The Financial Engineering Subject Assignment Vo Tran Dinh Hieu – EMFB 5

Lecturer: Prof. Dr. Markus Freiburghaus Topic B: Hedging Currency Risk

The discussion on Chinese government

exchange rate policy of the Yuan and its impacts
to the US economy and the hedging solution
What have been the exchange rate policies of the Yuan (CNY) or Reminbin (RMB) of the
Chinese Government? Let’s start with the reviewing of the exchange rates separately throughout
the history. There are not a lot of readers may know that the exchange rate of USD/CNY were
approximately close to one time at the beginning of 1980s. In 1983, two years before I were born,
one US Dollar (USD) was traded at 1.43x of the Chinese Yuan or Reminbin (CNY). Prior 1995, it
was unnoticeable period for the economic performance of China, the Chinese Yuan had been
depreciated for more than 5 times of its initial value in ten years time 1985 – 1995 to the US
Dollar. The exchange rate of USD to CNY had climbed sky-high from 1.5 times in 1984 to more
than 8.5 times in 1995. The most memorable event was the 50% devaluation as end 1993; the
local currency lost half of its value overnight. And what even more exiting was happened after,
the Chinese government has pegged the Yuan at around 8.2 Yuan to one US Dollar for the next
decade. The motive behind has been obviously clear to the world, however the questions are
how did the Chinese value the Yuan and is it undervalued consistently, very arguable. The
following analysis which bases on the general economy statistics would help us to understand
the situation better on the business administrative point of view.

The China’s real GDP growth rates had kept slowing down rapidly until the beginning of 2000.
Prior to that the Chinese government had done a lot of works to support the economy growth,
including the SOEs sector reform, the agricultural sector reform, modernization of the industrial
sector and especially the Yuan dramatic depreciation to support the country unique advantage –
export. For more than ten years, since 1994 to late 1995, the Chinese have maintained a fixed
exchange rate for their currency, the yuan, relative to the dollar. The rate has been pegged at
about 8.28 Yuan to one Dollar for the entire period. This has prolonged and attracted attention
as some have voiced concern that holding down the value of the Yuan is making the prices of
Chinese exports to the U.S. too cheap. It is pretty clear the Chinese’s strategy of the exchange
rate policy which is export-oriented and supporting the country development via new
investments from budget & trade surplus as well as foreign capital inflows. It was an obvious
success of the Chinese as new China has become the world “Porsche” of growth. But, did they
have any alternative but the fixed exchange rate policy?

In order to maintain the fixed exchange rate, the China’s Central Bank has had to participate in
the foreign exchange market actively. It had controlled the supply and demand of Dollar
denominated assets by pumping out or withdrawing back the money supply of Yuan on the
market to keep its balance. It could’ve been a double blade if the China national budget had not
been strong enough, fortunately it was. Thanks to the huge trade surplus, especially with the US,
every, the China has accumulated a giant amount of foreign reserve which has reached 1 trillion
US Dollar in 2006 while it was one tenth ten years ago (table 1). During the time, the
government budget deficit had also been kept below 2%, it began to be positive in 2008 (chart
2). As a result of strong reserve, more government spending, rapid expansion of the economy
tended to multiple its money supply too; the broader money in circulation continues to grow very
rapidly by adding more leverage to the economy as well as maintain high velocity of the money.
(Chart 5) the M2 growth YOY has been staying above 15% for a decade before peaking up in
2008, the Chinese government had stepped up in 2003 to sterilize the reserve accumulation by
issuing first time its central bank’s paper, however the pace didn’t stop for so long as we saw. It
was indeed a progress of mixed policies which are all focused on growth via export, hence the
exchange rate policy turned out to be very key element which can not be replaced. Leaving the
good side, what we want to know next is the impact on the United States; is its economy really
hurt that demands a violent voice to the international community in relation with China.

(Table 2) The US net deficit to China had been increasing rapidly over years. The net deficit to
US GDP was 0.84% in 2000, when it seemed to be small, but increased to 1.73% in just 6 years
later. Generally, the imports from China were mainly low-skilled labor to assemble and process
imported parts and materials originated in the Asian countries area that have traditionally
exported directly to the U.S. Consequently, the share of U.S. imports from these other countries
has reduced dramatically just as China’s share has become domination; whilst the US exports
haven’t done so well to China as well as the neighbor region. In the other word, the impacts of
China low-cost exports were severe directly and indirectly. Obviously, the US is not happy with
the situation while the flag isn’t in their hand.

So, will the Yuan appreciation in near future solve the problem; would it make the U.S. goods
exporting to China less expensive and it would it make U.S. good importing from China more
1
The Financial Engineering Subject Assignment Vo Tran Dinh Hieu – EMFB 5
Lecturer: Prof. Dr. Markus Freiburghaus Topic B: Hedging Currency Risk
expensive. Fortunately, we have had a nice precedent in 2006, when the Yuan appreciated
more than 15%. The consequence was very encouraging to US as the balance to China trade
has shown deceleration, even though it is still deeply negative. It is also very important to
emphasize that China still has had significant capital controls recently (especially after 2006), the
policy which allows for more inflows than outflows, thus bolstering foreign exchange
reserves. China is gradually loosening some controls (on securities rather than debt), and
outflows are likely to grow as new channels develop for Chinese to seek diversification and
better returns than those offered by low domestic interest rates (Chart 3: the China 1 year
government bill dropped to below the US comparable rate since early of 2008, the spread has
even been widen un 2010); the boom and burst of the equity and property markets are
examples. At the bottom line, I think the Chinese has lessened its support to the Yuan gradually
since 2006 via various methods, unless the US keeps deteriorating unexpectedly fast, the
pressure on Yuan will be reduced. On the other hand, China is also losing its competitive
advantage of the labor market to other Asia Pacific countries. In the other word, they hate to
concede against the US criticism but somehow are admitting it internally.

Moving to the case of the Vietnamese exporter, who has partial expenses, material to be exact,
in Yuan and revenue in USD. Because of the nature of textile industry, specifically in Vietnam,
we would estimate that the material costs would account for at least 70% of total expenses. So
hedging against the appreciation of RMB relative to USD is more important than the movement
of local currency, which is also technically pegged to USD. Based on the aforementioned
findings, I propose the following solutions. Firstly, we should think about the operational
diversification as it is possible to diversify the material suppliers away from China to avoid the
appreciation of Yuan. In fact, many companies in Viet Nam have done so, they have shifted the
import goods from China to other countries like India (for textile, motorbike, car …), ASEANs or
the South America countries. This is the cheapest solution and also most effective one because
it avoids the complexity of financial hedging method. Second, still operational, we can
immediately convert all the USD revenue into RMB and deposit at Chinese bank’s accounts; this
will secure the cash flow position in RMB for the next purchase of material or profit transfer back
to Vietnam. And may be at last, we can use various financial hedge tools or so-called the
derivatives. On the goods side, we can buy forward the RMB domestically for future usage and
sell forward the USD revenue to avoid its potential depreciation against RMB. For the tax-
purpose, we all can use the Exchange Traded Notes of USD tied to foreign currency (RMB in
this case) to materialize the financial gains from RMB appreciation as a provisions reserve for
the increasing in material costs for the same reason.

Table 1: China's Financial Indicators, 2000-09

Notes: NA = Not available. *USCBC calculations. **People's Bank of China (PBOC) rate on the last day of the year. Sources: China
Statistical Yearbook 2009; NBS website; PBOC
Main indicators 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
M0 supply 1,465 1,568 1,727 1,974 2,146 2,403. 2,707 3,037 3,421 3,824
% growth* 8.9 7.1 10.1 14.3 8.7 11.9 12.7 12.2 12.7 11.8
M1 supply 5,314 5,987 7,088 8,411 9,597 10,727 12,603 15,256 16,621 22,000
% growth* 16.0 12.7 16.8 18.7 13.6 11.8 17.5 21.0 9.0 32.4
M2 supply 13,461 15,830 18,500 22,122 25,410 29,875 34,560 40,344 47,516 60,600
% growth* 12.3 17.6 16.8 19.6 14.7 17.6 15.7 16.7 17.8 27.7
Exchange rate (RMB/$)* 8.28 8.28 8.28 8.28 8.28 8.07 7.81 7.30 6.83 6.83
Foreign exchange reserves ($ billion) 165.6 212.2 286.4 403.3 609.9 818.8 1,066.3 1,528.2 1,946.0 2,399.2
Foreign debt ($ billion) 145.7 170.1 171.4 193.6 228.6 281.0 323.0 373.6 374.7 NA

Table 2: China's Trade with the United States ($ billion)

Notes: US exports reported on FOB basis; imports on a general customs value, CIF basis
Source: US International Trade Commission
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
US exports 16.3 19.2 22.1 28.4 34.7 41.8 55.2 65.2 71.5 69.6
% change 24.4 18.3 15.1 28.5 22.2 20.6 32.1 18.1 9.5 -2.6
US imports 100.0 102.3 125.2 152.4 196.7 243.5 287.8 321.5 337.8 296.4
% change 22.3 2.2 22.4 21.7 29.1 23.8 18.2 11.7 5.1 -12.3
Total 116.3 121.5 147.3 180.8 231.4 285.3 343 386.7 409.2 366.0
% change 22.6 21.4 21.2 22.8 28 23.3 20.2 12.7 5.8 -10.6
US balance -83.7 -83.0 -103.1 -124.0 -162.0 -201.6 -232.5 -256.3 -266.3 -226.8

2
The Financial Engineering Subject Assignment Vo Tran Dinh Hieu – EMFB 5
Lecturer: Prof. Dr. Markus Freiburghaus Topic B: Hedging Currency Risk

Chart 1: The USD / CNY official exchange rate Chart 2: China & US statistics on real GDP & CPI growth
Source: Bloomberg; Unit: Chinese Yuan to one US Dollar Source: Bloomberg; Unit: % YOY
10 16
CN GDP CN CPI US GDP US CPI
9 14
8 12
7
10
6
8
5
6
4
3 4

2 2
1 0
0

97

99

01

04

06

08
94
95
96

98

00

02
03

05

07

09
10
-2

19

19
19
19
19
20
20
20
20
20
20
20
20
20
20
20
19
84 86 88 95 97 99 05 09
19 19 19 19 19 19 20 20 -4

Chart 3: One year treasury bill rate of US and CN Chart 4: Government budget surplus/deficit versus GDP
Source: Bloomberg; Unit: % per annum Source: Bloomberg Unit: %
7 4
US rate US
CN rate CN
6 2

0
5
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
-2
4

-4
3

-6
2
-8
1
-10
0
2004

2005

2006

2007

2008

2009

2010

-12

Chart 5: Money supply (M2) growth

Source: Bloomberg Unit: % YOY
30
US
CN
25

20

15

10

0
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Notes and reference: Raw data are collected from the Bloomberg Professional Service, which is available at my job. Based on that, the
views expressed and developed in the article are personally of my own. References are used moderately from various online resources
such as: news providers (Bloomberg, Reuters, WallStreet Journal...), statistics bureaus and official website of China and US governments.
The article is written on the discussing manor and does not specify detail references as well as disclaimers.