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ECONOMIC ANNALS, Volume LVI, No. 190 / July – September 2011UDC: 3.33 ISSN: ana Gligorić*Exchange rate policy, growth,and foreign trade in ChinaABSTRACT: This paper analyzes a hottopic: the influence of an undervaluedcurrency on macroeconomic variables –primarily on the economic growth andtrade balance of a country, but also onemployment, foreign exchange reserves,competition, and living standards. It alsoreviews and explains the consequences ofyuan undervaluation, points out the needfor its appreciation, and states the negativeeffects that stem from this measure. Specialattention is given to the problematic bilateralrelations between China and the USA andthe reasons why Americans are worriedabout the exchange rate policy that Chinaimplements. Although yuan appreciationwould decrease the American foreign tradedeficit, it also raises the question of furtherfinancing of the American deficit. Thereare also other problems that the possibleappreciation would cause for the Americaneconomy, due to the effect of J-curve, passthrough, larger costs of input importedfrom China, etc. Therefore, Chinese foreignexchange policy is an important subject,but it is not the solution to the problemsof the global economy – which have deeperroots than that. However, there is no excusefor China implementing unfair exchangerate policies, or replacing such policies withcontroversial protectionist policies (as someauthors have suggested).KEY WORDS:   undervalued yuan,appreciation, economic growth, foreigntrade balance, bilateral relations betweenChina and the USAJEL CLASSIFICATION: F31, F59, O24, O53*Faculty of Economics, University of Belgrade,

Economic Annals, Volume LVI, No. 190 / July – September 20111. Economic policy (policy mix) implemented by ChinaChina has achieved exceptional growth in the last thirty years using a growthstrategy based on exports. Since 1994 (when the country abolished its dualexchange rate regime) the exchange rate regime in China has been mostly fixed.Even during the periods of a managed floating exchange rate regime, the range ofallowed daily oscillation was narrowly set (particularly between 1994 and 1997:between 2005 and 2008 it was 0.3%, and after that 0.5%). Still, during thatperiod the Chinese Central Bank (People’s Bank of China – PBoC) has activelyimplemented its monetary policy, using instruments to influence the supply ofdomestic credits and has successfully maintained the price stability. After 1994,as foreign capital inflow increased and was accompanied by a fixed exchangerate, the government became increasingly unwilling to change the exchange rateregime towards bigger fluctuation1, in order to prevent the appreciation of theyuan. Along with a fixed nominal exchange rate, the real exchange rate wouldthus also appreciate, which would have resulted in inflation, had the PBoC notperformed sterilization.Since after foreign capital sterilization the money supply stays relatively stabledespite capital inflow, sterilization is best visible in the Central Bank’s balancesheet (Table 1). Foreign capital inflow in China would have lead to an assetsincrease, which would have been reflected in an increase in the supply of highpowered money on the liabilities side, had it not been for the sterilization – thesale of Central Bank’s other assets or increase of other liabilities.Table 1. Chinese Central Bank balance sheetAssets1999 2008 LiabilitiesRMB billionForeign assets1400 16300 Currency issueClaims on financial1900 2000 Deposit reservesentitiesClaims on government2001600 Bond issueOther assets0800 Other liabilitiesTotal Assets3500 20700 Total LiabilitiesSource: Ljungwall, Xiong and Yutong (2009, p. 5).1104Ljungwall, Xiong and Yutong (2009, p. 22)1999200815003700140092000600460031003500 20700

EXCHANGE RATE AND FOREIGN TRADE IN CHINAThe PBoC used two instruments intensively in order to sterilize the capital inflow:open market operations and a deposit reserve requirement.Since 2002 the Chinese Central Bank has been issuing and trading with shortand medium-term notes2 in order to absorb the capital inflow (Ljungwall, Xiongand Yutong, 2009, p. 9). The interest rate on these notes depends on the marketinterest rate on notes in general.The PBoC started the intensive use of a deposit reserve requirement as aninstrument in 2006. More precisely, in 2006 the deposit reserve requirement was6%, then after a gradual increase by the PBoC it reached its maximum of 17.5%in July 2008, and since then it has been slightly lowered to 16%3 due to the globaleconomic crisis.Besides sterilization, the PBoC also had to use instruments in the domesticcredit market in order to prevent inflation: interest rates and setting loan caps tocommercial banks (Ljungwall, Xiong, and Yutong, 2009).By setting price caps on deposit interest rates, as well as price floors on loan rates,the PBoC controlled the supply of money through the banking system. In 1994China, as a relatively closed economy with international reserves 50 times lowerthan now, had high deposit interest rates (which in 1994 exceeded 10%) in orderto lower the inflation rate. Because international reserves have been growingrapidly, lately the PBoC has been keeping deposit interest rates low, thus ensuringlow interest rates on its central bank notes and deposit reserves.It has been noted (Ljungwall, Xiong and Yutong, 2009, p. 10) that owing to thismeasure that the PBoC applies, the banks usually set a maximum interest rateon the deposits because of competition, and that mainly large companies haveaccess to loans with the lowest interest rate. Thus large companies are favoured atthe expense of small companies and individuals (Thorbecke, 2010 and Ljungwall,Xiong and Yutong, 2009). Also, even though it has not been publicly announcedor confirmed, it is said that the PBoC sets credit caps (the total amount of loansthat banks can give out annually)4.234Mainly with the maturity date of up to a year, with possible issue of three-year notes if needed(Ljungwall, Xiong and Yutong, 2009, p. 9).For details see Ljungwall, Xiong and Yutong (2009, pp. 9-10)Ljungwall, Xiong and Yutong (2009, p. 10).105

Economic Annals, Volume LVI, No. 190 / July – September 2011Such a combination of instruments applied by the PBoC, although successful, hascertain negative consequences. The high deposit reserve requirement decreasesthe profitability of commercial banks, whereas interest rates on deposits andloans, as well as possible limits to their sum, prevent free price forming in themarket (due to supply and demand disruption)5.Using econometric analysis, Ljungwall, Xiong, and Yutong (2009) proved thatfor now the PBoC is profitable, despite its considerable interventions. Withits strategy (primarily setting interest rates on deposits and possibly setting arelatively high deposit reserve requirement6), the PBoC has successfully avoidedinflation and kept sterilization costs low in the observed period after reformsin 1994. However, the authors (Ljungwall, Xiong, and Yutong, 2009) warn thatfurther development of the financial market will result in limited opportunitiesfor the use of a deposit reserve requirement – as a powerful instrument, whichwill significantly increase the costs of sterilization – and thus considerably limitfurther sterilization.2. Chinese exchange rate policyAt the beginning of the 1980s China introduced the dual exchange rate system7,8.Two exchange rate systems functioned simultaneously until 1994 and they weresignificantly different (Table 2). On the one hand, there was an official exchangerate – which in 1993 was used in only one fifth of all transactions – and on theother there was a market exchange rate – used in the large majority of transactions(about 80%). The official exchange rate was significantly lower than the marketexchange rate, which increased the pressure on the official exchange rate todevalue gradually 9. Thus the official exchange rate devalued several times up to1994, when the single currency was introduced. Exchange rate policy was subjectto criticism during the dual regime as well, because the system significantlylimited the supply of foreign currencies and thus impeded imports10.5678910106For more about negative implications of foreign exchange increase and sterilization see:Thorbecke (2010, p. 6)For details see Ljungwall, Xiong and Yutong (2009, p. 20).People’s Bank of China, 0Gang (2008), 0DaCosta (2004, p. 4).Morrison and Labonte (2011, p. 2).

EXCHANGE RATE AND FOREIGN TRADE IN CHINAWhen China abolished the dual exchange rate system in 1994 (Table 2), theinitial value of yuan was 8.70 yuan to the dollar. Between 1994 and 1996 Chinaimplemented a managed floating exchange rate regime. During this period thenominal exchange rate appreciated by 4.8%. From 1997 to July 2005 China’scurrency was pegged to the dollar at the rate of 8.28 yuan to the dollar. TheChinese Central Bank bought or sold its foreign reserves in dollars in order toneutralize the excess of supply or demand of the yuan. In this way the yuan wasstable regardless of the changes in economic factors, which would otherwise haveresulted in a change of rate between the two currencies.The exchange rate policy was changed once more in July 2005 (more precisely onJuly 21st when the yuan appreciated by 2.1% - from 8.28 to 8.11 yuan to the dollar).China officially abandoned the fixed exchange rate regime and allowed floatingwith daily oscillations of 0.3% (later 0.5%) to the basket of currencies, so from2005 onwards China officially implemented a managed floating exchange rateregime11 (Table 2 and Graph 1). In July 2008, at the start of global economic crisis,China decided to maintain the same level of exchange rate to the dollar, andthen finally, in June 2010, China announced another increase of the currencyfluctuation12.Table 2. Exchange rate in China, 1979 - 2010Source: People’s Bank of China: 0, p. 150and tmlThe Yuan appreciated after China introduced reforms in July 2005 as well as inthe year marking the beginning of global economic crisis (more precisely untilJuly 2008) by a total of 20.8%. When the crisis began this appreciation trend was1112People’s Bank of China, 0People’s Bank of China, pdf, p. 1107

Economic Annals, Volume LVI, No. 190 / July – September 2011stopped. From the onset of the crisis until June 2010 the value of the yuan wasapproximately 6.83 to the dollar. From mid 2010 the yuan has been graduallyappreciating13 (by a total of 2.9% until December 2010), but many expertsthink this appreciation was modest and not fast enough. During 2011 the yuanappreciated further (Graph 1).Graph 1. Value of the yuan against the dollar, January 2005 - February1 20111Value for February is a 9-day average of daily values of the yuan.Source: Author’s own calculation based on data from tmlThe real exchange rate of the yuan against the dollar appreciated from mid-2010to the end of January 2011 by about 10-12% annually (the nominal exchangerate appreciated by 3.7%, which, along with the estimated inflation rate for saidperiod, would mean real appreciation of at least 5%; that is - no less than 10%year-on-year). If this trend of real appreciation continues, it is estimated thatin two or three years China will sufficiently raise the value of the yuan by therequired 20-30%14.1314108In June 2010, China announced it would gradually increase the value of the yuan, see Reportsof PBoC from 2010 at: tmlAccording to Bergsten, 2012

EXCHANGE RATE AND FOREIGN TRADE IN CHINAThe real effective exchange rate15 has been moving somewhat differently fromthe nominal and real exchange rates of the yuan against the dollar. Its movementis particularly important because it is formed against the basket of currencies,and therefore it reflects real changes in the global competitiveness of Chineseproducts16. Considering the fact that the yuan has again been relatively peggedto the dollar since the start of the global crisis, dollar fluctuation against othercurrencies has first resulted in the appreciation, and then the depreciation, ofthe real effective exchange rate in China during 2009, but from the start of 2010there was another bout of appreciation (primarily because of the euro’s strongdepreciation against the dollar)17. From mid-2010 the appreciation of the realeffective exchange rate was significantly weaker than the nominal appreciationand real appreciation against the dollar (because of the dollar’s fall against othercurrencies).3. Determining the equilibrium level of the currency and theestimate of the yuan’s deviation from the equilibrium value3.1. Determining the equilibrium level of the currencyThere is no unique methodology for determining the equilibrium level of theexchange rate. This leads to many problems in estimating the optimal value andthe extent to which the existing value deviates from it. Therefore many economists(e.g., Isard 2007, Cline and Williamson 2008, 2009, 2010) emphasise the need tofind the best way to assess the equilibrium exchange rate and suggest methodswhich would, in their opinion, produce the most correct results. The importanceof this subject, emphasised by both these and other economists, lies above allin the influence the exchange rate has on prices and GDP growth, or rather inthe number of negative consequences that can result from its deviation from theequilibrium.A large number of methodologies for assessing the currency equilibrium valuehave been developed. All of these methodologies contain different simplifications151617Real – adjusted to inflation and effective – weighted exchange rate, where weights are sharesin China’s trade with 57 relevant countries. According to: Morrison and Labonte (2011, p. 3).Real change in China’s competitiveness should be traced through changes in the real effectiveexchange rate, which is often not the case, mostly because of its more complicated calculation.According to Morrison and Labonte (2011, p. 3), the total appreciation of real effectiveexchange rate (REER-where importance factors are shares in China’s trade with 57 countries)was 9% from July 2008 to mid-2010.109

Economic Annals, Volume LVI, No. 190 / July – September 2011and assumptions, which lead to approximate evaluations and therefore arbitraryconclusions. Implementation of different methodologies often leads to differentresults18.International Monetary Fund economist Peter Isard (Isard 2007) has analyzedsix different methodologies for assessing a currency’s equilibrium value. Here wewill single out the most important details of each method19:1) Purchasing power parity approachAccording to the purchasing power parity approach (PPP), real exchange rateshould be constant through time, whereas nominal exchange rate should movein such a way that it covers changes in domestic and foreign prices. By observingthe movement of nominal exchange rate and the price index, it is possible todetermine the equilibrium level of the real exchange rate – as its historical averageduring a “moderately long” time period.However, this approach has a serious flaw. The long-term relationship betweennominal exhange rate and the price level exists regardless of which price index isapplied (consumer price index, GDP deflator, export price index, wholesale priceindex, etc.), but the obtained results can be very different values of equilibriumexchange rate.2) PPP adjusted to Balassa-Samuelson effect and “Penn” effectThe PPP approach has been further modified, and now it takes into considerationthe results of studies which indicate that the price ratio of tradable and nontradable goods is lower in countries with lower income and higher in countrieswith higher income, whereas national income expressed in the same currency atthe market exchange rate is undervalued in the countries with lower income andovervalued in the countries with higher income (“Penn” effect)20. Additionally,with time the real exchange rate (which contains aggregate price indices ofcountries’ tradable and non-tradable goods) tends to appreciate in countrieswith faster growth and to depreciate in countries with slower growth. Balassaand Samuelson explained this phenomenon: development of a country brings181920110Isard (2007, p. 3).For details see Isard (2007).The result (which Samuelson called the “Penn” effect) was derived from the study InternationalComparisons Program (ICP), financed by the United Nations and mostly conducted byeconomists from The University of Pennsylvania, according to Isard (2007).

EXCHANGE RATE AND FOREIGN TRADE IN CHINAabout a faster productivity growth in the tradable goods sector than in the nontradable goods sector. It then leads to higher prices of non-tradable goods, andconsequently to the growth of relative prices and real appreciation of the currency(Balassa-Samuelson effect)21.Although empirical proof of the Balassa-Samuelson effect is weak, econometricalanalysis of contrasted data has proved that there is an empirical relationshipbetween the value of real exchange rate and GDP per capita22. Values onthe acquired regression line are interpreted as equilibrium currency valuesdepending on the income of the country, whereas residuals of this regressionshow overvalued or undervalued currency. Also, the resulting regression can beof benefit to countries, which can evaluate how high a real appreciation they canexpect with time depending on the expected GDP per capita growth.3) Macroeconomic balance frameworkMacroeconomic balance (MB) framework implies a demand for simultaneousinternal and external balances. This system consists of three basic parts: first,current account balance on one side; second, assessment of equilibrium value offactors on the other side of equation (assuming they are independent from thereal exchange rate); and third, the relation between current account, real exchagerate, and the size of the (domestic and foreign) gap in the output23.By the mid 1990s the approach was based on the following equation:CUR CAPwhere CUR is current account balance, and CAP is the net flow of private andofficial capital.Lately the following equation has been used:CUR S – Iwhere S is domestic savings, and I domestic investments.212223For a more detailed explanation of the Balassa-Samuelson effect, see Burda and Viploš (2004,pp. 164-165).According to Isard (2007, p. 13).Isard (2007, p. 14).111

Economic Annals, Volume LVI, No. 190 / July – September 2011Two methods are used for assessing the equilibrium value S – I. The first method is based on the econometric assessment of the equation, inwhich independent variable-balance S – I is on the left side, whereas a series ofexplanatory variables (which are assumed to be in equilibrium) is on the right. The second method is based on an assumption about the equilibrium level andthe structure of net foreign assets (liabilities), and so defines the equilibriumposition S – I as the balance between the related inflow of investment incomeand capital gains and losses24. This method is very good for the assessment ofexchange rate deviation from its equilibrium value in countries with mediumto high net foreign debt.In this approach it is also important to define the underlying current accountposition (UCUR), that is, the current account value at the current real exchangerate, providing all countries have full employment or potential output (internalbalance) and that the effects of past exchange rate changes have becomecompletely apparent25. The calculation of UCUR is based on the model of netexport: it is assumed that import is a function of domestic economic activity(measured by GDP), whereas export is a function of foreign countries’ weightedeconomic activity and past values of the exchange rate. By assessing and asfundamental values of import and export, we obtain the net export value whichwould be valid under the said assumptions of full employment and completenessof the effects of currency value changes on import and export demand.This approach is only the medium-term assessment of equilibrium exhange rate– since it includes an estimate of the balance of payments in the medium term –that is, it takes into consideration the time needed for the change of the exchangerate to influence the change in the quantity and value of exports and imports.Additionally, the MB approach is not appropriate for countries with high growthrates and simultaneous fast balance-of-payments deficit growth. In the case ofthese countries, the degree to which capital inflows support productive investmentand how much they contribute to the change in the current account positionshould also be taken into consideration, among other things (Isard, 2007).2425112For details see Isard (2007).Considering the fact that a period of time is necessary for the exchange rate change to causea change in import and export prices, immediately after currency value changes the J-curveeffect appears as a consequence. See e.g., Caves, Frankel and Jones (2001), as well as Petrovićand Gligorić (2010).

EXCHANGE RATE AND FOREIGN TRADE IN CHINA4) Estimate of the tradable goods sector’s competitivenessThe approach of the tradable goods sector’s competitiveness estimate is a narrowerconcept than the MB framework, and focuses on the tradable goods sector’scompetitiveness at the current exchange rate. Although the tradable goods sectorand competitiveness can be defined in different ways, it is best to observe therelevant indicators and use the information from all relevant available data. Theindustrial sector and its performance are often used as an approximation for thetradable goods sector, whereas profitability (mainly derived from unit labour costsor added value deflators), trends in the export volume or share in global exports,import penetration rate, etc., are seen as general measures of competitiveness.5) Assesments based on assessed exchange rate equationsThe estimate of the equilibrium exchange rate, according to this approach, is basedon the reduced form of exchange rate equations. Models of the reduced form, asin the case of the PPP hypothesis, are more reliable in the medium and longterm. Advances in econometrics – analysis of time series and the cointegrationby Engle and Granger – have contributed to a better rating of the long-termequilibrium relation between exchange rate and other economic variables. Forexample, the IMF noted in 2006 that the long-term exchange rate equation as anexplanatory variable includes the net foreign assets position (as average exportand import ratio), the difference between productivity (output per worker) in thetradable and non-tradable goods sector in relation to foreign trade partners, themeasure of the commodity terms of trade, the level of goverment consumption,trade restrictions index, and the measure of the extent of price control26.Regression exchange rate equations, particularly if they are well specified, canbe an excellent way to assess its equilibrium level. Because of this many centralbanks and market participants often use this approach in analyzing exchangerate issues.Still, it is very important to verify the reliability of results obtained through therelevant econometric tests and, of course, the economic logic of the obtainedparameter assessments (for example, if the parameters are of adequate size,of a correct sign, and so on). Also, assumptions about equilibrium value ofindependent variables in a model can be questioned, which in many cases limitsthe use of this approach.26IMF (2006): International Monetary Fund, 2006, “Methodology for CGER Exchange RateAssessments”. According to Isard (2007), for details see p. 21.113

Economic Annals, Volume LVI, No. 190 / July – September 20116) Assesments based on general equilibrium modelsThe estimate of the exchange rate equilibrium value obtained through thisapproach is considered to be better than assessments obtained through anteriorapproaches. Although only a small number of general equilibrium modelsimulations have been performed, they clearly point out the limitations andincompleteness of other approaches and the assumptions they are based on27.Still, even the estimate based on general equilibrium models has some limitations.First of all, complete macroeconomic models are only available for some countries.Also, these are often models that include short-term predictions and are not clearwhen it comes to long-term characteristics. Finally, like other approaches, thisone also requires the introduction of a series of assumptions in determining theexchange rate equilibrium level, which makes it harder to obtain the results andlimits their reliability.3.2. How undervalued is the Chinese currency?Peterson Institute economists William Cline and John Williamson gave anassessment of the Fundamental Equilibrium Exchange Rate (FEER) in theirpublications (2008, 2009, and 2010).Cline and Williamson (2008, 2009, 2010) define the Fundamental EquilibriumExchange Rate as an exchange rate that is expected to be stable on the basisof existing policies during an unlimited time period. Is is expected that thisexchange rate will result in the equivalence between current account deficit orsurplus and the basic capital flow during the observed period, assuming that thecountry aims for inner equilibrium and that it can practice free trade28. FEER isdefined as real exchange rate – adjusted to inflation as well as effective exchangerate – weighted bilateral exchange rate average, where weighting factors arecalculated on the basis of a share of certain countries with which the observedcountry trades, in the total foreign trade of the said country.The authors started with an assumption that external disbalance does not exceed3% of GDP. Still, they allowed for the surplus or deficit to exceed 3% of GDP intheir analysis, but only if it is consistent with the absence of possibility of anincrease of net foreign assets ratio in GDP.2728114Isard (2007, p. 21).see Cline and Williamson (2009, p. 2).

EXCHANGE RATE AND FOREIGN TRADE IN CHINANext, the authors primarily use IMF assessments of existing current accountimbalances (as a percentage of GDP) in the year which is analyzed (so, forexample, in the study from 2008 the authors use IMF assessments for that year).The current account forecast taken into consideration (first in US dollars andthen as a percentage of GDP) covers a three year period (forecasts for 2011, 2012,and 2013 are in the publications from 2008, 2009, and 2010, respectively). Thecurrent account forecast is then modified to include the assumption that Cline(2009) takes into account: an estimate of higher American deficit29 and higherglobal oil prices than the IMF forecasts.Then, after the authors estimated the value of the current account deficit/surpluswhich would cause a constant level of net foreign assets in the gross domesticproduct (NFA/GDP), they adjusted it so that there would be no change ofaggregate (global) current account level.The model is based on two relationships, economic and algebraic: The economic relationship takes into account the dependence of the currentaccount on the real effective exchange rate. According to the economicrelationship, changes in the current account will be equal to the product ofexchange rate change and influence parameters of a certain country30. In thisanalysis the authors obtained the impact parameters of a country in the rangebetween 0.15 (in relatively closed countries) and 0.5 (in highly open countries).This indicates that an exchange rate change of 1% would result in a change ofcurrent account in GDP of 0.15% and 0.5%. In this way the authors calculatea necessary change in the exchange rate value by simply dividing desirableadjustments in the current account balance (which represents the differencebetween current value and aimed current account imbalance) by the influenceparameter of the country. The values of needed currency appreciation ordepreciation by country are shown in Table 2, column 4, page 12, of thepublications of these authors from 2008, 2009, and 2010. The algebraic relationship takes into account the influence that the change ineach country's effective exchange rate has on all bilateral exchange rate valuesof the said countries in the process of calculating the value of the FEER. In2930According to Cline and Williamson (2009, p. 5).A country’s impact parameter is calculated as a product of export prices’ elasticity andthe share of exports in GDP (for details see Cline and Williamson 2009, p. 6). Cline andWilliamson assumed that the export prices’ elasticity is equal to one in cases of relativelyclosed economies (e.g., where the share of exports in GDP is up to 10%), whereas it is equal to0.5 in highly open economies (where exports equal 100 % of GDP and over).115

Economic Annals, Volume LVI, No. 190 / July – September 2011this part of the analysis the authors apply the Symmetric Matrix InversionMethod (SMIM) model, developed by Cline31, in order to obtain the neededappreciation or depreciation of a single currency against the dollar, so theexchange rate equlibrium level of 35 observed countries can be obtained.Using this method Cline and Williamson proved that in 2008 China’s real effectiveexchange rate was undervalued by 19.2%, whereas the yuan was undervaluedby 31.5% against the dollar. The authors estimate that in 2009 the real effectiveexchange rate was 21.4% lower than its equilibrium value and that the value ofyuan again

EXCHANGE RATE AND FOREIGN TRADE IN CHINA 107 When China abolished the dual exchange rate system in 1994 (Table 2), the initial value of yuan was 8.70 yuan to the dollar. Between 1994 and 1996 China implemented a managed floating exchange rate regime. During this period the nominal exchange rate appreciated by 4.8%. From 1997 to July 2005 China's

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