FREE FLOATATION OF THE CHINESE YUAN

INTRODUCTION
The currency of China is called the Chinese Yuan or the Renminbi, which translates tothe peoples currency. The Peoples Bank of China, the monetary authority of the PeoplesRepublic of China, issues the Renminbi. Popular press and most politicians are convinced thatYuan is undervalued which gives China an unfair competitive advantage. however, is largely mixed on this question and estimates from Yuan is fairly priced to Yuan is undervalued by as much as 50% can be found (Funke and Rahn, 2005; Sanford, 2005; Chang, 2007; Hannan, 2009; Morrison and Labonte, 2009; The Economist, 2010). Various studies suggest that based on Purchasing power parity (PPP), diverse economic models, Big Mac Index, and Starbucks tall latte Index, Chinese Yuan is about 30% to 50% undervalued. For instance, according to the Economist (2010), the Chinese Yuan is undervalued by nearly 50% below its PPP rate, based onthe latest Big Mac Index. We take a different approach by examining the pricing of the Renminbi or Yuan to determine whether the Chinese Yuan is undervalued if Chinese currency had not pegged to the U.S. Dollar. Chinese Yuan Renminbi Specifically, we choose a multi-currency basket including four currency values, such as Australian Dollar, Euro, U.K. Pound, and U.S. Dollar to determine whether the Chinese Yuan is relatively undervalued. Chinese Yuan had been pegged to the U.S. Dollar for most of the last two decades except during July 2005 to mid 2008. A fixed exchange rate such as this is also called a pegged exchange rate. Additionally, we examine the implication of this hard pegging both in short term and long term for China. Pegging a currency has both advantages and disadvantages for the country doing the pegging. Pegging a currency can be a method to control inflation if the currency being pegged to has a low inflation rate. Also pegging promotes stability for a developing country assuming that pegged currency is stable. If these advantages hold true then one of the largest disadvantage is that it prevents a country from using their own domestic monetary policy. A country can maintain a Fixed Exchange Rate or Peg by two methods. The first is to buy or sell currency on the open market so that the pegged value is maintained on the open market. The second is for the government to control the currency exchange and make it illegal to trade currency at any otherrate. China operates it peg by controlling the currency exchange and keeps pressure from black market or secondary trading by buying and selling currencies on the open exchange Chinas peg-to-Dollar became a positive stabilizing force and helped it in not getting affected by the Asian Currency Crisis in 1998. However, if the pegged currency suffers inflation and expansionary monetary policy then the peg becomes a disadvantage. This was the case for the collapse of the Bretton Woods System. After World War II the major world currencies were pegged to the U.S. Dollar and the

FREE FLOATATION OF THE CHINESE YUAN

Dollar was pegged to the price of gold at $35/ounce. Runaway spending for the Great Society Programs and the Vietnam War created expansionary monetary policy and rising inflation created an overvalued Dollar to the price of gold. President Nixon collapsed the Bretton Woods system in 1971. A free float of currencies evolved out of this system with the major world currencies. Another issue with pegging is there are no adjustments to the balance of trade, which leads to current account surpluses for China and large current account deficits for the U.S. This creates political tensions between both countries. In July 2005, before China adopted a managed float of the Yuan, the U.S. Congress was vocal about pressing a 27.5 percent punitive tariff across-the-board on all Chinese imports.This political pressure and the ever expanding Chinese economy allowed the Peoples Bank of China to initiate a managed float from 8.28 Yuan/Dollar which was instantly changed to 8.1 Yuan/Dollar and reached a high of 6.7899 Yuan/Dollar a 21.95 percent appreciation in 2008. It was political pressure and trade tensions between the U.S. along with market pressure that initiated the changes to Chinese currency policy. During the Financial Crisis of 2008, China reinitiated the direct peg to the U.S. Dollar starting in May of 2008 (6). This occurred mainly because China saw a 25.7 % drop in exports and 23 million unemployed migrant workers. China depreciated the currency only about 3% during the Financial Crisis from the highs in 2008 and the current price stands at 6.82698 Yuan/Dollar, which is only a 17.5 percent appreciation from the 2005 peg. The switch back to the full peg to the U.S. CHINESE YUAN RENMINBI Dollar was to weather the storm from the financial market meltdown in the U.S. and around the world. Now China is dealing with a double edge sword of the U.S. Dollar peg. As the U.S. Dollar depreciates, as it is at record lows with world currencies, the price of everything China buys increases. This is driving inflation throughout China which is becoming difficult to control. To make an analogy from Bretton Woods, an expansionary monetary policy in the U.S. as we currently see with this administration and any inflation, which could be coming soon, may require the Chinese to freely float the Yuan and permanently remove the Dollar peg. The question remains is the Yuan undervalued? This paper goes into further details on our analysis and valuation of the Chinese Yuan. The 2005 2008 managed float showed that the market is willing to appreciate the Yuan. This 22% appreciation in less than 3 years provides empirical evidence that the market expects the Yuan to appreciate. Consistent with the casual observations, our empirical results suggest that the Chinese Yuan is undervalued during the period of January 1999~October 2009 to the extent that the Chinese Yuan can be predicted by the change of four currency values, including Australian Dollar, Euro, U.K. Pound, U.S. Dollar.

From 1994 until July 2005, China maintained a policy of pegging its currency, the renminbi (RMB) or yuan, to the U.S. dollar at an exchange rate of roughly 8.28 yuan
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FREE FLOATATION OF THE CHINESE YUAN

to the dollar. TheChinese central bank maintained this peg by buying (or selling) as many dollar-denominated assets in exchange for newly printed yuan as needed to eliminate excess demand (supply) for the yuan. As a result, the exchange rate between the yuan and the dollar basically stayed the same, despite changing economic factors which could have otherwise caused the yuan to either appreciate or depreciate relative to the dollar. Under a floating exchange rate system, the relative demand for the two countries goods and assets would determine the exchange rate of the yuan the dollar. Many economists contend that for the first several years of the peg, the fixed value was likely close to the market value. But in the past few years, economic conditions have changed such that the yuan would likely have appreciated if it had been floating. The sharp increase in Chinas foreign exchange reserves (which grew from $403 billion in 2003 to $2.27 trillion as of September 2009) and Chinas large trade surplus with the world ($297 billion in 2008) are often viewed by critics of Chinas currency policy as proof that the yuan is significantly undervalued.

FREE FLOATATION OF THE CHINESE YUAN

HISTORY
RENBINBIS BEGINNING: The Chinese Communist first issued Partys Peoples Bank of China the Renminbi on December 1, 1948. At that time, the CCP was deep into the civil war with the Chinese Nationalist Party, which had its own currency, and the first issuance of the Renminbi was used to stabilize Communist held areas, which assisted in a CCP victory. After the defeat of the Nationalists in 1949, China's new government addressed the extreme inflation that plagued the old regime by streamlining its financial system and centralizing foreign exchange management. SECOND ISSUE: In 1955, the People's Bank of China, now China's central bank, issued it's second series of the Renminbi that replaced the first at a rate of one new RMB to 10,000 old RMB, which has remained unchanged since. A third series of RMB was issued in 1962, which used multi-color printing technology and used hand-engraved printing plates for the first time. In this period, the RMB's exchange value was unrealistically set with many western currencies, which created a large underground market for foreign exchange transactions. With China's economic reforms in the 1980s, the RMB was devalued and became more easily traded, creating a more realistic exchange rate. In 1987, a fourth series of RMB was issued featuring a watermark, magnetic ink and fluorescent ink. In 1999, a fifth series of RMB was issued, featuring Mao Zedong on all notes. UN-PEGGINF THE RENMINBI: From 1997 to 2005, the Chinese government pegged the RMB to the United States currency at about 8.3 RMB per dollar, despite criticisms from the United States. On July 21, 2005, the People's Bank of China announced that it would lift the peg to the dollar and phase in a flexible mechanism of exchange rates. Following the announcement the RMB was reevaluated to 8.1 RMB per dollar.

FREE FLOATATION OF THE CHINESE YUAN

FLOATING EXCHANGE RATE: MEANING

A floating exchange rate or fluctuating exchange rate is a type of exchange rate regime wherein a currency's value is allowed to fluctuate according to the foreign exchange market. A currency that uses a floating exchange rate is known as a floating currency. It is not possible for a developing country to maintain the stability in the rate of exchange for its currency in the exchange market. In most circumstances, floating exchange rates are preferable to fixed exchange rates. As floating exchange rates automatically adjust, they enable a country to dampen the impact of shocks and foreign business cycles, and to pre-empt the possibility of having a balance of payments crisis. However, in certain situations, fixed exchange rates may be preferable for their greater stability and certainty. This may not necessarily be true, considering the results of countries that attempt to keep the prices of their currency "strong" or "high" relative to others, such as the UK or the Southeast Asia countries before the Asian currency crisis. In cases of extreme appreciation or depreciation, a central bank will normally intervene to stabilize the currency. Thus, the exchange rate regimes of floating currencies may more technically be known as a managed float. A central bank might, for instance, allow a currency price to float freely between an upper and lower bound, a price "ceiling" and "floor". Management by the central bank may take the form of buying or selling large lots in order to provide price support or resistance, or, in the case of some national currencies, there may be legal penalties for trading outside these bounds.

FREE FLOATATION OF THE CHINESE YUAN

DIFFERENCE BETWEEN FLOATING AND FIXED EXCHANGE RATE

DETERMINED BY: A fixed, or pegged, rate is a rate the government (central bank) sets and maintains as the official exchange rate. A set price will be determined against a major world currency (usually the U.S. dollar, but also other major currencies such as the euro, the yen or a basket of currencies). A floating exchange rate is determined by the private market through supply and demand. A floating rate is often termed "self-correcting", as any differences in supply and demand will automatically be corrected in the market. HOW IT WORKS: The rate in a fixed exchange rate system is given by the government of the country itself considering various economic issues. The rate in a floating rate system is derived by the market forces of demand and supply. If demand for a currency is low, its value will decrease, thus making imported goods more expensive and stimulating demand for local goods and services. This in turn will generate more jobs, causing an autocorrection in the market. A floating exchange rate is constantly changing. NEED TO MAINTAIN FOREGN RESERVES: In order to maintain the rate, the central bank must keep a high level of foreign reserves. This is a reserved amount of foreign currency held by the central bank that it can use to release (or absorb) extra funds into (or out of) the market. This ensures an appropriate money supply, appropriate fluctuations in the market (inflation/deflation), and ultimately, the exchange rate. There is no such need of maintaining high level of foreign reserves as the imbalances are adjusted automatically.

SPECULATIVE TEDENCIES : The chances of speculation in order to make profits are quite less when a fixed exchange rate is followed. There are high chances of speculation in the rates in order to make personal profits.

FREE FLOATATION OF THE CHINESE YUAN

CHINESE EXCHANGE RATE

From 1994 until July 2005, China maintained a policy of pegging its currency, the renminbi (RMB) or yuan, to the U.S. dollar at an exchange rate of roughly 8.28 yuan to the dollar.1 The Chinese central bank maintained this peg by buying (or selling) as many dollar-denominated assets in exchange for newly printed yuan as needed to eliminate excess demand (supply) for the yuan. As a result, the exchange rate between the yuan and the dollar basically stayed the same, despite changing economic factors which could have otherwise caused the yuan to either appreciate or depreciate relative to the dollar. Under a floating exchange rate system, the relative demand for the two countries goods and assets would determine the exchange rate of the yuan to the dollar. Many economists contend that for the first several years of the peg, the fixed value was likely close to the market value. During the 1997-98 Asian crisis also when several other nations sharply devalued their currencies, China held the line by not devaluing its currency, which might have prompted a new round of destructive devaluations across Asia. This policy was highly praised at the time by U.S. officials, including President Clinton.

The Chinese government modified its currency policy on July 21, 2005. It announced that the yuans exchange rate would become adjustable, based on market supply and demand with reference to exchange rate movements of currencies in a basket (it was later announced that the composition of the basket would include the dollar, the yen, the euro, and a few other currencies) and that the exchange rate of the U.S. dollar against the RMB was adjusted from 8.28 to 8.11, an appreciation of 2.1%. Unlike a true floating exchange rate, the RMB would be allowed to fluctuate by up to 0.3% (later changed to 0.5%) on a daily basis against the basket.

After July 2005, China allowed the RMB to appreciate steadily, but very slowly.After July 2005, China allowed the RMB to appreciate steadily, but very slowly.From July 21, 2005 to July 21, 2009, the dollar-RMB exchange rate went from 8.11 to 6.83, an appreciation of 18.7%.The RMB depreciated against the dollar slightly in July-August 2008 and in December 2008, but has generally averaged 6.83 yuan per dollar through December 1, 2009. However, because Chinas currency is largely tied to the dollar, and since the dollar has depreciated against a number of major currencies in recent months, Chinas currency has depreciated against many (floating) currencies as well, such as

FREE FLOATATION OF THE CHINESE YUAN

the euro. On 20th of june china made an announcement that that it will end a two-year de facto currency peg to the U.S. dollar ,later the next day the bank backtracked, saying any adjustment in the currencys value would be small. The yuan still exits at somewhat 6.786 yuan per dollar.

Here is a chart showing average rate of yuans to 1 dollar this year i.e. 2010:

FREE FLOATATION OF THE CHINESE YUAN

ALLEGATIONS

AGAINST CHINA

China is alleged to devalue its curreny i.e. undervalue its currency than it would be in totally freely floting conditions(estimates range from 15% to 40% or higher).Many economists contend that for the first several years of the peg, the fixed value was likely close to the market value. But in the past few years, economic conditions have changed such that the yuan would likely have appreciated if it had been floating. The sharp increase in Chinas foreign exchange reserves (which grew from $403 billion in 2003 to $2.27 trillion as of September 2009) and Chinas large trade surplus with the world ($297 billion in 2008) are often viewed by critics of Chinas currency policy as proof that the yuan is significantly undervalued. The Chinese government modified its currency policy on July 21, 2005. It announced that the yuans exchange rate would become adjustable, based on market supply and demand with reference to exchange rate movements of currencies in a basketUnlike a true floating exchange rate, the RMB would be allowed to fluctuate by up to 0.3% (later changed to 0.5%) on a daily basis against the basket. Here is a chart showing the exchange rate of china to $ which shows how it was kept stable:

FREE FLOATATION OF THE CHINESE YUAN

Just before the meeting of the heads of state of the G20 countries in Toronto, Canada in June 2010, authorities in China announced that they would impart greater flexibility to their exchange rate management. This announcement caught the attention of policy makers worldwide. Evidently, in the run up to the G20 meeting in Toronto, Canada, there was significant international pressure building on China to review its exchange rate stance as many believed that Chinas exchange rate policy was one of the factors that were holding back global growth from gaining momentum .By announcing its decision to make Yuan exchange rate more flexible just days before the G20 summit, China was able to deflect some of the criticism it was facing.

Some charge that Chinas policy of accumulating foreign reserves (especially U.S. dollars) to influence the value of its currency constitutes a form of currency manipulation intended to make its exports cheaper and imports into China more expensive than they would be under free market conditions. They further contend that this policy has caused a surge in the
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U.S. trade deficit with China in recent years(which was $266 billion in 2008) and has been a major factor in the loss of U.S. manufacturing jobs. Although China made modest reforms to its currency policy in 2005, resulting in a gradual appreciation of its currency (about 19% through December 1, 2009), some Members contend the reforms have not gone far enough and have warned of potential punitive legislative action.

Many believed that Chinas exchange rate policy was one of the factors that were holding back global growth from gaining momentum.

what the Chinese government is doing here is engaging in massive capital export artificially creating a huge deficit in Chinas capital account. Its able to do this in part because capital controls inhibit offsetting private capital inflows; but the key point is that China has a de facto policy of forcing capital flows out of the country.By creating an artificial capital account deficit, China is, as a matter of arithmetic necessity, creating an artificial current account surplus. And by doing that, it is exporting savings to the rest of the world.

China is believed to hold more than $1 trillion in U.S. securities. A major concern for Chinese officials as it has gradually appreciated the currency (until recently) has been the decline in value of these assets brought about by that appreciation. Thus, halting the appreciation of the RMB halts further losses from U.S.-held assets.

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FREE FLOATATION OF THE CHINESE YUAN

CHINAS CONCERN OVER MODIFYING ITS CURRENCY POLICY

Chinese officials argue that its currency policy is not meant to favor exports over imports, but instead to foster economic stability through currency stability, as many other countries do. They have expressed concern that floating its currency could spark an economic crisis in China and would especially be damaging to its export industries at a time when painful economic reforms (such as closing down inefficient state-owned enterprises) are being implemented. They further contend that the Chinese banking system is too underdeveloped and burdened with heavy debt to be able to deal effectively with possible speculative pressures that could occur with a fully convertible currency. The global financial crisis has had a significant impact on Chinas trade and foreign direct investment (FDI) flows. From January to September 2008, China enjoyed nearly double-digit growth in monthly exports and FDI on a year-onyear basis. However, Chinas exports and imports dropped for 11 consecutive months from November 2008 to October 2009, and FDI declined 9 consecutive months from October 2008 to July 2009. From January-October 2009, Chinas total exports, imports, and FDI were down by 20.5%, 19.9%, and 12.6%, respectively, over the same period in 2008. Thousands of exportoriented factories reportedly were shut down and, according to the Chinese government, over 20 million migrant workers lost their jobs because of the global economic slowdown. Chinese officials view economic stability as critical to sustaining political stability; they fear an appreciated currency could cause even more employment disruptions and thus could cause worker unrest. However, Chinese officials have indicated that their long-term goal is to adopt a more flexible exchange rate system and to seek more balanced economic growth through increased domestic consumption and the development of rural areas, but they claim they want to proceed at a gradual pace. During the China-EU summit held in November 2009, Chinese Premier Wen Jiabao stated that a stable yuan was beneficial to a global economic recovery. He said that China will further improve the yuan exchange rate formation mechanism, acting on its own initiative and in a controllable and gradual manner, and keep the yuan exchange rates basically stable at a reasonable and balanced level."

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ECONOMIST VIEWS ON THE INTENT BEHIND CHINAS DECISION ON YUAN FLEXIBILITY

A conscious effort to invigorate domestic demand or a move to douse trade tensions Both domestic compulsions and external pressure were responsible for China to allow its currency to float within the intra-day trading band of +/- 0.5 percent. It is an occasion when global objectives coincided with Chinese objectives and this was the trigger for the announcement. Domestically, a stronger exchange rate would: 1)Help in transforming the growth structure from being export led to domestic consumption driven as imports would become cheaper 2)Help tackle the inflation situation, which is increasingly becoming a cause for concern Externally, by allowing its currency to be a little flexible, China has managed, albeit temporarily, to douse trade tensions with the US and EU as well.

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FREE FLOATATION OF THE CHINESE YUAN

CHINAS TAKE ON FREE FLOATATION

China has always tried to keep the exchange rate under control so as to fulfil its own selfish goals and it would not allow the exchange rate to free float. The current exchange rate system is benefitting china in the following ways:

EXPORTS AND FOREIGN DIRECT INVESTMENT: Keeping the exchange rate with the dollar stable may help to stem further declines in exports and FDI and thus halt further factory closings and layoffs in such sectors. CHINA AS A RESPONSIBLE STAKEHOLDER: Over the past several years, Chinese leaders have sought to portray China as a responsible stakeholder (and increasingly a leader) on global economic issues. Chinese officials contend that during the 1997-98 Asian crisis, when several other nations sharply devalued their currencies, China held the line by not devaluing its currency, which might have prompted a new round of destructive devaluations across Asia. This policy was highly praised at the time by U.S. officials, including President Clinton. Although devaluing the RMB against the dollar could help Chinas trade sector, it could cause other economies in the Asia to devalue their currencies, which could further undermine economic stability in the region and negatively affect Chinas relations with its neighbors.

AVOIDANCE OF TRADE TENSIONS: Chinese officials appear to be deeply concerned over growing protectionism in the United States and elsewhere. They are keenly aware that numerous congressional proposals have been introduced in the past which would take tough action against Chinas currency policy.

PROTECTING THE VALUE OF CHINAS INVESTMENT: China is believed to hold more than $1 trillion in U.S. securities. A major concern for Chinese officials as it has gradually appreciated the currency (until recently) has been the decline in value of these assets brought about by that

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appreciation. Thus, halting the appreciation of the RMB halts further losses from U.S.-held assets. So, china wont let free flotation happen as this might make RMB appreciate. China on the other hand has been alleged of undervaluing its own currency .If the RMB is undervalued vis--vis the dollar (estimates range from 15% to 40% or higher), then Chinese exports to the United States are likely cheaper than they would be if the currency were freely traded, providing a boost to Chinas export industries. Eliminating exchange rate risk through a managed peg also increases the attractiveness of China as a destination for foreign investment in exportoriented production facilities.Such a policy, in effect, benefits Chinese exporting firms (many of which are owned by foreign multinational corporations) at the expense of non-exporting Chinese firms, especially those that rely on imported goods. So if china makes any significant changes in its exchange rate system relating to free flotation it might loose on many benefits mentioned above, the only problem is the pressure by US and other countries to adopt complete free flotation.

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OPINION BY UNCTAD
According to United Nations Conference on Trade and Development (UNCTAD) the imbalances of the global economy cannot be resolved by a free floating Chinese currency, instead, the problem needs to be addressed by bold multilateral responses. UNCTAD said that the burden of rebalancing the global economy should not be put on a single country and its currency. It argued that "to leave currencies to the vagaries of the market" would not help solving the problem. Leaving currencies to irrational market forcers will not help rebalance the global economy, and a Chinese decision in this direction would risk an economic shock akin to the one Japan suffered in the 1990s, it said. That, in turn, could destabilize the entire world economy. The argument countered the advice of many economists, who said that China keeps its currency artificially low against the dollar to promote exports. This line of thought blames the currency control for the large and worrisome imbalances in the economic relationship between the US and China: Americans import and borrow too much, while the Chinese export and save too much. According to UNCTAD the imbalances in world trade and the global economy actually lie in systemic failures, which require comprehensive and inclusive multilateral action. As a response to the recent global crisis that originated elsewhere, China had done more than any other emerging economy to stimulate domestic demand, and as a result its import volume had expanded significantly. For China -- where private consumption was rising at breakneck speed and labor costs were surging -- dropping the yuan's peg to the dollar meant an accelerated loss of competitiveness with dangerous consequences for the world. This is unfair because China has done more than any other emerging economy to stimulate domestic demand,said UNCTAD. It noted that both absolutely fixed/pegged and fully flexible/floating exchange rate systems were "suboptimal". Experiences show that these "corner solutions" have added to volatility and uncertainty and aggravated the global imbalances. UNCTAD had said focusing on China's fixed rate ignores the larger problems that are hampering economic growth.

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U.S. CONCERNS OVER CHINAS CURRENCY POLICY

INTRODUCTION
The Chinese government modified its currency policy on July 21, 2005. It announced that the Yuans exchange rate would become adjustable, based on market supply and demand with reference to exchange rate movements of currencies in a basket (it was later announced that the composition of the basket would include the dollar, the yen, the euro, and a few other currencies) and that the exchange rate of the U.S. dollar against the RMB was adjusted from 8.28 to 8.11, an appreciation of 2.1%. Unlike a true floating exchange rate, the RMB would be allowed to fluctuate by up to 0.3% (later changed to 0.5%) on a daily basis against the basket. After July 2005, China allowed the RMB to appreciate steadily, but very slowly. It has continued to accumulate foreign reserves at a rapid pace, which suggests that if the RMB were allowed to freely float it would appreciate much more rapidly. The current situation might be best described as a managed floatmarket forces are determining the general direction of the RMBs movement, but the government is retarding its rate of appreciation through market intervention. From July 21, 2005 to July 21, 2009, the dollar-RMB exchange rate went from 8.11 to 6.83, an appreciation of 18.7%. The effects of the RMBs appreciation on U.S.China trade flows are unclear. The price index for U.S. imports from China in 2008, rose by 3.0% (compared to a 0.9% rise in import prices for total U.S. imports of non-petroleum products). In 2008, U.S. imports from China rose by 5.1% over the previous year, compared to import growth of 11.7% in 2007; however, U.S. exports over this period were up 9.5% compared with an 18.1% rise in 2007. The current global economic slowdown has led to a sharp reduction in bilateral trade. During the first nine months of 2009, U.S. exports to, and imports from, China were down by 14% and 15%, respectively. China appears to have halted its currency appreciation policy around mid-July 2008 (see Figure 1). The RMB depreciated against the dollar slightly in JulyAugust 2008 and in December 2008, but has generally averaged 6.83 Yuan per dollar through December 1, 2009. However, because Chinas currency is largely tied to the dollar, and since the dollar has depreciated against a number of major currencies in recent months, Chinas currency has depreciated against many (floating) currencies as well, such as the euro.3
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According to the Bank of International Settlements, Chinas real (inflation adjusted) trade-weighted exchange rate (based on its trade with economies) appreciated by 18.0% from January 2008 to February 2009, but from February 2009 to October 2009 it depreciated by 9.5%.

Figure 2. Change in Chinas Real Trade Weighted Exchange Rate: January 2008-

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FREE FLOATATION OF THE CHINESE YUAN October 2009- Index Based on Average Annual 2005 Data (2005=100)
130 125 120 115 110 105 100 95
2008-01 2008-03 2008-05 2008-07 2008-09 2008-11 2009-01 2009-03 2009-05 2009-072009-09

Notes: Weights calculated based on Chinas trade with 57 economies. Inflation calculated using measurements of national consumer price indexes.

IMPLICATIONS ON THE U.S. ECONOMY

EFFECT ON EXPOTERS AND IMPOTERS- COMPETITORS:

When a foreign reserve accumulation causes the yuan to be less expensive than it would be if market forces determined it, it causes Chinese exports to the United States to be relatively inexpensive and U.S. exports to China to be relatively expensive. As a result, U.S. exports and the production of U.S. goods and services that compete with Chinese imports fall, in the short run.
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Many of the affected firms are in the manufacturing sector, as will be discussed below. This cause the U.S. trade deficit to rise and reduces aggregate demand in the short run, all else equal. China has become the United Statess second largest supplier of imports (2006 data). A large share of Chinas exports to the United States are laborintensive consumer goods, such as toys and games, textiles and apparel, shoes, and consumer electronics. Many of these products do not compete directly with U.S. domestic producers the manufacture of many such products shifted overseas several years ago. However, there are a number of U.S. industries (many of which are small and medium-sized firms), including makers of machine tools, hardware, plastics, furniture, and tool and die that are expressing concern over the growing competitive challenge posed by China.55 An undervalued Chinese currency may contribute to a reduction in the output of such industries. On the other hand, U.S. producers also import capital equipment and inputs to final products from China. For example, U.S. computer firms use a significant level of imported computer parts in their production, and China was the largest foreign supplier of computer equipment to the United States in 2006. An undervalued yuan lowers the price of these U.S. products, increasing their output and competitiveness in world markets. And many imports from China are produced by U.S.-invested enterprises (as discussed above), which benefit from an undervalued exchange rate.

EFFECT ON U.S. BORROWERS:

An undervalued Yuan also has an effect on U.S. borrowers. When the United States runs a current account deficit with China, an equivalent amount of capital flows from China to the United States, as can be seen in the U.S. balance of payments accounts. This occurs because the Chinese central bank or private Chinese citizens are investing in U.S. assets, which allows more U.S. capital investment in plant and equipment to take place than would otherwise occur. Capital investment increases because the greater demand for U.S. assets puts downward pressure on U.S. interest rates, and firms are now willing to make investments that were previously unprofitable. This increases aggregate spending in the short run, all else equal, and also increases the size of the economy in the long run by increasing the capital stock. Private firms are not the only beneficiaries of the lower interest rates caused by the capital inflow (trade deficit) from China. Interest-sensitive household spending, on goods such as consumer durables and housing, is also higher than it would be if capital from China did not flow into the United States. In addition, a large proportion of the U.S. assets bought by the Chinese,

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particularly by the central bank, are U.S. Treasury securities, which fund U.S. federal budget deficits. According to the U.S. Treasury Department, China held $397 billion in U.S. Treasury securities (as of September 2007), making it the second largest foreign holder of such securities (after Japan). If the U.S.trade deficit with China were eliminated, Chinese capital would no longer flow into this country on net, and the U.S. government would have to find other buyers of its U.S. Treasuries at higher interest rates. This would increase the governments interest payments, increasing the budget deficit, all else equal.

EFFECT ON U.S. CONSUMERS: A societys economic well-being is usually measured not by how much it can produce, but how much it can consume. An undervalued Yuan that lowers the price of imports from China allows the United States to increase its consumption of both imported and domestically produced goods through an improvement in the terms-of-trade. The terms-of-trade measures the terms on which U.S. labor and capital can be exchanged for foreign labor and capital. Since changes in aggregate spending are only temporary, from a long-term perspective the lasting effect of an undervalued Yuan is to increase the purchasing power of U.S. consumers.

U.S.-CHINA TRADE AND MANUFACTURING JOBS: Critics of Chinas currency policy argue that the low value of the Yuan has had a significant effect on the U.S. manufacturing sector, where 2.7 million factory jobs have been lost since July 2000. While job losses in the U.S. manufacturing sector have been significant in recent years, there is no clear link between job losses and imports from China. First, only some manufacturers export to China or compete with Chinese imports. Second, the economic recession and subsequent jobless recovery that ended in August 2003 reduced employment across the entire economy. Since then, manufacturing output has reached an all-time high; manufacturing employment has fallen over this time because of productivity growth, not a decline in output. Third, the growing trade deficit has not been limited to China; the overall trade deficit is still increasing. Finally, there is a long-run trend that is moving U.S. production away from manufacturing and toward the service sector.58 U.S. employment in manufacturing as a share of total nonagricultural employment has fallen from 31.8% in 1960 to 22.4% in 1980, to 10.7% in 2005, to 10.5% in 2006.59 This trend is much larger than the Chinese currency issue, and is caused by changing technology (which requires fewer workers to produce the same
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number of goods) and comparative advantage. With enhanced globalization, comparative advantage predicts the United States will produce knowledgeand technology-intensive goods that it is best at producing for trade with countries, such as China, who are better at producing labor-intensive goods. Since the production of some manufactured goods is labor-intensive and some services cannot be traded, trade leads to more manufacturing abroad, and less in the United States. Over time, it is likely that the trend shifting manufacturing abroad will continue regardless of Chinas currency policy. The decline in manufacturing employment is not unique to the United States. According to a study by Alliance Capital Management, employment in manufacturing among the worlds 20 largest economies declined by 22 million jobs between 1995 and 2002. At the same time, the study estimated that total manufacturing production among these economies increased by more than 30% (due largely to increases in productivity). As indicated in Table 1, while the number of manufacturing jobs in the United States declined by 1.9 million (or 11.3%) during this period, they declined in many other industrial countries as well, including Japan (2.3 million or 16.1%), Germany (476,000 or 10.1%), the United Kingdom (446,000 or 10.3%), and South Korea (555,000 or 11.6%). The study further estimated employment in manufacturing in China during this period declined by 15 million workers (from 96 million workers in 1995 to 83 million in 2002), a 15.3% reduction. In the United States and United Kingdom, the employment decline began in 1999; in the other countries in Table 6, the decline began earlier. In 2004, the industrialized countries experienced a loss of 865,000 more manufacturing jobs, and a cumulative 6.3 million manufacturing job losses over the previous five years.

Table 1. Manufacturing Employment in Selected Countries: 1995 and 2002 (In thousands and percent change)

Manufacturing Employment

Change in Manufacturing

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(Thousands)

Employment: 1995/2002

Total Change 1995 2002 (Thousand s)

Percent Change

United States

17,251

15,304

-1,947

-11.3

Japan

14,570

12,230

-2,340

-16.1

Germany

8,439

7,963

-476

-10.1

United Kingdom

4,402

3,956

-446

-10.3

South Korea

4,796

4,241

-555

-11.6

China

98,030

83,080

-14,950

-15.3

The sharp increases in U.S. imports of manufactured products from China over the past several years do not necessarily correlate with subsequent production and job losses in the manufacturing sector. Alan Greenspan, former Chairman of the Federal Reserve, testified in 2005 that I am aware of no credible evidence that ... a marked increase in the exchange value of the Chinese renminbi relative to the dollar would significantly increase manufacturing activity and jobs in the United States.63 A study by the Federal Reserve Bank of Chicago estimated that import penetration by

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Chinese manufactured products (i.e., the ratio of imported manufactured Chinese goods to total manufactured goods consumed domestically) was only 2.7% in 2001.64 The study acknowledged that, while China on average is a small-to-moderate player in most manufacturing sector markets in the United States, it has shown a high growth in import penetration over the past few years, growing by nearly 60% between 1997-2001 (from 1.7% to 2.7%). However, the study concluded that the bulk of the current U.S. manufacturing weakness cannot be attributed to rising imports and outsourcing, but rather is largely the result of the economic slowdown in the United States and among several major U.S. export markets. NET EFFECT ON U.S. ECONOMY: In the medium run, an undervalued yuan neither increases nor decreases aggregate demand in the United States. Rather, it leads to a compositional shift in U.S. production, away from U.S. exporters and import-competing firms toward the firms that benefit from the lower interest rates caused by Chinese capital inflows. In particular, capital-intensive firms and firms that produce consumer durables would be expected to benefit from lower interest rates. Thus, it is expected to have no medium- or long-run effect on aggregate U.S. employment or unemployment. As evidence, one can consider that while the trade deficit with China (and overall) has widened, the overall unemployment rate has fallen from 6.3% in 2003 to 4.5% in February 2007. However, the gains and losses in employment and production caused by the trade deficit will not be dispersed evenly across regions and sectors of the economy: on balance, some areas will gain while others will lose.

Although the compositional shift in output has no negative effect on aggregate U.S. output and employment in the long run, there may be adverse short-run consequences. If output in the trade sector falls more quickly than the output of U.S. recipients of Chinese capital rises, aggregate spending and employment could temporarily fall. If this occurs, then there is likely to be a decline in the inflation rate as well (which could be beneficial or harmful, depending if inflation is high or low at the time). A fall in aggregate spending is more likely to be a concern if the economy is already sluggish than if it is at full employment. Otherwise, it is likely that government macroeconomic policy adjustment and market forces can quickly compensate for any decline of output in the trade sector by expanding other elements of aggregate demand. By shifting the composition of U.S. output to a higher capital base, the size of the economy would be larger in the long run as a result of the capital inflow/trade deficit. U.S. citizens would not enjoy the returns to Chineseowned capital in the United States. U.S. workers employing that Chineseowned capital would enjoy higher productivity, however, and correspondingly

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higher wages.

THE U.S.-CHINA TRADE DEFICIT IN THE CONTEXT OF THE OVERALL U.S. TRADE DEFICIT: While China is a large trading partner, it accounted for only about 15.5% of U.S. imports in 2006 and 26.0% of the sum of the bilateral trade deficits. Over a span of several years, a country with a floating exchange rate can run an ongoing overall trade deficit for only one reason: a domestic imbalance between saving and investment. This has been the case for the United States over the past two decades, where saving as a share of gross domestic product (GDP) has been in gradual decline. On the one hand, the United States has high rates of productivity growth and strong economic fundamentals that are conducive to high rates of capital investment. On the other hand, it has a chronically low household saving rate, and recently an ergative government saving rate as a result of the budget deficit. As long as Americans save little, foreigners will use their saving to finance profitable investment opportunities in the United States; the trade deficit is the result. The returns to foreign-owned capital will flow to foreigners instead of Americans, but the returns to U.S. labor utilizing foreign-owned capital will flow to U.S. labor. Chinas situation is very different. As Table 2 shows (based on 2006 data), Chinas gross national saving as a percent of GDP (51.3%) is nearly five times greater than the U.S. level (13.5%). Conversely, the rate of private consumption as a percent of GDP is significantly higher in the United States (70%) than it is in China (36.8%). China maintains a higher rate of gross fixed investment as a percent of GDP than does the United States (42.8% versus 20.0%). Finally, Chinas gross national saving, as a percent of its gross national investment is equal to 118% versus 68% in the United States. Thus, the United States must borrow from abroad to fund its investment needs while China has excess saving that it can invest overseas. The net result of these differences can be seen in the data on current account balances as a percent of GDP: 9.0% for China compared with -6.2% for the United States. These data imply that both China and the United States would need to make fundamental changes to their saving/investment patterns to reduce the overall U.S. trade deficit and Chinas overall trade surplus in the long run.

Table 2. Comparisons of Savings, Investment, and Consumption as a Percent of GDP Between

the United States and China, 2006

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China Gross savings as a % of GDP Private consumption as a % of GDP Gross fixed investment as a % of GDP Gross national savings as a % of gross National investment Current account balance as a % of GDP 9.0 51.3 36.8 42.8 117.8

United States 13.5 70.0 20.0 67.5

-6.2

SUMMARY
Some Members of Congress charge that Chinas policy of accumulating
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foreign reserves (especially U.S. dollars) to influence the value of its currency constitutes a form of currency manipulation intended to make its exports cheaper and imports into China more expensive than they would be under free market conditions. They further contend that this policy has caused a surge in the U.S. trade deficit with China in recent years and has been a major factor in the loss of U.S. manufacturing jobs. Although China made modest reforms to its currency policy in 2005, resulting in a gradual appreciation of its currency (about 19% through December 1, 2009), some Members contend the reforms have not gone far enough and have warned of potential punitive legislative action. Although an undervalued Chinese currency has likely hurt some sectors of the U.S. economy, it has benefited others. For example, U.S. consumers have gained from the supply of low-cost Chinese goods (which helps to control inflation), as have U.S. firms using Chinese- made parts and materials (which helps such firms become more globally competitive). In addition, China has used its abundant foreign exchange reserves to buy U.S. securities, including U.S. Treasury securities, which are used to help fund the Federal budget deficit. Such purchases help keep U.S. interest rates relatively low. For China, an undervalued currency has boosted exports and attracted foreign investment, but has led to unbalanced economic growth and suppressed Chinese living standards. The current global economic crisis has further complicated the currency issue for both China and the United States. China halted its gradual appreciation of its currency beginning around July 2008; since then it has kept the exchange rate of the renminbi (RMB) or yuan (the base unit of the RMB) to the dollar constant at about 6.83 yuan per dollar. Because Chinas currency is largely tied to the dollar, and since the dollar has depreciated against a number of major currencies in recent months, Chinas real (inflation adjusted) tradeweighted exchange rate has depreciated (by 9.5% between February 2009 to October 2009). Some analysts contend that this has induced other countries (especially in Asia) to intervene in currency markets (i.e., to depreciate against the dollar) to help their exporters remain competitive with Chinese exporters. Additionally, the U.S. federal budget deficit has increased rapidly since FY2008, causing a sharp increase in the amount of Treasury securities that must be sold. While the Obama Administration has pushed China to appreciate its currency, it has also encouraged China to continue to purchase U.S. securities. Legislation has been introduced in the 111th Congress to address Chinas currency policy. Chinas currency policy appears to have created a policy dilemma for the Chinese government. A strong and stable U.S. economy is in Chinas national interest since the United States is Chinas largest export market. Thus, some analysts contend that China will feel compelled to keep funding the growing U.S. debt. However, Chinese officials have expressed concern that the growing U.S. debt will eventually spark inflation in the United States and a further depreciation of the dollar, which would negatively impact the value of Chinas holdings of U.S. securities. But if China stopped buying U.S. debt or
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FREE FLOATATION OF THE CHINESE YUAN

tried to sell off a large portion of those holdings, it could also cause the dollar to depreciate and thus reduce the value of its remaining holdings, and such a move could further destabilize the U.S. economy. Chinese concerns over its large dollar holdings appear to have been reflected in a paper issued by the governor of the People's Bank of China, Zhou Xiaochuan, in March 2009, which called for replacing the U.S. dollar as the international reserve currency with a new global system controlled by the International Monetary Fund. China has also signed currency swap agreements with six of its trading partners, which would allow those partners to settle accounts with China using RMB rather than dollars. However, China will not likely be able to move away from its dependency on U.S. dollar assets until it is willing to make the RMB a tradable currency.

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CHINA YUAN DEVALAUATION: A DELICATE DANCE [Article]

By Kathleen E. McLaughlin - GlobalPost Published: June 21, 2010 10:52 ET in Asia

BEIJING Chinas announcement late Saturday night that it will end a twoyear de facto currency peg to the U.S. dollar should surprise exactly no one, but its implications seem to be confounding even the experts. In Beijing, economists are divided over how much the value of the currency will grow, or in some cases, if the yuan renminbi (RMB) will rise in value at all. Around the rest of the country, manufacturers are wringing their hands over whether their costs will rise and by how much, and especially how much they stand to lose on orders especially the deals already made in U.S. dollars. In other words, even though it was bound to happen at some point, it seems nobody was quite prepared for the somewhat vague announcement made by the Peoples Bank of China. The bank, it said, has decided to proceed further with reform of the RMB exchange rate regime and to enhance the RMB exchange rate flexibility.

The statement marks the end of a 23-month period during which China tied its currency to the U.S. dollar, it said, to help stabilize the economy through the global financial crisis. The stability of the RMB exchange rate has played an important role in mitigating the crisis impact, contributing significantly to Asian and global recovery, and demonstrating China's efforts in promoting global rebalancing, the bank said. On Monday, the value of the yuan rose to its highest ever, but that only meant a .4 percent gain. Even U.S. Treasury Secretary Timothy Geithner, who has been at the front of the Obama administrations push on China to revalue its currency, was guarded in his praise. This is an important step, but the test will be how far and how fast they let the currency appreciate, Geithner said in a statement from Washington.

Vigorous implementation would make a positive contribution to strong and balanced global growth. The U.S. argument has been that Chinas undervalued currency gives it an unfair competitive advantage in global trade, adding to Chinas political problematic trade surplus. China, of course, disagrees and says its currency policy is its own business. Just last week, Chinese leaders warned against brining up the currency issue at the latest meeting of the G-20 summit, scheduled for June 26-27 in Toronto. Now, economists in China are downplaying the impact of the central banks statement, with some even saying the currency untied from the U.S. dollar might decline in value rather than appreciate. Yuan Gangming, an economist with the Chinese Academy of Social Sciences, said that while hes a supporter of the rise of the yuan, he thinks the banks statement was intended simply to pacify the United States. Yuan said that Chinas economy is on shaky ground and the government wont make any sudden moves to undermine manufacturing. The currency wont change this year, Yuan predicted. Other economists werent so skeptical, but the fact remains that uncertainty is the rule right now when it comes to Chinas currency. Several export manufacturers said today that they expect costs to increase significantly as the value of the yuan declines. Thats added to potentially rising wages and other basic costs for factories in China. We still dont know what can be done, said Xiao Zhang, a trade specialist with a Xiamen-based company that makes toys for export. Do you have any suggestions?

 BIBLIOGRAPHY
WEBSITES:
1. www.google.com 2. www.investopedia.com 3. www.bing.com 4. www.usatoday.com 5. www.danwei.org 6. www.economist.com 7. www.seekingaplha.com 8. www.wikipedia.com 9. www.bnet.com 10. www.thepochtimes.com

NEWSPAPERS: 1. The Economica times 2. The Mint 3. The Hindustn times

BOOKS: 1. INTERNATIONAL FINANCIAL MANAGEMENT BY P.G.APTE .