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Revaluation of Chinese Yuan and Its Impact on US Economy Term Paper, ECO6226, Summer 2006

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

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Revaluation of Chinese Yuan and Its Impact on US Economy Term Paper, ECO6226, Summer 2006

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  1. Revaluation of Chinese Yuan and Its Impact on US Economy Term Paper, ECO6226, Summer 2006 Fan Zhang

  2. 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

  3. 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 assets by China. YS Value of Yuan YD Y

  4. 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))

  5. How much is Yuan undervalued? PPP indicators, 2000 (USA = 100, Source: Pakko and Pollard (2003)) Observation: It is not unusual for countries to have significant deviation from 100

  6. How much is Yuan undervalued? Trend in PPP indicators: Developing countries typically has undervalued currencies. (Source: Rogoff(1996))

  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) (data source: Rogoff(1996))

  8. 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.

  9. 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.

  10. 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.

  11. 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.

  12. 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

  13. Effect of a revaluated Yuan on US Economy Trade deficit with China

  14. 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?

  15. 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.”

  16. 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.

  17. 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, 647-668. • 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

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