By Victory Team

1
China should revalue the Yuan by at least 15

• By Victory Team
• Wu Shengli, Zhao Yaode, Ju Dianming
• Yang Shengyuan, Liu Yunfeng, Meng Hui
• June 14, 2005

2
Background

• RMB Chinese legal tender
• The basic unit of the currency is yuan.
• Exchange rate of RMB has been pegged with U.S.
  dollar.
• The exchange rate of the currency has been fixed
  for the most part of the past half century with a
  few major discrete changes.

3
Background

• The exchange rate between the RMB and the U.S.
  dollar was set at 2.46 yuan to the dollar from
  1955, the year when the new RMB was issued, to
  1971.
• The RMB revalued gradually since 1972 to 1.50
  yuan to the dollar in 1979.
• Chinas State Council introduced the internal
  settlement rate of the RMB at 2.80 yuan to the
  dollar at the beginning of 1980.

4
Background

• In 1980, the Bank of China, with approval of the
  Chinese government, started the foreign exchange
  swap market in Beijing, Shanghai and other major
  cities in China.
• At the beginning of 1985, China abolished the
  internal settlement rate and set the official
  rate, thus ending the dual exchange rate system.

5
Background

• In 1986, the exchange rate determined by the
  foreign exchange swap market was 6.50 yuan to the
  dollar while the official exchange rate was only
  3.72 yuan to the dollar. As a result, a dual
  exchange rate system reemerged in China.

6
Background

• In December 1989, the official exchange rate was
  adjusted to 4.72 yuan/US.
• In November 1990, the official exchange rate was
  adjusted to 5.22 yuan/US.
• This rate gradually increased up to 5.8 yuan/US
  in 1993.
• Despite the devaluations since 1985, the RMB was
  still considered overvalued in the early 1990s.

7
Background

• The overvaluation was reflected in the foreign
  exchange swap market where the rate reached as
  high as 11 yuan to the dollar in 1992, a premium
  of about 90 over the official rate.In 1993,as
  high as 8.70 yuan to the dollar.

8
Background

• The official exchange rate and the swap rate were
  merged to produce a single exchange rate, ending
  the dual exchange rate system again. The merged
  rate was set at 8.7 yuan to the dollar at the
  beginning of 1994.
• In April 1994, Chinas foreign exchange trading
  center, located in Shanghai, started operation
  and marked the commencement of Chinas inter-bank
  foreign exchange market.

9
Background

• Starting on December 1, 1996, China adopted
  currency account convertibility, a significant
  step toward fulfilling the agreements of the
  International Monetary Fund. The value of the RMB
  appreciated slightly from 8.70 yuan to the dollar
  in 1994 to about 8.3 yuan by mid 1995 and stayed
  at 8.28 yuan/US since September 1998 .

10
Background
RMB Exchange Rate (Yuan per U.S. dollar)
Data sources Official rate1. 1957-2002 from
IMF International Financial Statistics, end of
period data. 2. 1952-1956 from
Nicholas Lardy. 3. 2003 from
China State Administration of Foreign Exchange,
11
Background
Real exchange rates
Source US Federal Reserve System?International
Financial Statistics, IMF
12
Background
China import and export
13
Why RMB should be revalued

• Chinas foreign reserve dramatically increase.
• Chinas foreign trade surplus versus U.S. trade
  deficit.
• Excess money supply exacerbates the already
  excessive expansion in bank lending, money supply
  growth, and investment.
• U.S.?Japan?EU give pressure of revaluation the
  RMB on China.

14
Why RMB should be revalued
15
Why RMB should be revalued
Chinas foreign reserve
16
Why RMB should be revalued
U.S. Merchandise Trade with China 1994-2003
(billions)
17
Why RMB should be revalued
18
Why RMB should be revalued
19
Reasons for revaluation
Characters of Chinas economy

• Open economy
• 1979,export, import, attract foreign
  investment (SEZ)
• Fix exchange rate pegged with US Dollar
• Imperfect capital mobility (Current Account
  Dominated )
• 1)Current account more than capital account
• 2)Foreign currency policy convertible in
  current account

20
Reasons for revaluation
Factors relating to Chinas economy
G??
World economy
Fiscal policy
CA
Fixed ex rate BP/IS/LM
T??
Chanese open economy
BOP
KA
MS??
Income
r??
Monetary policy
r
S??
21
Reasons for revaluation

• Mundell Model Analysis

22
Reasons for revaluation
Mundell Model Analysis

• Devaluation --X?, Import?--- BP, IS shift right
  (y ?,r ?)-- BP surplus--MS ?--r ?, y ?(new
  equilibrium point C)
• Revaluation will lead opposite direction
• Based on the above model analysis, devaluation of
  domestic currency will lead BP surplus, whereas
  the revaluation lead BP deficit

23
Reasons for revaluation
Chinas capital account19942003
24
Reasons for revaluation
Chinas current account19942003
25
Reasons for revaluation
Mundell Model Analysis

• The previous slides show that both CA and KA
  surplus make China in the position of great BOP
  surplus.
• According to Mundell Model Analysis Revaluation
  is a necessary to reduce Chinas BOP surplus

26
Reasons for revaluation
Problems of great BOP surplus

• Raise trade conflicts with trade partners
• May Lead foreign reserve increase infinitely
• Lead domestic money supply increase dramatically
  (M1 ?) or central bank intervention
  (sterilization)
• Increase of M1 will lead inflation

27
Reasons for revaluation
Purchasing Power Parity Analysis

• Law of one price (LOP)
• Big Mac price in China is 10.5 yuan, in USA is
  2.49 respectively, according to the LOP, the ex
  rate should be S(/) 10.5/2.494.22. But the
  prevailing ex rate is about 8.27, therefore, RMB
  (yuan) is undervalued 49.

28
Reasons for revaluation
Estimates of Undervaluation
29
Pros of revaluation

• Reduce global payments imbalances, especially the
  correction of the US current-account deficit.
• The global adjustment process will then be shared
  across a broader base. Chinas role in adjustment
  of Asian currencies is crucial. An revaluation of
  RMB is a key that the currencies of Asian
  economies appreciate simultaneously.

30
Pros of revaluation

• A revaluation of the RMB is efforts to rein-in an
  excessive growth of bank lending.
• It is efforts to bring an end to overheating of
  the economy and to keep inflation from rising too
  much.

31
Pros of revaluation

• A revaluation of the RMB may reduce the
  governments subsidize to export products, the
  funds saved may be used for public
  infrastructures and facilities construction, this
  may create some new work opportunity and maintain
  the sustainable growth of the economy.

32
Pros of revaluation

• A revaluation of the RMB would actually improve
  Chinas prospects for healthy, sustainable,
  non-inflationary economic growth.
• A revaluation of the RMB increases the RMB
  purchasing power, is helpful in raising the
  peoples welfare level.

33
Pros of revaluation

• Revaluation of RMB will reduce the cost of
  imported products, this means that the price of
  imported production facilities will be lower.
  Domestic firms may buy more advanced technology,
  machine and material, and improve their
  competitiveness.
• As a result of revaluation, export products with
  low technology content will become less
  competitive in international market, this may
  lead to technical innovation, economic structure
  adjustment and product upgrading, otherwise the
  manufacturers could be defeated by its rivals,
  and be eliminated from market.

34
Pros of revaluation

• As a result of revaluation, the production cost
  of some export-oriented enterprises may increase,
  while the cost of some import-oriented
  enterprises may decrease, this may have the
  effect of allocating resources more rational. For
  example, we may import more crude oil and iron
  ore to meet the domestic demand, and reduce the
  domestic production, meanwhile alleviate the
  environmental pollution pressure.

35
Pros of revaluation

• As a result of revaluation, the repayment ability
  of foreign debts that nominated in foreign
  currency and repaid through converting RMB to
  foreign currency will be greatly enhanced. For
  example, each year the aviation industry spend
  huge amount in importing civil airplanes, if the
  RMB revaluate 15-20, the industry will great
  benefit from it.

36
Pros of revaluation

• To the foreign investors that have already
  invested in China, the RMB revaluation means that
  any investment profit earned by them in RMB
  represents more profit in foreign currency, this
  will increase their confidence in investing in
  China.
• The RMB revaluation represents that the Chinese
  overseas investment cost will drop, this may
  encourage more Chinese enterprises to invest
  overseas, and may foster some competitive
  multinational corporations held by Chinese firms.

37
Arguments against the revaluation

• The Yuan really undervalued?
• What FX reserves increase means
• Whether revaluation makes sense
• Why shouldnt revalue now
• What happens if RMB revalued
• Conclusion

38
Arguments against the revaluation

• The Yuan really undervalued?
• What FX reserves increase means
• Whether revaluation makes sense
• Why shouldnt revalue now
• What happens if RMB revalued
• Conclusion

39
The Yuan really undervalued?

• There are many economists, experts, scholars,
  professors, and researchers who argue or disagree
  that the Yuan is really undervalued as accused.
  They argue that there is no evidence that really
  indicates RMB undervalued.

40
The Yuan really undervalued?

• First, recalling the Big Mac prices, which is
  used to indicates RMB undervalued. But based on
  analyses, by Yang and Bajeux (2003), about U.S.
  China price comparison, Chinas trade, capital
  and international reserves, found no evidence
  that the RMB is undervalued. 40 Inclusive of both
  tradable and non-tradable components in prices
  indices, PPP tends to overestimate the value of
  the RMB.

41
The Yuan really undervalued?

• Otherwise, only take the Big Mac prices to
  indicate the Yuan undervalued is unscientific
  because lack of comparativenessi.e. ignoring
  the effect of non-tradable goods. Actually the
  Big Mac prices are not the appropriate guide for
  currency valuations. It seems that it is most
  used by policy makers and business executives to
  criticize others.

42
The Yuan really undervalued?

• Secondly, regarding the Chinas surpluses in
  trade and current accounts. They show no
  indication of currency misalignment too. While
  Chinas accumulation of international reserves
  appears higher than the international norm,
  factors other than the exchange rate (such as
  preferential treatment for foreign investment and
  control on capital outflows) have played the
  major role.

43
The Yuan really undervalued?

• According to 2003 statistics, Chinas global
  trade surplus account for 8 of US deficit, Japan
  for 15, EU zone for 28, the oil exporting
  country for 20 ,east Asia excluded Japan for
  19, total is for 80(excluding China), from this
  point, China exchange rate is not the cause of
  the US increasing trade deficit.

44
The Yuan really undervalued?

• Hamper US Manufacture industry???
• According to statistics by US labor
  organization,
• 1990 to 1995 increase rate 3.7
• 1995 to 2000 increase rate 5.7
• 2003 to 2004 increase rate 4.4
• 2004 increase rate 5.1

45
The Yuan really undervalued?

• In addition, part of the trade deficit is also
  caused by American policies they appear to be
  happy to buy from China, however unwilling to
  sell China products. Unless the two countries can
  have better understanding and trade flow between
  the two countries it is likely the deficit will
  remain. China wants to buy US products but in
  many cases is forbidden from doing so, especially
  in IT sectors.

46
The Yuan really undervalued?

• In fact, a stable RMB is essential to maintaining
  Asian economic stability. During the Asian
  financial crisis of the late 1990s, China was
  widely applauded for doing so to have prevented a
  round of competitive currency devaluations in
  Asia. It caused China losses of about 4 of GDP
  at that time.

47
The Yuan really undervalued?

• So, RMB is really undervalued? No. Sometimes, it
  is likely something about politics rather than
  economics itself. For instance, to transfer the
  domestic criticism what the government meet.
• E.g. according to the Plaza Accord imposed by
  Western Countries, Japan was forced to increase
  Yen by 30, this is one of essential factors of
  Japanese economy recession.

48
Arguments against the revaluation

• The Yuan really undervalued?
• What FX reserves increase means
• Whether revaluation makes sense
• Why shouldnt revalue now
• What happens if RMB revalued
• Conclusion

49
What FX reserves increase means

• By the end of 2004, Chinas FX reserves reached
  609.9 billion, increased by 206.6 billion, or
  51.2 from the previous year. According to the
  Chinas central bank, among the increase, CA is
  about 70 billion, KA about 112 billion
  (including FDI 60.6 billion, the rest is mainly
  so called hot money). It shows the KA is the
  main factor of the FX reserves increase.

50
What FX reserves increase means

• By the end of this March, FDI was about 12.4
  billion, trade surplus about 16.6 billion, but
  the FX reserves increased 49.2 billion from last
  year. It meant the continuous inflow of hot
  money due to the speculative expectation.

51
What FX reserves increase means

• Moreover, with everyone expecting RMB
  appreciation, foreign invested enterprises are
  accumulating their realized profits with the plan
  to remit them out in US dollars when the time is
  right. An estimated 15 billion in non-remitted
  profits have been accumulated in Shanghai, and
  the amount in Guangdong and other coastal cities
  is expected to be even higher.

52
What FX reserves increase means
The proportion of FIE in 2004 IEUnit100M
Note FIE- Foreign
Invested Enterprises
53
What FX reserves increase means

• Restrictions on the Chinese traveling to the US
  and other major countries restrict investment and
  spending opportunities, so as to give Chinese
  companies not only no means to sell products
  directly to end consumers, no means to find the
  latest technology necessary to stay competitive,
  but also no means to invest excess money in other
  countries' markets.

54
What FX reserves increase means

• Undoubtedly, a sizeable number of the hot money
  and non-remitted profits because of betting RMB
  appreciation is really threatening Chinas
  financial stability (In the second half of last
  year, China's short-term foreign loans accounted
  for 42 percent of total foreign loans, which was
  mainly hot money, far exceeding the
  international security level of 25 percent).

55
Arguments against the revaluation

• The Yuan really undervalued?
• What FX reserves increase means
• Whether revaluation makes sense
• Why shouldnt revalue now
• What happens if RMB revalued
• Conclusion

56
Whether revaluation makes sense

• Would a revaluation of the RMB would bring big
  help to the world economy? Or, say, cutting
  China's exports by floating or revaluating the
  yuan create broad-based prosperity or employment
  growth in the US? Probably not. Why?

57
Whether revaluation makes sense

• Recalling the Plaza Accord first. Since World War
  II, the United States has constantly lost
  industries to overseas competition. US jawboning
  resulted in the Plaza Accord of 1985 in an
  attempt to cut Japan's trade surplus. After the
  Plaza Accord, Japan floated its currency. US
  industries, primarily car makers, discovered that
  now they were competing on quality, not price,
  and they continued to lose market share.

58
Whether revaluation makes sense

• Secondly, Macroeconomic simulations conducted by
  Park show that a projected 10 percent revaluation
  of the RMB would only improve the US trade
  balance by 3.6 billion, a mere 0.02 percent
  change in the current account as a percent of
  gross domestic product (GDP). Even with a 20
  percent revaluation, the situation changes
  little, contributing only to a 0.05 percent
  reduction in the current account deficit,

59
Whether revaluation makes sense

• Thirdly, although China took the third position
  of the exporters to the US, China accounted for a
  relatively small share of total US imports, only
  13.4, far behind EU and Canada in 2004. Even if
  cutting the products importing from China by
  appreciating RMB, those goods should be imported
  from other countries.

60
Whether revaluation makes sense

• Fourthly, revaluation may bring little influence
  to the competitive edge of Chinese export
  products
• According to statistics by World Labor Union,
  the Chinese annual labor costs is about 1200,
  only account for 2.1 of Japans and 2.2 of
  USs, even if the labor costs doubled caused by
  RMB appreciation, still less than 5 of USs. so
  US labor intensive products is still not in favor.

61
Whether revaluation makes sense

• (contd)
• Stephen Roach, chief economist at Morgan
  Stanley, shared similar values since China does
  not compete on the basis of an undervalued
  currency, but mainly in terms of labor costs,
  technology, quality control, infrastructure, the
  improved human capital of its work force, and a
  passion for and commitment to reform. Therefore,
  if China were to revalue the RMB upward by 10,
  its exports would suffer minimal loss of market
  share.

62
Whether revaluation makes sense

• Fifthly, RMB revaluation is not hopeful for the
  improvement of the countries that claimed RMB
  undervalued, even worse to damage themselves.
• A Survey by Japanese Trade Promotion to 1300
  Japanese Companies in China, more than 50 of
  them are involved heavily in exports, showed none
  of them expected RMB appreciation because if RMB
  revaluated, their benefits would be badly
  influenced.

63
Arguments against the revaluation

• The Yuan really undervalued?
• What FX reserves increase means
• Whether revaluation makes sense
• Why shouldnt revalue now
• What happens if RMB revalued
• Conclusion

64
Why shouldnt revalue now

• First of all, China has a large heap of important
  reform issues on its plate, including a
  dysfunctional stock market, a weak financial
  system, badly needed SOE reforms, incomplete
  property laws and troubling real estate bubbles
  resulting from a lack of attractive investment
  options for local savings. As the country's
  leaders seem fully aware, revaluation or floating
  the RMB before the nation's financial
  institutions are in good order would be reckless
  in the extreme.

65
Why shouldnt revalue now

• Robert Mundell, 1999 Nobel laureate in economics
  and also known as the Father of euro criticized
  the international pressure on China to revaluate
  the yuan. According to him, appreciation or
  floating of the RMB would involve a major change
  in Chinas international monetary policy and has
  important consequences for growth and stability
  in China and the stability of Asia, and that
  China should float its currency only when sound
  financial and banking mechanisms are established.

66
Why shouldnt revalue now

• Stephen Roach also offered several reasons that
  China should keep the FX rate
• First, world wide supply chain needs stable RMB.
  The real export dynamic in China comes far more
  from the conscious outsourcing strategies of
  western multinationals than from the rapid growth
  of indigenous Chinese companies. Nearly
  two-thirds of Chinas foreign-driven export
  dynamic since 1994 is traceable to the impact of
  multinationals alone. So revaluation of the RMB
  would destabilize the very supply chain that has
  become so integral to new globalized production
  models.

67
Why shouldnt revalue now
Chinas rapidly expanding international trade
Chinas trade has increased more rapidly than
international trade for a sustained period (15
percent per year, compared to 7 percent for world
trade)
68
Why shouldnt revalue now
While Chinas trade surplus with the US and EU
has been increasing, the trade deficit with the
rest of Asia has also been increasing
69
Why shouldnt revalue now

• Second, China has consistently reiterated its
  long-term commitment to opening its capital
  account and making its currency fully
  convertible. So until there is greater progress
  on the road to financial reforms, it would be
  entirely premature and risky for China to float
  its currency.

70
Why shouldnt revalue now

• Third, besides these most compelling reasons
  above, an intensification of imported
  deflationary pressures for a Chinese economy that
  is just now climbing back out of deflation a
  possible outbreak of bubbles in other asset
  markets, especially property and a signal to
  market speculators that the RMB is now in play
  are all considerations against an RMB revaluation.

71
Why shouldnt revalue now

• The biggest problem China faces in terms of both
  political and economic stability is its 900
  million rural populations that is still living in
  poverty. This number represents 65 per cent of
  China's total population, much higher than a
  fully-industrialized country of about 25 per
  cent. It means there are still a lot of cheap
  laborers for the world to set up their factories
  in China.

72
Why shouldnt revalue now

• (contd)
• To industrialize, China will need to invest
  heavily in the rural areas and bring the rural
  population up to industrialization standards. It
  also means China will have to keep its labor cost
  or currency low to compete and generate new jobs
  for its people. Until China can successfully push
  at least half of its rural farming population
  into industrial production, the currency is not
  likely to budge.

73
Arguments against the revaluation

• The Yuan really undervalued?
• What FX reserves increase means
• Whether revaluation makes sense
• Why shouldnt revalue now
• What happens if RMB revalued
• Conclusion

74
What happens if RMB revalued

• The appreciation of the RMB would bring negative
  effects which include lower foreign investment
  and economic growth, bigger non-performing loans
  of banks, higher losses of State-owned
  enterprises and unemployment rates as well as
  more unstable factors for the Southeast Asian
  economies, which will affect the RMBs future
  influence in the regionRobert Mundell

75
What happens if RMB revalued

• First, observe the main influences on China.
• Negative impact on competitiveness of Chinese
  labor intensive products comparison with other
  Asian countries.
• If increasing export prices ? market
  contracting ? profits decrease
• If maintaining export prices ? costs increase
  ? profits decrease.

76
What happens if RMB revalued

• Negative impact on foreign direct investment
  (FDI)
• RMB appreciation ? foreign direct investments
  costs increase ? foreign direct investments
  decrease.

77
What happens if RMB revalued

• Increase employment pressure
• Besides the above mentioned decrease of the
  FDI which is one of the biggest sources bring new
  employment opportunities, an appreciation of RMB
  ? foreign invested enterprises profits decrease ?
  lay off workers ? both increase pressure of
  employment.
• Even worse the situation when export
  industries move factories to other countries due
  to labor costs or RMB becoming too high.

78
What happens if RMB revalued

• Negative impact on financial market.
• RMB appreciation ? hot money inflow ?
  financial crisis.
• Threaten to Shrink of foreign exchange reserve.
• If RMB appreciation by 15 compared with USD
  and other main convertible currencies ? shrink of
  15 of 659.1billion equal to 98.865billion
  accounting for 7.6 of China GDP!!!

79
What happens if RMB revalued

• According to a report by the Asian Development
  Bank
• If RMB appreciation by 10 in the second half
  of 2005 ? 15 billion trade surplus in 2006
• If RMB appreciation by 20 ? 31.8 billion
  trade deficit in 2006 ? contribution of CA to
  GDP will decrease by 1.7

80
What happens if RMB revalued
81
What happens if RMB revalued

• Secondly, to the rest of the world.
• Suppose Chinas economy is slowdown due to the
  revaluation of the RMB, as one of the world
  largest trade countries with huge potential
  market, the downward both of the import and
  export will bring negative effect to the world
  economic development.

82
What happens if RMB revalued

• Thirdly, specially to the US. The US Treasuries
  would suddenly become considerably less
  attractive to Asian central banks, which could go
  looking for other places to invest. Then the US
  economic dilemma would rapidly become a whole lot
  more complicated. The US Federal Reserve would
  have to raise interest rates to continue to
  attract foreign investors.

83
An example

• Effects of Chinese Currency Appreciation in the
  World Fiber Markets
• source Cotton Economics Research Institute
  Department of Agricultural and Applied Economics
  Texas Tech University (October 2004)

84
An example
85
An example
86
An example
87
Arguments against the revaluation

• The Yuan really undervalued?
• What FX reserves increase means
• Whether revaluation makes sense
• Why shouldnt revalue now
• What happens if RMB revalued
• Conclusion

88
Conclusion

• There is no evidence that indicates the RMB is
  really undervalued
• The Chinas FX reserves increase is not because
  of the undervalued RMB
• It is definitely not the right time for China to
  change its exchange system
• If China forced to revalue the RMB, it will
  damage the stability of its economy and society,
  and destruct the world economic development.
• If the dam does burst, the world will probably
  be the poorer for it as one expert said.

89

• THANKS!