Nov 14 2008
Exchange rates, currency manipulations, and the balance of trade
Published by Jason Welker at 4:35 am under
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WikipediaFT.com | The Economists’ Forum | Imbalances and undervalued exchange rates: Rehabilitating Keynes
In our year 2 IB Economics class, we are beginning the part of our International Trade unit on exchange rates and the balance of trade . While the market for a particular currency reflects many of the same characteristics as a product market (i.e. upward sloping su
pply curve, downward sloping demand curve), the consequences of a change the price of a currency (the exchange rate) is far more powerful than a change in the price of a particular good or service in a product market.
How does the value of a country’s currency affect that country’s balance of trade with other countries? To understand this important concept, we first need to know something about the process by which currencies are exchanged when two countries trade. Let’s look at an example:
When an American consumer wants to buy an iPod that was made in China she will have to pay for it in US dollars, since that’s what she earns her wages in from selling her labor in the resource market. Apple now has the consumer’s $300, which gets split up to cover all the costs the company faced in the manufacture, distribution, marketing and sale of the iPod. Part of that $300 (say $100) will go to the manager of the factory in China where it was made.
The factory manager in Shanghai faces his own costs he must cover. He must pay rent on his factory space, interest on the loans he took out to acquire capital, and wages to the workers assembling iPods on his factory floor. The problem is, these costs are all in Chinese yuan, but he’s holding the US dollars that Apple paid him for his iPod. In order to cover his costs, the Chinese factory owner must take the $100 to a Chinese bank and swap it for RMB. The local bank that changes his money now hands the $100 over to China’s central bank (the PBOC) which prints and exchanges RMB to the bank at whatever the prevailing exchange rate is at the time.
Ultimately, China’s central bank will decide what to do with its holding of US dollars. Most of the dollars are loaned back to the United States through China’s purchase of US Treasury securities (the IOUs the US government sells to finance its deficits). China’s voracious demand for US dollar denominated assets keeps the demand for (and the the value of) dollars high on foreign exchange markets, meaning the RMB remains relatively cheap for Americans and therefore Chinese manufactured goods attractive.
China’s policy of exchange rate manipulation has upset many American politicians over the years, who often blame China for America’s shrinking manufacturing sector. A weak RMB means the cost of producing things like iPods in China is far lower than it would be in the US. By keeping demand for dollars high on the foreign exchange markets through its incessant demand for US treasury securities and other financial and real assets, while simultaneously hoarding vast reserves of US dollars in its central bank, thus keeping supply of dollars on foreign exchange markets low (see graph), China has prevented the RMB from appreciating, fueling the growth of the country’s export-manufacturing sector.
China’s currency manipulations may soon ilicit a response from the United States as president-elect Barack Obama takes office next year. Facing a recession and rising unemployment, combined with the recent appreciation of the US dollar, the pressure is on Obama to take immediate action to restore America’s manufacturing sector. According to the Financial Times blog “the Economists’ Forum”:
If the US economy takes a downturn and the dollar continues to strengthen, a resurgence of protectionist pressures is likely. This time around, these pressures could well take the form of unilateral action against competitive currencies. It is noteworthy that President-elect Obama has actively and repeatedly supported action against “currency manipulation.”
The “competitive currency” perceived to pose the greatest threat to America’s inustrial sector is certainly the Chinese RMB. Currency manipulation is a form of protectionism, which in a time of global economic slowdowns poses a larger threat than ever to both developed and developing nations’ economies alike. For this reason, the World Trade Organization may need to employ carrot and stick methods to create incentives for China to liberalize its currency controls and allow the RMB to strengthan against the dollar and other major currencies:
How would this new rule against undervalued exchange rates be incorporated in the WTO? Through negotiation. The (WTO) should place rules on undervalued exchange rates…. The US and EU have been the principal demandeurs for action by China in the past. But it is important to remember that until very recently, a number of developing countries—Brazil, Mexico, Korea, Turkey and South Africa—were affected by the competitive pressure from the undervalued (RMB). Indeed, some months ago, the Indian Prime Minister urged China to follow a more market-based exchange rate policy. For obvious reasons, more emerging market countries have not voiced their concerns, but it is possible that a coalition of affected countries could unite on this issue.
Clearly, Chinese concerns have to be addressed for any new rules to be crafted and commonly agreed… First, China’s major trading partners could pledge granting China the status of a “market economy” in the WTO contingent on it eliminating currency undervaluation and moving to a market-based system. This status would have significant value for China by shielding it against unilateral trade actions such as anti-dumping and countervailing duties by trading partners. Second, as part of radical governance reform of the IMF, which is desirable in itself, China should be offered a substantially larger voting share in the IMF commensurate with its economic status.
Discussion Questions:
- How does China continuing to undervalue its currency threaten the industrial economies of its largest trading partners?
- What is China’s purpose for maintaining the low value of the RMB relative to the currencies of other nations?
- What would be a unilateral protectionist measure an Obama administration may advocate if the WTO refuses to take action against China’s currency manipulations? How would you advise president-elect Obama on the issue of whether to take protectionist action against China in the context of the current economic crisis in America?
About the author: Jason Welker is a teacher at Zurich International School in Switzerland, where he teaches Advanced Placement and International Baccalaureate Economics. Jason was an international school student in Malaysia before studying economics at Seattle University then earning his Masters in Education. He calls Seattle and Northern Idaho home. In addition to maintaining an economics wiki and this blog for economics student and educators, Jason also gives presentations on using Web 2.0 tools in education at workshops and conferences around the world. His economics wiki won the 2007 "Best Educational Wiki" award from the "EduBlog Awards". 
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In answer to the first 2 discussion questions:
China’s manipulation of currencies gives it an unfair advantage on the global market, in terms of exports. By having a weak currency, foreign consumers find chinese good more attractive: for example, the yen is very weak compared to the euro. As such, a german consumer has to exchange fewer euros for the same number of yens (compared to if the yen were strong). Chinese producers who export say, toys will still receive the same profit (as it is in yen) but the the german consumer, chinese toys appear cheaper, because he has to give less euros to pay the same price.
This “cheapness” causes a high demand for chinese exports, while, by the same token, as other currencies are strong compared to the yen, other countries’ goods (those of china’s biggest competitors) seem expensive to foreign consumers.
This threat to the exports of china’s competitors causes a significant fall in exports, and thus a fall in GDP and aggregate demand. In times of recession, as in the US right now, this poses a great potential problem, as it could worsen the recession.
How does China continuing to undervalue its currency threaten the industrial economies of its largest trading partners?
When a currency is devalued this means that the value of the currency is lowered. Even though it may seem strange some countries, like China, may prefer a devalued currency, or believe it can benefit. Like Palmi already said, with their weak currency China is able to attract foreign consumers with their exports by their low prices, therefore increasing exports. Clearly the lower prices will mean that now Chinese exports are the most in demand as opposed to other countries, due to the higher prices. This is an evident threat to the industrial economies of its largest trading partners, like the US, because when Chinese exports are going to be expanding, the trading partners imports are going to be increasing as well, and this can lead to a current account deficit.
What is China’s purpose for maintaining the low value of the RMB relative to the currencies of other nations?
Additionally, some possible purpose’s why China would try and maintain the value of the RMB low, relative to other currencies of the other nations is that by having a low value of currencies (therefore a low exchange rate) a country like China can increase exports, because they relatively cheaper. Thereby, they will be able to increase their employment in the export industry. Consequently, if there is greater exports and less imports (because now they are more expensive) the domestic industries may benefit because now their domestic consumers will prefer domestically produced goods, increasing employment.
I agree with the answers that Palmi gave for the questions. It is true that the foreign consumers will find Chinese products more attractive if the RMB is kept low. This is a benefit for the foreign consumer, and Palmi already explained this with her German consumer. She also mentions in terms on export, this is true because when china is importing with a weak RMB, it will have to pay more for the same amount. So when China imports it is not beneficial for itself. I think this is also the reason why it is called a form of protectionism. When the Chinese are keeping their RMB low they are also protecting their market, by decreasing imports. Since it is more expansive more firms to import, the imports will fall. But again there are benefit from this for China. Since the low exchange rates made the imports more expensive, the domestic consumer will buy the products in the domestic markets. This can led to a decrease in unemployment in China. Since there is also a high demand for the exports, it can also create employment in the export sector. These could also be China’s reason for keeping the value of the RMB low, relative to the currencies of other nations.
I thought this article was very interesting and a great way to show how economies can be influenced by exchange rates. I find it really amazing how China has controlled its economy because of exchange rates. What China has done is make its own currency seem really low so its exports seem relatively cheap to other exports and local products. This means that consumers prefer china’s exports because they are cheaper. This is how China has been able to grow so quickly in the past couple of years, because of its exports(most of China’s GDP is its exports). Another effect of a weak currency is that imports seem more expensive, causing consumers to buy more domestic products.
To solve this problem Obama can try to use protectionism against China, but the problem is that cheap imports from China also benefit the consumers in the US. Obama can try to use protectionism against Chinese goods but this would only benefit the US producers and not the consumers in the US.
China is using protectionism to protect its currency, RMB, by keeping it where the government want it to be, low, as Robin said.
If China would not chose to do that, it would affect their whole economy because as their currency would get a lower value, their prices on goods and services would have to increase and foreign consumers would therefor face a higer price and would chose to buy their goods and services elsewhere, and China would lose a lot of their exports and consumers.
(What China does to keep its currency where they want it is to keep as many of their dollars as possible, which is a good thing for the US right now aswell since if China would let go of their dollars, the dollar value would lose even more in value.)
I mean there are benefits to China lowering their value of their currency. However, are there no disadvantages in the long run?
If the exchange rate is in danger of falling, then the government will have to raise the interest rate in order to increase the demand for the currency - however, this will have deflationary effect on the economy, lowering demand and increasing unemployment. This means that the domestic macroeconomic goal (low unemployment) may have to be sacrificed.
Also, if the exchange rate is set at the wrong level, then export firms may find that they are not competitive in foreign markets.
If China sets artificially low exchange rates level, then that may cause international disagreements. That is because a low exchange rate will make a country’s exports more competitive on world markets and may be seen as an unfair trade advantage.
Are there chances of this happening to China?
That is exactly the problem if Obama protects the US economy from the cheap Chinese imports. He does not only fight the cheap RMB compared to the US$, but raise the prices of the imports and with that the real income of the average US citizen decreases as they mostly depend on these import. With this dependency that China has the advantage in trade. So with the artificial low currency China is in a way dumping its goods in the US and destroying the local economy which creates a dependency on Chinese goods. So the real problem in my opinion that the US is facing is dumping which resulted from the artificial weak currency.
How does China continuing to undervalue its currency threaten the industrial economies of its largest trading partners?
The policy of China is a combination of low cost of labour, its main competitive advantage, and exchange rate. Leveraging on low salaries and wages China has become the “world factory” for a huge variety of products with a low content of technology and know-how. Export consumers prefer chinese products simply because they are cheap. This poses a threat to the economies of the trading partners, as chinese exports increase and as well as the import of the traing partnrs, with opposite results: China boosts its exports, increases steadily its trade surplus and keeps rising current account surplus. The trading economies suffer from an increasing trade deficits and reduce their current accounts. On the other hand China is placing barriers with tariffs to imports of prducts with high content of technology to defend domestic emplpyment and the industries whose size and economy of scale is not comparable to that of western countries (like in the automotive sector).
‘This threat to the exports of china’s competitors causes a significant fall in exports, and thus a fall in GDP and aggregate demand. In times of recession, as in the US right now, this poses a great potential problem, as it could worsen the recession.’
I happen to agree here with what Palmi says here, and it seems as though (as stated in the article) protectionism is one of the only ways to protect the domestic industry, which could increase domestic employment. The employment stability could also put confidence back into the consumers to spend more money (because consumers with a stable job will tend to spend more of their income). As the article states: “It is noteworthy that President-elect Obama has actively and repeatedly supported action against ‘currency manipulation.’” In addition, economists claim that the government will need to increase expenditure to get out of the recession. This money could be put towards creating more jobs, and trying to develop more efficient industries (and not on irrational bailouts, but that’s not the point).
Sebastian said that: “Obama does not only fight the cheap RMB compared to the US$, but raise the prices of the imports and with that the real income of the average US citizen decreases as they mostly depend on these imports.” Hopefully Sebastian, the US will become less independent if they can create efficient, long lasting, successful industries.
Does this not sound advantageous to the US?
I’m wondering how China, politically is able to keep the exchange rate for the RMB this low? Wouldn’t it make sense for the WTO to have done something about it by now? I realize that it is a form of protectionism, but it has drastically harmed other economies (the US) keeping the RMB this low seems unfair to me.
Myrthe is making a really important point, because how is China able to keep its exchange rate of the RMB so low?
It has to do with the different exchange rate systems. On the one hand, the US has a floating exchange rate, meaning that the value of the dollar is allowed to be determined solely by the demand for, and supply of, the dollar on the foreign exchange market - there is no government intervention to influence the value of the dollar.
China, othe other hand, has a managed exchange rate, meaning that China is able to regulate the RMB through government intervention. Thus China decided to lower the exchange rate of the RMB in order to make chinese goods more attractive to foreign consumers such as US consumers. Hence there is a high demand of chinese exports because as the RMB depreciates, chinese goods and services are cheaper relative to expensive American goods.