The Effects of the Yuan’s Revaluation
Ryan Pitylak, University of Texas-Austin
10/28/2005
Introduction
This revaluation will be negative for the United States, but the negative impact of this revaluation of the Yuan vis-à-vis the dollar will be almost negligible. The revaluation will be beneficial for China for several reasons. First, the flexible exchange rate will help to protect it from macroeconomic volatility. Second, it will allow China to cool the over lending that has occurred with its new ability to raise interest rates. Before the revaluation, there was a fear that large capital inflows would result from higher interest rates. Chinese authorities are not against a gradual revaluation, but they want to make sure that the revaluation happens slowly (such as the recent 2.1% revaluation). China’s financial market is weak and it needs time to become better equipped to handle the large capital outflows that are expected to occur after a complete capital market liberalization.
Effects of the Revaluation for China
Revaluation should cause the demand for Chinese exports to decrease. The demand for these exports depends on the elasticity of demand for Chinese goods. Elasticities tend to be high for foreign goods because of substitutes in the long-run. Despite elasticities, the decrease in demand should be virtually unnoticeable because Chinese exports are composed of a large percentage of imported intermediate inputs. A revaluation causes imports to be cheaper for China.
According to textbook analysis using the DD-AA model, the initial response to revaluation is a leftward shift of the AA curve for China. This short-run position would be at a level of output that is lower than the full employment output level, but at the new exchange rate. The lower output level will afford workers cheaper wages because of the excess supply of workers. The lower output will cause less spending on productivity costs. Both of these effects will put downward pressure on prices in China. This price change will cause the DD curve and the AA curve to shift right in the long-run to the point where the exchange rate is at the revalued rate, and output is still at the full employment level.
Joseph Stiglitz and Robert A. Mundell argue that a revaluation of the Yuan will do nothing except hurt the poor in China’s rural areas (People’s Daily Online [2005]). Both of these men are noble laureates. Stiglitz was the chief economist of the World Bank, and Mundell is a professor of economics at Columbia University. They think that the revaluation will widen the income gap between the rural and urban workers. This will increase poverty in the rural sector and it will work to counter the recent efforts to decrease the income gap. Qing Wang [2005] disagrees with Stiglitz and Mundell. Wang says that the Chinese agriculture sector is internationally competitive, and therefore the food prices of domestic producers will be able to compete with the prices of foreign food imports. The result of the revaluation on the rural agriculture sector is ambiguous at this point.
The value added by China to exports is about 30% (People’s Daily Online [2005]). For this reason, a 2.1% revaluation should cause as much as a 0.63% increase in the price of exports, because the value-added portion of the exports is what should increase. Also, “trade data show that over 50 percent of Chinese export operations involves the final assembly of products using intermediate inputs produced by other countries” (Wang [2005]). The 0.63% export price increase would be diminished by a decrease in the prices of imports for intermediate goods because of the 2.1% revaluation. Since this decrease in the price of inputs should be passed through to the value of exports, exports should not to appreciate even 0.63%. Most economists agree that a revaluation of the Yuan will have little effect on the price of Chinese exports. There is debate over what the exact effect will be. However, economists seem to agree that a 10% revaluation of the Yuan will cause between a 1%-2% increase in the price of Chinese exports (Laus [2003]).
The Chinese authorities have been reluctant to rapidly revalue the Yuan. The main reason appears to be that a financial crisis could occur because of capital outflows. A large revaluation could cause a financial crisis because of China’s weak banking structure. The reason why Chinese authorities believe that a rapid revaluation would cause financial crisis comes from the fear that capital account liberalization will allow people to diversify their financial assets by exchanging their Yuan for foreign currency. This is a scenario that the current financial structure is not ready to handle. To circumvent this problem, gradual capital account liberalization should be implemented to allow the financial sector to adjust to the increased exchange rate flexibility. (Wang [2005])
The Chinese authorities realize that a revaluation will be good for China in terms of lessening its exposure to macroeconomic shocks. These shocks can be mitigated better after the banking structure has been strengthened. A flexible exchange rate will bring more independence in monetary control which, will allow China to adjust to these shocks. Independence will be gained in the form of different market oriented intrusments, such as more control over interest rates. China’s rapid growth and massive capital inflows have increased liquidity in the financial sector in the past few years. This has caused excess capacity and non performing loans. (Wang [2005])
One example to illustrate the level of excess capacity can be seen by noticing that “a staggering nine-tenths of manufactured goods in China are thought to be in oversupply” (Economist [2005]). With respect to over lending, the People’s Bank of China “highlighted the need to strengthen credit risk management, [and] improve the structure of loans,” (Lardy [2005]). Interest rate increases could not have been implemented in the past to mitigate the over lending because the rise in the interest rates would have resulted in more foreign capital inflows, which would have lead to increased liquidity, and therefore would not have helped resolve the problem. With exchange rate controls now available, interest rate policy can be implemented without heavy capital inflows (Wang [2005]).
Foreign direct investment, FDI, has been important for China’s growth. FDI is determined by “access to world markets, and rapidly expanding domestic demand,” so “there is little reason to believe that an exchange rate [revaluation] would have substantial negative effect on FDI inflows” (Qing Wang [2005]).
Effects of the Revaluation for the United States
The effect of the revaluation of the Yuan should have very little effect on the United States. As mentioned already, a 10% revaluation is expected to have a 1%-2% increase in the price of imports from China. The 2.1% revaluation would therefore have less than a 0.5% increase in the price of imports from China.
Figure 1
Source: Davis [2004]
According to textbook analysis using the DD-AA model, the increased price of imports from China (albeit negligible) would cause the DD curve to shift to the right. This shift will cause the dollar’s exchange rate vis-à-vis the Yuan to be at a depreciated level. This effect is countered by a leftward shift of the AA curve. This shift occurs because exchange rate expectations have adjusted to the new revalued level of the Yuan. Short-term output will not be the full employment level, unless the DD & AA effects exactly counter each other. Regardless of which effect is greater, in the long-run, the employment level will return to full employment as the AA and DD curves shift towards the full output level. Here, the exchange rate is at the depreciated level.
The People’s Bank of China will no longer need to purchase United States treasuries to keep its currency fixed. This is because China has made its currency more flexible by choosing a basket of currencies. However, this should have “virtually zero impact on short-term Treasury yields” (Davis [2004]). More broadly, the United States’ stock and bond markets should not change after the initial reaction from the announcement of the revaluation is over. After one year, if China stopped buying United States Treasury, the impact would be almost negligible (see Figure 1). (Davis [2004])
Conclusion
Even though United States policymakers blame China for their debt problem, this is not going to be resolved by a revaluation of the Yuan. The effect of the revaluation will be negligible to the United States. The exchange rate flexibility that China has gained will help it become stronger so that it will one day be able to support higher per capita incomes. The current weakness of the financial sector in China could have become a major problem for China in the future.
References
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