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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