Question

In July 2005 , the Chinese RMB became fixed to a "market-basket" of currencies, including the U.S. dollar and the Japanese yen, removing a decade- long peg to the U.S. dollar alone. The new formula slightly raised the value of the RMB. If China's trade surpluses continue, what will happen to the value of the RMB?

Short answer

The RMB is likely to appreciate due to sustained trade surpluses.

Step-by-step solution

Understanding Trade Surpluses

Trade surpluses occur when a country's exports exceed its imports, meaning more foreign currency comes in than goes out.

Impact of Trade Surpluses on Currency Value

A continuous trade surplus can lead to increased demand for a country's currency, as foreign buyers convert their currency to purchase the country's goods.

Supply and Demand in Currency Markets

According to the laws of supply and demand, if demand for the Chinese RMB increases while the supply remains constant, its value is likely to rise.

Factors Affecting RMB Value

China's trade policies and central bank interventions may influence the RMB value, but sustained trade surpluses typically exert upward pressure without intervention.

Key concepts

Trade Surplus

A trade surplus occurs when a country exports more goods and services than it imports. This means that the country is selling more to the rest of the world than it is buying. This can create a favorable economic situation, as more foreign currency is coming into the country than flowing out. For instance, if China sends more goods overseas than it purchases, it ends up with a surplus.
This is significant because excess foreign currency being exchanged for the Chinese RMB increases its demand.

• A sustained trade surplus enhances a country's foreign reserves.
• It can also signify a strong competitive edge in manufacturing or services.

However, a consistent trade surplus may lead to some global trade imbalances, as one country's surplus might be another's deficit.

Supply and Demand

In currency valuation, supply and demand play a crucial role in determining how much one currency is worth compared to another. The value of a currency, like the Chinese RMB, can increase if more people want to buy it than sell it. Considering the effect of a trade surplus:

• If there's high demand for Chinese goods, foreign importers must convert their currency to RMB to pay Chinese exporters, increasing demand.
• If the supply of RMB remains unchanged, higher demand can lead to a rise in value.

This is a straightforward application of the basic economics principle: when demand exceeds supply, prices go up. Therefore, if China's trade surplus persists, the RMB's value is likely to rise because more people need to buy RMB, not sell it.

Foreign Exchange Markets

Foreign exchange markets are where currencies are bought and sold. These markets set the value of one currency relative to another based on various factors, including trade balances. When a country like China has a trade surplus, the demand for its currency in these markets increases, leading to a potential rise in currency value.
However, aside from the straightforward supply and demand mechanics, other factors can influence these markets:

• Central bank policies which might aim to stabilize or devalue the currency for competitive export pricing.
• Global investor perceptions of economic stability and growth.

Therefore, while a persistent trade surplus generally pressures currency appreciation, actions from China's central bank or shifts in global investor sentiment can also impact the RMB's value in foreign exchange markets.