Prior to the financial crisis in 2007/2008, the U.S. Treasury Department as well

Question

Prior to the financial crisis in 2007/2008, the U.S. Treasury Department as well as Congress had been asking China to revalue upwards the value of their Renminbi or Yuan. China responded to these repeated requests by allowing the Yuan to trade within a narrow band. The band itself was then shifted upwards or downwards by small increments from time to time. Still, the U.S. claimed that China had not done enough and should raise the value of the Yuan by at least a further 20%. The reasons given to justify this requested increase were as follows:

The artificially low value of the Yuan makes U.S. manufactured exports unattractively priced in China.

The undervalued Yuan leads to excessive U.S. imports of Chinese-made goods, which in turn, leads to an unwelcome trade balance in China's favor. For example, the trade deficit with China was roughly -$258,506.0 million in year 2007. These numbers shrunk further during 2009 as recession hit the global economy. In year 2011, the trade deficit with China was roughly -295,456.5 million (http://www.census.gov/foreign-trade/balance/c5700.html).

China chose to change their 'floating' arrangement and pegged the Yuan to the USD at a rate they selected. China holds such a large investment in U.S. Treasuries as a result of the continuing U.S. trade surpluses that the U.S. does not have a great deal of leverage. If China sold those Treasuries the U.S. dollar would fall significantly in value.

Discuss the issues involved with pegging or floating the Yuan to the US dollar.

Explanation / Answer

Exchage rate is used in interational trade. two countries involved here are USA and China. Their currencies are $ ad Yuan. umber of uits of $ payable to get one unit of Yuan is exchage rate. This exchage rate changes frequently when it is floating in nature. For floating currency, exchange rate will depend upon demand and supply of the currency of exchange rate. If in international market more currencies are available, then supply will be more. So price of currency will decrease. In other words currency value will depreciate. In opposite situation currency value will appreciate.

Suppose, one dollar is equal to 10 Yuan. Now one dollar is equal to 12 Yuan. It will mean 2 extra Yuan is now available for one dollar. Thus $ value has increased and Yuan value has depreciated.

Sometimes it has been observed that some countries willigly maintains a low value of their currency. They intentionally devalue their currency to gain foreign trade advantage. Consider previous example again. Before devaluation of Yuan, US citizens can get goods equivalent to 10 Yuan by paying $1. Now they can get goods of extra 2 Yuan by paying same one dollar. Thus Chinese goods are now cheaply available to US citizens. They will import more and more goods from China. It will improve balance of trade favorably in China. Balance of trade of USA with China will be negative. It is clearly depicted by the actual trade balance of USA with China. In 2007, USA has negative trade balance of $258,506 million with China. It has increased adversly further in 2011 to $295,456 million.

In order to rectify this adverse balance, USA has requested China to appreciate their Yuan value. It will make the import from China costly. So Import in USA from China will decrease. Ultimately adverse balance of trade position will be corrected. China has responded to it by revising it a little. But USA wants further 20% apprecxiation which China is not ready. USA cannot put pressure on China on this issue as Investment in USA by China is already very high. Amount of dollar available in China treasury is very high. If they sale such dollar in international market, then $ value will depreciate very fast. US economy will suffer a serious set back in their economy.

Realizing this position. China has decided to peg its currency with US dollar. It will reduce uncertainty of exchange rate fluctuation. If US $ depreciates then due to pegging Yuan will also depreciate. Thus position will not worsen further.

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