ffw 2010

Outline Introduction Overview of China The Recent History Why? How? Removal of the Peg

China vs. the United States: the Battle forGlobal Economic Supremacy

Ryan W. Herzog

Gonzaga University

Fall Family WeekendOctober 22nd, 2010

Introduction

Overview of China

The Recent History

Removal of the Peg

Introduction

• Why has China decided to pursue an exchange rate target?

• How has China been able to maintain the pegged exchangerate without risking a crisis?

• Should we be pressuring China to let the renminbi appreciate?

• What has the United States gained/lost by China’s foreignpolicies?

Introduction

Key Numbers for China

• Real GDP grew at an annual rate of 9.6%.

• Unemployment in China is at 9.6%.

• Inflation is stable at 3.6%.

• China raised interest rates on deposits and lending to 2.5%and 5.56%, respectively.

• China has $2.6 trillion in reserves.

GDP per person US and China (1980-2015)

Economic Growth in China (1953-2007)

The Peg

• China has pegged the renminbi at 8.27 yuan per dollar from1997 through 2005.

• From 2005 to July of 2008 China let the renminbi slowlyappreciate to 6.82 yuan per dollar.

• On June 19th China announced a shift in the exchange rateregime to a managed float. Currently the renminbi is tradingat 6.73 yuan per dollar.

The Peg

Exchange Rate (1981-2010)

Asian Crisis

• In 1997 many East Asian economies were hard hit by afinancial crisis (including Thailand, Indonesia, South Korea,Malaysia, Philippines, and Hong Kong).

• The financial crisis was caused by quick deregulation in thefinancial system which removed capital control. Large sums of“hot money” flowed into these countries leaving themsuspectable to a currency crisis.

Asian Crisis

Export Led Growth

• Asian economies from 1960 through 1990 used exports to fuelgrowth.

• The Asian Tigers (South Korea, Hong Kong, Singapore,Taiwan) and Japan used their abundance of cheap labor tospecialize in low-skilled manufacturing exports.

• Combined with improved educational systems allowed theseeconomies to quickly improve labor productivity andsubsequent economic growth.

• China had a large surplus of low skilled labor andinfrastructure in place to promote low tech manufacturingproducts.

Export Led Growth

The Peg

• The recent financial distress in neighboring countries and thenegativity of trade barriers left China with really one option topromote exports.

• A pegged exchange rate allowed China to control the price oftheir exports without worrying about the retaliation thatnormally follows trade barriers.

The Peg

• The recent financial distress in neighboring countries and thenegativity of trade barriers left China with really one option topromote exports.

• A pegged exchange rate allowed China to control the price oftheir exports without worrying about the retaliation thatnormally follows trade barriers.

Currency Control through Monetary Policy

• We can view foreign exchange through simple demand andsupply diagrams.

• As the U.S. demanded China’s goods, the demand for theyuan increased.

• Under a floating exchange rate, an increase in the demand fora currency would cause the currency to appreciate.

• To offset the appreciation, China would then buy U.S. dollars.

• Essentially, China was buying U.S. debt (government bondsand mortgage backed securities) while the U.S. purchasedtrillions of China’s exports.

Trade with China (1999-2009)

Income Payments and Receipts (1999-2009)

Monetary Policy

• Countries are faced with a choice when using monetary policy.Countries can:

• Set interest rates

• Have free capital mobility• Fix exchange rates

• Countries cannot have all three.

• By choosing to peg the yuan to the dollar, China is giving upthe ability to set interest rates.

• If the United States lowers interest rates then foreign investorswill shift away from dollar assets. An decrease in the demandfor dollars causes a depreciation (an appreciation of the yuan).China must also lower rates to prevent the appreciation.

• China has also elected to keep a tight control on foreigncapital flows (opposite other Asian economies) which preventsagainst a large sudden shift in capital.

Monetary Policy

• Set interest rates

• Have free capital mobility

• Fix exchange rates

Monetary Policy

• Set interest rates• Have free capital mobility

• Fix exchange rates

Monetary Policy

• Set interest rates• Have free capital mobility• Fix exchange rates

Monetary Policy

Foreign Reserves

• Countries choosing to peg their exchange rate, must bewilling to buy and sell foreign currency on demand.

• The central bank needs to hold an ample surplus of foreignexchange. Many emerging markets (even some developedeconomies) failed to hold sufficient foreign exchange andfaced bank runs.

• China has followed the Federal Reserve’s massive increase inthe money supply, China created a stock pile of foreignreserves ($2.6 trillion).

• It is common for domestic and foreign policy goals to becomemisaligned. China is in a high growth, high inflationenvironment which calls for higher interest rates.

Foreign Reserves

General Effects on US

• Low interest rates as China became a large purchaser of U.S.debt.

• Cheap goods from China.

• A loss in competitiveness for US manufacturing.

Why are we Pressuring China?

• Cheap Chinese goods are having an adverse effect on our jobmarket.

• Will an appreciation in the yuan improve unemployment?

• To help restore global imbalances.

Current Account for US and China (1980-2010)

Concerns for China

• Will the United States be able to repay their debt in full?

• Higher inflation in the United States will reduce the value ofall U.S. denominated debt.

• Many economists are calling for a 3-4% inflation target.

• A appreciation in the yuan will make China’s exports moreexpensive and cause a potential slowdown in growth.

• A devaluation of the dollar will drastically reduce the value ofChina’s assets.

• Is China at risk for overheating?• By maintaining the peg, China is adopting the expansionary

monetary policy of the United States.• They are growing at a nearly 10% rate, and could soon

experience high inflation.• China just raised both their deposit and lending rates by 25

base points.

Concerns for China

• Will the United States be able to repay their debt in full?• Higher inflation in the United States will reduce the value of

all U.S. denominated debt.

• Many economists are calling for a 3-4% inflation target.

base points.

Concerns for China

all U.S. denominated debt.• Many economists are calling for a 3-4% inflation target.

base points.

Concerns for China

base points.

Concerns for China

base points.

Concerns for China

• Is China at risk for overheating?

• By maintaining the peg, China is adopting the expansionarymonetary policy of the United States.

• They are growing at a nearly 10% rate, and could soonexperience high inflation.

• China just raised both their deposit and lending rates by 25base points.

Concerns for China

monetary policy of the United States.

• They are growing at a nearly 10% rate, and could soonexperience high inflation.

Concerns for China

experience high inflation.

Concerns for China

base points.

Concerns for U.S.

• Will interest rates increase? Short-run or long-run?

• Will we be able to replace China as a large purchaser of U.S.debt?

• If China dumps dollars how far will the dollar depreciate?• Many U.S. firms use Chinese’s goods as inputs in the

production process.

• With the Federal Reserve pumping trillions to help stabilizethe economy will this push inflation over the edge?

• Will their be any improvement in jobs?

Concerns for U.S.

production process.

Concerns for U.S.

• If China dumps dollars how far will the dollar depreciate?

• Many U.S. firms use Chinese’s goods as inputs in theproduction process.

Concerns for U.S.

production process.

Concerns for U.S.

production process.

Concerns for U.S.

production process.

Holders of Federal Debt

• The gross national debt is $13.2 trillion of which:

• $8.6 trillion is held publicly.• $4 trillion is held by foreign and international investors.

• $800 billion is held by Federal Reserve banks

• $4.6 trillion is held by the government.

• The gross national debt is $13.2 trillion of which:• $8.6 trillion is held publicly.

• $4 trillion is held by foreign and international investors.• $800 billion is held by Federal Reserve banks

• $4 trillion is held by foreign and international investors.

• $800 billion is held by Federal Reserve banks

• $4 trillion is held by foreign and international investors.• $800 billion is held by Federal Reserve banks

Supplier of Funds to the U.S.

• The government debt is projected to increase to nearly $20trillion by 2020.

• China currently holds $900 billion in U.S. government debt.

• Federal Old Age and Survivors Trust Fund holds $2.4 trillion.

• As we deplete the retirement trust funds and government debtgrows we are going to need large buyers of government debt.

A Solution to Unemployment

• There will likely be a small change in manufacturing jobs.

• Nearly 8 million manufacturing jobs have been lost since2000.

• Above equilibrium wages will keep manufacturing suppressed.

• There are no insurances the jobs will return to the UnitedStates.

• Job losses could increase in industries that depend on Chineseimports.

• Exporting industries in the US will be hurt (carmanufacturing).

• Above equilibrium wages will keep manufacturing suppressed.• There are no insurances the jobs will return to the United

States.

• Above equilibrium wages will keep manufacturing suppressed.

• There are no insurances the jobs will return to the UnitedStates.

States.

States.• Job losses could increase in industries that depend on Chinese

imports.

States.• Job losses could increase in industries that depend on Chinese

imports.• Exporting industries in the US will be hurt (car

manufacturing).

Conclusion

• Should the United States be putting pressure on China to letthe yuan appreciate?

• U.S. made car exports totaled 56,597 from January 2010-July2010. An eightfold increase from the previous year (8,847). In2000, U.S. made car exports to China totaled 215.

• China is our third largest export market.

• Are we risking a bigger trade war? Smoot-Hawley Tariff Actwas a likely contributor to the Great Depression.

• Will market pressures be sufficient?

• What about the Currency Reform for Fair Trade Act that waspassed a few weeks ago.

Conclusion

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