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 after July \(2005 ?\) Explain how it works.

Short answer

China adopted a managed floating exchange rate in July 2005, allowing the yuan to fluctuate within set boundaries influenced by market and government intervention.

Step-by-step solution

Understanding the Context

In July 2005, China made a significant change to the way it managed its currency, the yuan, against other currencies like the U.S. dollar. It's important to distinguish this from the previous system they used.

Identify the New Exchange Rate Policy

After July 2005, China adopted a managed floating exchange rate system. This means the yuan's value is allowed to fluctuate in response to foreign exchange market mechanisms but within certain boundaries set by the Chinese government.

Analyzing How the Policy Works

Under the managed floating system, the yuan's exchange rate is influenced by both market forces and interventions by China's central bank. If the yuan moves too far outside the desired range, the central bank steps in by buying or selling U.S. dollardenominated securities to stabilize the yuan's value. This maintains a competitive exchange rate to promote exports.

Implications for Trade and Competitiveness

The managed floating system that undervalued the yuan made Chinese exports cheaper and more competitive in the international market while making imports from countries like the U.S. more expensive in China.

Key concepts

Exchange Rate Policy

An exchange rate policy is a strategy used by a country's government and central bank to manage its currency's value relative to other currencies. China’s exchange rate policy has evolved significantly over the years. Before 2005, China used a fixed exchange rate system, pegging the yuan to the U.S. dollar at a stable rate. In July 2005, China shifted to a managed floating exchange rate system. This change was geared towards allowing the yuan to fluctuate within a specified range in response to market forces while still enabling the government to intervene when necessary. By doing so, the Chinese government aimed to balance stability with flexibility.

The managed floating exchange rate system involves frequent monitoring and sometimes intervention by the central bank. When the yuan's value deviates too far from the government’s desired range, the Chinese central bank intervenes by buying or selling U.S. dollar-denominated securities. This practice is designed to stabilize the currency and prevent excessive volatility, ensuring Chinese exports remain competitively priced in the global market.

Trade Deficit

A trade deficit occurs when a country imports more goods and services than it exports. In 2007, the U.S. faced a massive trade deficit with China, reaching an all-time high of $256.3 billion. This significant imbalance indicates that the U.S. was purchasing far more from China than it was selling to China.

Several factors contribute to a trade deficit:

• High demand for imported goods due to their competitive pricing
• Weak domestic production compared to foreign production
• Exchange rate policies that undervalue a nation's currency, making its exports cheaper

In the U.S.-China relationship, the undervaluation of the yuan played a crucial role. By keeping the yuan's value lower, Chinese goods became more affordable for U.S. consumers, leading to higher imports from China and a large trade deficit.

Currency Manipulation

Currency manipulation is the deliberate act by a government to influence the value of its nation’s currency relative to others. Accusations of currency manipulation often arise when a country is suspected of keeping its currency artificially low to boost exports.

In the case of China, U.S. manufacturers argued that the yuan was undervalued by as much as 40%, despite rising by 18.4% against the dollar since mid-2005. They believed China was engaging in currency manipulation to give its exports a price advantage in international markets. By maintaining a lower yuan, Chinese products became cheaper for foreign buyers, fueling exports and creating trade imbalances. China accomplished this by buying U.S. dollar-denominated securities, which helped to maintain a stable and lower yuan value relative to the dollar.

Managed Floating Exchange Rate

A managed floating exchange rate system allows a currency's value to fluctuate based on supply and demand in the foreign exchange market, with occasional interventions by the country's government or central bank to stabilize or influence the currency’s value.

In China’s managed floating exchange rate system, the yuan is allowed to move within a specific range. If the exchange rate moves beyond this range, the Chinese central bank steps in by buying or selling foreign currency. For example, if the yuan weakens too much, the central bank might sell U.S. dollars and buy yuan to strengthen it. Conversely, if the yuan is too strong, the central bank might buy U.S. dollars to weaken the yuan. This approach helps China to maintain competitive export prices while also mitigating excessive currency volatility.

Chinese Exports

Chinese exports have played a pivotal role in the country’s economic growth. The strategy behind China’s exchange rate policy is closely tied to its export-driven economic model. By keeping the yuan undervalued, China makes its goods cheaper on the international market, which helps to boost exports.

The competitive pricing of Chinese exports has several effects:

• Increased demand for Chinese products worldwide
• Surge in China’s manufacturing sector and economic growth
• Trade imbalances with countries like the U.S., leading to trade deficits

However, an undervalued currency also makes imports more expensive for Chinese consumers, potentially leading to higher costs for foreign goods. Therefore, the shift to a managed floating system allows for some flexibility, helping to balance domestic growth with international trade competitiveness.