in the worst time as it doesn't let competitors to survive and destroys the competitive edges. China is exporting unemployment to the rest of the world by continuing its policy in this crisis. Considering China's huge reserve, it could have a much more constructive role in this economic crisis especially for its neighboring countries. This would also be the perfect time for China to change its policy and increase its expending and reduce saving.