Chinese Currency Revaluation
- Is the Chinese currency significantly undervalued?
MGMT 6350 International Business
April 2005
Weilong Zhang
Thesis Statement
There seems little doubt that Chinese currency, the yuan or renminbi (RMB) is
currently under pressure for appreciation. This view could be supported by the
massive inflow of foreign direction investment (FDI), significant current account
surplus and rapid accumulation of foreign exchange reserves in recent years.
There seems to hard to dispute that China’s effective peg to the US dollar has
recently led to a decline of the RMB exchange rate against other major
international currencies, particularly the euro, and yen. However, these do not
indicate that the Chinese currency is significantly undervalued. Nor does the
evidence advocated for RMB revaluation constitute a sufficient condition for a
RMB revaluation although some do put upward pressure for a RMB revaluation.
Abstract
Chinese currency, the renminbi (RMB) exchange rate issue has been recently
the focus of world attention, with many foreign trading partners urging China to
either revalue its currency or move to a flexible exchange rate regime. The RMB
exchange rate regime is also a key factor in China’s ongoing economic reform
efforts. In this paper, RMB revaluation issue was discussed on the basis of the
question whether Chinese currency is significantly undervalued or not. It is
admitted that the RMB may be on the undervalued side, but this is by a fairly
small margin, not dangerously so as some claimed. The evidences used for the
RMB revaluation argument are unpersuasive, misinterpreted, and some even
totally wrong although some do help produce the pressure for the RMB
revaluation.
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Introduction
Since late 2002, China has been under mounting pressure from the United
States, Japan, and the European Union to revalue its currency, the renminbi
(RMB) because of their concern that the decade-long pegged RMB/US exchange
rate has given China an unfair comparative advantage in international trade.
Despite persistent pressure for it to revalue, China has so far insisted that it will
not resort to any quick and large scale of the RMB revaluation but agreed that a
flexible exchange rate regime is the long-term goal of China’s ongoing reform on
foreign exchange administration system to achieve complete convertibility, and
thus pledged to gradually improve the exchange rate forming mechanism so that
the RMB exchange rate is completely determined by supply and demand in the
market.
This paper consists of three parts. The first part provides a brief introduction of
China’s current exchange rate regime (from 1994 to present). The second part
argues whether RMB is significantly undervalued. The third part examines the
flawed arguments for the RMB.
China’s exchange rate regime
China’s exchange rate regime has experienced several phases since China
started its economic reform and opening-up policy in 1978. The RMB current
exchange rate, a market-based, unified, and managed floating exchange rate
regime was introduced in 1994 when China started its foreign exchange system
reform. Under the current regime, certain banks are designated to sell and
purchase foreign exchange. In 1996, the RMB became convertible under current
account. It should be pointed out that China was very optimistic about full
convertibility of the RMB in 1996 and early 1997, and was planning to open its
capital account in the next 5 years or so following the full current convertibility in
1996. However, the outbreak of the 1997 Asian financial crisis has held its plan
for capital account liberalization. Up to today, China still maintains foreign
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exchange control on capital account, but stated that China will gradually open its
capital account in 2005 [1].
By many measures, China’s current exchange rate regime can be regarded as
very successful and effective, particularly in term of price stability (inflation
control) and economic growth for the past decade. As shown in Fig. 1, China’s
average annual economic growth has been maintained above 9% while the
inflation rate has been under the control (much less than 5%). Another strong
evidence for its success of China’s exchange rate policy during that period is that
China was able to weather the Asian financial crisis storm relatively unscathed.
During the 1997 Asian financial crisis, China was faced international pressure for
the RMB devaluation. In a bid to prevent the crisis from spreading further, China
made a commitment to its policy of non-devaluation, keeping the $8.28 pegged
RMB/US dollar exchange rate. Without any exaggeration, China has made a
great contribution to the stability and early recovery of the economy in the region
and in the whole world.
Since joined the World Trade Organization (WTO) in 2001, China’s economic
integration with the World has been accelerating. China’s integration with the
world is reflected in its rapidly growing role in international trade. China’s strong
export growth, expanding market shares in major trade partners countries,
particularly the record of the trade surplus with the United States, and rapid
increases in foreign exchange reserves have raised the questions about whether
the decade-long pegged RMB/US dollar exchange rate may have resulted in an
undervaluation of the Chinese currency. The RMB exchange rate issue has
quickly turn into a unique, and heated debate on whether the RMB is
undervalued, and whether China should revalue or float its currency immediately.
On one side, those who accused China is manipulating its currency to make its
exports much cheaper argue that RMB is undervalued, urge China to revalue or
float its currency. Those on the other side of the debate warn that a RMB
revaluation or floating will destabilize the world economy as well as the China’s
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economy. One of the key questions from this debate needs to be firstly clarified is
whether the Chinese RMB is significantly undervalued.
Is the Chinese currency RMB significantly undervalued?
It is true that the RMB has been pegged to the US dollar since 1994. However,
the RMB had appreciated against the US dollar by 6.7% from 1994 to the end of
2003, in nominal terms. The real RMB appreciation was as large as 20.1% if
inflation is taken into account. It is also true that China’s effective peg to the US
dollar has recently led to a decline of the RMB exchange rate against other major
international currencies, particularly the euro, and yen. However, this is simply in
the nature of a currency peg.
There is no clear indication that the RMB is significantly undervalued. First, the
real effective exchange rate, which is calculated by taking into account the multiliteral interaction of RMB exchanges with different foreign currencies, is the most
import factor judging the value of the RMB. As compared to 1998, the real
effective exchange rate (REER) has stayed roughly at the same level while the
real effective exchange rate based on the consumer price index (CPI) is
depreciated, but by only about 5-6%. Such a slight appreciation is also confirmed
by the small gap observed between the official exchange rate and the blackmarket rate in China.
Second, alternative analysis of the one-year non-deliverable forward (NDF)
RMB-US dollar rate (Fig.2) shows a similar result that the RMB has a only slight
undervaluation (less than 5%) against the current 8.28 RMB-US dollar pegged
rate.
Third, it is widely agreed that determining “equilibrium” exchange rates is a very
difficult task, and no one knows for sure how much any currency is over or under
valued. There are many techniques available to estimating “equilibrium”
exchange rates. However, there is no conclusive result with regard to the
“equilibrium” exchange rates of the RMB. There is such a substantial degree of
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uncertainty associated with each of those estimate of the RMB undervalued
range from 10% to 40%. It is difficult to draw a conclusion. It may be because of
that, in 2003, the International Monetary Fund (IMF) concluded that “most
Directors noted that there is no clear evidence that RMB is substantially under
valued at this juncture.” [3]. More recently, in its recent release of Staff Report for
the 2004 Article IV Consultation with the People’s Republic of China, IMF
estimated that in the first five month of 2004, China’s real effective exchange rate
have appreciated by 2.7% [4]. Given the above reasons, it does not seem to
indicate that the RMB-US dollar exchange rate is too far away from its current
pegged rate. While it may be said that the RMB is currently on the undervalued
side, this is by a very small margin, not significantly. Once it is clarified that the
RMB is not significantly undervalued. Next, let’s examine the arguments for the
RMB revaluation.
Argument for RMB revaluation
What is evidence for arguments that Chinese currency is undervalued? Those
who advocate an immediate revaluation of RMB quite often list the following five
reasons to support their arguments.

Exporting deflation

The higher RMB purchasing power parity, and Big Mac Index

Large surpluses both on China’s current account and capital account

The rapid increase of foreign exchange reserves

Overheating of China’s economy due to mass domestic credit expansion
by “undervalued” RMB
Exporting deflation
“Exporting deflation” was advocated by Japan in December 2002, arguing that
China was spreading deflation “through export growth and a combination of
domestic price deflation and an exchange rate pegged to the dollar.” [5]. The
“exporting deflation” argument for RMB’s revaluation stems from the fact that
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from 1998 to 2002 (see Fig.1), China had seen mild deflation even though its
average economic growth rate of 7.6% was much above the world’s (average
less than 3.0%). Chinese exports were not only substantial, but also were
growing voraciously. However, the basis of the argument can not stand by the
fact that China’s share of exports is still too small to effect deflation to any
significant degree to the world economy.
It is estimated [6] that China’s
merchandise exports as a share of the world total, despite its fast growth, were
only about 6.8%, less than 1% of world GDP, less 1.5% of Japan’s GDP, and
less than 1.3% of US’s GDP, respectively in 2002. Given such a small share in
the world trade, China’s contribution to the world deflation is overstated. Another
fact is that Japan have had deflationary problem for more than 10 years. There is
no link between the RMB undervaluation and Japan deflationary problem.
The higher RMB purchasing power parity (PPP), and the Big Mac Index
The higher RMB PPP and the Big Mac Index have been cited as another
evidence for the RMB revaluation argument. Using the purchasing power parity
(PPP) model, some people calculated that the “equilibrium” exchange rate of
RMB against the US dollar would stand at 2:1, about four times more appreciated
than the current 8.28 RMB/US dollar peg rate [7]. Similarly, the “Big Mac Index”
suggests that the RMB is undervalued by over 50% against US dollar [8].
However, both the purchasing power parity and “Big Mac index” should not be
taken as a reliable guide for currency valuation. First, the theory of PPP is based
on the “law of one price”. Some recent studies [9] has shown that how sizable
are departure from the “law of one price” for industrial countries. As admitted by
The Economist that the PPP and “Big Mac Index” is not a totally serious exercise
and reliable way of evaluating real exchange rate. There has been no evidence
on the validity of PPP in the literature for developing economics like China where
substantial structural changes can make the underlying relationships unstable.
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Second, this is common for all developing countries that the purchasing power
parity of the RMB is higher than its official exchange rate. For example, the same
ratio for India and Russia are 5.33 and 4.18 respectively. If based on purchasing
power parity, the Russia ruble would have appreciated by over 50% since 1997
instead of experiencing a persistent fall against the US dollar from 6:1 at the end
of 1996 to the current level of 31:1. Furthermore, more and more empirical
studies show that PPP theory often tends to overvalue the exchange rate of the
developing countries. In fact, one recent analysis conducted by IMF concluded
[10] that it is difficult to arrive at any firm and robust conclusion about whether a
currency is undervalued or overvalued in developing economics like China using
existing techniques. As Kenneth Rogoff, chief economist of the International
Monetary, pointed out: “it is impossible to determine whether the pricing of RMB
is too high or too low, since capital account and interest rates are both under
control in China.” [11].
Large surpluses both on China’s current account and capital account
Should large trade surpluses both on China’s current account and capital
account dictate a revaluation of the RMB? From the theories on international
balances of payments, it does suggest that the RMB should appreciate if China
wants to restore balance of payment and when supplies of foreign currencies
surpass demands. Also, it is true that these are signs, in a poor country, that the
currency is undervalued. However, in case of China, they do not necessarily
justify for a revaluation of the RMB although do help build some pressure for the
RMB appreciation. There are several “Chinese characteristics” for that.
First, the Chinese save heavily instead of spending. China has the highest
saving’s rates (more than 45% of GDP) in the world. Meanwhile, options for
investment are very limited due to China’s underdeveloped financial market.
Such a huge amount of household savings deposits makes it quite possible for
China to record a certain amount of trade surplus, as implied by this equation
EX(Export)-IM(Import)=S(Saving)-I(investment) from an international finance
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textbook. Second, majority of Chinese may still favor the US dollar over the RMB
due to historical reason, particularly, for those wealthy Chinese who transfer their
assets abroad and finance their Children’s education overseas take up a very
high percentage of the China’s household savings.
It should be pointed out that the recent insistency for a RMB revaluation is
essentially motivated by bilateral trade surplus China has with the US. The US
trade deficit with China in 2003 recorded to $124 billion, or 23.2% the total US
deficit. This leads to a perception that China’s exports are the major factor to the
growing US trade deficit and to the loss of US manufacturing jobs. However, this
is misunderstood. The basic principles of economics tell us that exchange rates
are not the only factor affecting trade balance. First, the large US-China trade
deficit is fundamentally determined by US large savings and investment
imbalance. Second, the increasing US-China trade imbalance is mainly the
results of the triangular regional trade patterns among China, the US, and the
rest of the East Asia [12]. A unilateral RMB revaluation will not help reduce the
large US-China trade deficit. For example according to a research paper by
Goldman Sachs, a 10% revaluation of the RMB has almost no effect on the US
trade deficit reduction.
The rapid increase of foreign exchange reserves
The recent surge in China’s foreign exchange reserves has been misinterpreted
as another evidence for RMB’s undervaluation. However, some recent research
shows that the increase in reserves appears to have been significantly influenced
by inflows of international short-term “hot money”, suggesting that the evidence
on whether the RMB is dangerously undervalued in term of fundamental is far
from conclusive. In fact, the speculation on RMB revaluation has already fueled
big inflows of hot money into China and hided in its currency reserves. It is
reported [x] that until 2002, almost all of the balance-of-payments surplus could
be accounted for by foreign direct investment (FDI). However, FDI took up only
40% of the surplus in 2003.
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Overheating of China’s economy due to mass domestic credit expansion
The undervalued RMB is also hypothesized as a cause of the overeating
economy in China. It is true that China’s economic overheated economy over the
last two years is due to mass domestic credit expansion. Some have mistakenly
attributed the overheating to an undervalued RMB by the textbook explanation. In
reality, it had little to do with the RMB undervaluation.
According to the international business textbook, on one hand, China’s
undervalued currency raises the expectation of a near-term revaluation of the
RMB, which then attracts large capital flows into the country, and therefore
causes the monetary base to expand, leading to mass domestic credit expansion
in China. On the other hand, the dollar pegged RMB also makes it hard to cool
the overheated economy as it can not raise the interest rate much higher than
US rates. Otherwise, even more dollars would flow in as Chinese companies
boosted borrowings of cheaper money from abroad, which will in turn cause the
monetary base to expand further. As a result, the only way out is to revalue the
RMB.
However, above textbook explanation on the cause of China’s current economic
overheating needs some reality verification. The real situation in China is that the
recent mass domestic credit expansion was brought about by increased bank
lending. The reasons for the large increase in bank lending include that the
China’s banks want to lower their non-performing ratios in order to get listed in
stock market, and that local government push ahead with large development
projects for local development and job creation, resulting a rapid growth in fixed
capital investment.
In short, all above five evidences that have been advocated as the argument for
the RMB revaluation are unpersuasive, misinterpreted, and some are even totally
wrong although some do help create the pressure for the RMB revaluation.
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Conclusions
No evidence either indicating that the RMB is significantly valued, nor constituting
a sufficient condition for a RMB revaluation.
References
1. China to open capital account in 2005, Feb. 26, 2005, China Daily News
2. China Monetary report, Quarter 4, 2004, The People’s Banks of China
3. IMF 2003 Article IV Consultation with People’s Republic of China, PIN.
No. 03/136, Nov. 18, 2003.
4. IMF 2004 Article IV Consultation with People’s Republic of China, July 6,
2004.
5. Kuroda and Kawai, “Time for a Switch to Global Deflation”, Financial
times, Dec. 2002.
6. P. Ryan, “Is China Exporting Deflation Globally, Hollowing –Out Japan?”
Economic Research Institute, Japan ,March 2003
7. Barry Bosworth, “Valuing the RMB”, Tokyo Club Research Meeting,
Japan, Feb. 2004.
8. Big Mac Index
9. Scott Bradford, and Robert Lawrence, “Has Globalization Gone Far
enough?”, Institute for International Economics, Washington USA, 2004
10. Tao Wang, “China: Sources of Real Exchange Rate Fluctuations”, IMF
Policy Discussion Paper WP/04/18, Feb. 2004
11. Pete Engardio, “Untying the Yuan would Get China Out of a Bind”,
Business Week, Oct. 18, 2004.
12. International Business: Competing in the Global Marketplace, 5th Edition,
By Charles W.L. Hill (2005)
13. A symposium of view: “Is the Chinese currency, the renminbi, dangerously
undervalued and a threat to the global economy?”, The International
Economy, Spring 2003.
14. Li-Gang Liu, China’s Role in the Current Global Economic Imbalance,
RIETI Discussion Paper Series 05-E-010, March 2005
15. Morris Goldstein, Adjusting China’s Exchange Rate Policies,
16. P. Ryan, “Is China Exporting Deflation Globally, Hollowing –Out Japan?”
Economic Research Institute, Japan (March 2003)
17. Daniel R. Joseph, The Coming China Crisis: Fact or Fiction? Ceramic
Industry (Sept. 2004)
18. Tom Holland, The day of the Renminbi, Far Eastern Economic Review,
Nov. 30, 2003
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Figure 1 China Economic Growth and Inflation Rate Since 1978 [2]
Figure 2 Non-Deliverable Forward RMB-Dollar Rate
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04