International Currency and Exchange Rates in China

Subject: Finance
Pages: 6
Words: 2421
Reading time:
9 min
Study level: PhD

Abstract

This paper discusses the international currency structure and proceeds to investigate the Chinese exchange rate. As such, it is evident that most countries use different currencies and exchange rates to trade with different countries according to the comparative trading capabilities of those countries. Up to 1994, China was using this system to trade with other countries around the world. After that year, the government of China adopted a fixed rate against the USA dollar to stabilize the rather volatile Asian region. Currently, however, the fixed rate has destabilized the economies of other countries such as USA and India. This is based on the fact that it exports few products at a low price and imports volumes of goods at a low cost. As such, the international community and USA is piling pressure on China to allow is currency to appreciate.

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Introduction

China has become one of the most influential countries to the economic and political ability. Importantly, the economic capability of China has become a crucial factor in the world’s economy (Barry, 2012). Indeed, it has become a leading exporter of products and services worldwide dues to its huge manufacturing capability. This tendency and ability have put China in a position where it has acquired a huge market in other continents such as Europe, America and Africa. Due to this enormous influence and exporting capability, the Chinese currency has a critical implication in the international currency structure. Importantly, their exchange rate against the dollar has affected the trading capability of countries such as the USA and others. In fact, the USA has called upon China to appreciate its currency in order to stabilize the trading capability of the American investors. In addition, USA seeks to engage China in order to ensure that its current deficit reduces. In fact, Pugel (2012) indicated that USA had a trading deficit of about 161 billion dollars with China in 2004. As such, this was about 17 percent of the total trading deficit of USA with the entire world. Since these factors have a critical implication on the economy of the entire world, this paper seeks to analyze the international currency structures and the China’s exchange rate policy.

International Currency Structure

There are two fundamental exchange rates adopted by countries globally including the flexible and fixed rates.

Flexible Exchange Rate

In this currency system, countries have different exchange rates for the countries they engage and make business partners. The exchange rates there for change in accordance to the forces of the economy such as inflation. This system has various advantages and disadvantages to the countries that adopt the system.

Advantages of the Flexible System

  1. The flexible system allows flexibility when making critical economic decisions in country. When there is payable deficit, the country is able to make short term decisions in order to stabilize the deficiency
  2. It ensures that the government does not make decisions that conflict other macroeconomic aspects in pursuit of making a fixed exchange rates.

Disadvantages of the Flexible System

  1. The flexible system causes fluctuation of the prices such that the economy is very volatile and unstable. This was one of the issues that confronted the Asian region before China decided to shift to a fixed rate system
  2. It minimizes the possibility of

Fixed Exchange Rates

The fixed system is adopted when a country chose a fixed rate against the dollar and regulates it to maintain the level. This system has been implemented by China effectively since 1994 to stabilize their economy and get a competitive advantage.

Advantages of the Fixed Exchange Rates

  1. The system allows the stabilization of the economy as a result to lack of price fluctuation. Indeed, the fixed rate of exchange in reference to the dollar plays a fundamental role when it comes to the stabilization of the economy. For example, this currency system was in fact adopted by China in order to assist the Asian region to stabilize its economies.
  2. It encourages investment in the country that adopts such as a system. A stable economy brings about the stability of the prices for investors. As a result, the investors prefer investing in economies with the appropriate export capability. For example, some investors from Japan have expressed their concerns with the exchange rate in UK bearing in mind that Britain has refused to join the Euro and stabilize its currency.
  3. It also allows the reducing inflation as opposed to the flexible system. If a government allows it currency to devalue due to the comparative economic performances, the devaluation of the currency can cause inflation. This is based on the fact that the devaluation of currency leads to an increment in the import prices such that the investors do not have the motivation to cut cost. As a result, the fixed rates enable the government to avoid inflation in the economy by maintaining a favorable exchange rate in a fixed system.
  4. It ensures the protection of manufacturers. The flexible rates can affect the manufacturers adversely when they seek to export their products especially when the currency appreciates. As such, the fixed rates help to avoid such cases when the currency is essentially appreciating due to economic trends.

Disadvantages of Fixed Exchange Rate

  1. It leads to the conflict in objectives. In order to maintain a fixed currency rate, the government is forced to intervene and make regulations that might contravene with other macroeconomic processes and interests. For example, when the currency is falling, the government has to intervene and increase the interest rates in order to maintain the rate. As a result, the increases rates of interest lower the economic growth and the AD.
  2. In addition, it causes less flexibility. The fixed rates reduce the flexibility of the company especially when it needs to make changes to absorb some temporary shocks. For example, if am oil-producing country incurs reduction of oil prices, there might be a deficit in the balance of deficit. However, the fixed rate cannot allow a vast opportunity to devalue the currency in order to control the deficit.

History of Chinese Exchange Rate Policies

The significant and dramatic changes in the Chinese foreign policy started in 1994 when the government of China sought to review its economic status. Before this year, the Chinese Yuan included several rates of exchange in accordance with the normal economic world order. From the period running from 1997 to 2005, the Chinese Yuan traded at a fixed rate of 8.28 with the USA dollar in accordance with the new policy. In fact, according to the simulation conducted by Tyers and Ying (2011) this rate was far away from the real exchange rate because the actual value was 100 Yuan by 1995. Indeed, the foreign policy was very beneficial to the Asian content because the region was essentially volatile and its trade productivity was very low. The European countries and America considered the decision as a beneficial move to the global and regional economy. However, it was evident that the Europeans and the American applauded the decision because the Chinese trade productivity was very low during that period (Lawrence, 2013). As such, the decision did not have any critical implication on the European and American economy because they imported only a few products from China. However, the Chinese productivity and exports grew rapidly from 1998 to 2005 so that USA and the rest of the world started importing volumes of manufactured products from the country. As a result, this managed to increase the trading deficit of countries such as USA because the Chinese are able to import big volumes of good at a low price and export few products at a high price. As such, the international community and USA pressured China to let the currency appreciate without any control. Amidst the pressure and stubbornness, the Chinese government allowed the currency to appreciate from 2005 to 2008 up to a rate of 21% (Wayne, 2014). From 2008, the Chinese government has maintained a fixed and undervalued currency to enable cheap labour and operation of the business. In fact, despite the current pressure and inflation that have been facilitated by the undervalued currency, the Chinese government has shown clear intentions to continue the trend.

Reasons for Chinese Undervalued Exchange Rate

Bearing in mind the critical pressure and criticism from the international community, the stubborn and resolute decision by the Chinese government to undervalue the Yuan evokes many questions. As such, one of the questions is as to why the Chinese government seeks to stubbornly undervalue the Yuan despite the logical and factual arguments launched by the international community. First, China uses the undervalued currency and the exporting capability to acquire a competitive advantage over other countries such as USA. In this case, the low-value currency enables them to import volumes of foreign products at a low price and export very few goods at high prices. As such, this is one of the ways in which the Chinese have managed to flood the USA’s economy with their own products. In the recent situation, most of the American use products that have been made from China. Of course, this condition has been fueled by a combination of strategies. In fact, some of these strategies are not only unfair to human rights but also illegal. For example, the Chinese government does not fight the use of child labor and sweatshops in the manufacturing industry. Recently, the students from an American university led a strike to boycott the use of Nike shoes due to the alleged use of sweatshop and child labor. As such, this is not related to the currency policy but it helps to bring out the determination that China portrays to obtain comparative advantage regardless of the legality of those decisions.

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Second, the Chinese government has undervalued its currency on the basis of the old argument which was used in 1997. During the period, China decided to reduce its exchange rate based on the opinion that the stability of the Yuan would lead to economic benefits to the Asian countries. In this case, China argues that the fixed rate can help to prevent a set-off of the competitive devaluation of currencies in the region. However, this view is based on very mean and narrow statistical evaluation because the circumstances that necessitated the undervaluing of the Yuan in 1997 are not prevalent in the current world order. For example, China was undergoing a critical economic crisis in 1997 due to the prevalent recession. As such, the country used the devaluation as one of the strategies to develop its financial and economic power once more. However, the recent condition is very different because Asia has become economically stable and China has afforded to manufacture massively. Additionally, the Chinese currency was undergoing a downward pressure during the economic crisis that happened between 1997 and 1998.

Manipulation of Currency

The manipulation of the Chinese Yuan has been quite significant especially with the current data. In reality, it has been stated that the Chinese currency has been undervalued by a percentage ranging from 20 to 40. This implies that the Chinese currency if far and above the current value. This has a critical implication on the investment capability in China. Evidently, the manipulation of currency by this margin has enabled investors in China to incur a good investment environment. This factor is based on the fact that the investors are able to sell their good at a very low price and import the raw material at a very low cost. As such, the investors prefer investing in China rather than setting up their businesses in China. In fact, it is evident that most of the investors in America are closing down their businesses to relocate them to China. The manipulation of currency has allowed this eventuality. However, this manipulation has led to inflation in China in the past and the current economic condition. In fact, the Chinese economy is experiencing critical inflation currently owing to the undervaluation. However, the Chinese government, according to their central bank report, refuses to allow the Yuan appreciate due to the fact that USA is gradually reducing its interest rates and controlling its currency. As such, China has decided to continue working with the current fixed rate despite the pressure by USA and the international community.

Impact of Chinese Exchange Rate on Other Economies

Whereas the Chinese government chose a fixed rate in relation to the USA dollar, the undervalued Yuan has led to critical implication in the economy of other countries. Importantly, India has been subjected to an economic dawn following the manipulation. Indeed, the undervalued Yuan has replenished the attitude of the Indian products on the face of Americans and Europeans. As such, wholesalers prefer the Indian toys and textile products to the ones that are produced in China. This trend is becoming more evident and real as China continues to operate with a fixed rate against the dollar. However, the engagement of India with China as business partners experiences a different situation when it comes to the undervaluation. Indeed, India enjoyed about $15 billion trade surplus with the Chinese economy. However, the Indian director from Central Bank has indicated that the decision by China to let its currency increase in value will benefit the Indian economy. In fact, the director proceeds to state that such benefits will be determined by the speed at which the Chinese allow the currency to appreciate. Besides India, other countries are losing their competitiveness when compared to China due to the currency manipulation. For example, it was evident the South Korean currency increased by 42 percent in 2009 (Wu, 2011). In another example, the Brazilian currency appreciated by 36 percent during the same year. As such, their competitive advantage against China has reduced drastically since that year.

Conclusion

Indeed, it cannot be disputed that the international currency structure is normally comprised of many exchange rates. As such, countries have different exchange rates for different countries due to the diverse trading relations. However, China adopted a different system by adopting a fixed rate against the USA dollar. This has given China a competitive advantage over USA and other countries in Europe and Asia. In that regard, China is using the undervalued currency to export few products at low prices and export many goods with high returns. In addition, the undervalued currency has helped the country to woo investors and disparage the investment environment in other countries such as USA. However, the government of China has promised to allow the Yuan to appreciate but the time schedule remains unknown.

References

Barry, B. (2012). Conflicts in the U.S.-China Economic Relationship: Opposite Sides pf the Same Coin? Brookings Institution. 4(12), 3-30.

Lawrence, S. (2013) U.S-China relations: Overview of Policy Issues. Congressional Research Service. 3(12), 1-65.

Pugel, T. A. (2012) International economics. London: Richard Irwin Publishers.

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Tyers, R., & Ying, Z. (2011). Appreciating the Renminbi. The World Economy, 2(34), 265-297

Wayne, M. (2014). China Economic Rise: History, Trends, Challenges and Implications for the United States. Congressional Research Service, 3(7), 1-42.

Wu, X. (2011). China and the United States: Core Interests, Common Interests, and Partnerships. United States Institute of Peace. 9(6), 1-12.