Question

U.S. Declines to Cite China as Currency Manipulator In \(2007,\) the U.S. trade deficit with China hit an alltime high of \(\$ 256.3\) billion, the largest deficit ever recorded with a single country. Chinese currency, the yuan, has risen in value by 18.4 percent against the U.S. dollar since the Chinese government loosened its currency system in July \(2005 .\) However, U.S. manufacturers contend the yuan is still undervalued by as much as 40 percent, making Chinese goods more competitive in this country and U.S. goods more expensive in China. China buys U.S. dollardenominated securities to maintain the value of the yuan in terms of the U.S. dollar. Source: MSN, May 15,2008. What was the exchange rate policy adopted by China until July 2005 ? Explain how it worked. Draw a graph to illustrate your answer.

Short answer

China used a fixed exchange rate policy until July 2005, maintaining a constant value of the yuan against the U.S. dollar through government intervention in the foreign exchange market.

Step-by-step solution

Understanding the Exchange Rate Policy

The exchange rate policy adopted by China until July 2005 was a fixed exchange rate system. Under this system, the Chinese government pegged the value of the yuan (also known as the renminbi) to the U.S. dollar. This means that the value of the yuan was kept constant at a fixed rate relative to the U.S. dollar.

How the Fixed Exchange Rate Worked

To maintain a fixed exchange rate, the Chinese government intervened in the foreign exchange market to buy and sell U.S. dollars as needed. When the demand for the yuan increased, the government would sell yuan and buy dollars to keep the yuan's value from rising. Conversely, if the demand for the yuan decreased, the government would buy yuan and sell dollars to prevent the yuan's value from falling.

Graph Representation

Draw a graph with the exchange rate on the vertical axis and the quantity of currency on the horizontal axis. Under a fixed exchange rate system, the supply and demand for the currency cross at a fixed rate. The Chinese government intervenes to adjust the supply of yuan so that the exchange rate remains at this fixed level.In the graph, draw a horizontal line at the fixed exchange rate level to show the constant value against the U.S. dollar. Label this line as 'fixed exchange rate'.

Key concepts

currency manipulation

Currency manipulation refers to actions taken by a government to influence the value of its national currency. In China's case, before July 2005, the government maintained a fixed exchange rate by pegging the yuan to the U.S. dollar. This practice involved active interventions in the foreign exchange market, buying and selling dollars to maintain the fixed value of the yuan. By doing so, China could control the competitiveness of its exports. U.S. manufacturers claimed the yuan was undervalued by as much as 40%, giving Chinese goods a price advantage in international markets.

This undervaluation contributed to the growing U.S.-China trade deficit. The U.S. government has often scrutinized China for currency manipulation but has been cautious in formally designating it as a 'currency manipulator.' Doing so would have significant political and economic repercussions.

foreign exchange market

The foreign exchange market is where currencies are traded. It plays a vital role in determining exchange rates based on supply and demand. For countries like China that used a fixed exchange rate policy, the government’s role in the foreign exchange market is crucial. They actively buy and sell currencies to maintain desired exchange values.

When the Chinese government experienced increased demand for yuan, it would sell yuan and buy U.S. dollars. This action prevented the yuan from appreciating. The reverse happened when demand for yuan dropped; the government bought yuan and sold dollars to stop the currency from depreciating.

China's involvement in the foreign exchange market ensured that the yuan remained stable relative to the yuan-dollar fixed rate until mid-2005. This impacted global trade, especially affecting countries like the U.S. that imported large quantities of Chinese goods.

trade deficit

A trade deficit occurs when a country's imports exceed its exports. In 2007, the U.S. faced a record trade deficit with China amounting to $256.3 billion. This deficit was partially attributed to the undervalued yuan, which made Chinese goods cheaper for U.S. consumers and U.S. goods more expensive in China.

The persistent trade deficit between the U.S. and China has led to economic tensions. U.S. industries argued that the artificially low value of the yuan made it difficult for them to compete. This deficit wasn't just a matter of imbalanced trade but also affected jobs and industries within the U.S. economy. Over time, addressing this deficit has become a key point in U.S.-China trade relations and policymaking.

yuan valuation

Yuan valuation is the process of determining the value of China's currency, the yuan, relative to other currencies like the U.S. dollar. Before July 2005, the yuan was pegged at a fixed rate to the dollar, making its value stable but not reflecting market forces.

U.S. manufacturers argued that the yuan remained undervalued by as much as 40%. This undervaluation made Chinese goods much cheaper in foreign markets and hampered fair competition. In 2005, China started to loosen its tight control, and the yuan appreciated by 18.4% against the dollar.

However, many felt this appreciation wasn't enough to level the playing field in international trade. Accurate yuan valuation is important for global economic stability and fair trade practices.

U.S.-China trade relations

U.S.-China trade relations are complex and have been significantly impacted by currency policies. China's fixed exchange rate policy before July 2005 contributed to a large trade deficit with the U.S., adding to economic tensions. Frequent accusations of currency manipulation by China have been a source of friction.

These imbalances have influenced trade policies, tariff implementations, and negotiations between the two nations. For instance, U.S. policymakers demanded that China allow the yuan to appreciate to reduce the trade deficit. The economic interdependence calls for careful balancing acts to maintain stable relations while addressing trade imbalances and currency disputes.

Moving forward, resolving currency concerns and trade deficits remains a key focus in maintaining healthy U.S.-China trade relations.