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Two of the most important and closely related economic issues today are the value of the Yuan
and the huge assets accumulated by China, mainly in the form of United States Treasury bills
and other US government assets.

China's central bank had the Yuan¶s value fixed at a little over 8 per US dollar during the 1990s
and until 2005. It then allowed the Yuan to rise gradually to less than 7 a dollar until 2008, when
it again fixed the rate of exchange at about 6.9 Yuan per dollar. This exchange rate is
considerably above a free market rate that would be determined in a regime of flexible exchange
rates. So there is no doubt that China is intentionally holding the value of its currency below the
rate that would equate supply and demand.

The value of the greenback has fallen substantially against other currencies since May 2009.
Since the Yuan is tied to the dollar its value, too, has declined in the same ratio: 16 percent
against the euro, 34 percent against the Australian dollar, 25 percent against the Korean won, and
10 percent against the Japanese yen. This substantial devaluation of the Yuan has made many
countries angry with China's policy of pegging it to the US dollar.

For years, Chinese leaders looked to the millions of poor workers from the country¶s interior as
the engine of a roaring export economy. They would move to coastal provinces, toil in factories
and churn out the world¶s household goods.

The currency shift brings immediate political benefits, since China will now presumably come
under less pressure at the Group of 20 summit meeting this weekend. But there are important
domestic considerations as well. The breaking of the renminbi¶s de facto peg to the dollar means
the currency is likely to appreciate in value, making Chinese exports somewhat less competitive
in the global marketplace but strengthening the purchasing power of Chinese consumers.
Likewise, government policies to encourage wage increases for poor laborers ² there are an
estimated 150 million migrant workers in cities ² could also spur consumption, if the pay
increases outpace inflation.

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Vill there be any major effects in the world economy as well as China¶s Economy due to the
revaluation of the China¶s Renminbi? This article reflects on the effects the Revaluation will
have on the Global Economiesac

 
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A 20% appreciation in the Chinese Renminbi will have effects in the world economy especially
hitting the US markets.
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The Primary objective in preparing this Research Paper is to understand the impact of China¶s
Currency Revaluation and also the effects it carries along which will be seen in the Vorld
economy as a part of Global Trade.

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The paper will attempt to study carefully the effects of China¶s Revaluation in the Chinese
markets & in the US markets. The Scope of the paper will be as follows:

1.c istory of Chinese Currency

2.c Exchange rate of the American dollar vs. China's Currency
3.c Financial consequences of revaluating or floating China's Currency
4.c Should China revalue its currency?
5.c An RMB Revaluation: Could It Reduce Global Trade Imbalances?
6.c China's Renminbi Revaluation: Small Step, Big Impact?
7.c Expanding RMB Reforms: Big Bang or Another False Start?

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Secondary Data Articles have been sourced from magazines and journals dealing with current
issues in China¶s Currency Revaluation. Internet & Text books related to effects of this financial
reform have been a major secondary source for the extraction of the expert¶s opinion.

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The Renminbi was first issued shortly before the takeover of the mainland by the Communists in
1949. One of the first tasks of the new communist government was to end the hyperinflation that
had plagued China near the end of the Kuomintang era.

During the era of the command economy, the value of the RMB was set to unrealistic values in
exchange with western currency and severe currency exchange rules were put in place. Vith the
opening of the mainland Chinese economy in 1978, a dual track currency system was instituted,
with Renminbi usable only domestically, and with foreigners forced to use foreign exchange
certificates. The unrealistic levels at which exchange rates were pegged led to a strong black
market in currency transactions.

In the late 1980s and early 1990s, the PRC worked to make the RMB more convertible. Through
the use of swap centers, the exchange rate was brought to realistic levels and the dual track
currency system was abolished.

The RMB is convertible on current accounts, but not capital accounts. The ultimate goal has
been to make the RMB fully convertible. owever, partly in response to the Asian Financial
Crisis of 1998, the PRC has been concerned that the mainland Chinese financial system would
not be able to handle the potential rapid cross border movements of hot money, and as a result, as
of 2003, full convertibility remains a distant goal.

The official currency of the People's Republic of China (PRC) is Renminbi (meaning in Chinese:
"people's currency"). The People's Bank of China, the PRC's monetary authority, issues the
Chinese currency. The official ISO 4217 abbreviation of China's currency is CNY, but it is also
abbreviated as "RMB". Colloquially, the Chinese currency is also called Yuan and Kuai.

During the previous decade, Mainland China's Currency was pegged to the U.S. dollar at 8.28
RMB. On July 21, 2005, it was revalued to 8.11 per U.S. dollar, following the removal of the peg
to the U.S. dollar. The revaluation resulted from pressure from the United Stated and the Vorld
Economic Council.

The People's Bank of China also announced that the Renminbi would be pegged to a basket of
foreign currencies, rather than being strictly tied to the U.S. dollar, and would trade within a
narrow 0.3 percent band against this basket of currencies. China has stated that the basket is
dominated by a group of international currencies including the U.S. dollar, euro, Japanese yen
and South Korean won, with a smaller proportion made up of the British pound, Thai baht and
Russian ruble.

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From 1994 until July 2005, the policy on currency has been to peg informally the value of the
Renminbi against the value of the United States dollar. This policy was praised during the Asian
financial crisis of 1998 as it prevented a round of competitive devaluations.

In 2003, this policy came under criticism by the United States. The fall in the value of the dollar
caused the value of the Renminbi to fall also, making mainland Chinese exports more
competitive. This led to some pressure on the PRC from the United States to increase the value
of the RMB in order to encourage imports and decrease exports. This is a policy that some feel
would preserve manufacturing jobs in the United States. The G7 and European Union are also in
favor of a re-evaluation of the exchange rate.

The PRC government has resisted pressure to increase the value of the RMB, out of concern that
it would cause mainland Chinese jobs to disappear and would also expose domestic banks to
currency risks that they are not prepared to handle. Many economists believe that only fixed
exchange rates or floating exchange rates are stable over the long term, because a one-time
change in exchange rates might cause speculators in the future to take positions on possible
exchange rate fluctuations which would lead to pressure to completely float the currency.

The PRC government has also claimed that, while mainland China runs a large surplus with
respect to the United States, its overall balance of payments is not out of balance.

Some independent analysts conclude that mainland Chinese currency is undervalued, because the
People's Republic forbids citizens from moving their currency abroad. If this sort of financial
diversification were allowed, the massive outflow of Yuan could have a substantial effect on the
currency.

Vithin the United States, the issue of appreciating the RMB is also controversial. Manufacturers
and textile producers are in favor of appreciating the RMB. owever, many American
companies that depend on mainland Chinese factories to supply inexpensive products and
components, such as aerospace companies, computer manufacturers, discount retailers, and other
companies are against appreciating the RMB. Furthermore, many economists have pointed out
that manufacturing jobs have been declining in the United States for decades. Some people have
suggested that blaming the lack of job growth on the value of the RMB is merely a convenient
misdirection on the part of the vested interests, including the George V. Bush administration,
inefficient businesses, and labor unions fearful of competition.

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The financial consequences of free valuation are complicated. Many economists believe that
appreciation of the Yuan would cause the PRC government to buy fewer United States treasury
bonds, causing bond prices to fall and bond yields to rise, hampering improvement in the U.S.
economy. The ensuing depreciation of the US dollar might price oil out of the reach of the
American economy, causing stagflation, a collapse of US oil dependant industries, massive
unemployment and other dire economic consequences.

owever, the potential risk to global balances from mainland China's inflexible exchange rate
would be more critical if the PRC relaxed its controls on short-term investment flows without
first introducing exchange rate flexibility. This is because shifting exchange rates nullify
expected profits from investment flows seeking to take advantage of higher interest rates in
another country. Vithout flexibility, speculative flows could quickly become large, as they did
during the Asian financial crisis, and threaten economic stability and orderly world trade.

First of all, just how much China will allow their currency to strengthen remains to be seen; in its
announcement the central bank said that there is no basis for a ³large-scale appreciation´. Not to
mention that any major strengthening wouldn¶t be ³in China¶s interest´. At the end of the day,
we can expect China¶s exchange rate to be ³basically stable´.

And the central bank¶s announcement shouldn¶t be seen as a blueprint for action, but more as a
statement of principal and intent, according to UBS economist Larry athaway (Forbes). The
value of the Yuan will still be determined by the government, not by the foreign exchange
markets: China has a .5% daily trading band within which the currency can float, so any moves
will be controlled and gradual.

Just how much will the Yuan appreciate? According to Bloomberg, a survey of economists
suggests a gain of 1.9% this year. That¶s hardly a change, considering that analysts estimate the
Yuan is undervalued somewhere between 20 to 40%. The bottom line: any strengthening will
likely be too slight to have a major impact in rebalancing the global economy.

That¶s not to say there won¶t be any effect. A stronger Yuan will boost Chinese consumer
demand. As their currency strengthens, imports became cheaper, giving Chinese consumers
more purchasing power for foreign goods. The result: China could become less dependent on
exports, and more dependent on growing consumer demand. And slowing exports will calm
China¶s rapid growth (and slow the risk of inflation). That¶s a good thing.

And there is some concern that China¶s demand for Treasuries could taper off. After all, if a
stronger Yuan narrows China¶s trade surplus, they will have fewer dollars to invest in
Treasuries. But again, any appreciation will be slow and deliberate, and probably won¶t equal a
sweeping change in China¶s demand for Treasuries. And besides, China wouldn¶t want that
anyway. If the Yuan were to strengthen too much, the value of China¶s foreign exchange

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reserves ($2.5 trillion) would be diminished: a 20% Yuan revaluation would equal a loss
equivalent to $500 billion (in Yuan terms), according to igh Frequency Economics economist
Carl Veinberg.

But here¶s the real problem: we are making a dangerous assumption. All of this conjecture is
based on the conclusion that, allowed floating, the Yuan will gain against the dollar. But it¶s
entirely possible that the currency could depreciate. If the euro continues to slide, then the Yuan
would also weaken relative to the dollar.

If anything, the People¶s Bank of China¶s policy change looks like a political play: at the G20
summit over the weekend (appropriately held in Canada), the focus shifted away from China as
leaders discussed global imbalances and deficits. The bottom line: China¶s policy isn¶t going to
result in a dramatic change in the economic landscape.

Still, some sectors stand to benefit as imports become cheaper for China (the country is the
largest importer of industrial commodities). China is the world¶s largest copper consumer, and
second largest oil consumer.

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China's central bank had the Yuan¶s value fixed at a little over 8 per US dollar during the 1990s
and until 2005. It then allowed the Yuan to rise gradually to less than 7 a dollar until 2008, when
it again fixed the rate of exchange at about 6.9 Yuan per dollar.

This exchange rate is considerably above a free market rate that would be determined in a regime
of flexible exchange rates. So there is no doubt that China is intentionally holding the value of its
currency below the rate that would equate supply and demand.

The value of the greenback has fallen substantially against other currencies since May 2009.
Since the Yuan is tied to the dollar its value, too, has declined in the same ratio: 16 percent
against the euro, 34 percent against the Australian dollar, 25 percent against the Korean won, and
10 percent against the Japanese yen. This substantial devaluation of the Yuan has made many
countries angry with China's policy of pegging it to the US dollar.

US President Barack Obama has apparently complained to President u Jintao about the Yuan¶s
low value and urged him to revaluate it substantially.

The US and other countries are worried that the undervaluation of the Yuan increases the
demand for Chinese exports and reduces China's demand for imports from countries like the US
because China keeps the dollar and the currencies of other countries artificially expensive
compared to its currency.

The US and other countries hope that greater demand from China for their exports, resulting
from a higher value of the Yuan, will help them resume sizable economic growth as they recover
from severe recession. Their governments especially want to reduce the high levels of
unemployment.

Indeed, in good part due to the low value of its currency, China has run substantial surpluses in
its current trade account because it imports fewer goods and services than it exports. As a result,
it has accumulated enormous reserves of assets in foreign currencies, especially US government
assets denominated in dollars. At the end of last year, China had an incredible more than $2
trillion in foreign currency reserves, which included US Treasury bills. This is by far the largest
reserve in the world and its ratio to China's GDP is huge: a quarter of about $8 trillion
(purchasing power parity adjusted).

I doubt the wisdom of the US for complaining against China's currency policy and of China for
its response. On the whole, I believe most Americans benefit rather than being hurt by China's
long-standing policy of keeping the Yuan at an artificially low exchange value. The policy
makes the goods imported from China, such as clothes, furniture and small electronic devices,
much cheaper than they would have been if China revaluated its currency substantially. The
main beneficiaries of China's current policy are poor and lower middle class Americans and
people in other countries who buy made-in-China goods at remarkably cheap prices in stores
such as Val-Mart that cater to cost-conscious families.

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US companies that would like to export more to China have indeed been hurt by China's
currency policy. They employ fewer people than their capacity and thus contribute to the high
rate of unemployment in the US. But I believe the benefits to American consumers far outweigh
any losses in jobs, especially because the US economy continues its recovery.

Since the opposite effects hold for China, I cannot justify the country's policies from the
viewpoint of its interests. Its consumers and importers are hurt because the government has kept
the cost of foreign goods artificially high for them. Their exporters gain, but as in the US, that
gain is likely to be considerably smaller than the negative effects on the well-being of the
average Chinese family.

I have reached a similar conclusion on China's excessive reserves. The US has little to complain
if China wants to hold such high levels of low interest-bearing US government assets in
exchange for selling inexpensive goods to the US and other countries. China's willingness to
save so much reduces the need for the Americans and others to save more. But are not
differences in savings rates part of the specialization that global markets encourage? It is difficult
to understand why China is doing this because it is giving away goods made with hard work and
capital for paper assets that carry little returns.

One common answer is that China hopes to increase its influence over international economic
and geo-political policies by holding so many foreign assets. Yet it seems to me just the opposite
is true - that China's huge levels of foreign assets put it more at the mercy of American and other
countries' policies. China can threaten to sell large numbers of the US Treasury bills and other
US assets it holds, but what will it buy instead? Presumably, it would buy European Union or
Japanese government bills and bonds. That will put a little upward pressure on the interest rates
of other governments. But to a considerable extent, the main effect in our integrated world
capital market is that sellers to China of euro and yen-denominated assets would then hold the
US Treasuries sold by China.

On the other hand, the US can threaten to inflate some of the real value of its dollar-denominated
assets - not an empty threat because of the large US government fiscal deficits and the sizable
growth in US bank excess reserves. Inflation would lower the exchange value of the dollar, and
also of the Yuan as long as China keeps it tied to the greenback. That would further increase the
current account surpluses of China, and thereby induce it to hold more US and other foreign
assets, which is not a very attractive scenario for Beijing.

So my conclusion is that the US in its own interest should not urge China to revaluate its
currency - countries such as India have a much greater potential to gain from such a revaluation.
On the other hand, I see very little sense at this stage of China's development for Beijing to
maintain a very low value of its currency and accumulate large quantities of reserves.
Paradoxically, presidents Obama and u should have been arguing each other's position on these
economic issues.

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In testimony before the U.S. ouse of Representatives in March, C. Fred Bergsten, director
of the Peterson Institute for International Economics (PIIE), a Vashington, D.C.-based think
tank, blamed the "severe" undervaluation of China's currency -- by as much as 40% against
the dollar -- for major job losses in the U.S. and global trade imbalances. e also laid out an
action plan, including enlisting a multilateral coalition of countries for help or even slapping
tariffs on Chinese goods, if China did not relax its tight currency control and allow the
Renminbi (RMB) to gain strength. "The case for a substantial increase in the value of the
Renminbi is thus clear and overwhelming," he said. "An appreciation of 25% to 40% is
needed to cut China's global [account] surplus even to 3% to 4% of its GDP. This
realignment would produce a reduction of $100 billion to $150 billion in the annual U.S.
current account deficit."

On June 19, the People's Bank of China, the country's central bank, obliged -- at least in part.
It announced that it will indeed abandon the two-year-old peg that has kept the RMB tied to
the dollar and allow the RMB to respond more naturally to supply-and-demand forces.
Effective immediately, it said the country would begin moving to a floating exchange rate
regime, although a very tightly managed one, similar to what it used between 2005 and 2008,
basing the RMB's value on a basket of currencies, rather than just the dollar, within a very
narrow band upward or downward.

But then came the news the next day that dashed the hopes of many China watchers: Its
policy makers have insisted that any appreciation they allow to the RMB, which has been
pegged at 6.83 to the dollar since July 2008, will be "gradual." Analysts have interpreted that
as only a few percentage points a year.

Relaxing its RMB policy "is kind of a convenience for China," says Kent Smetters, a
Vharton professor of insurance and risk management. "It's not going to make that much of a
difference for them right now. The demand for dollars is still going to be high and they can
come across as being the good guys, but it's not really costing them that much right now."

Yet regardless of the amount that the RMB appreciates -- or depreciates -- China's decision is
important, not only in debates about the future clout of the dollar and the RMB in global
trade and politics, but also for correcting global economic imbalances, experts say.

^
 



Against this backdrop, "it is quite understandable why [China is] returning to this managed
floating exchange system," says Vang Jianmao, economics professor and associate dean at
the China Europe International Business School (CEIBS) in Shanghai. "Ve will try some
small steps and wait to see what the outcome will be. I'm not expecting any [sort of] shock
therapy or that kind of thing in China, no matter what the external pressure is."

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 According to Vang, lessons from the past at home and elsewhere explain why China is
taking this approach. Consider the Japanese yen. Vith a long undervalued currency and an
export-dependent economy that boomed through the 1970s and mid-1980s -- much like
present day China -- "the Japanese tried to delay the appreciation of their currency, and in the
end they had to adjust the exchange rate under U.S. pressure too quickly," he says. After
Japan agreed to the Plaza Accord of 1985, which depreciated the dollar against the yen and
Germany's deutsche mark, the yen surged ahead, eventually leaving the country to face an
asset price bubble that was bound to burst dramatically.

In the next 10 to 15 years, China needs to make the RMB fully convertible and have it
become a reserve currency," he says. "The real problem in the international architecture,
since all the problems with the euro began, is that the dollar has become the only reserve
currency, when we need three [currencies] to represent three regions. It may be better to have
more, but three would be a good start."

owever, there's a more pressing issue for China's government: The impact of the
revaluation on its vast foreign exchange reserves, 70% of which are said to be in dollars.
"Much of these reserves are financed with debt in RMB. So if the RMB appreciates, they are
effectively losing out," says Allen. Any movement -- even a gradual one -- causes a
significant change in the value of its reserves, which reached $2.5 trillion in March, roughly
half of its GDP. "If they have a 10% revaluation against the dollar, that's the equivalent of
5% of GDP, which is a big amount to lose. They need to think very carefully about their
long-term strategy for that."

Vhere does this leave the dollar? "For China, saying they're going to let go of the peg really
means they're going to let go of trying to buy enough U.S. debt in order to maintain [the
new] exchange rate," notes Smetters. "The problem is, the U.S. is still going to try to sell a
bunch of debt over the next few years, and that will create a demand for dollars. Demand for
dollars is still going to be pretty strong because [the dollar] is a safe haven."

Ú
 

 

All this raises questions about whether the RMB revaluation matters to the person on the
street. Many observers in the U.S. say it does. According to them, the weak-currency policy
has meant China is giving its firms an unfair competitive advantage over their counterparts in
other countries by making Made-in-China products cheaper. As a result, "[China]
is exporting very large doses of unemployment to the rest of the world -- including the United
States, but also to Europe and to many emerging market economies, including Brazil, India,
Mexico and South Africa," noted PIIE's Bergsten in his testimony on Capitol ill. In a blog
published in January, New York Times columnist and Nobel laureate Paul Krugman wrote
that "Chinese mercantilism" has cost the U.S. 1.4 million jobs.

Krugman, Bergsten and a host of other China-policy critics say that while letting the value of
the RMB rise might leave consumers in the U.S. and elsewhere paying higher prices for
formerly cheap Chinese goods, it will help make America's goods more attractive both at
home and abroad, which in turn will give employment levels a big boost. Bergsten reported

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 in his testimony that "every $1 billion of exports supports about 6,000 to 8,000 [mainly high-
paying manufacturing] jobs in the U.S. economy."

But not everyone is as certain about how large a role the RMB's value played during the
global economic downturn, or is as optimistic about the effects of China's new policy.
"America needed a whipping boy to blame for the crisis," says Simon J. Evenett, professor of
international trade and economic development at the University of St. Gallen, Switzerland.
e predicts that the exchange-rate debate is far from over. "It has all the ingredients of a
long-running drama." Meanwhile, he says that China Inc.'s competitive advantages could
very well strengthen, rather than weaken, over time. "If an increase in the RMB value is
gradual, it will just encourage a lot of Chinese companies to upgrade their products, not
knock them out [of business], as some Americans hope. The principal losers would be U.S.
firms."

As for workers in the U.S., Evenett predicts that a revalued RMB won't lead to the rosy
scenario which many people say higher exports and lower imports would bring. e cites
recent research on U.S. output and employment that he conducted earlier this year with
Joseph Francois, professor of economics at Johannes Kepler University in Linz, Austria. For
example, their research found that the majority of China's exports to the U.S. are not destined
for American consumers, but for firms in the form of components and other unfinished
goods. "This is not just true for imports from China, but for all imports," the two professors
wrote in an article about their findings, published in April on Voxeu.org, a policy-analysis
web site. "Consequently, imports from China and elsewhere feed into the overall cost
structure of the U.S. economy and thus influence the global competitiveness of U.S. firms."

Moreover, they observed, "in a world where only finished goods were sold -- where the
principal effect of revaluations is on export prices -- then it might have been sensible to link
revaluation, current account improvements and job creation. owever, this is not the world
we live in." Evenett and Francois calculate that roughly 420,000 U.S. jobs could be lost if the
RMB is revalued by 10%.

½
 
 

In terms of what the Chinese should expect from the revaluation, Vang of CEIBS
underscores the importance of looking at it alongside another big change: The rise of Chinese
wages. "China is at a turning point," he says. "For the past 25 years, wages have been
growing slower than GDP. That caused a bigger problem in China" than the currency policy.
The country's current account surplus of about 15% of GDP -- caused by chronic savings-
consumption imbalances -- has had a negative impact on the health of its economy. "Unless
wages grow faster than GDP, I don't think we can achieve an internal rebalancing," he notes.
"And it was internal imbalances that caused external imbalances."

Marshall V. Meyer, Vharton professor of management, agrees that rising wages have a key
role to play. "The wage increases are a 'backdoor' RMB revaluation. I'm sure prices will go
up with wages, which will have to be passed on to consumers -- which are pretty much what
the effect of a RMB revaluation is. Unless, of course, [Chinese companies] nail down some

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 efficiency in productivity or distribution processes, which means prices [for consumers]
won't go up as much."

But as both Vang and Meyer note, the government has been in a corner when it comes to
wages. "The government can't avoid wage increases. It's very conscious of its role of being
'on the side of the people,'" says Meyer. And though still wanting to hang on to maintain the
GDP's growth trajectory, the only way the government can pursue a strategy to reduce its
dependency on exports while increasing domestic consumption is to encourage higher
salaries, he adds.

In terms of whether a stronger RMB could lead to Chinese exporters losing business in key
international markets and forcing layoffs at home, Vang believes it is unlikely, given China's
strong foothold in the U.S. and elsewhere. "You have to realize that with Chinese imports,
there are no substitutes in the short term. Maybe in 10 years, importers will have a choice,
but right now they will just have to pay more," he says. "No other country can step in on a
big scale. Some countries will try, [but] to build a manufacturing base and the entire
infrastructure that you need -- transportation, energy, and the entire value chain to the final
good -- takes many years."

Certainly, currency revaluations alone can't address the bigger global challenge, experts note.
According to Bergsten, "Successful international adjustment ... requires corrective action by
the United States, particularly with respect to its budget deficit and low national saving rate,
and other countries as well as by China. But it is impossible for deficit countries to reduce
their imbalances unless surplus countries reduce theirs."

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On March 16, five U.S. senators re-introduced a new bill to crack down on unfair currency
manipulation by countries such as China, which they say is having a negative effect on the U.S.
economy. Even if the bill is not passed, President Obama will increasingly be expected to step up
pressure on China to raise the value of the Renminbi against the U.S. dollar. The proposed
legislation has aroused a hot debate in both countries about the pros and cons of a Renminbi
revaluation.

China has pegged its currency to the U.S. dollar since 1994. After 2002, its trade surplus
burgeoned, causing a huge global current account surplus. Meanwhile, as China¶s major trading
partner, the United States suffered from a growing current account deficit. Many U.S. legislators
attributed their nation's deficit to the Chinese government's currency manipulation to keep the
Renminbi artificially low. Ever since, a Renminbi revaluation has been the center of the trade
dispute between China and the United States.

Today, ³legislators are trying to make constituents believe that the joblessness [in the U.S.] is
caused by the trade deficit, and the trade deficit is the result of China manipulating its currency,´
says Charles Freeman of the Center for Strategic and International Studies, a Vashington, D.C.-
based public policy research institute, and a former assistant U.S. trade representative for China
affairs. ³owever, I see no correlation between joblessness and the trade deficit, as well as the
trade deficit and the undervalued Renminbi.´

e also says it is unlikely that increasing the value of the Renminbi vis-à-vis the dollar will
reduce the trade imbalance between the two countries. ³If you look at the average cost of
consumer goods in China and the equivalent wholesale costs of manufacturing goods here in the
United States, you would see that the margin between the two is too high,´ he notes. ³The labor
costs are so high in the United States that it would be difficult for the U.S. to regain
competitiveness solely through forcing the Renminbi to appreciate by another 20%." In fact, he
doubts whether any increase in the value of Renminbi will move the production back to the U.S.
If Chinese exports to the U.S. were to become more expensive, "the United States would shift its
demand to other third party developing countries, such as Mexico,´ he says.

Echoing Freeman's view is a new article titled, ³The RMB: Myths and Tougher-to-Deal-Vith
Realities,´ by Pieter Bottelier, a senior adjunct professor of China studies at Johns opkins
University's School of Advanced International Studies, and Uri Dadush, director of the
international economics program at the Carnegie Endowment for International Peace, a
Vashington, D.C., think tank. According to Bottelier and Dadush, the immediate effect of a
Renminbi appreciation would be an increase in prices for U.S. consumers. ³A 25% revaluation
of the Renminbi, which some economists have said is needed, would -- if not offset by a
reduction in China¶s prices -- add $75 billion to the U.S. import bill, since the United States
imports three times as much from China as it exports there," they wrote. That rise in costs will
most likely be passed on to the consumer. As they see it, a revaluation of the Renminbi on its

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own would do little to redress global imbalances, and could initially lead to a wider U.S.-China
trade deficit.

 

 

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Among the scholars from both countries offering suggestions about how China should respond to
the U.S.'s pressure, ua Min, director of the Institute of Vorld Economy at Fudan University,
asserts that China should ³stay the course´ and continue pegging the Renminbi to the dollar. ³It
is very risky for China to appreciate the Renminbi, especially at this juncture of the financial
crisis,´ he notes. ³China is relying on its labor-intensive manufacturing industries to bolster its
economic growth. An appreciation of the Renminbi would reduce demand for Chinese goods
from the U.S. If China¶s exports were to plummet, the country's exporters would go bankrupt or
lower wages to maintain profit margins. Many workers would lose their jobs and it would
destabilize society.´

The Renminbi is undervalued to allow China's exporters to gain competitiveness. If the Chinese
government continues to peg the [Renminbi] to the dollar, there will be a price distortion
between tradable commodities and non-tradable commodities « in China, The excessive
investment in China¶s manufacturing industries and underinvestment in service sectors would
continue. China's exporting sector would keep growing while other sectors, such as the services
producing non-tradable commodities, would never develop, and the economy would continue to
grow unhealthily, with a negative impact on China¶s long-term economic development. China
should allow a modest Renminbi appreciation, especially after the global economy recovers from
the downturn.

Another negative impact of the Renminbi remaining pegged to the dollar. Vith China¶s rapid
productivity growth, the rate of capital return in China becomes higher than the rate of capital
return in the United States. A large amount of capital denominated in U.S. dollars flows into
China seeking investment opportunities. In order to maintain the peg between the Renminbi and
the U.S. dollar under the fixed exchange rate regime, China¶s central bank has to buy all the
extra U.S. dollars at the fixed rate and place them on its balance sheet. So the high-powered
money on the central bank¶s balance sheet would go up, resulting in an increase in the money
supply in China.

That growth in money supply would either result in the increase of the price in the goods market,
or the increase of the price in the asset market. The latter is exactly what China experienced in
the past two years ± the asset bubble, that is, a periodic real estate and stock market booms that
heighten the financial risk.


  

In a book titled, The Future of China's Exchange Rate Policy, published in July last year by
Vashington, D.C.-based Peterson Institute of International Economics, Morris Goldstein and
Nicholas R. Lardy, two of its senior fellows, stated that the ³stay-the-course´ strategy is not
feasible, particularly because its external imbalance is much bigger than it was "five or six years
ago." Rather, they wrote, ³A currency appreciation could reduce the growth of exports and
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increase the growth of imports, thus reducing China¶s external surplus so that China could reach
an internal balance.´

Under the peg, they added, ³the Chinese authorities frequently have been slow to raise general
interest rates for fear of attracting higher levels of capital inflow. In contrast, a more flexible
exchange rate policy in the short run would allow the central bank greater flexibility in setting
domestic interest rates and pave the way for the introduction of more market-determined interest
rates.´ Finally, they noted that allowing China¶s export sector to gain unfair competitiveness
through an undervalued Renminbi undermines "the Chinese government¶s policy of fostering
innovation, improving and upgrading China¶s industrial structure, and accelerating the
development of service industries.´

Goldstein and Lardy highlighted the fact that that by 2007, China¶s global current account
surplus was 11% of GDP and the undervaluation of the Renminbi was much larger, at 30% to
40%. "No longer could the exchange rate disequilibrium be eliminated in one step without a
large contradictory impact on the domestic economy,´ they wrote.

Their book offers a ³three-stage´ approach to assisting China gradual move to a floating
exchange rate regime. ³In stage one, China should continue to appreciate the real value of its
currency vis-à-vis its trading partner at a pace of 4% to 5%. Difficulties in labor-intensive export
industries as a result of the continued appreciation of the Renminbi should be addressed through
trade adjustment assistance to redundant workers,´ noted the authors, adding that the assistance
would help the labor-intensive manufacturers that are no longer viable and "could propel the
needed structural adjustment of China's economy."

In stage two, as the financial crisis reaches an end and global growth recovers, the government
should allow the Renminbi to appreciate more rapidly so that much of China¶s current account
surplus would be eliminated over three to four years. In stage three, when China¶s current
account surplus has been dramatically reduced, "intervention in the exchange market should be
curtailed still further so that the Renminbi would essentially be floating.´

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In August, China took further steps to liberalize its currency and open its financial markets by
launching a pilot program in ong Kong to provide new channels for foreign investment in
mainland assets. The program, initially limited to bonds, is expected to pave the way for holders
of offshore deposits in Renminbi (RMB) to invest in China¶s A-share stock market. Vhile these
moves have been welcomed by analysts and economists, there is debate about whether they --
along with other RMB-related actions this year -- indicate a major turning point in China¶s long-
term foreign exchange policy.

As part of the latest initiative, the mainland¶s China Merchant Securities and CITIC Securities
announced cash injections of more than US$500 million into their ong Kong units. And in
mid-August, ai Tong Asset Management (ong Kong), a subsidiary of China-based aitong
Securities, launched what it described as the first retail fund outside the mainland to be fully
denominated in RMB. Initially, the brokerage said, the fund would invest in fixed-income assets.

The plan for the new A-share investment channels has not yet been finalized but is expected to
be in place by late this year or in early 2011. Two types of stocks are issued in China: A shares,
which are priced in Renminbi, and B shares, priced in dollars. For a time, foreign investors were
limited to B shares. Since 2003, however, a select number of foreign institutions have been
allowed to trade in A shares under the Qualified Foreign Institutional Investor program, or QFII,
but only after converting foreign currencies into RMB and subject to restrictions and quotas. The
new initiative, dubbed mini-QFII, allows ong Kong subsidiaries of domestic brokerages and
fund managers to channel offshore RMB deposits back into mainland markets, though still
subject to quotas.

The first inflow of capital under the new initiative will be more of a trickle than a torrent. The
initial quota of RMB 10 billion set for new bond market funds is minuscule compared with
China¶s fixed-income market of more than US$7 trillion. Even after the program permits
offshore-RMB investment in A shares, the inflows will still be relatively small ± the total market
capitalization of A shares is around US$3.2 trillion.

Vhether the burst of RMB-related activity this year signifies an approaching tsunami or simply a
testing of the waters remains to be seen. As is generally the case with China¶s financial reforms,
the changes will be incremental. Vith that, most analysts are adopting a wait-and-see position.

Nevertheless, though the initial flows under the bond and A-share programs will be a drop in the
ocean, some analysts are decidedly optimistic. They say that the latest shifts could have much
broader significance for China¶s willingness to liberalize and internationalize its currency
(ultimately giving the RMB reserve currency status alongside the dollar and euro) and could also
reduce China¶s dependence on the dollar for trade and further open its financial markets.

As global trade is settled more and more in RMB, foreign holders of the currency will find more
investment options available to them because of the mini-QFII program. Indeed, those options
should help spur the trend to settle in RMB.

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One of the most bullish views on the latest developments comes from Nomura International. The
mini-QFII moves are a significant step in a ³big bang´ reform plan, Nomura says in a report
written by its chief Asia equities strategist, Sean Darby, along with analysts Amy Lee and Mixo
Das. ³Excitingly, the changes in China¶s capital account are occurring alongside reforms to the
mainland financial markets, particularly the mainland A-share markets,´ the Nomura team wrote.

Nomura predicts that the moves will accelerate inward investment of RMB because ong Kong-
based banks will now have access to higher-yielding instruments. ³In the past, RMB rates were
so low in ong Kong because the banks had little opportunity to utilize the funds for lending or
to develop financial products,´ the report said. ³Moreover, they had little access to China¶s
capital markets.´ Now, along with other recent announcements, ³we are close to getting two
interbank markets for RMB allowing access to China¶s financial markets. Ve think that perhaps
the mini-QFII facility and the pilot scheme allowing foreign institutions access to China¶s RMB
market will be seen as the beginning of a µbig bang.¶ ´

The analysis is based not only on the August initiatives but also on the progressive expansion of
RMB business in ong Kong and other offshore centers, including Macau and member countries
of the Association of Southeast Asian Nations (ASEAN). The use of RMB for cross-border trade
settlement between ong Kong and the mainland has multiplied geometrically this year, from
RMB 400 million on a monthly basis until February 2010 to 2.5 billion in March, 2.9 billion in
April, and 7.2 billion in May.

The market for RMB-denominated bonds issued in the Southeast Asia region has also been
broadened. After initially being limited in 2007 to the mainland¶s major domestic commercial
and policy-oriented banks (such as the China Development Bank and the Export-Import Bank of
China, which were established in 1994 to take over the policy-oriented loans of the state-owned
commercial banks), the market was extended to foreign units of financial institutions in China in
2009 (with SBC and Bank of East Asia¶s mainland units both issuing bonds in July of that
year). Now, it has been extended to non-financial foreign corporations operating in China, with
fast-food giant McDonald¶s on Aug. 19 announcing an RMB-denominated issue in ong Kong
worth RMB 200 million.

 
 
 
Ú
  

Currently, legal foreign investment in onshore RMB-denominated equities has been limited to 97
major institutions under the QFII program, with total investment quotas of only around US$30
billion (not significant enough to have a major market impact). The size of the quotas under the
mini-QFII will initially be a fraction of that amount.

According to the report, the mini-QFII and other pilot programs allow ong Kong to be a testing
ground in which mainland regulators can slowly liberalize their currency regime and
internationalize the RMB, without losing control over the currency or risking volatility. ³Capital
account convertibility has to be implemented in a gradual and steady manner,´ the report said,
noting that ³South American and Southeast Asian countries have . . . offered important lessons in
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their financial liberalization as international funds posed attacks on their financial markets amid
premature liberalization.´

By limiting RMB initiatives to ong Kong, the report said, the mainland can adjust the pace of
internationalization according to ³policy needs and market development, and maintain control
over the inflow and outflow of RMB funds.´ Vithin this controlled framework, trials of different
kinds of RMB transactions can be conducted in ong Kong to test the market¶s reaction, the
report added.

In this gradualist model, currency liberalization remains distant and financial stability is the
priority. As RMB pricing power remains in China, the report by the Bank of China (ong Kong)
noted, ³funds cannot flow freely between the two markets, [and an] offshore financial crisis
would not affect the onshore market.´

 




Over the long term, China¶s stated policy is to promote the internationalization of the RMB and
reduce the country¶s reliance on the dollar for trade settlement. But the nation¶s incremental
approach, if maintained, will not necessarily yield quick results, or profits.

Fraser owie, managing director of Asia-focused brokerage house CLSA in Singapore, points
out, for instance, that investments in the established funds under QFII and the Qualified
Domestic Institutional Investor program (QDII), which allows outflows for investment in
approved foreign securities, have not resulted in major gains ± particularly as China¶s currency
appreciation failed to materialize. e argues that the new mini-QFII program may be another
false dawn.

³The question of how important this is cannot really be decided, and we¶ll only know in several
years time,´ says owie. ³If there is a substantial change in the currency, not just if it goes one
way but if it actually starts showing volatility reflective of risk appetite for China, the domestic
situation and the international situation, and, say, the freeing up of interest rates« then today
will actually have been significant.´ But, he adds, ³istory is probably going against it because
almost every other cross-border initiative has basically been a damp squib compared to what
people had believed it could be.´

owie argues that the QDII and the QFII have both been far less revolutionary than many had
forecast. ³Each one of these steps has been announced as a µstep forward¶ and a µliberalization¶
but what¶s not necessarily happening with all of these steps is everything being pulled together to
make a coherent picture,´ he says. ³It¶s still a little bit here and a little bit there, all with some
sort of international cross-border dimension « but it¶s not necessarily leading to what you think
it was going to.´

owie says there is no reason to think that recent reforms indicate a big bang. ³The fundamental
problems are not going to be resolved until you liberalize interest rates and make the currency
convertible.´

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