MACROECONOMI CS PROJECT

CURRENCY WARS-CHINA VS USA

VISHAL AGARWAL(201) AMIT CHOPRA(206) POONAM CHOUDHARY(207) HINA JHAMB(219) RACHITA BEHL(241) PRANIT TULSI(253) RAHUL JAIN(260) GROUP 1 13/12/2010

Table of Contents
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1.

INTRODUCTION

The world is on the brink of a nasty confrontation over exchange rates now spilling over to affect trade policy and public support for economic globalization. In this report we explore who is to blame for this situation getting so out of control, and what is likely to happen next? First of all, what is a currency war? A "currency war" is more of a political than an economic condition. Governments frequently intervene in their currency markets, increasing the money supply to stimulate trade and reduce unemployment, or decreasing the supply to combat inflation. The problem is that in an interlinked global economy, currencies don't rise or fall in a vacuum. This face-off started when partly by design and partly by chance, about a decade ago China found itself consistently accumulating large amounts of foreign reserves by running a trade surplus and intervening to buy up the dollars that this generated. In most countries, such intervention would tend to push up inflation, because the central bank issues local currency in return for dollars. But, because the Chinese financial system remains tightly controlled and the options for investors are very limited, the usual inflationary consequences have not followed. This gives China the unprecedented for a large trading country ability to accumulate foreign-exchange reserves (now approaching $3 trillion). And its export lobby is fighting fiercely to keep the exchange rate roughly where it is relative to the dollar. The US claims that China is unwilling to let the value of the yuan float. An undervalued currency, like the Chinese yuan, is one whose value is kept lower than where it should be and its value could rise absent of manipulation. Consequently, its low-cost exports hurt Americas ability to sell its own goods competitively in the global markets and adversely affected jobs in the US. On the other hand, Chinas stand is that the currency is a sovereign issue and should not be an issue to be discussed between two countries. Now the question arises whether Chinas currency is actually undervalued. There are several things that indicate the yuan has been and continues to be undervalued, the estimate of the undervaluation running from 25% to 45%. For one thing, China has been raking record level of trade surpluses against its major trading partners such as the U.S. Second, Chinas trade surpluses have resulted in a rapidly growing currency reserves for the country. Among other things, large foreign exchange reserves signal financial strength which boosts international
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confidence for the yuan. Third, Chinas economy has been growing at a more rapid rate, with annual GDP growth rates ranging between 8% and 11% per year than those of the U.S., Japan and Europe. Let us now understand the causes, actions and likely consequences of this ongoing currency war between China and the US. 2. MAJOR CAUSES FOR THIS CURRENCY WAR
i.

China constantly buys billions and billions of dollars-worth of US assets (usually Treasury bills), which increases the supply of Yuan relative to dollars in currency markets, and thus keeps the price of Yuan artificially low. This then makes Chinese exports artificially cheaper, relative to products priced in dollars (and many other countries' currencies too). Various estimates are that the Yuan is currently between 25 and 40% undervalued against the dollar. China wants to maintain its competitiveness in exports and so doesnt let its currency appreciate. This leads to decrease in competitiveness of western countries specially US leading to problems like unemployment.

ii.

China cannot alone be blamed for this currency war. US adopted an expansionary fiscal and monetary policy and hence extensive money printing was done by the US Federal. The increased cash flow and liquidity in the markets caused the depreciation of dollar against other global currencies. As a result, other countries felt the heat as their currencies were appreciating. As a reaction to this, countries like South Korea, Brazil and Singapore, interfered in the currency markets to artificially hold their currencies down. The Japanese government took a number of measures to intervene in the exchange market and keep the price of yen low against other major currencies. These countries also doubled taxes on capital inflows and as a result the appreciation of their currencies stopped. When all these currencies started depreciating, currencies like euro and especially the US dollar kept appreciating.

iii.

IMF also holds responsibility to a certain extent. In principle, the IMF is supposed to press countries with undervalued exchange rates to let their currencies appreciate. But the reality is that the IMF has no power over China (or any other country with a current-account surplus).

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As a result, emerging-market countries, aiming to ensure that they avoid needing financial support from the IMF in the foreseeable future, are increasingly following Chinas lead and trying to ensure that they, too, run current-account surpluses. In practice, this means fervent efforts to prevent their currencies from appreciating in value. Now that we understand how it all began, let us delve further into this raging debate. 3. THE FACE-OFF
3.1 ARGUMENTS OF CHINA
i.

China says that it is its ability to produce certain products at lower comparative costs than its competitors. One of the major factors contributing to this is the availability of cheap labour in China unlike in the US. Thus, China argues that they still have a competitive edge over the US.

ii.

China argues that the US does not produce a lot of goods anymore. It instead buys more goods from the rest of the world than it sells to them. Therefore, appreciating the value of Renminbi would only hurt the trade between US and China and will not address the real problem behind the US trade deficit.

iii.

China claims that U.S. policymakers have no moral superiority regarding the handling of exchange rates since it irresponsibly let its unsustainable boom in housing prices and mortgage lending practices corrupt the balance sheets of the world's financial institutions.

iv.

China also claims that the Federal Reserve's "irresponsible," loose monetary policy is destabilizing world capital markets.

v.

The US has been witnessing a pattern of overconsumption. Also, since it imports large quantities of goods to satisfy its huge demand, it is liable to have a trade deficit. Therefore, these deficits facilitate the surpluses that emerging markets such as China want to run the worlds current accounts add up to zero, so if one large set of countries wants to run a surplus, someone big needs to run a deficit.

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US dollar vs Chinese renminibi 3.2 ARGUMENTS OF USA i. Exporters and Import-Competitors: An undervalued currency has the potential to make Chinas exports cheaper and imports into China more expensive than they would be under free market conditions. By giving China a competitive edge, the undervalued dollar puts pressure on American exporters and import-competitors and creates job losses. ii. The US has been claiming that China has intentionally kept the value of its currency undervalued in order to sell more goods at the expense of its trading partners.
iii. As a result of Chinas undervalued yuan, manufacturing in Europe and the US has

moved overseas, pushing their economies into decline as a result of which the US is witnessing a decline in growth rate. iv. The Chinese have no intention of revaluing. Most moves they have made to date are cosmetic and done in a calculated fashion ahead of international meetings to deflect criticism.
v. The artificially undervalued currency is blamed for driving up China's huge trade

surpluses against the United States while at the same time raising the prices of US exports. The US argument has been that Chinas undervalued currency gives it an unfair competitive advantage in global trade, adding to Chinas political problematic trade surplus.

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vi. The US believes that the Chinese should be consuming more, that is, their growth

should be based more on domestic consumption than on export driven growth. But can an undervalued yuan, in any way, be good for the US? And other nations as well? We look at the trade-off. 3.3 THE TRADE-OFF
i. The undervalued Chinese currency allows American consumers for their dollar to buy

more goods than would be otherwise, effectively raising their purchasing power and standard of living. American consumers also benefit from the increased variety brought to the market. ii. The undervalued yuan will boost innovation and competition among American manufacturers and exporters. This will help world trade and make it more viable and competitive.
iii. American manufacturers, particularly those importing capital (intermediate) goods

also benefit from the undervalued yuan. By lowering the cost of their inputs, that is, sourcing their raw material from China, the undervalued yuan helps American producers to be more competitive in world markets than they would otherwise be. iv. The undervalued yuan also has an effect on U.S. government and the U.S. economy as a whole. America benefits when China uses the surplus of funds that it accumulates and buys U.S. Treasury notes, which have the effect of lowering U.S. interest rates.
v. Since the major cost of investment capital is the interest rate, lower domestic interest

rates allow American borrowers, businesses and consumers alike, to increase their spending, which in the end increase the size of the U.S. economy. America also benefits from the flow of capital from China when China and/or its citizens buy American assets. vi. Dollar depreciation will also serve longer-term interests by generating inflation and easing the debt burden that the financial crisis dumped on the US government.
vii. A stronger yuan rate would also be good for the rebalancing of the domestic and

global economies by shifting Chinas growth from exports and investment to private consumption.
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viii. Revaluating the RMB will solve the trade imbalance - currently, the United States vs

China deficit stands at about 62.4%. This is staggering as much of the imports for Chinese products into the United States translates into revenue for the Chinese. And as long as the revenue streams come trickling in, the China economy will continue to grow - at the expense of the United States. 4. CHINAS COURSE OF ACTION Chinas GDP is dependent on the exports, fixed investment and not enough on domestic consumption. The contention of Chinese government is that they dont want appreciation of Yuan which will directly impact the exporters, which in turn will lead to unemployment in the manufacturing sector and it will hurt the GDP of China. The result of a survey done by People Bank of China has revealed that for every 1 percent rise in the Yuan against the dollar, the profit margin of the labour-intensive exporters would decline by around 1 percent. Due to rising international pressure Chinese government under international pressure has allowed appreciation of Yuan by minimal extent of 3.1% from June 2010. However Peoples Bank still controls the daily pricing of Yuan v/s US Dollar. Greater scope for Yuan appreciation comes at a reasonably good time for China. A stronger renminbi would help to reduce rising inflationary pressure in China by reducing the cost of imports, which would also increase Chinese households real incomes a key goal of Chinas new five-year plan. Because a countrys economy cannot continue to grow only on exports it has to increase its domestic consumption. The diagram alongside explains the appreciation of Yuan and rising inflation in China.

The

Chinese

know

Yuan

appreciation is in their long term interest but they wont allow it because current objective of Chinese govt. is to create jobs and if CPC (Communist Party of China) fails to create and sustain

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enough jobs, the party's hold on power will be in danger, as is China's entire authoritarian model. So China would not allow much appreciation of Yuan. 5. USAS COURSE OF ACTION The United States conducts monetary policy the same way it conducts foreign policy; unilaterally. Unemployment in the United States (which is currently at 9.6%, and may reach 10% by the end of the year) is causing enormous problems for the Obama administration. The US labour market and welfare system are simply not designed to run with these levels of unemployment for any length of time. US administration has decided to reduce the unemployment rate, and close the current account deficit, and that the only way to achieve this is to force the value of the dollar down. The United States wants Group of 20 finance chiefs to commit to allowing market forces to set currency values and will discuss using targets for trade to measure progress, a senior U.S. Treasury Department official said on Wednesday. Ahead of weekend G20 meetings in Gyeongju, South Korea, the U.S. official made clear Washington wants currency levels to be a focal point of the meetings and sees current account surpluses and deficits a vital part of the discussion. Neither the Obama administration nor the Fed want a full-blown trade war with China. They'd rather see China assume its position in the global system. 6. IMPLICATIONS ON THE REST OF THE WORLD The currency wars have a spillover impact on rest of the nations, especially many emerging economies (EMEs) as the EME currencies have appreciated and their international competitiveness has weakened. Sample this. In the last three years, the Indian rupee has seen a high of Rs 51 and a low of Rs 39.20 to a US dollar. Such sharp swings impacts exporters and have a long-term impact on their hedging abilities. Although rising commodity prices in U.S. dollar offset the strength of emerging-market currencies somewhat for commodity exporters, the manufacturing sectors in emerging
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economies are suffering as a result of uncompetitive exports. The barriers of entry into the U.S. and China have therefore increased significantly. Furthermore, although the emergingmarket currencies remain fairly stable against the euro, the Euro zones demand for goods and services is likely to decline rapidly, resulting in lower demand for manufactured goods from emerging economies. These factors greatly increase the risks of running large current account deficits and hamper the economic growth in the emerging economies. So what are the countries doing about this? Some have resorted to countermeasures: Brazil has doubled its tax (levied a few months ago) on debt inflows; Thailand has announced a new 15 per cent withholding tax on bond purchases by foreigners; Taiwan has placed restrictions on portfolio inflows; and several EMEs (and Japan) have intervened in currency markets to moderate their currency appreciations. China, for example, has allowed very modest appreciation. What about India? The government and the RBI seem to have succumbed to watchful inaction. The central bank hardly intervenes in the currency market and refuses to take a clear view on the currency levels. Since March 2009 the rupee has been allowed to rack up the sharpest appreciation (by a long margin) in real effective exchange rate (REER) terms in our recorded history: about 25 per cent up till September 2010 according to the six-currency index (major trading partners) and 15 per cent according to the 36-currency index (includes significant competitor countries). At some point in time, our central bank has to step in. It has to actively arrest the inflow of hot money. At the end of the day, a strong currency with a high trade deficit not supported by long-term highquality capital flows is not in Indias best interests. In the end, everybody wants to get everything back to equilibrium. While the European Central Bank may eventually start quantitative easing, but its said itd take much more time than the Federal Reserve to do so. Governments in emerging economies are already under severe pressure to take action to devalue their currencies by either reducing interest rates or by some other methods to curb the inflows of money in their domestic market. 7. OUR INSIGHTS INTO THE FUTURE
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We feel things will continue to be the same for some time. China would not let its currency appreciate and US would not be able to do much about it. Reasons for this are mentioned below. 1) China : "Currency Manipulator" Yes, China is a currency manipulator. But there is a rational behind it. Goods marked as 'made in China' actually involve collective division of labour across the region. In the past 15 years East-Asian economies including Japan, South Korea, Taiwan, Singapore, Hong-Kong have moved their assembly lines to mainland China to take advantage of its labour cost, but they continue to target their exports to US market, world's biggest consumer. As a result these economies have greatly reduced their trade surplus with US while China is perceived as having the largest trade surplus with US. Chinese economy will suffer serious damage if it does not manipulate currency . First of all, a surcharge tariff of 20 per cent or more will drive a large proportion of Chinese exports out of the U.S. markets, and will significantly reduce external demand; secondly, many workers in coastal export processing zones will lose jobs, resulting in slowdown of economic growth and social unrest; third, as more speculative capital enters China with a bet on RMB appreciation, the problem of an asset bubble in the Chinese economy will worsen and could spiral out of control. 2) Next Super Power Recently it has been speculated that Chinas GDP will surpass USAs economy in 2016. It is going to be the most powerful nation on earth so USA States needs Chinas continued cooperation. USA cannot afford to enter into a trade/currency war with China. 3) What if Yuan appreciated? From the past data we can see that though the Yuan appreciated by 21% since july 2005 this has not significantly improved US trade deficit nor reduced China's trade surplus. The driving forces of todays exchange rate have gone far beyond bilateral trade. It is unlikely that further yuan appreciation, as demanded by some US congress representatives, can alter Chinas status as workshop of the world and substantially boost American exports. 4) If so then why does US continue to put pressure on Yuan?
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The weakening political support for Democratic Party and President Obama is evident. Maintaining a Congressional majority will be a difficult challenge for the Democrats. scapegoating China is always helpful to domestic politics, as it diverts popular dissatisfaction with the Administrations economic policies. Taking action on Chinese RMB would please voters who complain about the USs high unemployment rate. 5) What should be done in future? We must be extremely prudent about the impact of the global economy in which China, the United States, East Asia and other regions are closely linked. We have to handle the RMB exchange rate with rational analysis. There are signs which show that the US and China will find a sensible way to solve their problem and avoid the tremendous negative consequences to the recovering global economy. In the US, domestic political imperatives will hopefully give way to a more rational policy making process. A rational decision will benefit all economies, including that of the US. Rebalancing is the work of years. China and America have been building their export and import orientation over years and it can't be reversed overnight. Rebalancing should take place gradually, through nominal exchange rate adjustments and complementary structural adjustments on both sides, and we have ample reason to believe that this is achievable, and little reason to threaten trade war over slow initial progress. 8. REFERENCES:
http://www.telegraph.co.uk/finance/currency/8002719/Chinese-think-tank-warns-US-it-will-emerge-as-loser-intrade-war.htmlhttp://www.voxeu.org/index.php?q=node/5740 http://www.economist.com/node/17251850 http://www.project-syndicate.org/commentary/johnson13/English http://www.newbusinessethiopia.com/index.php?option=com_content&view=article&id=305:undervaluedyuan-currency-wars-and-their-implications&catid=45:opinion&Itemid=62 http://seekingalpha.com/article/229660-what-to-expect-the-impact-of-the-global-currency-wars http://www.economist.com/blogs/freeexchange/2010/03/chinas_currency_4 http://seekingalpha.com/article/194713-u-s-and-china-macroeconomics-brad-de-long-please-elaborate http://delong.typepad.com/sdj/2010/03/department-of-huh-stephen-roach-edition.html

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