Foreign Exchange Rate – Assessing Chinese Exchange Rate Regime and Its Complications on US

Executive Summary

Since mid 2008 and due to economic crisis China has initiated a soft peg exchange rate regime pegging its currency to US dollar at a rate of about 6.83 RMB per US dollar. This change in policy terminated Chinese managed float exchange regime between 2005 and 2008. There is no time table set for this policy to end. Chinese currency is about 40% undervalued in compare to major currencies such as USD and Euro, however, this statement is not considered valid by Chinese authorities. China buys about $1 billion a day to keep the exchange rate constant which costs US about 6 to 8 thousands job every day. This is also hurting China’s neighbors as they can not compete with in the export market. As world entered the economic crisis and demand for Chinese goods dropped, China has started seeing inflation as it had not seen before.

Inflation is mainly caused by the stimulus package and cheap money available in China. RMB’s appreciation at this time not only can help ease the inflation but also can lower the world’s trade imbalance especially between the US and China which can stimulus the world economy. China argues its currency is not undervalued and keeps implementing monetary policies to keep the rates low. It is concluded that China is manipulating its currency to keep its export high and to increase its foreign reserve. This can not be sustainable as it increases the trade imbalance and hurts US and China’s neighboring countries dramatically. It is highly recommended to pressure China to re-think its exchange rate policy. Chinese change of policy can reduce the trade balance in the world and ends the recession sooner than later. This would eventually help China’s economy in the long run. Many factors affect a country’s trade balance besides exchange rate and one of those factors would be saving rate. As long as American saving rates are as low, appreciation in RMB will not eliminate trade imbalances, although it would narrow it.

Exchange Rate Regimes

There are two extreme exchange rate regimes, floating and fixed. Floating regime (US Dollar and Euro) is a market-driven policy that determines the foreign exchange rate based on the external demand and supply caused by free market forces. In this policy rate does not get intervened by government policies. This regime could be fully independent or managed, where as in independent regime exchange rate is completely a function of free market movements and supply and demand but in the managed regime government may intervene with some monetary policies to prevent sever fluctuation in the rates, if needed.

The benefit of such a regime is the automatic adjustment of exchange rate based on supply and demand. This regime will automatically balance the trade of deficit; when deficit increases the foreign currency values go up and therefore reverses the deficit as it makes exports cheaper and imports more expensive. Other benefit is the independence of the domestic inflation from possible inflations in the world economy as the rate floats accordingly. Furthermore, governments will have more freedom choosing their domestic policies (monetary) as those policies will not affect the balance of payment equilibrium.

However, uncertainty and instability in exchange rate is a huge concern in this regime as government will have no control over the rates. This fear is bigger for emerging markets as they carry liabilities in foreign currencies and assets in domestic currencies. Sever fluctuations in exchange rate can adversely affect liabilities and assets on the books which could be substantial for emerging market with weak economies.

Fixed or pegged regime is typically defined by rate fluctuation in a fixed band around a central rate. The rate is usually pegged to a certain currency (typically US Dollar) or a basket of currencies or sometimes gold. Therefore, the government needs to use several policies to keep the rate in that range.

Under this regime, devaluation of the currency will lead to rise in current account balance resulting in artificially cheaper exports and more expensive imports. This will increase the export level while decreasing the import and therefore, higher positive surplus and decrease in deficit. Another advantage of this regime is the certainty in exchange rate that it creates which would result in less risky international investment, especially between two countries with a lot of investments in each other and in countries where external investment and trades make a big portion of their economy.

A problem with this regime is not having the flexibility to adjust quickly to international waves and having less control on inflation caused by changes in international markets. This limits the government power in using monetary policies to affect macroeconomics of the country freely as the monetary policies will affect the exchange rate. The government needs to have a relatively strong foreign currency reserve to be able to buy/sell its own currency or the foreign currency to keep the exchange rate in that window (like China as it will be discussed in the following Sections).

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