Implications of Yuan/dollar exchange rate for trade

Author:Amy Hilland
Position:Department of Agricultural Economics and Rural Sociology, University of Idaho, Moscow, Idaho, USA
SUMMARY

Purpose – Though an undervalued Yuan is not the only factor that contributes to the US bilateral trade deficit with China, it is widely accepted as being one of the leading factors. The heightened debate over the value of the Yuan may lead to “beggar thy neighbour” retaliation. The purpose of this paper is to provide a historical review of the Y/$ exchange rate movements, review the US... (see full summary)

 
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1 Introduction

The USA claims that the undervaluation of Yuan (Y) against the dollar ($) adversely impacts the competitiveness of US exports, and debate on what measures to take to correct this undervaluation problem has created considerable tension between China and the USA. This paper identifies the stances of each country's debate and views on what action is appropriate to adjust the value of Y/$ exchange rate. The objectives of this paper are to:

  • provide a historical review of the Y/$ exchange rate movements;
  • present estimates from various studies of the degree of the Yuan undervaluation against the dollar;
  • review the policy proposals including US congressional bills and Chinese Government's reactions and explain the complexity of the contentious debate of US and Chinese stances;
  • illustrate the effect of the undervalued Yuan on selected commodities;
  • present a conceptual analysis of the effect of the undervalued Yuan on trade between China, the USA, and the rest of the world;
  • discuss the arguments for and against revaluation of Yuan; and
  • present the case for the Yuan's value to be determined by market forces.
  • This paper is organized as follows. Section 2 reviews the history of the Y/$ value to provide background and the source of the current tension the value of the exchange rate has caused between the USA and China. Section 3 discusses various studies which quantify the extent of the Yuan devaluation against the dollar. Section 4 describes various legislative bills that were considered by the US Congress to tackle the Y/$ undervaluation. Section 5 shows the undervalued Yuan's effect on selected commodities. Section 6 section presents the conceptual analysis to illustrate in greater detail how Y/$ undervaluation affects world trade and shows the benefits and losses for various countries. Section 7 highlights the stances of China and the USA and the arguments for and against the Y/$ revaluation. Section 8 presents our justification for the Yuan to be determined by market forces and concluding remarks.

    2 Recent history of Yuan value

    Before 1994, China had a dual system for its currency, the renminbi (RMB) or more commonly known as the Yuan, which consisted of an official exchange rate and a market-based exchange rate ( Koo and Zhuang, 2007 ). For example, in 1993, the official exchange rate was 5.77 Y/$ and the market-based exchange rate was 8.7 Y/$ ( Labonte and Morrison, 2011 ). Not only were there two different types of exchange rates, but two different types of currencies as only Chinese citizens had access to the Yuan, and foreigners were only allowed to purchase foreign exchange certificates to use at certain locations such as tourist hotels. In 1994, China made two major changes to its currency: first, it unified the two types of exchange rates, and second, it pegged its currency at 8.7 Y/$ and foreigners were allowed to purchase the Chinese currency ( Browne, 2011 ). Between 1995 and 2005, the Yuan was pegged to the US dollar at 8.28 Y/$ ( Poleg, 2005 ). The USA considered the Yuan to be undervalued at this fixed rate ( Goujon and Guérineau, 2006 ), which allowed China to export more to and import less from the USA, creating a bilateral trade deficit that has been a major concern for the USA ( Labonte and Morrison, 2011 ). Therefore, several bills were considered by USA. Congress to revalue the Yuan. These bills aimed to take corrective measures, such as imposition of tariffs on Chinese goods to force China to adjust the value of the Yuan in line with market value. In fact, in 2003, a bill (S. 1586) called for a duty of 27.5 ad valorem in order to compensate for the low value of the Yuan which was estimated to be undervalued at 27.5 percent against the dollar ( S. 1586 – 108th Congress: a bill to authorize appropriate action if the negotiations with the People's Republic of China, 2003 ).

    In response to persistent US complaints, China, in 2005, ended its fixed exchange rate system and reformed its pegging based on a basket of currencies ( Poleg, 2005 ). The currencies covered in this basket of pegging are the US dollar, euro, Japanese yen, South Korean won, and a small component of the British pound, Thai baht, and Russian ruble. This managed float, also known as a dirty float, allows the Yuan to be determined by market forces within a certain band set by Chinese monetary authorities, but it is susceptible to misalignment because it is not completely determined by currency supply and demand ( Appiah-Danquah, 2011 ). This policy caused the Yuan to appreciate by 2.1 percent to 8.11 Y/$ ( Goujon and Guérineau, 2006 ). After this appreciation, the Yuan was allowed to fluctuate within a band of 0.3 percent under this managed-float currency regime ( Frankel and Wei, 2007 ). The slow appreciation of the Yuan reached 6.83 Y/$ by 2008, but it stalled due to the global financial crisis ( Labonte and Morrison, 2011 ). However, instead of revaluing the Yuan, China repegged the Yuan to the US dollar because of the financial crisis. Although the Yuan appreciation would resume in 2010, it still remains considerably undervalued ( USITC, 2011 ) and currently it is at 6.21 Y/$ in 2012 ( USDA, 2012 ).

    3 Degree of Yuan undervaluation

    There is a considerable controversy over the extent of Yuan undervaluation. Ferguson and Schularick (2011) , for the period of 1980-2008, estimated that Yuan was undervalued between 30 and 48 percent and would take an exchange rate adjustment of 30 to 50 percent to counter China's comparative advantage. For example, an undervalued Yuan interferes with US comparative advantage in exporting commodities such as soybeans. Reisen (2009) reported that the Yuan was undervalued by 12 percent in December 2009. In contrast, Rodrik (2010) provided an estimate of the Yuan undervaluation of 25 percent in December 2009 and that correcting for the undervaluation would reduce Chinese growth by 2.15 percent. Subramanian (2010) estimated a 30 percent undervaluation of Yuan in April 2010. In a series of studies, Cline and Williamson (2010b, a and 2011a, b) found a 40.2 percent undervaluation in January 2010, a 24.2 percent undervaluation in June 2010, a 28.5 percent undervaluation in May 2011, and a 23.5 percent undervaluation in November 2011. Goujon and Guérineau (2006) observed that 10-15 percent misalignment is more reasonable. Even though the methods and range of Yuan undervaluation varies in these studies, it is generally agreed that the Yuan is indeed undervalued. According to IMF (2011) and US Department of Treasury – Office of International Affairs (2011) , the Yuan is still extensively undervalued. The US Department of Treasury – Office of International Affairs (2011) , in their semi-annual report to Congress, concluded that the rate of appreciation of the Yuan is insufficient. The US Department of Treasury also states that, even though Yuan appreciated by 7.5 percent against the dollar since December 16, 2010, the appreciation of the Yuan is “incomplete”. The IMF (2011) also indicates that the Yuan continues to be undervalued. Consequently, the USA attempted to pass a series of bills to compel China to revalue the Y/$ exchange rate, which are discussed in detail in the next section.

    4 US congressional bills

    Over the past decade, the US Congress has extensively debated and considered several bills to address the value of Y/$ exchange rate. The China Currency Manipulation Act of 2008 (S. 2813) was introduced in the Senate of the 110th Congress ( S. 2813 – 110th Congress: China Currency Manipulation Act of 2008, 2008 ). This bill was to direct the Secretary of the Treasury to determine if the People's Republic of China is manipulating its currency. If the currency is found to be manipulated, the Secretary was to establish a plan of action to report to Congress, initiate negotiations to ensure that the currency is adjusted, eliminate unfair competitive advantages, and instruct the International Monetary Fund to compel China to take corrective measures. This bill was not passed because of lack of consensus within the Senate.

    The Currency Reform for Fair Trade Act 2009 (H.R. 2378 and S. 1027) was introduced by the US House of Representatives and the Senate to amend Title VII of the Tariff Act of 1930 ( S. 1027 – 111th Congress: Currency Reform for Fair Trade Act of 2009, 2009 ). This bill aimed at imposing countervailing duties to remedy implicit subsidies caused by the undervalued currencies. The bill describes that Department of Commerce would have the power to decide whether a currency is undervalued if a country is involved in large-scale intervention of one or more exchange rates, has a real effective exchange rate undervalued by 5 percent or more, has a current account surplus, and has excess foreign asset reserves. The US House of Representatives passed this bill, but the Senate did not pass this bill because of disagreements over the need for the Yuan revaluation.

    A bill titled, “The Currency Exchange Rate Oversight Reform Act of 2009 (S. 1254)” was introduced in the Senate during the 111th Congress to address the issue of misaligned currency ( S. 1254 – 111th Congress: Currency Exchange Rate Oversight Reform Act of 2009, 2009 ). This bill required the US Secretary of the Treasury to prepare a biannual report of monetary policy, exchange rates, and a list of currencies found to be misaligned. The US Department of the Treasury was to analyze and determine misalignment and decide appropriate action to address the problem. Such action would include negotiations, consulting, and corrective policies. Although it was reintroduced in 2010 as the Currency Exchange Rate Oversight Reform Act of 2010 (S. 3134) and again in 2011...

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