ECON 867 International Financial Management
Lecturer: Dr. George Milunovich
The value of the Chinese renminbi, its management and risks associated with investing in China
Mahmut Berdan 41404068 Arthur Britto 41087054
Rasmus Heim 40981088 Joanne Papanikitas 40321711
Table of Contents
The current economic situation and the present exchange rate regime in mainland China 2
The equilibrium value of the Chinese renminbi under a flexible exchange rate regime 4
Reasons behind the Chinese government’s decision to keep the renminbi pegged to a basket
of currencies 7
Risks commercial participants face from a managed float versus a fully flexible exchange
rate in China 9
In recent times, the Chinese economy has become a topic of great interest within economic literature and global affairs. In particular, China’s rapidly exceeding economy has sparked extensive discussion on the value, management and stability of the Chinese renminbi, as well as considerable debate concerning the strengths and potential risks associated with investing in China. In what appears to be an economy with immense potential to further expand its global influence, several key factors need to be analysed.
Firstly, the advantages and disadvantages associated with the current economic situation and present exchange rate regime existing in mainland China. Secondly, the motivations behind the Chinese governments decision to peg its national currency to a basket of currencies and moreover, the potential risks associated with replacing a fixed exchange rate system with a more flexible one. By considering such factors, it is seemingly clear that China’s recently introduced peg to as basket of currencies will more adequately reflect its economic position, as well as the renminbi’s currency value, within global financial markets.
The current economic situation and the present exchange rate regime in mainland China
China possesses one of the fastest growing economies in the world, with its rapidly booming economy seaming ahead of its global competitors. Undoubtedly, China is the primary contributor to the growing economic strength of Asia, as well as for global economic growth. Over the last four years, China’s economy has expanded at an average of 10.4 per cent per year which, during the same financial period, more than doubled the average growth rate of the world economy. Factors considered bring responsible for China’s startling economic growth are the rise in GDP, GDP Per Capita, investment, trade and the success of Chinese enterprises (Full Steam Ahead for Chinese Economy 2007).
China contributes a strong 5.5 percent of the worlds GDP, with growth stable, remaining within 1.1% fluctuation points. Predictions have been made that in 2008, Chinas GDP could possibly increase to 10.7% with the Olympic Games taking place in Beijing (Full Steam Ahead for Chinese Economy 2007).
Chinese government officials wish to sustain economic growth in order to reduce poverty (Chinese Economy Exceeds Forecast 2007). In 2006, China appeared to have succeeded, with its per capita income reaching the 2000US threshold for the first time. Rural resident incomes increased by 7.4 per cent, whilst urban residents increased by 10.4 per cent. According World Bank statistics, such an increase suggests that China can no longer be considered a low-income nation (Full Steam Ahead for Chinese Economy 2007).
In the last four years, China’s national fixed assets investment has increased by 26.6 per cent, whilst its trade volume has made rapid progress, reaching the third largest volume globally at 1.76 trillion in 2006. Moreover, Chinese enterprises have recorded impressive profit margins, which have undoubtedly strengthened national economic growth (Asia Economy: The Impact of the Renminbi Revaluation 2005).
It is seemingly clear that in present terms, the Chinese economy has conditions of high levels of growth and sustainability. However, a nation with such rapidly exceeding growth may face problems of surplus production capacity, the risk of deflation and overheating, if the proportion of exports in GDP capacity continues to rise into the future (Future worries for Chinese Economy 2007).
The main priority of the ruling Chinese Communist Party (CCP) is to maintain strong rates of economic growth, political and economic stability, as well as implement reforms in a country experiencing significant economic transformations (China: Country Outlook 2007). As an eloquent example of economic reform, Chinese officials made a moderate revaluation of the currency by ending the eight year fixed exchange rate policy of pegging the Renminbi against the US dollar and replacing it with a floating exchange rate regime, targeting its value against a basket of currencies (Asia Economy: The Impact of the Renminbi Revaluation 2005). Under the reform, a ‘reference basket’ of currencies is referred to when selecting targets for the Renminbi (Asia Economy: The Impact of the Renminbi Revaluation 2005). Such basket currencies will have assigned ‘index weights’ administered by The State Administration for Exchange Control (SAEC), under direct control of the People’s Bank of China (PBOC) —China’s Central Bank—, that reflect which currencies are most commonly traded in terms of foreign trade, external debt and foreign direct investment (People’s Bank Of China 2007). The Peoples Bank of China (PBOC) stated that trade weighted indexes will not be followed rigidly, as account considerations such as the share of other major currencies in foreign debt and foreign direct investment will also be considered (People’s Bank of China 2007). The revaluation has exhibited a moderate appreciation of 2.1 per cent, from 8.28 per cent against the US Dollar to 8.11 per cent (Asia Economy: EIU’s October Assumptions 2005). An announcement of the People’s Bank of China (PBOC) states that the changes ‘…enables the market to fully play its role in resource allocation…as well as further strengthen the managed floating exchange rate regime based on supply and demand’ (People’s Bank of China 2007). Chinas trade patterns have moderately altered, relieving pressures caused by China’s capital and current account surpluses.
Despite its advantages, the present exchange rate regime may create uncertainty of the future exchange rate level, the appreciation or depreciation of the currency, as well as prices of imported goods and level of export costs in the longer term (Kuroda 2003).
The equilibrium value of the Chinese renminbi under a flexible exchange rate regime
In order to calculate the equilibrium value of the renminbi, first, one has to decide which of the three basic versions of PPP to use: the Law of One Price (LOP), the absolute PPP or the relative PPP (Yang & Bajeux-Besnainou 2006). In this report, the relative PPP will be used to determine RMB’s equilibrium value. Like the other two options, relative PPP does not differentiate between tradable and non-tradable input goods. So, wages are included in prices used to calculate the PPP exchange rate, but not in the market exchange rate. Therefore, the former is lower than the market equilibrium exchange rate given a low per capita income currency such as the RMB being the quoted currency. Hence, the RMB’s value, implied by PPP, is higher than the value indicated by actual exchange rate.
However, the relative PPP overcomes LOP’s problem of lacking representativeness. Moreover, in contrast to the absolute PPP, it also reduces the impact of including traded as well as non-traded goods by relying on the equilibrium exchange rate S0 of a base year t=0. The PPP exchange rate then is determined by adjusting S0 by the relative price changes of the two currencies (Yang & Bajeux-Besnainou 2006). Since this model is based on an equilibrium value of the exchange rate, the results obtained will be more reliable than those of the other two versions. Therefore, to determine the equilibrium value of the renminbi, the relative PPP method will be used by applying this formula:
To ascertain the base period, one has to select a period in which the actual exchange rate was equal to the PPP exchange rate (Artus 1978). Moreover, according to Artus (1978), since biases in measuring relative price changes rise with time, the base period chosen must not lie too far in the past. Yang and Bajeux-Besnainou (2006) chose a period, in which major changes in China’s exchange rate system occured. Given this and Artus’ claim that the base period must not be too distant from the current period, therefore, the exchange rate of July 23 2005 will be taken as a base period. Two days before, the People’s Bank of China announced that the renminbi would be pegged to a basket of currencies. Before that, it was pegged to the US-Dollar only. The following data is used to calculate the PPP exchange rate:
Exchange rate 8.12110
exchange rate of July 23, 2005, i.e. two days after the revaluation
(Oanda.com ) 7.0222 (7.55580)
exchange rate of March 31, 2008, chosen in accordance with the latest CPI month available
Domestic price level p (RMB) 101.3
CPI of August 2005, i.e. the month after the revaluation
(National Bureau of Statistics of China 2007) 108.3(106.5)
latest available CPI, March 2008
(National Bureau of Statistics of China 2008)
Foreign price level p* (USD) 196.4
CPI of August 2005, i.e. the month after the revaluation
(US Department of Labor 2007) 213.5 (207.9)
latest available CPI, March 2008
(US Department of Labor 2008)
Since the long-run equilibrium exchange rate implied by relative PPP is higher than the actual exchange rate S2007, the foreign currency USD is undervalued by
and the domestic currrency RMB is overvalued by
Using PPP as a trading rule, buying USD and selling RMB is recommended.
It is important to bear in mind that, since there are, in reality, differences between traded and non-traded goods as well as restrictions in the movement of goods, relative PPP can only be employed as an estimate. More specifically, governments should solely use it as guide for their exchange rate policies, rather than as a precise means to determine deviations of actual exchange rates from an equilibrium value.
Reasons behind the Chinese government’s decision to keep the renminbi pegged to a
basket of currencies
In order to establish the reasons behind the Chinese government’s decision to keep the RMB pegged to currencies such as the US dollar, Euro and Japanese Yen, it is important to first differentiate between the reasons given by the Chinese government and the ones pointed out by the US government.
Two major justifications made by Chinese policymakers include concerns that moving to a more flexible system would exacerbate deflationary pressures and undermine export competitiveness (Tung & Baker 2004). In other words, with the RMB at a higher value against the dollar, there would be an increase in the price of exports and that could lead to a downward pressure on domestic prices. In addition, the Chinese government has also mentioned that the current exchange rate adjustment aims to promote the basic equilibrium of the balance of payments and safeguard macroeconomic and financial stability (Xinhua 2005a). The People’s Bank of China says that it has chosen an exchange rate system “that caters to its domestic situation by taking into consideration its fundamental interests and economic and social development” (Xinhua 2005b). In other words, China argues that the pegged system more likely guarantees stable economic growth.
On the other hand, Americans—namely US lawmakers and manufacturers—have stated that China gives its exporters an unfair price advantage in global markets by keeping the RMB’s value artificially low (Reuters 2007a). For Ben Bernanke, US Federal Reserve Chairman, the yuan regime provides an effective subsidy to Chinese exporters, even though it is not a “subsidy” in the legal sense of the word (Kaiser 2007). Finally, Condoleezza Rice, US Secretary of State, has recently called for “reform of the currency to one that will be reflective of the market” (Reuters 2007b). In response to these claims, Chinese President Hu Jintao has currently indicated that China would continue to reform the currency exchange system and let the market play an increasing role (Pulizzi 2007). However, as written by David Cohen in the article China Hints at Further Appreciation of Yuan, “China remains committed to proceeding [yuan’s revaluation] at its own pace” (2007).
Despite Yang and Bajeux-Besnainou’s research finding no convincing evidence to support that the RMB was undervalued (2006), the US Treasury noted in June 2007 that China’s currency was in fact undervalued. However, it had been “unable to determine that China’s exchange rate policy was carried out for the purpose of preventing effective balance of payments adjustment or gaining unfair competitive advantage in international trade.” (Somerville & Palmer 2007). Intended or not, considering both countries’ points of view, the Chinese government’s decision to peg the yuan to a basket of currencies has undeniably given a competitive edge to China (The Economist 2007).
It is this particular competitive edge that China does not want to lose. This would occur if the country allowed the renminbi to fully float. As Burdekin (2006) stated, losing export markets would slow down economic growth and negatively affect employment. Hence, to make sure that displaced workers can find employment, the government hesitates in accepting even a modest reduction in the country’s high economic growth. To conclude, another reason for keeping the exchange rate system as it is, as Cohen (2007) suggests, is to refer to the old saying “if it is not broken, do not fix it”.
Risks commercial participants face from a managed float versus a fully flexible
exchange rate in China
According to Davis (2004), the future development of China’s economy is highly determined by its efforts to become more integrated with global financial markets. The necessity of this is also reflected by China’s strict capital controls combined with an immature banking system, which deteriorates external funding for local companies (Davis 2004).
Such integration could be achieved by aiming for a market driven ergo floating currency of the Yuan. However Davis (2004) envisages that a sudden change of China’s currency policy would adversely affect China’s interest, due to a continuing underdeveloped banking system, which is being rated one of the worst in the world. In this context, Moosa (2006) suggests that for countries with poor financial systems such as China, a freely floating currency is not suitable since such systems require sophisticated futures and forward markets. Due to this, the pegged currency has proven itself as a major pillar of stability, especially during the Asian crisis (Das 2005). However, the pegged currency is subject to policy decisions which have announced destabilizing effects on the financial markets as compared to periods in which the exchange rates are held constant.
Davis (2004) argued that the change towards a free float would lead to an asset flight stemming from Chinese depositors who would diversify their portfolios by investing in other international markets. The economic slow-down and/or potentially resulting crisis would most likely be combated by an enormous rise in interest rates in China.
For this reason, Davis suggests that implementing a freely float would not be a viable option for another decade. The change that is most likely to occur in the short term is a revaluation of the pegged exchange rate by appreciating the Yuan, which would require China some time to develop a more competitive and functional banking system.
U.S. direct income investors would be majorly affected by such revaluation, since the need for the Chinese Central Bank to buy large quantities of U.S. securities would decrease. This is due to the decreasing proportion of the U.S. trade deficit China is currently backing. Naturally, an appreciation of the Yuan would make Chinese exports more expensive for foreign countries such as the U.S. and therefore possibly reduce imports stemming from China. As a consequence of the revaluation, there could be inflationary impacts on the world economy whose magnitude however would differ between countries (Yang & Bajeux-Besnainou 2006). Nevertheless it is important to note that an increase in Chinese exports prices might not have an effect on China’s exports at all due to the general low level of prices stemming from extremely low labour cost.
Generally, investors are concerned with exchange rate fluctuations, for they impact on the net worth of their investments. In this context, floating exchange rates are often viewed as a way to achieve higher flexibility and avoid costs associated with policy changes in parities which create greater uncertainty (Aliber 1972). In the case of China, the risk that stems from a floating exchange rate is related to its immature banking system and unforeseeable reaction from investors that suddenly face a more volatile currency. These reactions could generate a chain reaction similar to Thailand which triggered the Asian financial crisis in 1997 (Das 2005).
There are a number of political and economic issues for China such as the high degree of corruption for instance, which could increase the likelihood of disorderly national behaviour, creating additional uncertainty (Aliber 1972), (Business Monitor International 2007). This becomes critical in a scenario where the Chinese foreign exchange should depreciate. In that scenario, Chinese exporters and investors will be worse off, whilst political pressure may deteriorate appropriate adjustment of the exchange rate.
Additionally, despite China’s accession to the WTO, adequate reform needs to be made in addressing issues such as intellectual property protection, which is still a major impediment on FDI in China according to Business Monitor International (BMI 2007).
Moreover, there remain possibilities of financial crisis in China forecasted by BMI (2007) due to a number of factors. Firstly, the lack of effective reduction of non-performing loans (NPLs) in the state-owned banking sector negatively impacts investors’ confidence. Secondly, the currently rapid investment in China could lead to over-capacity, which in turn could lead to the re-emergence of deflationary pressures. Furthermore, the undisputed growth of China’s economy is widely feared as being unsustainable and the impacts of a slow-down are unclear creating uncertainty for investors. Lastly, China is still classified as a non-market economy with most of its trading partners within WTO regulation, which makes China more vulnerable against anti-dumping duties.
It is apparent that China is highly integrated and influential in today’s global economy. The impact of a revaluation of the Yuan has triggered widespread controversy, with changes in China’s monetary policy being deemed a potential threat to stable global market movements which could trigger economic instability and future crisis. On the one hand, it is feared that the appreciation of the RMB may result in inflationary impacts on the world economy, as well as a decrease of Chinese exports to major trading partners. However, structural aspects such as low labour costs and increasing levels of Foreign Direct Investment (FDI) provide a competitive advantage to China over most economies in the world. Therefore, impacts of an appreciation of the RMB may not, as widely assumed, adversely impact China’s competitiveness as a strong exporting nation.
In the long term, China will aspire to achieve a more market driven exchange rate system in order to become more closely associated and integrated within global financial markets. In order to successfully sustain and operate a sophisticated and well functioning financial system, financial authorities need to invest time and effort in its structural development.
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