Undervaluation Of Chinese Currency


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Undervaluation Of Chinese Currency

  1. 1. UNDERVALUATION OF CHINESE CURRENCY Mohamed Ragab Mostafa Mazen ¥
  2. 2. AGENDA <ul><li>History of Chinese Currency </li></ul><ul><li>Fixing the Exchange Rate & Undervaluation of RMB </li></ul><ul><li>American Trade Deficit </li></ul><ul><li>Chinese Currency Valuation </li></ul><ul><li>Implications of Undervaluation of RMB </li></ul><ul><li>Future Expectations </li></ul>
  3. 3. THE RENMINBI 人民幣 <ul><li>RMB:“People’s Currency” </li></ul><ul><li>Unit is yuan (¥) “round coin” </li></ul><ul><li>1 Yuan </li></ul><ul><ul><li>10 Jiao </li></ul></ul><ul><ul><ul><li>100 Fen </li></ul></ul></ul><ul><li>Issued by Communist Party in 1948 before winning the war and establishing People’s Republic of China </li></ul><ul><li>Reevaluation in 1955 to end hyperinflation </li></ul><ul><li>at 1 new yuan = 10 000 old yuan </li></ul>
  4. 4. FIXING THE EXCHANGE RATE <ul><li>For the last decade RMB’s exchange rate was fixed at 8.2765 yuan to the U.S. dollar. </li></ul><ul><li>Rate fixed by making it illegal to trade at any other rate and government monopoly over currency exchange. </li></ul><ul><li>Another fixing method is by manipulating </li></ul><ul><li>supply and demand. </li></ul><ul><li>RMB is significantly undervalued. </li></ul>
  5. 5. AMERICAN TRADE DEFICIT <ul><li>China contributes with 25% of US Trade Deficit </li></ul><ul><li>Appreciation of RMB will affect the deficit </li></ul><ul><li>The impact is proportional to the overall trade </li></ul><ul><li>China contributes with 11% of US Trade </li></ul><ul><li>Ex: a 20% appreciation would result in a 2% decrease in the American trade deficit </li></ul>
  7. 7. PURCHASE POWER PARITY (PPP) <ul><li>Based on the “Law of one price.” </li></ul><ul><li>E.g. Big Mac Index ( The Economist ) </li></ul><ul><li>Chang & Shao’s regression model variables </li></ul><ul><ul><li>e : Nominal exchange rate </li></ul></ul><ul><ul><li>p : Country’s domestic price </li></ul></ul><ul><ul><li>p* : U.S. dollar price </li></ul></ul><ul><ul><li>RER : Real Exchange Rate </li></ul></ul><ul><ul><li>GDP per capita </li></ul></ul>
  8. 8. PURCHASE POWER PARITY (PPP) <ul><li>Chang & Shao’s regression model’s Results </li></ul>
  9. 9. PURCHASE POWER PARITY (PPP) <ul><li>International Monetary Fund RMB Valuation </li></ul><ul><ul><li>2004: 1 USD = 2.021 yuan </li></ul></ul><ul><ul><li>2005: 1 USD = 2.047 yuan </li></ul></ul><ul><ul><li>2006: 1 USD = 2.062 yuan </li></ul></ul><ul><ul><li>2007: 1 USD = 2.095 yuan </li></ul></ul>
  10. 10. PPP LIMITATIONS <ul><li>Does not take into consideration: </li></ul><ul><li>Purchase patterns </li></ul><ul><li>Difference in quality of goods in different countries </li></ul><ul><li>Inflation </li></ul>
  11. 11. EQUILIBRIUM EXCHANGE RATE <ul><li>d: domestic demand; e: REER </li></ul><ul><li>I: internal balance; E: external balance </li></ul><ul><li>A: equilibrium exchange rate </li></ul>
  12. 12. FUNDAMENTAL EQUILIBRIUM EXCHANGE RATE (FEER) <ul><li>Determining the internal balance GDP </li></ul><ul><li>Determining a target current account balance that conforms to the sustainable capital account flows </li></ul><ul><li>Calculating the equilibrium REER required to achieve the balance. </li></ul><ul><li>Limitation : Uncertainty in estimating internal and external balances. </li></ul>
  13. 13. BEHAVIORAL EQUILIBRIUM EXCHANGE RATE (BEER) <ul><li>BEER model overcomes the FEER model's shortcoming by only modeling the economic fundamentals that explains the historic performance of the REER. </li></ul><ul><li>The BEER model does not go into the details of estimating the internal and external balances. </li></ul><ul><li>Limitation : </li></ul><ul><li>Assumes the economy was in equilibrium during the historical period; </li></ul><ul><li>China had a surplus of Balance of Payments </li></ul>
  14. 14. VALUATION SUMMARY Method PPP FEER BEER RMB Undervalued by 20-25% 15%-30% 5%
  16. 16. ADVANTAGES OF UNDERVALUATION <ul><li>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. </li></ul><ul><li>Low inflation and high financial stability. </li></ul><ul><li>Accumulating a large amount of reserves which has decreased the susceptibility to external shocks. </li></ul>
  17. 17. DISADVANTAGES OF UNDERVALUATION <ul><li>Expected Inflation on the long term to reach RER </li></ul><ul><li>Opportunity Costs </li></ul><ul><ul><li>Sacrificing purchasing power over imports </li></ul></ul><ul><ul><li>Accumulated foreign reserves could have been used to pay foreign debts </li></ul></ul>
  18. 18. CURRENT EXTERNAL PRESSURES <ul><li>Reasons: </li></ul><ul><li>Increasing of the U.S. current account deficit to over 6 percent of US GDP. </li></ul><ul><li>Depreciation of the US dollar </li></ul><ul><li>China’s rapid economic growth at the expense of other economies </li></ul><ul><li>The scale of China’s accumulation of foreign reserves </li></ul><ul><li>US manufacturing interests </li></ul><ul><ul><li>US threat to impose retaliatory </li></ul></ul><ul><ul><li>duties on Chinese imports </li></ul></ul>
  19. 19. CHINA’S REACTION TO GLOBAL PRESSURE <ul><li>July 2005: Chinese Government revalued the RMB by 2 percent against the US dollar to be 8.11 yuan to the US dollar. </li></ul><ul><li>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. </li></ul><ul><li>As of February 29, 2008 the RMB’s exchange rate became 7.1058 yuan per U.S. dollar </li></ul><ul><li>(16.5% increase). </li></ul>
  20. 20. FUTURE EXPECTATIONS <ul><li>Long term: achieve a flexible exchange rate </li></ul><ul><li>Weak banking system and immature financial markets stand in the way </li></ul><ul><li>Need to set the pace of the adjustment </li></ul>
  21. 21. FUTURE EXPECTATIONS <ul><li>Challenges: </li></ul><ul><li>Banks have a positive foreign asset position; currency appreciation will be bad </li></ul><ul><li>Risks from the loans exposure to the export sector </li></ul><ul><li>Limited capacity to manage currency risk and deal with currency fluctuations </li></ul>
  22. 22. QUESTIONS ?