Undervaluation Of Chinese Currency

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  • 1. UNDERVALUATION OF CHINESE CURRENCY Mohamed Ragab Mostafa Mazen ¥
  • 2. AGENDA
    • History of Chinese Currency
    • Fixing the Exchange Rate & Undervaluation of RMB
    • American Trade Deficit
    • Chinese Currency Valuation
    • Implications of Undervaluation of RMB
    • Future Expectations
  • 3. THE RENMINBI 人民幣
    • RMB:“People’s Currency”
    • Unit is yuan (¥) “round coin”
    • 1 Yuan
      • 10 Jiao
        • 100 Fen
    • Issued by Communist Party in 1948 before winning the war and establishing People’s Republic of China
    • Reevaluation in 1955 to end hyperinflation
    • at 1 new yuan = 10 000 old yuan
  • 4. FIXING THE EXCHANGE RATE
    • For the last decade RMB’s exchange rate was fixed at 8.2765 yuan to the U.S. dollar.
    • Rate fixed by making it illegal to trade at any other rate and government monopoly over currency exchange.
    • Another fixing method is by manipulating
    • supply and demand.
    • RMB is significantly undervalued.
  • 5. AMERICAN TRADE DEFICIT
    • China contributes with 25% of US Trade Deficit
    • Appreciation of RMB will affect the deficit
    • The impact is proportional to the overall trade
    • China contributes with 11% of US Trade
    • Ex: a 20% appreciation would result in a 2% decrease in the American trade deficit
  • 6. CHINESE CURRENCY VALUATION
  • 7. PURCHASE POWER PARITY (PPP)
    • Based on the “Law of one price.”
    • E.g. Big Mac Index ( The Economist )
    • Chang & Shao’s regression model variables
      • e : Nominal exchange rate
      • p : Country’s domestic price
      • p* : U.S. dollar price
      • RER : Real Exchange Rate
      • GDP per capita
  • 8. PURCHASE POWER PARITY (PPP)
    • Chang & Shao’s regression model’s Results
  • 9. PURCHASE POWER PARITY (PPP)
    • International Monetary Fund RMB Valuation
      • 2004: 1 USD = 2.021 yuan
      • 2005: 1 USD = 2.047 yuan
      • 2006: 1 USD = 2.062 yuan
      • 2007: 1 USD = 2.095 yuan
  • 10. PPP LIMITATIONS
    • Does not take into consideration:
    • Purchase patterns
    • Difference in quality of goods in different countries
    • Inflation
  • 11. EQUILIBRIUM EXCHANGE RATE
    • d: domestic demand; e: REER
    • I: internal balance; E: external balance
    • A: equilibrium exchange rate
  • 12. FUNDAMENTAL EQUILIBRIUM EXCHANGE RATE (FEER)
    • Determining the internal balance GDP
    • Determining a target current account balance that conforms to the sustainable capital account flows
    • Calculating the equilibrium REER required to achieve the balance.
    • Limitation : Uncertainty in estimating internal and external balances.
  • 13. BEHAVIORAL EQUILIBRIUM EXCHANGE RATE (BEER)
    • BEER model overcomes the FEER model's shortcoming by only modeling the economic fundamentals that explains the historic performance of the REER.
    • The BEER model does not go into the details of estimating the internal and external balances.
    • Limitation :
    • Assumes the economy was in equilibrium during the historical period;
    • China had a surplus of Balance of Payments
  • 14. VALUATION SUMMARY Method PPP FEER BEER RMB Undervalued by 20-25% 15%-30% 5%
  • 15. IMPLICATIONS OF UNDERVALUATION OF CHINESE CURRENCY
  • 16. ADVANTAGES 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.
    • Low inflation and high financial stability.
    • Accumulating a large amount of reserves which has decreased the susceptibility to external shocks.
  • 17. DISADVANTAGES OF UNDERVALUATION
    • Expected Inflation on the long term to reach RER
    • Opportunity Costs
      • Sacrificing purchasing power over imports
      • Accumulated foreign reserves could have been used to pay foreign debts
  • 18. CURRENT EXTERNAL PRESSURES
    • Reasons:
    • Increasing of the U.S. current account deficit to over 6 percent of US GDP.
    • Depreciation of the US dollar
    • China’s rapid economic growth at the expense of other economies
    • The scale of China’s accumulation of foreign reserves
    • US manufacturing interests
      • US threat to impose retaliatory
      • duties on Chinese imports
  • 19. CHINA’S REACTION TO GLOBAL PRESSURE
    • July 2005: Chinese Government revalued the RMB by 2 percent against the US dollar to be 8.11 yuan to the US dollar.
    • People’s Bank of China announced RMB will no longer be pegged to the US dollar. Instead the RMB would be valued with reference to a basket of currencies.
    • As of February 29, 2008 the RMB’s exchange rate became 7.1058 yuan per U.S. dollar
    • (16.5% increase).
  • 20. FUTURE EXPECTATIONS
    • Long term: achieve a flexible exchange rate
    • Weak banking system and immature financial markets stand in the way
    • Need to set the pace of the adjustment
  • 21. FUTURE EXPECTATIONS
    • Challenges:
    • Banks have a positive foreign asset position; currency appreciation will be bad
    • Risks from the loans exposure to the export sector
    • Limited capacity to manage currency risk and deal with currency fluctuations
  • 22. QUESTIONS ?