Since July 2005, first time being revalued after 11 years of fixing at 8.27, Chinese Yuan has been heading towards only one direction – all the way from 8.27 to 6.27. Although Yuan is a highly regulated currency by government, Chinese officials could no longer peg the Yuan as it used to be in a closed economy because WTO had opened up doors for Chinese manufacturers in 2001 to export cheap goods and services to developed countries. With trillions of foreign capital flooding into the country, Yuan has appreciated over 30% over seven years. However, this one-way money flow cannot be sustained. Though it is not sure whether Yuan is at the absolute equilibrium, it is currently neither significantly undervalued nor overvalued. This essay is going to explain why Yuan is modestly priced with analysis in both the fundamentals and money flows.
Needs for appreciation in past
In theory, two open economies should have equivalent purchasing power – that is, if 10 units of foreign currency can buy something that is valued at 1 unit of domestic currency, the implied equilibrium exchange rate should also be 10(domestic as based money). Otherwise, there is an arbitrage opportunity. We call this Purchase Power Parity. In reality, despite some limitations about this theory, it explains most of the valuation problem in China. Take a look at China’s Balance of Payments over 2003-2010 and it is obvious to observe huge surplus annually in both current and capital & financial account, accumulating to a foreign reserve of $3.3 trillion.
Table 1: China’s Balance of Payments (2003 – 2010)
（100 millions USD）| 2003 | 2004 | 2005 | 2006 | 2007 | 2008 | 2009 | 2010 | current account | 431| 689| 1,324| 2,318| 3,532| 4,206| 2,433| 2,378| goods and services balance | 358| 512| 1,246| 2,089| 3,080| 3,488| 2,201| 2,230| capital & financial account | 549| 1,082| 953| 493| 942...