prof. simply simple - the story of the chinese yuan20aug2010013819

7/28/2019 Prof. Simply Simple - The Story of the Chinese Yuan20Aug2010013819

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You would have read in several

newspapers about the pressure onChina to appreciate its currency Yuan.

Lets try and understand the reasonwhy China likes to keep its currency

undervalued.

The Story of the Chinese Yuan By Prof. Simply Simple TM


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Throughout the 1990s, Chinawas highly successful at

maintaining a currency pegagainst the US dollar (USD)

using a government monopoly.


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But earlier this year, China said itwould allow a more flexible Yuan,

signaling an end to the currencys pegto the USD.

The move has helped deflect criticismfrom global economies, who have

blamed China for relying on anundervalued currency to promoteexports.


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By reducing the value of its currencyagainst the USD, China stands to gain in

the following ways:-1. Its exports become more competitive.2. It attracts higher foreign investment.


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So how does this happen?As always, an example will help us to

understand.

Lets presume the exchange rate isUSD 1 = Yuan 100

Now if a good costs Yuan 200 inChina, a buyer in the US would have

to pay USD 2.


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Now if China were to devalue its currency to

USD 1=Yuan 200, what would happen???

Quite clearly the same product which wascosting Yuan 200 in China would now costthe American buyer only USD 1 instead of

USD 2.

While such drastic changes in exchange ratesnormally do not happen in real life, use ofthis example was to explain the concept.


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So you can see why Chinese exporterswould always be happy with a weak Yuan.

This is one of the reasons why Chinesegoods have been selling across the world.Most countries find it inexpensive to buy

from China.

As China gets access to larger globalmarkets, it further gains from economies ofscale which if may pass on to its customers,

thereby, making their goods even morecompetitive.


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And now lets look at the second advantage,that of attracting foreign investment (foreign

capital)

Lets say, I am a US investor looking foravenues to invest my money.

I would naturally seek a destination where I

can get good returns.


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And good returns are dependent on the

following:-

1. A large market that can absorb theproduction easily at a good price.

2. Low cost of the factors of productionlike land and labour.


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Now China offers both:1) Its a large market due to its

population. It also has access toglobal markets for finished goods.

2) Due to its depreciated currency thecost of land and labour for a

foreign investor works out to bevery attractive.


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Lets again fall back on our example.

Say the cost of land in China wasYuan 100,000 & the exchange rate wasUSD 1 = Yuan 100.

This land would then would have cost USD

1000.If China were to depreciate its currency toUSD 1 = Yuan 200, then the land would cost

USD 500.


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Again in the example, we have shown acase of extreme depreciation which is

not the case in a practical scenario.

However the impact is similar.

A depreciated Yuan makes both landand labour inexpensive for a foreign

investor.


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But then why do other countries, letssay a Singapore not devalue its

currency.

Actually they too can. But then thismove may not attract as many foreigninvestors into Singapore as it does into

China.

Now why does this happen??????Think about it

orgo to the next slide


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The reason is clear. Singapore cannotoffer a market as large as China. And

hence simply depreciating itscurrency will not be enough forSingapore to compete with China.


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The second challenge is of rising inflation.

As the Yuan depreciates, the central bankwill have to print more Yuan to balancethe surge in dollars through increased

trade.

But as China has abundant land andlabour, they are able to off-set theinflationary pressures by higher

productivity through economies of scale.


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It is also interesting to note that unlikeIndia, China is not a democracy.

Hence, it is a nation where the peoplesvoice against inflation could be silenced.


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After all China takes away a largerproportion of global markets on one handand global capital on the other depriving

other nations from their share.

Hence there was global pressure on China toappreciate its currency.


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Hope you have now got some idea as towhy China was under pressure to

appreciate its currency and how currencydepreciation can be used as a tool by

nations to increase their competitiveness.

However, the underlying fact is that if onewants to benefit from such policies one

will have to have the prowess tomanufacture quality products in the first

place.


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Hope you have now understood the larger role of

currency exchange rates in trading strategiesvis--vis China.

Do write to me [email protected]
mailto:[email protected]:[email protected]


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The views expressed in these lessons are for information purposes onlyand do not construe to be of any investment, legal or taxation

advice. The lessons do not cover the depth of the subject.

The contents are topical in nature & held true at the time of creation ofthe lesson. They are not indicative of future market trends, nor isTata Asset Management Ltd. attempting to predict the same.

Reprinting any part of this presentation will be at your own risk andTata Asset Management Ltd. will not be liable for the consequences

of any such action.

Disclaimer

prof. simply simple - the story of the chinese yuan20aug2010013819

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