SHAHEED SUKHDEV COLLEGE OF BUSINESS

STUDIES

CHINESE YUAN AND ITS UNDERVALUATION

PROJECT WORK FOR INTERNATIONAL TRADE
AND FINANCE

SUMBITTED BY: SUBMITTED TO:

RAJAT GARG (13228) MR. AMIT KUMAR
RISHABH SINGHANIA (13242) FACULTY
RISHABH CHOUDHARY (13240)
RAHUL ABUJAM (13222)

(BMS 2E)
 ACKNOWLEDGEMENT
The note of acknowledgment is an indispensable part of the project. I would like to
give due credit to the people who have helped me through the course of this project.
I would like to thank my faculty for International Trade and Finance, Mr. Amit
Kumar for helping me throughout the course of my project work. I extend my
heartfelt gratitude to him for his pedagogy which has been instrumental in enhancing
my learning. I would also like to thank the library staff that have been of immense
help to me in my research work.
 CHINESE YUAN

The yuan is the base unit of a number of former and present-day

Chinese currencies, and usually refers to the primary unit of account of the renminbi,
the currency of the People's Republic of China. It is also used as a synonym of that
currency, especially in international contexts – the ISO 4217 standard code for
renminbi is CNY, an abbreviation of “Chinese yuan”.
A yuan is also known colloquially as a kuai . One yuan is divided into 10 jiao or
colloquially mao . One jiaois divided into 10 fen

The symbol for the yuan (元) is also used in Chinese to refer to the currency units
of Japan and Korea, and is used to translate the currency unit dollar as well as some
other currencies; for example, the US dollar is called Meiyuan in Chinese, and
the euro is called Ouyuan . When used in English in the context of the modern
foreign exchange market, the Chinese yuan (CNY) refers to the renminbi (RMB)
which is the official currency used in mainland China.
 Undervaluation of Chinese currency
A broad consensus exists among western economists who agree that the renminbi is
undervalued.The 2010 IMF report on China's economic policies also contends that
the country's currency remains undervalued.According to the IMF, the yuan is
undervalued somewhere between 5 to 27 percent. Peterson Institute of International
Economics study says the yuan is 20 percent undervalued versus the dollar.

Implications of Undervaluation
Great export-led economic growth due to the fact that Chinese goods are inexpensive
and thus have invaded most of the markets of the world. The undervalued renminbi
is a major cause of inflation. In an effort to hold the value of the yuan comparatively
low, the government has to buy foreign currencies through trade surpluses and
investment. China’s foreign reserves, already the world's biggest, soared to $3.84
trillion at the end of 2014. In order to buy foreign currencies, the government has to
print the RMB “at a furious pace” and therefore incur inflation. The undervalued
renminbi undermines domestic consumer’s purchasing power when it comes to
goods from outside the country. An undervalued currency makes foreign goods more
expensive in terms of yuan.
 Renminbi currency value Issue

Renminbi currency value is an issue that affects the Chinese currency unit,
the renminbi and which as of 2013 is at the forefront of world economic discussion.
Since the 1980s, China has emerged as a growing economic power due to its vast
population, resources, economic reforms and industrialization. Therenminbi is
classified as a fixed exchange rate currency "with reference to a basket of
currencies" is drawing attention or scrutiny from other western industrialized nations
which have freely floated currency and has become a source of trade friction. The
currency's chief antagonist is the United States which has labelled the persistent
fixed rate as making Chinese goods unfairly competitive, slowing the recovery of
the United States employment and economic growth.
Some commentators have argued that with current economic conditions, the value
of the renminbi should be allowed to appreciate in value by between 20 and 40
percent against the US dollar. According to the International Monetary Fund (IMF),
the renminbi is undervalued somewhere between five and 27 percent.

The renminbi was introduced in October 1949 after the communists took power on
the Chinese mainland and established the People's Republic of China. Since
the Chinese economic reforms of 1978, China has become the world's biggest
exporter, second largest economy and biggest manufacturer in the world.
For most of its early existence, the renminbi was pegged to the US Dollar. Its value
gradually declined as China embarked on a new economic course during Deng
Xiaoping's leadership and transformed into a more market-based capitalistic
economy.
Since 2005, the Chinese government has overturned its previous its policy of
pegging the Renminbi to the US dollar. The renminbi now floats within a small
margin compared to a basket of currencies selected by the Chinese government. This
is seen as a move to a more fully free-market floating of the Renminbi. The
Renminbi has appreciated 22 percent since the mechanism reform in 2005 of the
Yuan exchange rate. However, during the onset of the 2007-2008 global financial
crisis, the renminbi was unofficially repegged to the US dollar. It was again
depegged from the dollar in June 2010.
A broad consensus exists among western economists who agree that the renminbi is
undervalued. The 2010 IMF report on China's economic policies also contends that
the country's currency remains "undervalued." Prominent economists
including World Trade Organization (WTO) Director-General Pascal Lamy, U.S.
Federal Reserve Chairman Ben Bernanke, Nobel Laureate Paul Krugman, Director
of the Peterson Institute for International Economics Fred Bergsten, and Cornell
University Professor Eswar Prasad have repeatedly stated that China's currency is
undervalued. According to the IMF, the yuan is undervalued somewhere between
five to 27 percent. Peterson Institute of International Economics study says the yuan
is 20 percent undervalued versus the dollar.
The undervalued currency causes serious problems given international criticism,
China's current economic circumstances and its longer-term policy objectives:

1. As a member of the WTO and IMF, China's undervalued renminbi violates

Article XV(4) of the General Agreement on Tariffs and Trade Article 1, and
3 of the WTO Agreement on Subsidies and Countervailing Measures, and
Article IV Section 1 of the IMF that prohibiting countries from currency
manipulation.
2. The trade dispute with the U.S., caused by the undervalued renminbi,
damages China’s most important bilateral relationship. New tariffs aimed at
retaliating the undervalued currency are possible in the new United States
Congress, as the U.S. House of Representatives passed legislation that would
impose economic sanctions on China. “Chinese officials do not understand
the intensity of anger in Washington and could face a backlash if they fail to
mollify their critics,” according to analyst Jason Kindopp at the Eurasia
Group. A trade war with the U.S. would be disastrous for China’s export-
dependent economy.
3. The undervalued renminbi is a major cause of inflation. In an effort to hold
the value of the yuan comparatively low, the government has to buy foreign
currencies through trade surpluses and investment. China’s foreign reserves,
already the world's biggest, soared to $2.8 trillion at the end of 2010. In order
to buy foreign currencies, the government has to print the RMB “at a furious
pace” and therefore incur inflation. China’s inflation is running five percent
at the consumer level (the official number might understate true inflation.)
4. The undervalued renminbi has contributed to very large portfolio foreign
capital inflows. Motivated by expectations of further appreciation,
international investors have pumped a large amount of money into the
economy. This further inflates already overvalued asset prices and adds to
pressure for the currency to rise.
5. The undervalued renminbi undermines domestic consumers’ purchasing
power when it comes to goods from outside the country. An undervalued
currency makes foreign goods more expensive in terms of yuan.
6. The undervalued renminbi exacerbates Chinese banks’ long existing capital
misallocation problems and hence hampers the banking system reform, which
has been one of the goals of the Chinese government. The link of capital
allocation to the exchange rate comes about via the impact of an undervalued
exchange rate on accumulation of international reserves and in turn, the effect
of reserve accumulation on the expansion of bank reserves and on bank-
lending behavior. As mentioned above, the undervalued yuan attracts a large
amount of foreign capital inflow . When reserves increases, banks sell them
to the central bank and receive in exchange for yuan, as required by law.
Then, the bank can use the yuan to increase bank lending. Chinese
commercial banks’ lending behavior, aka capital allocation, is severely
inefficient. The weaknesses in the capital allocation can have enormous fiscal
costs. China transferred $200 billion to fund the recapitalization of its four
major state-owned banks from 2003 to 2006. The $600 billion stimulus
package in 2008, which contains extensive bank lending, could cause long-
term consequences for excess capacity in a number of sectors and for non-
performing loans in banks that lent heavily to support such projects. The
report by Bank of America Merrill Lynch in July 2010 estimates that 23
percent of the $1.1 trillion that Chinese banks lent to finance local
government infrastructure projects are “clearly rotten” and the vast majority
of such loans were not “financially viable”
 The Story Of Yuan So Far

Throughout the 1990s, China was highly successful at maintaining a currency peg
against the US dollar (USD) using a government monopoly
But earlier this year, China said it would allow a more flexible Yuan, signaling an
end to the currency’s peg to the USD. The move has helped deflect criticism from
global economies, who have blamed China for relying on an undervalued currency
to promote exports.
By reducing the value of its currency against the USD, China stands to gain in the
following ways:-
1) Its exports become more competitive.

So how does this happen? As always, an example will help us to understand. Let’s
presume the exchange rate is USD 1 = Yuan 100 Now if a good costs Yuan 200 in
China, a buyer in the US would have to pay USD 2.
Now if China were to devalue its currency to USD 1=Yuan 200, what would
happen??? Quite clearly the same product which was costing Yuan 200 in China
would now cost the American buyer only USD 1 instead of USD 2. While such
drastic changes in exchange rates normally do not happen in real life, use of this
example was to explain the concept.

So you can see why Chinese exporters would always be happy with a weak Yuan.
This is one of the reasons why Chinese goods have been selling across the world.
Most countries find it inexpensive to buy from China. As China gets access to larger
global markets, it further gains from economies of scale which if may pass on to its
customers, thereby, making their goods even more competitive.

2) It attracts higher foreign investment

Let’s say, I am a US investor looking for avenues to invest my money. I would

naturally seek a destination where I can get good returns.

o And good returns are dependent on the following:-
o A large market that can absorb the production easily at a good price.
o Low cost of the factors of production like land and labour.

Now China offers both:

o It’s a large market due to its population. It also has access to global
markets for finished goods.
o Due to its depreciated currency the cost of land and labour for a foreign
investor works out to be very attractive.
Let’s again fall back on our example. Say the cost of land in China was Yuan
100,000 & the exchange rate was USD 1 = Yuan 100. This land would then would
have cost USD 1000. If China were to depreciate its currency to USD 1 = Yuan 200,
then the land would cost USD 500.
Again in the example, we have shown a case of extreme depreciation which is not
the case in a practical scenario. However the impact is similar. A depreciated Yuan
makes both land and labour inexpensive for a foreign investor.
NOW THE BIG QUESTION ARISES
But then why do other countries, let’s say a Singapore not devalue its currency.
Actually they too can. But then this move may not attract as many foreign investors
into Singapore as it does into China. Now why does this happen?

The reason is clear. Singapore cannot offer a market as large as China. And hence
simply depreciating its currency will not be enough for Singapore to compete with
China.

Now one must understand the flip side of depreciating its currency.

1) A depreciated currency makes China’s import more expensive. But quite

clearly, China’s exports surpass its import requirement and hence the trade-
off is in China’s favour.

2) The second challenge is of rising inflation. As the Yuan depreciates, the

central bank will have to print more Yuan to balance the surge in dollars
through increased trade. But as China has abundant land and labour, they are
able to off-set the inflationary pressures by higher productivity through
economies of scale.

It is also interesting to note that unlike India, China is not a democracy. Hence, it is
a nation where the people’s voice against inflation could be silenced.

Thus it makes sense for China to depreciate its currency and laugh all its way to the
bank. But such a situation is not conducive politically and strains relations between
China and other nations.

After all China takes away a larger proportion of global markets on one hand and
global capital on the other depriving other nations from their share. Hence there was
global pressure on China to appreciate its currency.
 The Non-problem of Chinese currency manipulation

However, there are some studies in this matter which state that the Chinese
currency is not undervalued anymore .Two economists at the Peterson Institute for
International Economics, perhaps the world’s top econ think tank conclude that the
Chinese yuan is no longer undervalued, as it has been for decades. Also, Jeffrey
Frankel, a professor at Harvard University's Kennedy School of Government, has
suggested the same in a study conducted by him.

They have argued that even if one accepts that it is possible to identify currency
manipulation, China no longer qualifies. Under recent conditions, if China allowed
the renminbi to float freely, without intervention, it would be more likely
to depreciate than rise against the dollar, making it harder for US producers to
compete in international markets.

But there is a more fundamental point: From an economic viewpoint, currency

manipulation or unfair undervaluation are exceedingly hard to pin down
conceptually. The renminbi's slight depreciation against the dollar in 2014 is not
evidence of it; many other currencies, most notably the yen and the euro, depreciated
by far more last year. As a result, the overall value of the renminbi was
actually up slightly on an average basis.

The sine qua non of manipulation is currency-market intervention: selling the

domestic currency and buying foreign currencies to keep the foreign-exchange value
lower than it would otherwise be. To be sure, the People's Bank of China (PBOC)
did a lot of this over the last ten years. Capital inflows contributed to a large balance-
of-payments surplus, and the authorities bought US dollars, thereby resisting upward
pressure on the renminbi. The result was as an all-time record level of foreign
exchange reserves, reaching $3.99 trillion by July 2014.

But the situation has recently changed. In 2014, China's capital flows reversed
direction, showing substantial net capital outflows. As a result, the overall balance
of payments turned negative in the second half of the year, and the PBOC actually
intervened to dampen the renminbi's depreciation. Foreign-exchange reserves fell to
$3.84 trillion by January 2015.
There is no reason to think that this recent trend will reverse in the near future. The
downward pressure on the renminbi relative to the dollar reflects the US economy's
relatively strong recovery, which has prompted the Federal Reserve to end a long
period of monetary easing, and China's economic slowdown, which has prompted
the PBOC to start a new period of monetary stimulus.
Similar economic fundamentals are also at work in other countries. Congressional
proposals to include currency provisions in the Trans-Pacific Partnership, the mega-
regional free-trade agreement currently in the final stage of negotiations, presumably
target Japan (as China is not included in the TPP). Congress may also want to target
the eurozone in coming negotiations on the Transatlantic Trade and Investment
Partnership.
But it has been years since the Bank of Japan or the European Central Bank
intervened in the foreign-exchange market. Indeed, at an unheralded G-7 ministers'
meeting two years ago, they agreed to a US Treasury proposal to refrain from
unilateral foreign-exchange intervention. Those who charge Japan or the eurozone
with pursuing currency wars have in mind the renewed monetary stimulus implied
by their central banks' recent quantitative easing programs. But, as the US
government knows well, countries with faltering economies cannot be asked to
refrain from lowering interest rates just because the likely effects include currency
depreciation.
Indeed, it was the US that had to explain to the world that monetary stimulus is not
currency manipulation when it undertook quantitative easing in 2010. At the time,
Brazilian Finance Minister Guido Mantega coined the phrase “currency wars" and
accused the US of being the main aggressor. In fact, the US has not intervened in a
major way in the currency market to sell dollars since the coordinated
interventions associated with the Plaza Accord in 1985.
Other criteria besides currency-market intervention are used to ascertain whether a
currency is deliberately undervalued or, in the words of the International Monetary
Fund's Articles of Agreement, “manipulated" for “unfair competitive advantage."
One criterion is an inappropriately large trade or current-account surplus. Another is
an inappropriately low real (inflation-adjusted) foreign-exchange value. But many
countries have large trade surpluses or weak currencies. Usually it is difficult to say
whether they are appropriate.
Ten years ago, the renminbi did seem to meet all of the criteria for undervaluation.
But this is no longer the case. The renminbi's real value rose from 2006 to 2013. The
most recent purchasing power statistics show the currency to be in a range that is
normal for a country with per capita real income of around $10,000.
By contrast, the criterion on which the US Congress focuses – the bilateral trade
balance – is irrelevant to economists (and to the IMF rules). It is true that China's
bilateral trade surplus with the US is as big as ever. But China also runs bilateral
deficits with Saudi Arabia, Australia, and other exporters of oil and minerals, and
with South Korea, from which it imports components that go into its manufactured
exports. Indeed, imported inputs account for roughly 95% of the value of a
“Chinese" smartphone exported to the US; only 5% is Chinese value added. The
point is that bilateral trade balances have little meaning.
Congress requires by law that the US Treasury report to it twice a year which
countries are guilty of currency manipulation, with the bilateral trade balance
specified as one of the criteria.
WILL CHINESE YUAN BECOME WORLD
CURRENCY?

WE HAVE JUDGED THE CHINESE CURRENCY ON THE FOLLOWING CRITICAL FACTORS:

1) Economic Size:
China now accounts for:
a. 10% of the world gross domestic product (15% by PPP rather than
market exchange rates)
b. Nearly 9% of the foreign direct investment
c. > 10% of the world trade

2) Open Capital Account:

China is gradually and selectively easing restrictions on both inflows and
outflows.
a. The limit of foreign exchange purchases by residents for remittance
abroad for personal reasons was increased to $50000 a year.
b. More recently, the government has been encouraging outflows by
institutional investors (e.g., pension funds and insurance companies)
and corporations.
c. Controls on inflows are also being gradually eased, although with many
restrictions still in place.

3) Flexible Exchange rate:

a. Reserve currencies generally trade freely, and their external value is
market determined.
b. China follows a quasi-pegged exchange rate and manages capital
control.

4) Financial market Development:

 a. China has relatively shallow and underdeveloped government and
corporate bond markets.
b. In order to establish Yuan as a reserve currency it also has to strengthen
its foreign exchange and derivatives market.

5) Macro-economic policies:
a. Investors in a country’s sovereign assets must have faith in its
commitment to low inflation and sustainable levels of public debt.
b. China has a lower ratio of explicit public debt to GDP than most major
reserve currency economies and has maintained moderate inflation in
recent years.

INTERNATIONALIZATION
 China is promoting the international use of its currency by:
a. Permitting the settlement of trade transactions with the Renminbi.
b. Easing restrictions on cross-border remittances of the Renminbi for
settlement.
c. Allowing the issuance of Renminbi-denominated bonds in Hong Kong
and by foreigners in the Mainland.
d. Permitting selected banks to offer offshore Renminbi deposit accounts.

GROWTH OF YUAN IN INTERNATIONAL TRADE

 The Yuan is already being traded directly between China and countries like
Australia and Japan. That means, both countries do not need US dollars to
trade with China.
  Does it mean the Yuan is gradually encroaching into the dollar reserves of
other countries?
 Yes and no. The encroaching only goes as far as the bilateral trade between
China and that other country.

REASONS WHY YUAN WON’T REPLACE DOLLAR’S:

According to us Chinese still does not possess such qualities that it will be able
to replace dollar in the international market. We think so because of the following
reasons:
Money Talk is not enough:
 Dollar’s holds 62% of the world’s aggregated reserve currency. Most of the
central banks in other countries hold a lot of dollars for the capital market.
Government Transparency:
 The lack of transparency will be the main drawback against the Yuan. Stability
is the biggest factor why countries gravitate to the dollar, which has not been
devalued ever.
 The Yuan, on the other hand, is tightly controlled by China, even as Western
countries led by the US call for more liberalization of the Yuan.

FRIENDLY PRESSURE:
 IN WORLD TRADE, THE US WILL EXERT FRIENDLY PRESSURE TO MAINTAIN THE
DOLLAR AS THE EXCHANGE CURRENCY, AND THE REST OF THE WORLD OTHER
THAN PERHAPS NORTH KOREA, IRAN, AND CHINA WILL NOT LIKELY MIND.
 BIBLIOGRAPHY
Articles:
a. http://en.wikipedia.org/wiki/Chinese_yuan
b. http://www.project-syndicate.org/commentary/chinese-currency-manipulation-by-jeffrey-
frankel-2015-02
c. http://www.quora.com/How-do-currency-pegs-work-How-does-the-Chinese-government-
peg-the-Renminbi-to-the-dollar

Books:
a. Robert Minikin (Author), Kelvin Lau, The Offshore Renminbi: The Rise of the Chinese
Currency and Its Global Future.
b. Sun Yaodong, Sun Zhaodong, Xie Yong, Renminbi: The Internationalization of China's
Currency.