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Analysis of the Performance of the Chinese Yuan Relative to the US Dollar

Chinese Yuan Relative to the US Dollar

The Chinese yuan has been appreciating steadily against the US dollar over the last decade. In 2005, the Chinese government tweaked its currency against the US dollar, which caused the Chinese yuan to appreciate at an average rate of 4.5% per annum (Shih & Steinberg, 2012). The performance of the Chinese yuan has been improving steadily over the years, at a rate incomparable to that of any other currency in the world. While the inflation rate of 5% to 10% has been eroding the value of the Chinese yuan against the dollar, over the past few years, the appreciation of the yuan has exceeded 25-40% undervaluation allegations of the Chinese yuan made by politicians and economist (Shih & Steinberg, 2012). Since China’s gross domestic product (GDP) per capita is 10 times smaller than that of the United States, the relative price levels in China are 10 times higher than in the United States of America. Therefore, the further appreciation of the Chinese currency would only result in the further distortion of relative prices. This paper will analyze the performance of the Chinese currency relative to the US dollar between 2006 and 2010 and its macroeconomic implications.

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In the period between 2006 and 2010, the yuan-dollar pegged Chinese economy has expanded by 28%, which can be translated to an average rate of 5.6% annually (Shih & Steinberg, 2012). The deduction of the three year period (2008-2010) when the Chinese currency was frozen shows that the appreciation rate of the Chinese currency has been at the rate of 14% per annum. There is no other currency in the entire world that experienced such a rapid and risk-free appreciation as the Chinese yuan did (“Exchange Rates against the US Dollar,” 2015). The aforementioned appreciation is illustrated below.

Analysis of the Performance of the Chinese Yuan Relative to the US Dollar

Source: Forex blog

Investors in China continue to brace the 5% to 6% appreciation of the Chinese yuan relative to the United States dollar. During the period under discussion (2006-2010), contractors would price their contracts highly because they expected the appreciation of the Chinese currency relative to the dollar, which adversely affected their operation costs (Gavranić, 2016). The main indicator of the currency appreciation was the 9% of capital injection to the Chinese economy from foreign economies, which was dubbed “hot money” during that period. Despite the fact that the Chinese yuan was not fully tradable like the US dollar during the period under discussion, its continued appreciation had a negative effect on the foreign exchange market. Furthermore, “follow-on effects” emerged during this period, which further worsened the position of the Chinese yuan against the US dollar (“Exchange Rates against the US Dollar,” 2015).

Moreover, emerging markets, such as Indian and South Korean markets, tried to compete with China, and all the emerging market economies were fully aware that China had tweaked its currency against the US dollar (Shih & Steinberg, 2012). To make matters worse, emerging economies were under pressure to intervene daily on their forex markets to ensure that their respective currencies did not appreciate at a faster rate compared to the Chinese yuan. The Chinese currency had been undervalued for a significant time, and the appreciation of the Yuan during this period played a central role in converging the Chinese currency to that of the United States of America. All the aforementioned measures contributed to the depreciation of the US dollar. As a result of the depreciation of the US dollar, the Chinese yuan accounted for 20% of the trade-weighted index for the Federal Reserve Bank between 2006 and 2010 (Gavranić, 2016).At the same time, with the appreciation of the Chinese yuan, people all over the world lost confidence in the dollar.

Unfortunately, exchange-traded funds (ETFs) were not in a position to present the Chinese yuan effectively. Besides, there was no perfect substitute for the Chinese exchange-traded fund. The currencies of emerging markets, such as Malaysian ringgit, South Korean won, Indonesian rupiah, New Taiwanese dollar, and Thai baht, can be a relatively effective substitution to the Chinese yuan, but these currencies are still imperfect (Gavranić, 2016). This is because the appreciation of these currencies of emerging economies is driven by specific factors unique to each of the emerging economies as compared to their association with China or the United States of America.

Studies indicate that one year after the People’s Bank of China submitted to international pressure and made its policy regarding the yuan-dollar peg less strict, the Chinese yuan rose in value by more than 26% (Nair & Sinnakkannu, 2011). At that time, Chinese economists had no doubt that the yuan would keep appreciating even after 2010. Prior to 2006, economists asserted that the Chinese yuan had been underestimated by 15-40%, and the US politicians used this argument to advocated for 27.5% cross-border tariffs for all Chinese goods to compete fairly with US products in the market (Shih & Steinberg, 2012). The fact that between 2006 and 2010 the Chinese currency appreciated by over 28% made US politicians decide whether they should continue agitating for higher tariffs for products originating from China (Barros, Gil-Alana, & Chen, 2015).

However, there is a general misconception that China facilitated the devaluation of its currency against the US dollar to export more goods to the international market, since this market’s main currency is the US dollar. China experienced a sharp decline in the trade surplus, which is a clear indicator that Chinese products are no longer cheaply priced. Studies indicate that in 2006 alone, China’s trade surplus declined by 11% of GDP, and in 2010, China’s trade surplus declined by 5% of GDP (Barros, Gil-Alana, & Chen, 2015). According to the World Bank’s forecast at that time, the trade surplus of China would decline by approximately 3% of GDP annually.

Economist argues that the appreciation of the Chinese currency between 2006 and 2010 led to the narrowing of the trade imbalance between China and the United States of America. Besides, during this period, China’s economy was steadily reorienting itself towards domestic consumption and spending. In addition, China experienced growth in terms of domestic tourism, the number of automobiles on the road, the expansion of infrastructure by the government, and the increased cases of conspicuous consumption (Nair & Sinnakkannu, 2011).

The rise in the value of the Chinese yuan led to an increase in the price of commodities and fueled inflation. Studies indicate that in 2010, the average inflation rate in China constituted 5.4% (Nair & Sinnakkannu, 2011). The high inflation rates led to an increase in the cost of production and, consequently, to a rise in the prices of commodities. The People’s Bank of China reacted to the rising inflation rate by increasing the required reserve ratio for commercials banks several times to control the circulation of currency. While the prices of basic commodities continued to remain low compared to the same prices in the United States of America, the prices of such manufactured products as electronics and automobiles were already at par or exceeded the prices in the USA. However, the People’s Bank of China delayed the increasing of the interest rate, since such an action would discourage domestic borrowing, and it feared that “hot money” from other economies would penetrate the Chinese economy, which would have a negative impact on the banking industry during the period of the rapid overvaluation of the Chinese currency (Shih & Steinberg, 2012).

Furthermore, the examination of the Chinese economy against that of the United States of America in the period between 2006 to 2010 revealed that there was a strong connection between the foreign exchange turnover ratio to GDP per capita and trade. This implies that the Chinese currency experienced rapid growth in terms of the foreign exchange turnover as the Chinese economy grew and entered the apex of industrialization. In 2010, the People’s Bank of China relaxed the tough regulation over the Chinese yuan, which led to the appreciation of the yuan by 4.5% in the same year (Shih & Steinberg, 2012). Moreover, it was obvious that the Chinese yuan would keep rising in value after 2010. Nevertheless, the global community continued to portray China negatively and to accuse it of all the economic ills affecting the foreign exchange rates despite the People’s Bank of China’s and the government’s efforts to fix the problem of the Chinese currency (Nair & Sinnakkannu, 2011).

In conclusion, the devaluation of the currency of a country’s economy makes exports cheaper and imports more expensive. The trade surplus of China dropped sharply in the period between 2006 and 2010 as the Chinese yuan had begun to appreciate rapidly. The appreciation of the currency was inversely related to the balance of trade. As the Chinese yuan had continued to appreciate, the imbalance of trade between the United States of America and China narrowed. The overvaluation of the Chinese currency between 2006 and 2010 had the potential of destabilising the Chinese banking sector. It is the role of the People’s Bank of China and the Federal Reserve to ensure that the Chinese currency is fairly valued against other currencies in order to avoid such macroeconomic issues as inflation, price surge, and the rise in the interest rate through relevant financial institutions, decline in trade surplus, declined export, and adverse balance trade.