China is under significant international pressure to appreciate its currency because it is believed that it is having a substantial negative impact on foreign economies (Zhang and Fung, 2006, Yang et al, 2013). This article will weigh up the pros and cons of allowing the Yuan to appreciate.
Many believe that the Yuan is undervalued compared to other currencies such as the US dollar, although by how much is contested; estimates range from 5%-25% (Tung and Baker, 2004). In contrast some studies find little evidence that the Yuan is undervalued (Cheung, Chinn and Fujii, 2007). Since 2005 China has had a managed exchange rate system, wherein the value of the Yuan is weighted to a basket of foreign currencies (a managing float regime). However a limit is set on how much the value can change.
The benefit of such as system is it has helped create a stable macroeconomic environment which helped facilitate china’s extraordinary growth (Tung and Baker, 2004). This has also helped stabilised the regional and global economy.
Figure 1 shows that the Yuan has steadily appreciated since 2005; among other things, this is because China’s growth has been consistently high which has increased purchasing power. China has been limiting the appreciation of the Yuan because it reduces the cost of exports making them more competitive in the global market, fuelling China’s rapid growth (Tilford, 2009).
Benefits of an appreciating Yuan:
As the Yuan appreciates there are benefits which are expected to follow for the economy and for the nation as a whole. It has helped to control inflation, which in a developing nation like China is very important (Davies, 2014). High inflation puts a squeeze on consumers, which in a country where 27% of the population live on less than $2 a day (World Bank, 2009), can have dire consequences; rising food prices risks triggering unrest.
One of the main reasons allowing the currency to appreciate is it may help with vital efforts to reduce the trade surplus and rebalance the economy. There are several reasons for this and for why it will be beneficial.
China is over reliant on exports, (See figure 2) a situation which is not helped by high global demand. Appreciation would increase the price of its exports, reducing the surplus and the demand which will help prevent overheating in the economy which jeopardises growth (Yang et al, 2013). At present in the population, consumption is too low and saving is too high. A stronger Yuan means citizens have more spending power which will help increase consumption, raising living standards (Tilford, 2009). It will also help rebalance the economy, reducing reliance on exports making the economy more stable.
An undervalued currency also exerts a negative impact on the development of a service sector (Ozyurt, 2013). This is significant because development of services is crucial to rebalancing and modernising the economy; because it will lead to higher incomes (Tilford, 2009). Moving away from manufacturing towards service industries will ease the environmental costs of economic growth that China has experienced (Tilford, 2009). However, to boost services, and consumption, china will also need to invest in social security and reform domestic financial markets (Ozyurt, 2013)
Another key benefit of allowing the Yuan to appreciate is it eases tensions with other nations, particularly the USA, reducing the danger of policy confrontations. At one point popular discourse in America labelled China a “currency manipulator”, because it was giving its exports an unfair advantage which was hurting U.S businesses (BBC, 2012). This is controversial because China’s purchasing of huge quantities of US dollars in bonds kept the Yuan low, but also helped the US stay solvent (Amadeo, 2014). As the Yuan has appreciated this criticism has died down. Another widely held belief is that a stronger Yuan will reduce the US’s trade deficit with China (Cline and Williamson, 2009). Modelling by Yang et al (2013) and others find that China’s trade balances improve, but not with the US.
Disadvantages of letting the Yuan appreciate
Concerns with an appreciating Yuan centre around the effects it will have on the continuation of China’s economic growth. In an ex ante study, Yang et al (2013) warn that the economy would shrink significantly and would suffer decreasing exports leading to a reduction in output. Tung and Baker (2004) contest this prediction, believing cheaper import costs will make up for it. A reduction in output, particularly labour intensive industries, will lead to job loses which may threaten social stability. The employed population would benefit from higher real wages while the hardship for the unemployed would be compounded (Zhang and Fung, 2006). Influences on real GDP would affect welfare and living standards which will hinder efforts to increase consumption (Yang et al, 2013). From a global perspective there are concerns a stronger Yuan will lead to a global welfare loss as the purchasing power of other currencies falls (Zhang and Fung, 2006).
The cost-benefit analysis of an appreciating Yuan is a highly complex and contested issue. There are prospects for many benefits to come, however the CCP is wise to be concerned. A weak Yuan has served China well, however in order to complete the transition to a developed economy it needs to take this step. The most pressing economic hurdle is the rebalancing of the economy and imports need to be boosted. Economic models such as those employed by Zhang and Fung and Yang et al warn that appreciation will hinder rebalancing, however there are limitations with these models, they only look at short term effects and they do not provide an alternative currency policy to solve the imbalance.
It is quite likely that there will be short term pain, as many predict, however if it means china can wean itself off exports, allowing it to develop a strong service industry and enjoy more of the fruits of its labour by increasing consumption, it may be worth it in the long term. The Yuan is going to appreciate no matter what the CCP does, what is important is the how the appreciation is managed and the policies which are put in place to mitigate negative effects.
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