CASE STUDY – China’s Pegged Currency

Read the case study “China’s Pegged Currency” on p. 701 in Chapter 22 of International Economics Theory and Practice.According to published reports, China today manufactures more goods for global consumption than any other nation. As a result, its foreign currency reserve as of January 7, 2016 stands at $3.4 trillion (IMF) compared to $118 billion for the United States. According to this metric, China ranks number one while the US ranks number 18. Most analysts attribute China’s massive accumulation of reserves to the pegging of its currency to the US dollar as discussed in the case. Critics call this currency manipulation on the part of China.Analyze in a minimum of 1,050 words, using this case study as the basis, the impact of currency manipulation on cross-border trade and investment activities.Cite a minimum of 3 peer-reviewed references from the University Library.CASE STUDY: China’s Pegged CurrencyOver the first decade of the 2000s, China developed a substantial overallcurrent account surplus and a large bilateral trade surplus with the UnitedStates. In 2006, the current account surplus reached $239 billion, or 9.1percent of China’s output, and the bilateral surplus with the United States,at $233 billion, was of similar size. A good part of China’s exports to theUnited States consists of reassembled components imported from elsewherein Asia, a factor that reduces other Asian countries’ exports to the UnitedStates and increases China’s. Nonetheless, trade frictions between theUnited States and China have escalated, with American critics focusing onChina’s intervention in currency markets to prevent an abrupt appreciationof its currency, the yuan renminbi, against the U.S. dollar.Figure 22-2 shows how China fixed the exchange rate at 8.28 yuan perdollar between the Asian crisis period and 2005. Facing the threat of tradesanctions by the U.S. Congress, China carried out a 2.1 percent revaluationof its currency in July 2005, created a narrow currency band for theexchange rate, and allowed the currency to appreciate at a steady, slowrate. By January 2008, the cumulative appreciation from the initial 8.28yuan-per-dollar rate was about 13 percent—well below the 20 percent ormore undervaluation alleged by trade hawks in Congress. Early in thesummer of 2008, in the midst of the financial crisis, China pegged itsexchange rate once again, this time at roughly 6.83 yuan to the dollar. Inresponse to renewed foreign pressure, China in June 2010 announced it wasadopting a “managed float” exchange rate regime, and under thisarrangement, the yuan had appreciated to about 6.12 per dollar by the fallof 2013—a further appreciation of about 10 percent. FIGURE 22-2 Yuan/Dollar Exchange Rate,1998–2013 China’s yuan was fixed in value against the U.S. dollar for several yearsbefore July 2005. After a 2.1 percent initial revaluation, the currency hasappreciated gradually against the dollar.China’s government has moved so slowly because of fears that it would loseexport competitiveness and redistribute income domesically by allowing alarge exchange rate change. Many economists outside of China believe,however, that a further appreciation of the yuan would be in China’s bestinterest. For one thing, the large reserve increases associated with China’scurrency peg have caused inflationary pressures in the Chinese economy.Foreign exchange reserves have grown quickly not only because of China’scurrent account surplus, but also because of speculative inflows of moneybetting on a substantial currency revaluation. To avoid attracting furtherfinancial inflows through its porous capital controls, China has hesitated toraise interest rates and choke off inflation. In the past, however, highinflation in China has been associated with significant social unrest.What policy mix makes sense for China? Figure 22-3 shows the position ofChina’s economy, using the diagram developed earlier in this bookas Figure 19-2. In the early 2010s, China was at a point such as 1in Figure 22-3, with an external surplus and growing inflation pressures—but with a strong reluctance to raise unemployment and thereby slow themovement of labor from the relatively backward countryside into industry.The policy package that moves the economy to both internal and externalbalance at Figure 22-3’s point 2 is a rise in absorption, coupled withcurrency appreciation. The appreciation works to switch expendituretoward imports and lower inflationary pressures; the absorption increaseworks directly to lower the export surplus, at the same time preventing theemergence of unemployment that a stand-alone currency appreciationwould bring. FIGURE 22-3 Rebalancing China’s Economy China faces a current account surplus and inflationary pressures. It can fixboth without raising unemployment by expanding absorption and revaluingits currency. Economists argue further that China should focus on raising both privateand government consumption.19 China’s savers put aside more than 45percent of GNP every year, a staggering number. Saving is so high in partbecause of a widespread lack of basic services that the government earliersupplied, such as health care. The resulting uncertainty leads people to savein a precautionary manner against the possibility of future misfortunes. Byproviding a better social safety net, the government would raise private andgovernment consumption at the same time. In addition, there is a strongneed for expanded government spending on items such as environmentalcleanup, investment in cleaner energy sources, and so on.20While China’s leaders have publicly agreed with the needs to raiseconsumption and appreciate the currency, they have moved very cautiouslyso far, accelerating their reforms only when external political pressures(such as the threat of trade sanctions) become severe. Whether this pace ofchange will satisfy external critics, as well as the demands of the majority ofChinese people for higher security and living standards, remains to be seen