It’s not World WAR I, not World War II

And not Cold War either

It’s

The Currency War

By: Vivek Bhutani

IBS-Bangalore

Background
China has a fixed currency system which is also
known as pegged currency system. In this type of
currency system, the value of currency is fixed to the
value of another currency or basket of currencies .

Till 2005, Renminbi was pegged against US dollar at

8.28 Renminbi/USD. To keep the Renminbi at
pegged level, Chinese central bank had to supply
Renminbi and demand dollars in foreign-exchange
markets. This pegged system created a severe
problem for US markets as US producers have to compete with Chinese cheap products due to
undervalued Renminbi. To
prevent this in US
markets, a tariff of 27.5
percent was announced
on Chinese imports until
China adjusted the value
of its currency.

In July 2005, China

announced that it would
move in the direction of a
floating exchange rate.
 As per this new policy, it still intervenes in foreign-exchange markets to prevent large and
sudden movements in the exchange rate, but it also permits gradual changes. This measure
resulted in 20% appreciation of Renminbi against USD in three years.

Since mid 2008, Renminbi barely moved against the Dollar as Chinese exporter’s sales overseas
had dropped sharply because of the global economic downturn. It was almost certain that
Chinese central bank returned to the policy of controlled exchange rate.

Why US is getting too much problem with Undervalued

RENMINBI?
“Calamities are of two kinds: misfortunes to ourselves, and good fortune to others.”

Why US is so much worried with Devaluated Renminbi? Is it because being a super power it
can’t see a developing country or a so called developing country (because 2nd largest economy
of the world with GDP of USD 10 trillion and 2nd largest US reserves holder) like China
performing really well and on its way to become a super economy? Or is it something related to
their economy.

The reason is that China has 2nd largest Dollar reserves after JAPAN. With these reserves,
China is continuously buying US treasury bonds. Bonds valuing of $889 billion which
makes China the biggest holder of US treasury bonds and the biggest creditor of US. So,
US wants the value of the Renminbi to get appreciated so that the value of US reserves
with China will fall which will bring down Chinese economy leading to release in
pressure of Debt.

Because of Chinese undervalued currency, RENMINBI against US Dollar, US current

deficit and Unemployment rate has increased. Also, China’s cheap imports give intense
competition to US markets which results in low domestic demand of US products and
increase in demand of Chinese products.

This is not only affecting US economy but also other Asian Developing economies, as exports of
other countries have also decreased because of cheap Chinese products and their dumping
activities in other countries.
“China's undervalued currency is costing the U.S. economy more than $200 billion per year in
lost growth and is reducing American employment by as much as 1 million jobs.” US Economist

Why China devaluated its currency?

1. To capture the major global export market leaving behind other Asian countries.

2. Devaluating currency also attracts many foreign investors which strengthens the foreign
reserves and generates more employment in China.

Due to devaluation of RENMINBI in the time of recession when global economy was struggling,
China was the only country which came out with the best figures in their Trade balance and
economic growth. The simple reason is the Undervaluing Renminbi against various currencies
like USD i.e. undervaluing 40%, Euros, Pound. This makes the exports of China cheaper. So
most of the countries prefer Chinese products against their own products resulting in Trade
Surplus for China which leads to improvement in Economic condition of China while other
countries struggle because of high debt and huge trade deficit.

What can be done from both the sides?

“It is better to know some of the questions than all of the answers.”

If China Appreciate Renminbi

China can easily revalue its currency as it follows fixed currency system but:

If china appreciates Renminbi it will indirectly affect US economy as it will lead to inflation in US
economy and decline in the real value of household income because US population will stop
getting benefits of Cheap Chinese products as after appreciation ,Chinese products will not be
economical to the US or World economy.
After effects on Chinese Economy

Exporters and manufacturers will see low margin as Renminbi will appreciate making their
goods and services expensive to other countries or the companies which have stockpiled
inventories that are priced internationally will have bad effect on the value of inventories due
to appreciation of Renminbi.

The people who will gain from the revaluation of RENMINBI will be the importers in Chinese
economy as imports will be cheaper as compared to what they were before.

If US Stop selling Bonds to China:

US should stop selling government bonds to china because large percentage of USG bonds are
with China indicating China as the major creditor of US economy. But US can’t do this because
China buys a major part of bonds leading to the increase in the Value of US bonds i.e. indirectly
benefitting US.

If china stops buying US bonds then US has to print more Dollars to pay off its DEBT which will
lead to inflation in US.

If China Sells USD in open market:

If China starts selling US dollar i.e. its reserves in open market or calling off US Treasury Bonds,
this will lead to devaluation of US dollar leading to inflation in US because imported goods will
be expensive for US consumers as well as for producers. To curb this inflation, US government
would have to increase the interest rate in its economy which will further lead to recessionary
situation as people who have their real income already affected from inflation cannot borrow
much.

Conclusion
“Solving a problem is a two way Street”

The approach that can be taken is this that China should allow Yuan to appreciate slowly
otherwise it will lead to high inflation and recession in US economy and it will bring
unemployment and losses to the manufacturers in Chinese economy as discussed above.

Another measure can be that US should stop providing subsidies and other benefits to US
households but government should try to increase the investment part in the economy because
US economy consumes a lot and saves very less (Saving = Production – Consumption)which is
causing imbalance in US economy. US savings are 10.6% of GDP.
But in China it is totally opposite; savings rate in China
is much more than the consumption rate. So to trim
down the savings in Chinese economy, China needs to
privatize and deregulate large state-owned
enterprises. Chinese savings is 55% of their GDP.
Corporate savings amounts to about half of the
national savings and a major contributing factor are
the savings of China’s State-owned enterprises which
China has to balance.

So it’s not only US or China who can solve the problem by themselves alone rather they have to
work on their respective economies and should balance the structure of savings and
consumption so that US as well as China can come out of trade imbalance in their economy.