Undervalued Chinese Currency and Its Impact on US Economy

BUSINESS ENVIRONMENT

Undervalued Chinese Currency and its Impact on the US Economy

Major Focus: Manufacturing Sector

Submitted By –

Pankul Kohli – 11DCP031

Prantar Goswami – 11DCP034

Saptarshi Roy Chowdhary – 11DCP041

Sarang Jain – 11DCP042

Vishal Zaveri – 11DCP052

Section A – Sarang Jain

Business Environment Research Paper IMTG DCP – 2011-13

Acknowledgement

We wish to express our deepest gratitude and warmest appreciation to the following, which have contributed and inspired us during the course of this Research Study.

We are highly indebted to Dr. Sanjeev Prashar, for his continuous guidance, support and valuable advice in the duration of the study without which this research would not have been possible.

We are very grateful to Dr. Shaheen Shojai, for his valuable inputs related to our research.

Undervalued Chinese Currency and its Impact on US Economy Page 1


Table of Contents

Acknowledgement.................................................................................................................................1

Abstract.................................................................................................................................................3

1. Introduction to ‘Undervalued Chinese Currency and its Impact on US Economy’.............................4

1.1 History of Yuan and Dollar...........................................................................................................4

1.2 The RMB and Claims of it being Undervalued..............................................................................5

1.3 Is the RMB really undervalued.....................................................................................................6

2. Introduction to ‘US Manufacturing Sector and Lessons learnt from Yen Devaluation’......................7

2.1 U.S. Manufacturing Sector...............................................................................................................7

2.2 Similarities of Yen Devaluation claims in 80’s to present allegations on Yuan Devaluation.........8

3. Project Overview.............................................................................................................................10

3.1 Literature Review.......................................................................................................................10

3.2 Problem Description..................................................................................................................13

3.3 Scope of Study...........................................................................................................................13

3.4 Research Methodology..............................................................................................................14

3.5 Limitations.................................................................................................................................16

4. Analysis............................................................................................................................................16

4.1 RMB Exchange Rate Reforms & Claims of Undervaluation........................................................16

4.2 Counter Argument.....................................................................................................................18

4.3 Both Ways..................................................................................................................................18

4.4 Econometric model....................................................................................................................19

4.5 Results.......................................................................................................................................21

4.5.1 Stock Index Data (Fluctuation Range) [for a change of 10%]..............................................21

4.5.3 Long Range Data.................................................................................................................22

4.5.5 Short Rate Data...................................................................................................................23

5. Interpretations and Conclusions......................................................................................................25

References...........................................................................................................................................27



Abstract

In the past few years, many U.S. policy makers and business executives have argued that the Chinese currency, the Renminbi (RMB), is undervalued at its current exchange rate (around eight Yuan to the dollar). The alleged low value of the RMB has been blamed for the loss of manufacturing jobs in the United States and a general deflation in the industrial countries. Thus, the RMB has been under increasing pressure to revalue or float. Is the RMB, however, really undervalued at its current level? This paper addresses this question through basic analyses in terms of purchasing power parity (PPP) and Multi-Country Econometric Model (Fair Model). We found no convincing support for this claim.

Upon analysis it was found out that the different percentage point – revaluations have a deep impact on the Chinese economy while having a substantially milder effect on the US economy.



1. Introduction to ‘Undervalued Chinese Currency and its Impact on US Economy’

1.1 History of Yuan and Dollar

One of the principal allegations levelled against China in the United States stems from a misunderstanding of the Dollar-Yuan relationship. A number of critics from government officials to corporate executives and union leaders are charging China with keeping the Yuan undervalued by pegging it to the dollar in order to gain an unfair export advantage. This unfair advantage is the main cause of the U.S. trade deficit with China, which grew from $124 billion in 2003 to $272 billion in 2011(till November).

Since the beginning of the economic reform process in 1979, the Chinese currency (Yuan) was devalued on many occasions until 1994 when the two-tier foreign exchange system was ended. The official rate of Yuan had been maintained constant over 7 years since 1998, and the pressure on the revaluation of Yuan has intensified ever since. After years of speculation China finally revalued the RMB by 2.1% in July 2005.

There is a general consensus among economists around the world that the Chinese Yuan is undervalued by as much as 40% against U.S. Dollar. China’s undervalued Yuan has serious implications for the global economy. Recognizing this global impact, leaders in the major world economies as well as the IMF and the Asian Development Bank have all urged China to infuse greater flexibility in its exchange rate system.

USA has been one of the world’s largest manufacturing bases since the last century. Exports currently support millions of jobs across the country as currently one in every five American factory jobs depends on exports. Global corporations such as Coca Cola and Pepsi have made more money in East Asia and Western Europe than in the United States in recent years. Currency fluctuations have more pronounced effect on the US businesses button line than any other time in the US history. Profits earned in foreign currencies are worth more when the US dollar declines in value.

There are arguments currently on how and to what extent the official rate of the Yuan should be further revalued. However, due to a de facto real appreciation of the Yuan relative to its neighbour countries since 1994, the competitiveness of China’s exports has been reduced. It would be therefore very difficult for the Chinese authorities to allow the Yuan to revalue considerably in the near future as that will not only harm China per se but also have a dominoes effect on the global economy leading to a potential slowdown.



Since the major effects of the Chinese devaluation are faced by the US manufacturing sector, it is our prime area of analysis in this research paper.

1.2 The RMB and Claims of it being Undervalued

Chinese money is called Renminbi (RMB) means "The People's Currency". The popular unit of RMB is Yuan. 1 Yuan equals 10 Jiao, 1 Jiao equals 10 Fen. The current official exchange rate between U.S. Dollar and Renminbi Yuan is about 1:6.3 (1 US dollar = 6.3 Yuan RMB).

The two major problems related to currency devaluation are – Devaluation makes a country's exports relatively less expensive for foreign country residents and it makes foreign products relatively more expensive for domestic consumers, discouraging imports.

Owing to the above reasons there is dip in a country's trade deficit. Thus, As China pursued its gradual transition from central planning to a free market economy, and increased its participation in foreign trade; the RMB was devalued to increase the competitiveness of Chinese industry in the world.

Critics further argue that the undervalued currency has been a major factor behind the burgeoning U.S. trade deficit with China. Other factors viewed by some as evidence of Chinese currency manipulation are China’s massive accumulation of foreign exchange reserves, which, on a year-end basis grew from $403 billion in 2003 to $2.85 trillion 2010, and its large annual current account surpluses, which grew from $46 billion in 2003 to $412 billion in 2008.

The IMF’s September 2011 World Economic Outlook projected that China’s current account will rise from $361 billion in 2011 and to $852 billion by 2016.

“The U.S. government wishes to eliminate trade deficit and ease its high unemployment rate by pushing Yuan appreciation. That was only its wishful thinking.” said Yi Xianrong, an expert with Chinese Academy of Social Sciences (CASS).

In 1986, the Economist (a weekly publication) began publishing a survey comparing the prices of Big Macs in a number of countries as “a rough-and ready guide to whether a currency is under- or over-valued,” in the hope of making economic theory more digestible (The Economist, 1991). China was covered in the survey starting in 1992 (though omitted in 1996). There have been sizable deviations for the RMB from Big Mac Parity; it has been under-valued by more than 50 percent for most years during the period 1994-2003.

This basically means that the Big Mac has been selling in China at less than half the price as in the United States. According to the Economist survey, the average price of a Big Mac in



four American cities was $2.71 in April 2003. The cheapest burgers were those in China (at $1.20 each) while the dearest were those in Switzerland (at $4.52 each).

Based on Big Mac prices, the exchange rate between the RMB and the U.S. dollar should have been 3.65 Yuan to the dollar. The actual exchange rate was 8.28 Yuan to the dollar, implying that the Chinese currency was undervalued by 56 percent against the dollar (The Economist, 2003).

Paul Krugman (American Economist, Nobel Prize Winner) states that, “China’s currency policy has a “depressing effect” on economic growth in the U.S., Europe and Japan, as measured by gross domestic product. If the Yuan were not undervalued, it would have a “significant” impact on the global recovery”, he said. “If we could get some change in China’s currency policy, it would help the world.”

1.3 Is the RMB really undervalued

Goldstein (2003) and Goldstein and Lardy (2003) believe that as long as China maintains controls on capital outflows, runs surplus on both the overall current and capital accounts in its balance of payments, and accumulates international reserves in large amounts, there is a compelling case that the Chinese currency is significantly undervalued.

Their preliminary estimates suggest that the undervaluation of the RMB is on the order of 15 to 25 percent. These estimates, according to Goldstein (2003), can be obtained either by “solving a trade model for the appreciation of the RMB that would produce equilibrium in China’s overall balance of payments,” OR “by gauging the appreciation of the RMB that would make a fair contribution to the reduction in global payment imbalances, especially the reduction of the US current-account deficit to a more ‘sustainable’ level.”

Relatively recent estimates of the RMB’s undervaluation include 12% (December 2009) by Helmut Reisen with the Organization of Economic Cooperation and Development; 25% (December 2009) by Dani Rodrik of Harvard University; 30% (April 2010) by Arvind Subramanian at the Peterson Institute for International Economics; 50% (October 2009) by Niall Ferguson (Harvard University) and Moritz Schularick (Free University of Berlin); and 40.2% (January 2010), 24.2% (June 2010), 28.4% (April 2011), 23.5% (November 2011) by William R. Cline and John Williamson at the Peterson Institute for International Economics.

Two main methods used to derive the estimates mentioned above are –

1. Fundamental Equilibrium Exchange Rate (FEER) Method – It is based on the belief that current account balances around the world are temporarily out of line with their fundamental value. After making an estimate of what the fundamental current account balance should be one can calculate how much the exchange rate must



change in value to achieve that current account adjustment. To calculate the level of Devaluation or overvaluation for one country under this method, estimates of how far exchange rates for every country are out of equilibrium, including countries with floating exchange rates must be made (Wayne M. Morrison Specialist in Asian Trade & Finance and Marc Labonte Specialist in Macroeconomic Policy).

2. Purchasing Power Parity (PPP) Method – It states that the same good should have the same price in two different countries. If it does not, then arbitrageurs could buy it in the less expensive country and sell it in the more expensive country until the price disparity disappeared. While PPP is a simple idea that is theoretically powerful, it has proven to be unreliable in reality: prices are consistently lower in developing countries than industrialized countries.

2. Introduction to ‘US Manufacturing Sector and Lessons learnt from Yen Devaluation’

2.1 U.S. Manufacturing Sector

The Bureau of Labour Statistics (USA) defines manufacturing sector as, “The Manufacturing sector comprises establishments engaged in the mechanical, physical, or chemical transformation of materials, substances, or components into new products. The assembling of component parts of manufactured products is considered manufacturing, except in cases where the activity is appropriately classified in Sector 23, Construction.”

The US manufacturing sector consists of about 290,000 establishments (single-location companies and units of multi-location companies) with combined annual sales of about $4 trillion. Major companies include Boeing, Caterpillar, DuPont, Ford, GE, GM, Hewlett-Packard, IBM, Procter & Gamble, Pfizer, and Tyson Foods. The manufacturing sector is fragmented: the largest 50 companies account for less than half of overall sales.

Despite claims from Industry experts that the U.S. Manufacturing sector is disappearing, the quantity of manufactured goods and capacity utilization has kept pace with global standards. When measured in value added production, manufacturing sector contributes about 11% to GDP. This is primarily due to higher productivity and lack of pricing power and the sustained growth of the services sector.

U.S. manufacturing is much more engaged in global trade than other sectors. 57% of all U.S. exports are manufactured goods. Despite a large trade deficit in goods, mostly due to imports of oil and of manufactured products from Asia, the United States enjoys a trade



surplus with all countries with which we have a free trade agreement, including the NAFTA countries. On the negative side, U.S. exporters are losing market share in Asia to China and the EU.

2.2 Similarities of Yen Devaluation claims in 80’s to present allegations on Yuan Devaluation

There is a similarity of pattern between the present international pressures for RMB revaluation and pressures which were exerted on Japan in the ‘80s for Yen revaluation. At the same time there are obviously major differences between China and Japan in terms of development and rhythms of economic growth, weight of foreign trade and FDI, patterns of competitiveness, exchange controls, currency regime, etc.

Similarities between the cases of China presently and Japan during the '80s: positive trade balance, important current accounts surplus invested in US Treasury Bonds, same pattern of the US and Europe scapegoating China now like Japan at that time, etc.

Two main lessons may be drawn from Japan’s experience during the 80’s -Dangers of a steep revaluation as well as, Limited effects of currency revaluation on trade balances.

From the beginning of the 80’s, the US began to record a growing trade deficit with Japan which reached US$ 50 billion in 1985. From the US point of view, this was essentially due to the undervaluation of the Yen and Washington first tried to internationalize the use of Yen thru the 1984 Yen-Dollar Agreement; then in September 1985, it obtained from the G5 members an agreement (the” Plaza Agreement”) whereby Central Banks would intervene to push the US$ down, in particular vis-à-vis the Yen.

The overreaction of the markets pushed the Yen far higher than was originally intended: the parity Yen/US$ almost doubled between 1985 and the end of 1987, the so-called Endaka (Yen expensive recession).

The overreaction of the markets was followed by an overreaction of the Japanese monetary authorities. In order to prevent a recession, they enforced a loose monetary policy, which fuelled speculation and asset inflation. This speculative bubble bursts in 1990 with far-reaching detrimental effects on the economy throughout the '90s: Low growth of 1% on average and acute financial system problems, which threatened the very stability of the international financial system.

Actually the shock of a doubling of the Yen value against the US $ in 18 months was almost impossible to be absorbed smoothly. The overreaction of markets, which was triggered by Central Bank’s intervention, was made possible by the combination of three factors, 1. The exchange rate regime (floating rate), 2. The removal of exchange controls and 3. The financial liberalization (in particular on the euro-yen markets).



It triggered a vicious spiral due to mismanagement of risks, both in the public and the private financial sector: on the side of public authorities, there has been mismanagement of monetary policy and inadequate supervision of financial institutions, while in the private financial institutions; a hasty deregulation was not accompanied by the control and management of the new risks involved.

Thus, in the light of this Japanese Endaka, several elements may be kept in mind when debating about the RMB revaluation. An immediate and steep revaluation may be dangerous and risky. The revaluation process of the RMB should be gradual and spread out over time, thus giving time to the economy and the financial system to progressively adjust; It would be preferable that the exchange controls on capital account be maintained (and made more efficient regarding hot money) during this process of a gradual appreciation of the currency; The liberalization of the financial system shall also be made step by step.

It is remarkable that even after this Endaka leading to the quasi-doubling of the Yen against Dollar, Japan has up to now continuously maintained a trade surplus in the range of $50-80 billion vis- à-vis America, so that clearly the undervaluation of the Yen was not the real reason of US deficit with Japan in the '80s.

The real reason was and remains Japan's competitiveness in many high technology sectors, as can be seen by the number of Japanese patents families recorded, as compared to the US ones.

Similarly, in the case of China, the undervaluation of the RMB is might not be the main factor of Chinese products' competitiveness: in the same way that Japan's competitiveness was and is primarily based on its technological supremacy, China's competitiveness derives mainly from the relative cost of labour in exported goods and not from the undervaluation of the RMB.

While it is important to keep this essential point in mind, it does not solve the huge problems and challenges which USA is facing in terms of job destructions and manufacturing hollowing out due to the pressure of growing Chinese exports. On this point too, Japan offers an example to be followed.

Japan, which is permanently moving up on the technological ladder, exports to China mainly machinery and equipment with high technological added value, and it imports manufactured products with low or medium technological content. Therefore, Japan maintains a balanced trade with China and runs a high trade surplus with the USA.

Although the process will take time and will not solve quickly the trade deficits, American public authorities as well as companies will have to follow Japan's example, in particular by



increasing their R&D expenses. Job destructions are unavoidable in some industrial sectors and have to be set off by job creations at a higher level of technological ladder.

3. Project Overview

3.1 Literature Review

Gresham's law is an economic principle that states: "When a government compulsorily overvalues one type of money and undervalues another, the undervalued money will leave the country or disappear from circulation into hoards, while the overvalued money will flood into circulation. It is commonly stated as: "Bad money drives out good", but is more accurately stated: "Bad money drives out good if their exchange rate is set by law."

Now, according to the general consensus, the undervaluation of a currency is the situation of a currency whose value on the exchange market is lower than is believed to be sustainable. This may be due to a pegged or managed rate that is below the market-clearing rate, or, under a floating rate, it may be due to speculative capital outflows.There is a general consensus among economists that the Chinese Yuan is undervalued by as much as 40% against U.S. dollar (Morrison & Labonte, 2010). China’s currency remains substantially undervalued. The reforms adopted by China in July 2005 have resulted in only an approximately 3% increase in the Yuan value vis-à-vis the U.S. dollar. China still keeps the Yuan value from rising to levels that reflect a market-based value.

Many researches have been done in recent times as the undervalued Chinese currency in one way or other has seriously affected the trade relations and the US economy in particular. An analysis of china’s currency and its impact on the economic issues (Morrison & Labonte, 2010) suggests that a sharp appreciation of the RMB would help to rebalance the global economy, but also notes that this must be accompanied by lower saving and greater consumption in China. An immediate and sharp appreciation of China’s currency could disrupt its export industries and lead to widespread lay-offs, which in turn could slow its economic growth and reduce import demand.

Moreover, there would be wide spread impacts within the US economy too. Elimination of the Chinese misalignment would create about half a million US jobs, mainly in manufacturing and with above-average wages, over the next couple of years. The budget cost of this effective stimulus effort would be zero (Correcting the Chinese Exchange Rate, C. Fred Bergsten, September 2010). Although the imbalances have trimmed owing to various factors like the Great Recession in 2009 and sizeable currency adjustments of previous years (The Renminbi, as already noted, was permitted by the Chinese authorities to rise by 20 to 25 percent from the middle of 2005 to the middle of 2008, before they re-pegged it to the dollar), there still remain many imbalances which have again begun to climb sharply.



19801982

19841986

19881990

19921994

19961998

20002002

20042006

20082010

0.001.002.003.004.005.006.007.008.009.00

10.00

Yuan/USD

Year

Yuan/USD

57.4% devaluation between July 1986 and January 1994

5.5% appreciation from June 2010 to current

Source: Federal Reserve System 2011

The full benefits of full currency realignment are many. Taiwan, Singapore, Hong Kong, and Malaysia are also massively and illegally manipulating their currencies. They would also benefit from reduced inflation and an increase in the purchasing power of their workers if they revalue.

The studies that have been done so far, estimate the impact of Chinese revaluation on the U.S. real exchange rate, holding everything else constant. These estimates are developed using 2011 currency weights as estimated by the staff of the Board of Governors of the Federal Reserve (2011). It is important to note that these weights combine elements of the competition between U.S. and Chinese goods, including China’s share of U.S. total imports and exports and also a measure of competitiveness in third country markets (The Benefits of Revaluation, Robert E. Scott; June 2011).

China’s undervalued Yuan has a demonstrable trade effect on U.S. manufactured goods. The low value of the Yuan makes Chinese exports cheaper in the U.S. and U.S. exports more expensive in China. A broad cross-section of U.S. manufacturers have cited overwhelming evidence of job losses, plant closures, bankruptcies, and weakened financial performance due to price constraints influenced by the large influx of low-priced Chinese imports into their markets.

The United States has lost many manufacturing jobs even in the capital intensive industries, as imports from the People Republic of China (PRC) have surged in recent years. Since 1985, the United States has incurred its largest bilateral trade deficit with China. US trade deficit with China increased from a balance trade in 1986 to $227 billion in 2009. Today, China is the largest exporter to the United States. In 2009 the US imported approximately $297billion, exceeding the import from the EU of $281 billion. Many associate this deficit with the loss of American jobs in industries competing with rapidly rising imports from China, and other South East Asian countries.



China’s exports to the US have been unprecedented, increasing from $4 billion in 1985 to approximately $297 billion in 2009. At the meantime, the US exports to China also increased, but at a significantly lower rate from approximately $4 billion in 1985 to approximately $70 billion in 2009. As we observe, the trade situation with China has deteriorated from a relative balance trade in 1985 to a huge imbalance in favour of China in 2009.

Monga (World Bank - 2010) stressed the need for China to reduce its current account surplus and for the USA to reduce its current account deficit. In this literature, the attention of many developed world observers tends to be fixated on the role of exchange rate adjustment, particularly the appreciation of the Chinese Yuan.

Although it is now widely agreed that China needs to rebalance its economy, to reduce its reliance on export demand and to stimulate domestic demand, especially personal consumption, the United States Manufacturing sector cannot rely on the appreciation of the Yuan to increase exports. In addition, the appreciation of the Chinese Yuan against the US dollar may not be in the long-term interest of the US, as China moves away from using the dollar in international transactions.

According to Ming Zhang (2009) the Chinese Government has stepped up its drive to reconstruct its international financial strategy after the sub-prime crisis developed into a global financial crisis in 2008. Manufacturing's share of the US economy, as measured by real GDP, has been stable since the 1940s (Global Manufacturing – the China challenge, Jim Pinto, January 2005).

During this entire time, the ratio of manufacturing output to GDP has ranged from 16 to 19%. As of 2002, it was 16%. During this same 50-year time span, with alternating booms and recessions, the number of manufacturing employees has remained fairly constant, oscillating at around 16.5 million. In the recent downturn, manufacturing employment fell to about 14.2 million.

To support the positive impact on US economy, particularly the manufacturing sector, there are number of facts given by various agencies.

According to the 2008 report of US Bureau of Labour Statistics, the average wage in China is $1.36 per hour and $2.38 per hour with labour load. China produces 19.8% of global manufacturing output; USA produces 19.4% and many politicians think US manufacturing is dead…– (Industry Week: March 14, 2011). US Productivity is 8 times that of China – it takes 100 Chinese to produce what 11.5 Americans produce – (Industry Week: March 14, 2011). China wages are growing at 17% per year, US are growing at 1.3% – (BCG May 2011 Survey). The BCG survey suggests that Chinese and US labour costs will converge by 2015.

The basic idea underlying PPP is that, under a frictionless trade situation (that is, where there are no transportation cost, no transaction cost, and no trade restrictions), the prices



of internationally traded commodities should be the same in every country; hence, the exchange rate between any two currencies should be the ratio of the prices of the commodities (or ‘a specified basket of commodities’) in the two countries (Jiawen Yang & Isabelle Bajeux-Besnaino, 2006).

Currencies of low per capita income countries tend to be undervalued based on PPP, has been well documented in the academic literature. Since the US manufacturing sector has not seen rapid growth in the past few decades compared to China’s boom in the same sector, the trade imbalance has grown substantially.

3.2 Problem Description

China has a strong incentive to raise its amount of export by undervaluing its currency in order to take advantage of learning-by-exporting. One way China undervalues its currency is accumulating a current account surplus, and since the principal factors of production are cheaper in China, the pegging makes it all the more difficult, resulting in more losses of jobs.

These losses of jobs have primarily taken place in the manufacturing sectors due to massive dumping of goods by the Chinese leading to cheap imports thereby substituting the manufacturing processes in the US economy. But will then revaluation of the Yuan be able to take over the inelasticity related to the imports from China? Will the Trade Deficit of USA really reduce? Will the Manufacturing Sector really boom in the USA?

These are certain issues that we will try and address in our research paper with the help of various statistics from the Chinese and US Government websites and interpretations from various world renowned economists and the model that we use as stated in the research methodology.

3.3 Scope of Study

Through this research paper we intend to study the US Manufacturing Sector and the potential implications of revaluation of the Chinese Yuan on it.

3.4 Research Methodology



In order to tackle the impact of the Yuan revaluation and to show the impacts of the revaluation of Yuan on the U.S economy, we have tried to impose certain Models of Economies in our Research Paper.

1. Fair Model - Fair Model is a Multi-Country Econometric Model. It was given by Ray Fair in the year 2004. In multi-country models, the international economic linkages are of fundamental importance. International economic interdependencies have to be considered in the analysis of economic policy measures. The explicit modelling of other important countries helps enhance the consistency of forecasts in the model context. A macro-econometric multi-country model therefore possesses a considerable comparative advantage over national econometric models in the analysis of international economic policy problems. It was our main reason for choosing this multi-currency model of Ray Fair in our Research.

In the MCU model, any changes in one or more exogenous variables in a country will make a difference between the projected dataset and its original dataset which is based on regressions of long term historical statistical data (1960-2005) for each variable and for each country. By running the MCU model, one thus could compare the two datasets and estimate the “net effect” of the proposed policy. A group of endogenous macroeconomic variables including GDP growth, inflation, consumption, investment, export, import and employment could be compared and analysed.

There are 39 countries in the MCU model in which up to 15 stochastic equations are estimated econometrically for each country. Including the 31 stochastic equations in US model, which is part of the MCU model, there are 363 stochastic equations and about 4500 variables in the overall model. Based on its estimation of values of the coefficients for all stochastic equations, the model allows its users to forecast some proposed policy changes such as revaluation or devaluation of a currency in a proposed time period.

2. Mundell-Stiglitz Hypothesis - Mundell-Stiglitz Hypothesis states that A Currency can have constant exchange rate policy against the dollar or the Currency can even have floating exchange Rate Policy. But, the Precondition of shifting a Foreign Currency from a constant exchange Rate to a flexible exchange rate Policy needs to go through a proper Mechanism. In this Hypothesis even it is assumed that Rapid Change in Exchange Policy of a Currency from Constant to Floating may even Cause a financial Crisis in that Country.

In the light of Chinese Currency’s Revaluation Problem, We have already seen that Mundell States that he doesn’t think the Chinese Currency needs a rapid revaluation. Mundell in his online discussion in 13th February 2006 pointed out that a too sharp revaluation of Yuan would even cause a financial crisis because the revaluation will speed up the deflation and lead to a fall in import price which brings more pressure on Yuan. It will also pile more



pressure on Yuan of Unemployment. In Our Research, we are entitled to taste this Hypothesis in light of our proposed models.

3. ARMA-GARCH Model :-ARMA-GARCH Model was first established by GARCH & ARMA in the year 1986. It is basically a Comparison between Bayes estimation and maximum likelihood estimation (MLE) of a linear regression model with an ARMA error whose conditional variance follows a generalized autoregressive conditional heteroskedasticity (GARCH) process. In this Method we have to compare the Estimation Result s of the ARMA-GARCH model between the Bayes estimation and the MLE in various scenarios by Monte Carlo experiments. As the measurement of accuracy of estimation, we calculate root relative mean square errors (RRMSE) of the posterior mean (Bayes estimation) and the MLE of parameters in the ARMA-GARCH model replicated in the Monte Carlo experiments, and see which estimation produces smaller RRMSE's. In our Study we are entitled to check that how the Change in GDP for the revaluation of Yuan will likely have an impact on the Manufacturing Sector and that too up to what extent.

4. Marshall-Lerner condition - Marshall-Lerner Condition is a Condition which is an elastic approach to measure the Balance of Payments. The Condition seeks to answer the following Question:-

When does a real devaluation (in fixed exchange rate) or a real depreciation (in floating exchange rates) of the currency improve the current-account balance of a country?

5. PPP & Big Mac Index - The basic idea underlying PPP is that, under a frictionless trade situation (that is, where there are no transportation cost, no transaction cost, and no trade restrictions), the prices of internationally traded commodities should be the same in every country; hence, the exchange rate between any two currencies should be the ratio of the prices of the commodities (or ‘a specified basket of commodities’) in the two countries.

We have used this PPP theory for evaluating the economic Condition of both the Countries (Courtesy China & U.S).

3.5 Limitations



The major limitation is that we are focussing upon only one sector of the US Economy and that may lead to a bias with respect to our final verdict on the implications of the Chinese Yuan’s revaluation on the US Economy.

Though the manufacturing sector contributes about 11% to the US GDP, it still remains way behind the service sector which is unrelated to the Chinese Yuan movements. But yes, the current account movements will change severely with any change in the Chinese Yuan’s value vis-à-vis the US Dollar.

The data that is needed for the proper implementation of the models on the evaluation of the manufacturing sector under consideration is not available on secondary sources. However efforts are being made to obtain them on a personal basis.

4. Analysis

4.1 RMB Exchange Rate Reforms & Claims of Undervaluation

Yuan, the Chinese currency, had been a non-convertible currency for more than 50 years until quite recently. China’s road toward convertibility has involved a number of important reforms which have been implemented in a step-by-step manner. Table 1 shows the exchange rate of the RMB against the USD in the last decade. The nominal rate is deflated through by a consumer index for both countries.

In this due course, we would like to add some theories & considerations in this case. 1986 onwards The Economist conducted an annual survey to compare BIG MAC prices in a number of countries which served as a rough guide to whether the currency is undervalued or overvalued. China was included in the survey 1993 onwards. As the following table shows, there have been huge deviations for the Yuan from Big Mac Parity and it has been under-valued by more than 50 per cent for most years during the period 1994-2003.

Based on Big Mac prices, the exchange rate between the RMB and the U.S. dollar should have been 3.65 Yuan to the dollar. The actual exchange rate was 8.28 Yuans to the dollar, indicating that the Chinese Yuan was undervalued by approx 55% against the.

The following Table Shows the Rate & the data according to the Big Mac Index

Year Prices in RMB Prices in Dollars Actual Rate PPP Implied Rate1993 8.50 1.50 5.68 3.73



1994 9.00 1.03 8.70 3.911995 9.00 1.05 8.54 3.881996 9.40 1.09 8.43 3.971997 9.70 1.16 8.33 4.011998 9.90 1.20 8.28 3.871999 9.90 1.20 8.28 4.072000 9.90 1.20 8.28 3.942001 9.90 1.20 8.28 3.902002 10.50 1.27 8.28 4.222003 9.90 1.20 8.28 3.65

We can see from all the data & stats that the Chinese Currency was undervalued by around 50-55% in all these years. Appreciation to the Yuan was done in the light of such circumstances as viewed from the Literature Review. The currency started to appreciate since the second half of 2005. Along with the officially permitted range of fluctuation of 0.3% per working day, the Chinese authority also announced that the Yuan now is now linked to a basket of internationally traded currencies based on their importance in China’s external transactions including the USD, the Euro, the Japanese Yen and the Korean Won.

But, we can see that Chinese Currency was undervalued by around 50-55% as per the Big Mac Standard. So, we can say that it should be appreciated by a Substantial margin. Other arguments hold that the RMB is undervalued based on U.S. trade deficits with China and China’s accumulation of international reserves. Judging from the “rough orders of magnitude based on the gross figures in play,” and China’s “protracted and very large-scale official intervention of the past several years,” Preeg (2002) asserted that the Chinese Renminbi was “probably in the order of 40 per cent weaker.” Other economists have drawn similar conclusions, although the magnitudes of their estimates have not always been so dramatic. Goldstein (2003) and Goldstein and Lardy (2003) are of a belief that as long as China maintain control on capital outflows and have capital and current account surpluses there is going to be a strong case against their currency being undervalued. According to their initial estimates the undervaluation was around 15 to 20%.

We would now like to give some other arguments.

4.2 Counter Argument



The Chinese authorities have argued that firstly the country’s foreign reserves are largely a result of the “hot money”, inflows of foreign capital hoping to instantaneously capitalize on a Yuan revaluation, rather than long term foreign direct investment in capital projects. In addition, China’s trade surplus is increasingly a story of slowing imports, rather than growing exports. As investment in fixed capacity has declined, so has the demand for equipment and machinery, much of which is imported. In addition, while China’s trade surplus with the US exceeded $200 Billion in 2005, China runs a deficit with most other countries it trades with. Should the Yuan be significantly revalued, China will face stronger competition from its Asian developing economies in the markets of North America, Europe and Japan, as well as in these economies themselves.

Ironically, the views presented by some American economists, including Mundell (2006) and Stiglitz (2005), are similar to the Chinese authorities who deny the necessity of rapid Yuan revaluation. They believe that preconditions for the Yuan to shift to a flexible exchange rate mechanism have not yet been met. Speedy devaluation of the Yuan can cause financial crisis due to hiked deflation leading to increase in import prices thereby putting more pressure on Yuan.

4.3 Both Ways

Let’s now focus on exactly by how much percentage the Chinese Yuan is undervalued. Western Countries & the U.S demands it to be around 25-40% but, we can appreciate the fact that Chinese Govt. will not be really interested & will not favour a move of appreciating the Yuan by more than 3-6%. The adverse impact of Yuan revaluation intensifies as long as deflation is concerned.

Successive revaluations may eliminate China’s trade surplus but will have very little effect of the global issue of Trade Imbalance and more importantly on US Trade Deficit. China gained in textile tremendously owing to developing countries and US will still keep buying from them due to inelasticity and costly replacement thereby leading to high import costs to them and further deteriorating their trade deficit.

So, we can take both the arguments & will try to show how this revaluation of around 20% and as well as 5% will impact the U.S economy & its trade policies in future.

In the Multi-Country Econometric Model we know that if a stochastic process y(t) is covariance stationary if the expected value of y(t) is independent of t, its variance is finite, a positive constant and independent of t; and the covariance of y(t) and y(s) is a finite function of t-s, but not of t or s. It is common to assume that the innovations are independently



generated from one period to the next, with the following assumptions:E[ε(t)] = 0Var[ε(t)] = a^2[a= Measure of Inequality from the nearest Scholastic Value]Cov[ε(t), ε(s)] = 0 [Except for no value of t=s]

4.4 Econometric model

Figure: Major Currency Area Detailed Model Structure

Here are three investment categories or major asset classes, namely Cash, Bonds and Equity. We have found possible explanatory dependence to be subjected to co-efficient hypothesis testing and only the statistically significant relations are kept in the Econometric model.

In the following equations,

S = Stocks

R = Cash

L = Bonds

X = Domestic Currency / USD

i = Chinese currency

So,

Scholastic equations are as follows:


GDP CPI PSBWages & Salaries

Exchange Rates

BondsCashStocks


dss

=μsdt+σ sd Z s

dR=μRdt+μRd ZR

dL=μL dt+σ L d ZL

dXX

=μXdt+σ X d Z X

Here,

d Z i(i=S , R , L, X )

It is an increment of correlated Wiener Process. The left hand side variables are measured in rates. Explanatory state variables in the specification are in original levels (S and X) or rate (R and L).

µ = Drift in the currencies

σ = Volatility in the currencies

So,

dSS

=μS (S ,R , L , X ,t )dt+σS (S ,R ,L , X , t )d ZS

Or, dR=μR (S , R , L, X , t )dt+σ R(S ,R , L , X , t)d Z R

Or, dL=μL (S , R , L, X , t )dt+σ L (S ,R , L , X ,t )d Z R

Or, dXX

=μX (S , R ,L , X , t )dt+σ X (S ,R ,L , X , t)d ZR

After realisations of the equations and the impacts, we get

dSS

=(α S1+α S2+α S3R+α S4 L+α S5 X )dt+σSd ZS

dRR

=(αR1+αR 2 SR +αR3/R+αR4+α S5XR )dt+σ Rd Z R

dLL

=(α L 1+α L2S+α L3 R+α L 4 L+α L5 X )dt+σ Ld Z L

dSS

=(α S1+α S2+α S3R+α S4 L+α S5 X )dt+σSd ZS

dXX

=(αX 1+αX 2 SX +αX 3(RF−R)X

+αX 4(LF−L)X

+αX 5X )dt+σ Xd Z X



So, if we put this in in a matrix form from the U.S. perspective, the U.S. economic variables (CPI, WS, GDP, PSB) form part of the explanatory variables for the US capital markets (S, R and L).

4.5 Results

4.5.1 Stock Index Data (Fluctuation Range) [for a change of 10%]

Year US China1994 100 1001996 150 2001998 150 2002000 170 2502002 202 5202004 206 7502006 300 13502007 375 28002008 520 15002009 800 12002010 1250 15002011 1020 800

Graphical Representation

19941996

19982000

20022004

20062007

20082009

20102011

0

500

1000

1500

2000

2500

3000

USChina

Year

Fluc

tuati

on R

ange

4.5.3 Long Range DataYear US China2011 7 7.4



2012 6 9.82013 10 7.62014 7.5 102015 12 11.52016 9 142017 3 152018 7.5 172019 3 11.52020 6 13.52021 1 162022 2.5 6


20112012

20132014

20152016

20172018

20192020

20212022

0

2

4

6

8

10

12

14

16

18

USChina

Year

Fluc

tuati

on R

ange

4.5.5 Short Rate DataYear US China2011 5 6.252012 7.5 3.5



2013 9 7.52014 5 8.52015 15 8.52016 16 62017 13 6.52018 7.5 42019 9 12.52020 6 82021 4 3.52022 2 1


20112012

20132014

20152016

20172018

20192020

20212022

0

2

4

6

8

10

12

14

16

18

Series1Series2

Year

Fluc

tuati

on R

ange

When the Fair model is evolved and used, the net effect of the Yuan revaluation is obtained by comparing values between the projected change and the original data available. By using the same method, the impact on the Chinese economy and the rest of the world can also be identified quantitatively.

By following the model, the percentage change of five major macroeconomic variables namely GDP, Price Index, Exports, Imports and Current Account Balance was calculated and put up in the form of a table:

20% changeYear GDP (%) Price Index (%) Exports (%) Imports (%) Current account balance (%)

China2005 -11.78 -8.14 -21.43 -5.88 1132006 -12.88 -14.92 -20.76 -10.54 181



2007 -12.43 -19.71 -19.91 -12.9 2272008 -11.57 -22.86 -19.03 -13.6 2502009 -11.90 -28.64 -18.27 -17.11 3072010 -11.79 -33.54 -17.46 -19.66 3532011 -11.68 -38.43 -16.66 -22.21 3982012 -11.57 -43.33 -15.86 -24.77 4442013 -11.46 -48.22 -15.05 -27.32 490

US2005 0.04 0.37 0.59 -1.05 3.542006 -0.19 0.8 0.15 -1.84 2.322007 -0.39 1.09 -0.2 -2.58 1.252008 -0.61 1.27 -0.49 -3.07 1.772009 -0.82 1.63 -0.88 -3.84 0.632010 -1.04 1.93 -1.24 -4.52 -0.012011 -1.26 2.23 -1.60 -5.19 -0.652012 -1.47 2.53 -1.96 -5.88 -1.292013 -1.69 2.83 -2.32 -6.56 -1.93

10% change

Year GDP (%)

Price Index (%)

Exports (%)

Imports (%)

Current account balance (%)

China200

5 -5.96 -6.11 -8.80 -3.33 42.94200

6 -6.55 -11.60 -8.50 -6.35 68.52200

7 -6.35 -15.46 -8.13 -7.88 85.80200

8 -5.86 -18.00 -7.77 -8.33 94.44200

9 -6.01 -22.68 -7.42 -10.59 115.88201

0 -5.92 -26.65 -7.08 -12.25 133.06201

1 -5.93 -30.59 -6.73 -13.89 150.23201

2 -5.87 -34.55 -6.39 -15.55 167.43201

3 -5.77 -38.50 -6.04 -17.21 184.60USA

2005 0.02 0.19 0.30 -0.53 1.783

2006 -0.10 0.40 0.08 -0.92 1.169

200 -0.19 0.55 -0.10 -1.29 0.630



7200

8 -0.31 0.64 -0.25 -1.54 0.892200

9 -0.41 0.82 -0.45 -1.92 0.314201

0 -0.51 0.97 -0.63 -2.26 -0.005201

1 -0.64 1.12 -0.81 -2.60 -0.327201

2 -0.76 1.27 -0.99 -2.94 -0.649201

3 -0.85 1.42 -1.17 -3.29 -0.969

5% changeYear GDP (%) Price Index (%) Exports (%) Imports (%) Current account balance (%)

China2005 -2.98 -3.05 -4.30 -1.76 19.712006 -3.26 -5.60 -4.16 -3.16 31.582007 -3.15 -7.39 -3.99 -3.87 39.602008 -2.93 -8.57 -3.82 -4.08 43.612009 -3.01 -10.74 -3.66 -5.13 53.562010 -2.98 -12.58 -3.50 -5.90 61.532011 -2.96 -14.41 -3.34 -6.66 69.502012 -2.93 -16.25 -3.18 -7.43 77.482013 -2.90 -18.08 -3.02 -8.20 85.45

USA2005 0.010 0.092 0.148 -0.262 0.8862006 -0.048 0.200 0.038 -0.459 0.5812007 -0.098 0.272 -0.050 -0.643 0.3132008 -0.153 0.317 -0.123 -0.765 0.4432009 -0.207 0.407 -0.222 -0.956 0.1562010 -0.262 0.482 -0.312 -1.125 -0.0032011 -0.316 0.557 -0.402 -1.295 -0.1632012 -0.370 0.632 -0.492 -1.464 -0.3232013 -0.424 0.706 -0.582 -1.634 -0.482

The relevant changes in the factors were calculated using the regression-correlation model and the Multi-Country Econometric Model given by Ray Fair (Fair Model).

5. Interpretations and ConclusionsFrom the results we see that the revaluation of Yuan on different percentage points has a major impact on the current account balance and all other economic factors like GDP,



Exports and Imports of China. However, it is not having the similar kind of effect on the same factors in the case of US. The huge decline in the GDP and other economic factors could lead China into deep recession. Although the current account balance has increased manifold because of the huge increase in the value of Yuan.

Moreover, it can be seen that the percentage change in the GDP of China is more sensitive than the price index but it is reverse in the case of USA where it is having a lesser sensitivity. From this we can conclude that the PPP model that we have used is not that robust even when it comes to bilateral price indices.

Also, after using the Multi-Country Econometric Model, it can be seen that the real time effect on the US economy is very less than that proposed by the US demand. Moreover, due to the huge negative impact on the Chinese economy, the rest of the world is also going to be affected because China has become one of the largest economies in the world and many other countries are dependent upon its functioning well, as already explained in the “Dominoes Effect” earlier.

In short term, as can be seen from the graphical representations, Chinese manufacturing sector has been severely affected, but signs of recovery with the passage of time are visible. Even towards the end of the time series under consideration, the rate of change in short terms are much more stable in case of China than United States. But the same cannot be seen in the long term as US is much more severely affected in the long term than the Chinese, particularly in the manufacturing sector.

Both these factors highlight the fact that Chinese manufacturing success may not be solely because of Chinese undervalued currency, but there are a lot of other factors that contribute to China’s stupendous leaps in the last years. Sole balancing of the undervalued currency will result in long term impact on the US economy. But even a revaluation of as much as 5% will have not much of an impact as thought in the manufacturing sector in particular in US.

From GARCH specification, when we calculated a 5% change in the revaluation of Chinese currency, it was observed that US will have a gross change of 0.03%. As seen in the analysis earlier, Chinese manufacturing sector can deviate as much as 7.42% in the short term, meaning a severe threat to their economy, as manufacturing is one of the key contributing sectors in China.

Whereas US will have a 3% change in the manufacturing sector. But as manufacturing sector contributes to only about 11% to the country’s output, US will not be affected to the level that is being threatened by economists and lobbyists in their country.

Hence we can conclude that the undervaluation of the Chinese currency is not the thrust reason for the trade deficits of USA as was in the case of Yen in 1980s. And as proved by the Mundell – Stiglitz hypothesis, it can be safely said that too sharp a revaluation in the Chinese



currency Yuan will have a severe impact in the manufacturing sector in China and a moderate impact in US. But since the dependence on this sector varies greatly between these two nations, China will be much more affected in the revaluation than US. So the allegations against China raise some serious questions about the internal policies of USA and the governance issues under the current administration and a proper balancing mechanism be followed instead.

References

US-China Economic Relations by Marcus Noland, Peterson Institute – 2003 http://www.iie.com/publications/wp/wp.cfm?ResearchID=162

Renminbi Undervaluation, China’s Surplus, and the US Trade Deficit by William R. Cline – 2010 http://www.iie.com/publications/pb/pb10-20.pdf

The Benefits of Revaluation by Robert E. Scott - Director of Trade and Manufacturing Policy Research, Economic Policy Institute - http://w3.epidata.org/temp2011/BriefingPaper318%20%282%29.pdf

Is Chinese Yuan Undervalued? A Multi-Currency Basket Approach by Santa Clara University Report – 2009 http://www.aabri.com/LV2010Manuscripts/LV10079.pdf

Currency Manipulation and World Trade by Robert W. Staiger - Stanford University and NBER - 2009 http://www.stanford.edu/~rstaiger/china.paper.111209.pdf

The China Currency Issue: Why the World Trade Organization Would Fail to Provide the United States with an Effective Remedy by Marcus Sohlberg Cornell University - 2011

http://scholarship.law.cornell.edu/cgi/viewcontent.cgi?article=1072&context=lps_clacp&sei-redir=1&referer=http%3A%2F%2Fwww.google.co.in%2Furl%3Fsa%3Dt%26rct%3Dj%26q%3D6.%2520the%2520china%2520currency%2520issue%253A%2520why%2520the%2520world%2520trade%2520organization%2520would%2520fail%2520to%2520provide%2520the%2520united%2520states%2520with%2520an%2520effective%2520remedy%26source%3Dweb%26cd%3D1%26ved%3D0CCQQFjAA%26url%3Dhttp%253A%252F%252Fscholarship.law.cornell.edu%252Fcgi%252Fviewcontent.cgi%253Farticle%253D1072%2526context%253Dlps_clacp%26ei%3DAYQ2T_SoDuqn0QX61pW0Ag%26usg%3DAFQjCNEdT_xQx5W0VAhf6CJJB5tKPQsk_g#search=%226.%20china%20currency%20issue%3A%20why%20world%20trade%20organization%20would%20fail%20provide%20united%20states%20an%20effective%20remedy%22

China’s Currency: Economic Issues and Options for U.S. Trade Policy by Wayne M. Morrison and Marc Labonte – Congress Report - 2008 http://www.fas.org/sgp/crs/row/RL32165.pdf

Is the Chinese Currency Undervalued? By Jiawen Yang - 2006 http://www.eurojournals.com/IRJFE%202%208%20Yang.pdf


http://www.eurojournals.com/IRJFE%202%208%20Yang.pdf

http://www.fas.org/sgp/crs/row/RL32165.pdf




http://www.stanford.edu/~rstaiger/china.paper.111209.pdf

http://www.aabri.com/LV2010Manuscripts/LV10079.pdf

http://w3.epidata.org/temp2011/BriefingPaper318%20(2).pdf

http://www.iie.com/publications/pb/pb10-20.pdf

http://www.iie.com/publications/wp/wp.cfm?ResearchID=162


Should China revalue its currency? Lessons from the Japanese experience By Dr Claude MEYER - 2008

http://gem.sciences-po.fr/content/publications/pdf/Meyer_China_Currency042008.pdf

Fair Model - http://economics.sas.upenn.edu/

The Economic Impact of the Chinese Yuan Revaluation By Xiaohe Zhang – 2006 http://www.cfses.com/06confchina/documents/Final_Papers/Paper_ZhangXiaohe_Economic_Impact_Of_Chinese_Yuan_Revaluation.pdf

The impact of the Appreciation of the Chinese Yuan on the US Manufacturing Sector, By John G. Kooti - 2010 http://warrington.ufl.edu/academics/pdbp/docs/proposals/2010_JohnKooti.pdf


http://warrington.ufl.edu/academics/pdbp/docs/proposals/2010_JohnKooti.pdf

http://www.cfses.com/06confchina/documents/Final_Papers/Paper_ZhangXiaohe_Economic_Impact_Of_Chinese_Yuan_Revaluation.pdf

http://www.cfses.com/06confchina/documents/Final_Papers/Paper_ZhangXiaohe_Economic_Impact_Of_Chinese_Yuan_Revaluation.pdf

http://economics.sas.upenn.edu/

http://gem.sciences-po.fr/content/publications/pdf/Meyer_China_Currency042008.pdf

Undervalued Chinese Currency and Its Impact on US Economy

Documents

research study

us manufacturing sector

research methodology

us economy page

yuan devaluation

us economymajor focus

manufacturing sector

scope of study