The Discussion on Chinese Government Exchange Rate Policy of the Yuan and Its Impacts to the Us Economy and the Hedging Solution

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The Financial Engineering Subject Assignment Lecturer: Prof. Dr. Markus Freiburghaus

Vo Tran Dinh Hieu – EMFB 5 Topic B: Hedging Currency Risk

The discussion on Chinese government exchange rate policy of the Yuan and its impacts to the US economy and the hedging solution What have been the exchange rate policies of the Yuan (CNY) or Reminbin (RMB) of the Chinese Government? Let’s start with the reviewing of the exchange rates separately throughout the history. There are not a lot of readers may know that the exchange rate of USD/CNY were approximately close to one time at the beginning of 1980s. In 1983, two years before I were born, one US Dollar (USD) was traded at 1.43x of the Chinese Yuan or Reminbin (CNY). Prior 1995, it was unnoticeable period for the economic performance of China, the Chinese Yuan had been depreciated for more than 5 times of its initial value in ten years time 1985 – 1995 to the US Dollar. The exchange rate of USD to CNY had climbed sky-high from 1.5 times in 1984 to more than 8.5 times in 1995. The most memorable event was the 50% devaluation as end 1993; the local currency lost half of its value overnight. And what even more exiting was happened after, the Chinese government has pegged the Yuan at around 8.2 Yuan to one US Dollar for the next decade. The motive behind has been obviously clear to the world, however the questions are how did the Chinese value the Yuan and is it undervalued consistently, very arguable. The following analysis which bases on the general economy statistics would help us to understand the situation better on the business administrative point of view. The China’s real GDP growth rates had kept slowing down rapidly until the beginning of 2000. Prior to that the Chinese government had done a lot of works to support the economy growth, including the SOEs sector reform, the agricultural sector reform, modernization of the industrial sector and especially the Yuan dramatic depreciation to support the country unique advantage – export. For more than ten years, since 1994 to late 1995, the Chinese have maintained a fixed exchange rate for their currency, the yuan, relative to the dollar. The rate has been pegged at about 8.28 Yuan to one Dollar for the entire period. This has prolonged and attracted attention as some have voiced concern that holding down the value of the Yuan is making the prices of Chinese exports to the U.S. too cheap. It is pretty clear the Chinese’s strategy of the exchange rate policy which is export-oriented and supporting the country development via new investments from budget & trade surplus as well as foreign capital inflows. It was an obvious success of the Chinese as new China has become the world “Porsche” of growth. But, did they have any alternative but the fixed exchange rate policy? In order to maintain the fixed exchange rate, the China’s Central Bank has had to participate in the foreign exchange market actively. It had controlled the supply and demand of Dollar denominated assets by pumping out or withdrawing back the money supply of Yuan on the market to keep its balance. It could’ve been a double blade if the China national budget had not been strong enough, fortunately it was. Thanks to the huge trade surplus, especially with the US, every, the China has accumulated a giant amount of foreign reserve which has reached 1 trillion US Dollar in 2006 while it was one tenth ten years ago (table 1). During the time, the government budget deficit had also been kept below 2%, it began to be positive in 2008 (chart 2). As a result of strong reserve, more government spending, rapid expansion of the economy tended to multiple its money supply too; the broader money in circulation continues to grow very rapidly by adding more leverage to the economy as well as maintain high velocity of the money. (Chart 5) the M2 growth YOY has been staying above 15% for a decade before peaking up in 2008, the Chinese government had stepped up in 2003 to sterilize...
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