Money Talks

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On 21 July 2005 Beijing made its biggest monetary shift in more than a decade by revaluing the Chinese currency, the yuan (also known as the renminbi) : it reset the fixed value of its currency and dropped the fixed exchange rate, or peg, with the U.S. dollar. Nevertheless, the Chinese government has still set tight parameters on how much the yuan can rise. While the United States, Japan, and the European Union have pressured China to institute further revaluations, Beijing has been reluctant to make more changes due to concerns that a currency appreciation would lead to slower export growth, higher unemployment, and, over time, a decline in foreign direct investment. This article will explore the future of U.S.-Asian trade imbalances by examining how China's central bank has managed the yuan exchange rate in the past. second, it will analyze the significance of China's undervalued yuan. Last, it will examine why further revaluations are needed and which outside pressures will affect China's decision to revalue. China's central bank, the People's Bank of China (PBOC), is a government agency that oversees the banking system and is responsible for regulating the money supply in the economy, issuing currency, and managing the exchange rate. Central banks regularly engage in international financial transactions called foreign exchange interventions in order to influence exchange rates. While in the current international financial environment some exchange rates float freely, fluctuating from day to day, most operate under a managed float regime. Specifically, under a managed float (sometimes also known as a "dirty float"), the central bank attempts to influence exchange rates by buying and selling currencies. Under a managed floating currency, the PBOC will keep exchange values, especially the dollar/yuan rate, from experiencing big shifts by resetting the value of the yuan at the end of each trading day. In 1994 the value of the yuan was pegged to the U.S. dollar at a rate determined by the PBOC. Since 2000 it had been trading within the range of 8.27 to 8.28 yuan to the dollar. Now, Beijing has abandoned the peg and has moved to a system that links the yuan to a basket of currencies, effectively raising the yuan's value by 2-1 percent. This means that, prior to the revaluation, $1 bought 8.28 yuan; following revaluation, $1 buys roughly 8.11 yuan. Clearly, the yuan will not float by a big margin but will appreciate-or increase its value-by a modest 2 percent by moving within a tight range of 0.3 percent against a group of major foreign currencies. Initially, the PBOC kept secret the basket of currencies, but it was speculated to include roughly a dozen currencies, including the dollar, euro, and yen. By not disclosing the basket's composition, the PBOC could play with the exchange rate by changing the mix, giving dollars more or less weight as needed to keep rates from shifting too dramatically. However, on IO August 2005, the central bank governor, Zhou Xiaochuan, provided more details on the meaning of the term "basket," noting that the currencies in the basket depend on the amount of foreign trade China conducts. Why Revalue NOW? Arguably, over the past two years China's macroeconomic situation has become more conducive to the yuan's revaluation. The GDP growth rate, which averaged between 7.1 percent and 8.8 percent from 1997 to 2002, accelerated to over 9 percent in the last two years. The undervalued yuan has also contributed to excessive credit growth and "overheating" because it has attracted large capital inflows motivated by expectations of appreciation, or the rise in value relative to other currencies. Overheating occurs when there is an attempt to raise consumption without simultaneous increases in production. Once demand for goods and services that are not supported by production rises, overheating will occur, often taking the form of a general increase in prices.1 Expecting an imminent rise of the yuan,...
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