China's Exchange Rate Peg Concerning

China's Exchange Rate Peg concerning

Trade Policy with U.S.

Overview of the Problem

The U.S. and China trade imbalance continue to be on the rise. U.S. manufacturing firms and workers voiced complaints over the competitive challenges posed by cheap Chinese imports. China's trade policy of pegging its currency, the yuan, to the U.S. dollar has enabled an unfair trade advantage according to the U.S. Some have gone as far as calling it "currency manipulation." The outcome has been loss of U.S. manufacturing jobs and a U.S. trade deficit (Labonte & Morrison, 2005).

Political Pressure

According to the Bush Administration, China's undervalued currency has contributed to America's record $16 billion trade deficit with China last year and is responsible for the loss of 3 million U.S. manufacturing jobs since 2000. The G-7 discussions addressed the issue, but opinions differed. China felt that linkage to the U.S. dollar was a necessity. Expressing that currency volatility could disrupt the nation's fragile banking system. The U.S. has placed political pressure on China by introducing bills to both the House and Senate to impose economic sanctions on China, if it does not move to a floating currency, such as 27.5 percent across-the-board tariffs on Chinese goods coming into the U.S. until the Chinese change it's currency regime (Fiscal Study, 2005). China, a major rapidly growing economy, has a per capita income of only about $1,000 per year and with financial, legal and regulatory systems in desperate need of reform. For China to obtain a developed economy status they will have to address how they peg the yuan (Labonte & Morrison, 2005).

China's Exchange Rate Peg

Chinese for ten years now have maintained a fixed exchange rate for their currency, the yuan, relative to the dollar. The rate has been pegged at about 8.28 yuan/dollar for the entire period. What has resulted from this is that when the dollar has appreciated or depreciated in value relative to other currencies, such as the Euro, the yuan has appreciated or depreciated by the same amount. The central bank of China has maintained a fixed exchange rate by intervening in the foreign exchange market. This is done by selling yuan in exchange for dollar denominated assets. When the demand for the yuan increases the Chinese bank buys yuan with dollar denominated assets when the demand for the yuan decreases. The goal is to prevent the yuan from appreciating. This has resulted in foreign reserves held by the Chinese government to have risen by $153 billion to over $360 billion. The Chinese bank accomplishes this by either supplying or removing as much currency, as is needed to bring supply back in line with market demand, accomplished by increasing or decreasing foreign exchange reserves uses the following formula:

Net Current Account = Net Capital Account

[(Exports-Imports) + Net Unilateral = [(Price Capital Outflow-Inflow) + Change in Foreign Exchange Reserves]

Formula was taken from CRS Report for Congress

Currency Peg Impact on the U.S.

Due to the China's currency being significantly undervalued vis-Ðo-vis the U.S. dollar by as much as 40%, resulting in cheaper exports from China and more expensive exports from the U.S., than if they were determined by market forces in which President Bush is a strong advocate for. The undervalued currency has contributed to the growing U.S. trade deficit with China. The U.S. trade deficit has risen from $30 billion in 1994 to $162 billion in 2004. The outcome has been a decrease in U.S. production and employment in manufacturing sector that can be especially observed in textiles, apparel and furniture due to low-cost goods from China. China also influences other East ern Asian countries to do the same to remain competitive (Labonte & Morrison, 2005).

The change in the value of the yuan relative to the dollar may cause an appreciation of U.S. exports to China by being less expensive, resulting in U.S. imports from China being more expensive. The price of Chinese goods in the United States would not change by as much as the change in the exchange rate, because only a portion of most exports from China are produced in China, and because the retail price in the U.S. includes marketing, transport, and other costs. One must recognize the following: True, China has a large trade surplus with the U.S. but one must also realize that China has a large deficit with the rest of the world, it does not have a large overall current account surplus. China's bilateral trade surplus was 103 billion in 2002 with the U.S. but at the same time had a deficit with the rest of the world of $73 billion (Taylor, 2003).

Why China does not want to Eliminate the Currency Peg

The argument in China is that its currency peg policy is not meant to favor exports over imports, but instead to foster economic stability by linking its currency to the U.S. just as many other countries do. Eliminating the peg could result in an economic crisis in China by damaging the ability to export efficiently. They also argue that the Chinese banking system is to underdeveloped and burdened with heavy debt to be able to deal effectively with the pressure of a convertible currency making reference to the 1997-1998 Asian financial crisis where the combination of a convertible currency and poorly regulated financial system was its causation (Labonte & Morrison, 2005).

China fears that appreciating currency could result in a reduction of foreign investment. The outcome of such a reduction would be deflation, reduction in employment, and lower wages causing great distress for the worker. If China wants to adopt a floating exchange rate China must develop strong financial markets and such a task must be done in collaboration with the U.S. (Labonte & Morrison, 2005).

China's Trade Statistics

During 2001 t0 2003 overall trade balance did not change significantly. During the first half of 2004, China's U.S. surplus was up to $137 billion at annual rate. Showing an overall trade surplus of about $29.6 billion in 2003. True with exports and imports both soaring at annual rates of around 40 percent, the Chinese economy has suddenly gained outstanding importance in the global economy but one must take in account the rising deficits in Asia (Richenbacher, 2005).

China's