Nov 03 2009
Exchange rates and trade: a delicate balancing act, currently out of balance!
Published by Jason Welker at 4:01 am under
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WikipediaFT.com / Asia-Pacific – Renminbi at heart of trade imbalances.
“The Americans get the toys, the Chinese get the Treasuries and we get screwed.” Thus a European Union official once characterised the pattern of Beijing accumulating US assets by selling renminbis for dollars, while nothing stood in the way of a rapid and destabilising appreciation of the euro.
In a world of freely floating exchange rates trade imbalances between countries would ultimately be reduced and eliminated. At least, that’s the belief of those advocating a floating exchange rate between East Asian currencies and the United States.
Here’s how it is supposed to work:
- Cheap labor and cheap imports from China following China’s joining the world economy 30 years ago led to a rapid increase in demand for Chinese manufactured goods in the US, creating growth, jobs, and rising national income for China.
- A trade imbalance emerges between the US and China as US spending on imports increases more rapidly than America’s sale of exports. If the Chinese currency were allowed to float freely on foreign exchange markets, however, this imbalance would be temporary, because…
- The US current account deficit means, literally, that Americans are supplying more of their dollars in the foreign exchange market, while demanding more Chinese RMB. The forces of supply and demand would naturally lead to an appreciation of the RMB and a depreciation of the dollar.
- The weaker dollar resulting from the trade deficit with China would eventually make Chinese goods less attractive to Americans. Despite their lower costs of production, the weak dollar makes imported Chinese goods more expensive and less appealing to the American consumer.
- The strong RMB, on the other hand, makes American produced goods and services cheaper to Chinese consumers, who begin to import more from the US at the same time that Americans demand fewer of China’s products.
- Through free-floating exchange rates, a current account imbalance is eventually reduced and eliminated as exchange rates adjust to the flows of goods and services between trading partners.
A graphical version of this story is told here:
This, of course, is precisely what has NOT happened, thanks to China’s strict management of the value of the RMB. In order to keep its currency weak, Beijing directly intervenes in foreign exchange markets, “by selling renmenbi for dollars” to accumulate American assets. As seen in the next graph, such interference has the effect of keeping the dollar strong against the RMB.
As any IB student knows, the Balance of Payments between two countries includes not only the trade in goods and services, but also the flow of real and financial assets, such as government securities, stocks, real estate, factories, and so on, between the countries. China has actively promoted a policy of acquiring such American assets, which keeps demand for dollars strong in China, and supply of RMB high in America, without creating any jobs in manufacturing or services for Americans. China has financed America’s current account deficit by assuring it maintains a capital account surplus!
Put more simply, China has exported goods and services to America, while America has exported ownership of its real and financial assets to China. This is a major area of concern for US policy makers, who would like to see a more balanced current account between the two countries, since it is the export of goods and services that creates jobs for American workers, not the sale of bonds, stocks and real estate.
Discussion Questions:
- Why does Europe care about China’s fixed exchange rate with the US dollar?
- Do you believe that American demand for Chinese goods would actually decline if the RMB were allowed to appreciate against the dollar? Why or why not?
- Besides American workers and firms, who else suffers from a weak Chinese currency? How could China actually benefit from allowing the RMB to strengthen against the dollar?
- How does China maintain the RMB’s peg against the dollar without buying large quantities of US exports?
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". Related posts:
- Exchange rates, currency manipulations, and the balance of trade
- How do changing interest rates affect exchange rates? The example of the RMB
- Lesson plan: Elasticity, exchange rates and the balance of payments – understanding the Marshall Lerner Condition
- Another question from the Help Desk: Relative price levels as a determinant of exchange rates
- Silver lining of US recession- more balanced trade
Teachers!
Submit your Econ questions here. Replies will be posted to the blog
1. Why does Europe care about China’s fixed exchange rate with the US dollar?
Firstly the default currency for naming the value of an economy is calculated in dollars; therefore a weak dollar against a strong Euro would seem as a vast increase in the GDP of EEA nations. Vice versa a weaker currency against a strong dollar could collapse an economy (Asian financial crisis; late 90s).
Secondly so long as China keeps its currency fixed, thus keeping the US dollar strong the EEA is able to export comparatively cheaply to the United States any products that it does so produce, but also creates incentives for Americans to travel over the pond to Europe which further increase the GDP of a nation.
2. Do you believe that American demand for Chinese goods would actually decline if the RMB were allowed to appreciate against the dollar? Why or why not?
The problem with the whole idea is that Chinese firms are able to produce goods at such a low price; a few dollars from manufacturing to shipping to tariffs to distribution costs to store add ons and so on. When the price of a good is at such a low level it seems unreasonable to assume any grat changes in price level. If the exchange rate is 10RMB per one dollar; then a balancing out of the exchange rates, say five to one, means that the price of a good made in China that cost 10RMB to make would go from costing 1 dollar to 2 dollars to make in China. The US however is more costly to produce in, comparatively to China, so therefore it is unlikely that there is going to be a great shift in demand as the price will still be extremely low.
4. How does China maintain the RMB’s peg against the dollar without buying large quantities of US exports?
The article says it above; by buying up non-goods and services the Chinese are buying assets that do not affect the unemployment levels of the states. These include things such as Government bonds, and financial assets (such as stocks – or debts that won’t be paid back – economic crisis what?). By doing this they are taking away the amount of dollars in the US and increasing the number of RMB in the US – without buying items that create jobs for Americans; competition for China.
The problem with floating exchange rates, is that it would destroy both the american and the Chinese economy. As Chinese goods became more expensive, americans would become less wealthy because they would be purchasing goods which were more expensive. The idea is also that the chinese start buying US goods at this point, because the US dollar would depreciate, but the average consumer has hardly any money in their pocket. It is true that as the rmb appreciates, what little money they have will increase in value, but if america stops buying their goods, unemployment will sperad like wildfire in china, and consumers will be hesitant to buy anything, let alone imported goods.
What the chiniese government is doing is not only saving their own economy, but allowing for the supercharged growth the US has been enjoying for the last dozen years or so. Who cares if Chinese people own american assets, the west has owned chinese assets for centuries. In fact, the more foreign countries start investing in each other, the more pressure will be on governments to lower tarrifs, and help make the global economy more effitient.
JOHN LENNON WAS AN ECONOMIST!!!!! sort of….
Benji,
By re-investing billions of dollars back into the US economy through the purchase of assets in the capital account, the Chinese government is essentially denying the Chinese people the ability to buy goods and services from the US in the current account. Wouldn’t a stronger RMB make the Chinese consumer better off as they’d be able to partake in consumption of imports?
3.Besides American workers and firms, who else suffers from a weak Chinese currency? How could China actually benefit from allowing the RMB to strengthen against the dollar?
Chinese consumers suffer from a weak Chinese currency because they have to pay higher prices for imports from America. Thus, they do not get the chance to enjoy a wider range of foreign products with a higher quality.
China could benefit from a stronger RMB because it would be able to acquire imports more cheaply. Chinese firms would be able to lower their production cost because of lower raw material costs and Chinese consumers could enjoy greater product variety and higher quality.
4.How does China maintain the RMB’s peg against the dollar without buying large quantities of US exports?
China maintains the RMB’s peg by acquiring American financial assets which keeps demand for dollars and supply of RMB high. This would cause the dollar to appreciate and the RMB to depreciate.
1.Why does Europe care about China’s fixed exchange rate with the US dollar?
There is a lot of trade between them going on. Like America, Europe depends a lot on Chinas imports. Especially firms often buy import products needed for their production from foreign countries. A flunctuating exchange rate would reduce business confindence.
2.Do you believe that American demand for Chinese goods would actually decline if the RMB were allowed to appreciate against the dollar? Why or why not?
If the Chinese RMB appreciates against the dollar than American demand for Chinese goods will go down as they seem more expensive. The RMB will have risen relative to the USD. On the other hand Chinese goods might be SO cheap that it would not affect its demand for Chinese goods very much, as they are dependant on it.
3.Besides American workers and firms, who else suffers from a weak Chinese currency? How could China actually benefit from allowing the RMB to strengthen against the dollar?
Chinas firms which depend on imports suffer and of course chinese consumers, as the foreign currency seems expensive relative to the domestic currencu. The chinese benefit from a stronger dollar as their costs of production goes down when this “tarriff on imports” is eliminated/reduced. The prices for consumer will be cheaper, which will have a disinflationary affect.
4.How does China maintain the RMB’s peg against the dollar without buying large quantities of US exports?
It has a fixed exchange rate with the US dollar which means that its exchange rate is pedged by the government to a certain rate of the dollar.
2.
Yes, I believe that demand for Chinese goods would decrease, the reason they are so attractive to US consumers is because they are relatively cheap compared to the US dollar. If the RMB would appreciate US consumers would only import Chinese good with inelastic demand. Meaning the exports from China to America and also other nations would decrease. This would harm the Chinese export industry.
3.
Producers all over the world suffer from the weak RMB, it forces them to keep their prices low in order to compete with the RMB, China has such a booming economy because the RMB is so low and manufacturers look to China in order to produce goods and sometimes services and the lowest price.
China would benefit from a stronger RMB because they could import goods and services at a relatively cheaper price than they do now. However China does not import many goods as it produces most necessary goods and services domestically.
1. Because when the value of the dollar is high, Americans will also demand more European goods. And thus, if the the dollar would depreciate, demand for European goods would decrease.
2. I think the demand for Chinese goods would decrease, but not by a lot. Many firms might have gone out of business due to the cheap imports from China and so those goods cannot be bought in the US anymore. So they will continue to import those from China. Also due to specialization America will need to continue to import goods from China, even though they might be more expensive now.
3. The Chinese people suffer from it because they cannot buy many goods from the US because they are relatively expensive. So imports are very low and it is also very expensive for Chinese to for example travel to the US. So consumers are hurt by this weak currency. Also as Basti said producers for example from Europe suffer because they have to keep their currency low compared to the dollar so that Americans will still demand their exports.
4.With the surplus they get from their current account, because they are exporting more than importing, China buys for example US government bonds. This way their money is safe and they will even make more money out of it due to interest, but at the same time they are supplying huge quantities of their currency on the foreign exchange market and thus keeping their currency weak.
2. Do you believe that American demand for Chinese goods would actually decline if the RMB were allowed to appreciate against the dollar? Why or why not?
Yes, I do believe that American demand for Chinese goods would decline if the RMB were to appreciate against the Dollar. There are several nations, especially in Asia, who would be able to supply cheaper goods and services than China. The only reason that the US is importing so much from China is that the RMB is still so weak compared to the Dollar, allowing US citizens to purchase large amounts of Chinese goods and services. If the RMB appreciates, however, there is nothing to stop the US from importing from other, more to trade favorable nations.
3. Besides American workers and firms, who else suffers from a weak Chinese currency? How could China actually benefit from allowing the RMB to strengthen against the dollar?
Many have stated that the weak Chinese currency is bad for the Chinese citizens, simply for the reason that they have to pay higher prices when buying goods and services from the US. Obviously, this is true. However, the weak Chinese currency is not only bad for those who import American goods, but rather for the whole Chinese society. Why? Because of inflation. The weak currency means that imports will be very expensive, and this will drive up prices in the Chinese economy, leading to inflation.
If the RMB were to appreciate against the Dollar this may benefit China greatly, as low import prices keep inflation down. However, it is still important to remember that a high exchange rate may lead to greater unemployment. China, a giant with one of the world’s largest population, needs to continue to decrease its unemployment if it wishes to develop in the future. Its large population is an amazing capital resource that should be used, which will be harder to accomplish if too much is imported from the US.
1. Why does Europe care about China’s fixed exchange rate with the US dollar?
Europe would also be affected by a appreciation or deppreciation of the dollar. As soon as the dollar appreciates, Americans will demand more European goods but when it depreciates, the demand for products produced in Europe would decline. A lot of the value of the US dollar depends on the trade between China and the US.
2. Do you believe that American demand for Chinese goods would actually decline if the RMB were allowed to appreciate against the dollar? Why or why not?
I agrre with Alex in saying that the demand for Chinese goods in the US would decline if the RMB would appreciate over the dollar. Reason being that there are many other countries in the world, that could supply the US with cheaper products. The competition is too high for the US to be dependent on China for cheap labor and products.
3. Besides American workers and firms, who else suffers from a weak Chinese currency? How could China actually benefit from allowing the RMB to strengthen against the dollar?
As we learned in class, a government that is artificially keeping its exchange rate low is supporting its producers and not the consumers. Chinese consumers are affected by the low RMB because foreign goods seem relatively expensive n comparison to domestically produced goods. Other countries are also affected by the low RMB, because it forces them to lower their exchange rate to still be able to compete with China.
2) Probably not because the cost of chinese goods will still be significanly lower than those in the US because of low production costs
3) A disadvantage of weak currencies is inflation. Imported resources will now seem more expensive. Thus the costs of production for China will be higher meaning prices will be higher due to a decrease in supply. As a result Chinese consumers are burdened. Additionally, as Chinese firms are earning high profits. So they are not forced to be as efficient as possible due to lower competition. Hence resources are misallocated. So China as a country could see a disadvantage
1. Why does Europe care about China’s fixed exchange rate with the US dollar?
Europe cares about China’s fixed exchange rate with the US dollar because they also trade with both countries. If China would not control its exchange rates, the depreciation of the USD could make importing from the US cheaper, but could be destructive for the industries that export to the US as their products would become more expensive to Americans.
2. Do you believe that American demand for Chinese goods would actually decline if the RMB were allowed to appreciate against the dollar? Why or why not?
Initially, as these goods are not produced within the US, the demand for such goods would increase in other nations willing to export to the US as it becomes cheaper to import from other nations. If the new free floating exchange rates did cause the RMB to appreciate greatly to the USD, eventually the toys could become produced within the US, moving the US current account deficit towards a surplus.
3. Besides American workers and firms, who else suffers from a weak Chinese currency? How could China actually benefit from allowing the RMB to strengthen against the dollar?
Many suffer from the weak RMB because it destroys their domestic production and causes their nation’s exports to stay low. China could benefit from an appreciating RMB, as it would make its exports more expensive, lead to domestic industry growth, an overall growth in national GDP and an improvement in the standard of living.
4. How does China maintain the RMB’s peg against the dollar without buying large quantities of US exports?
China maintains the value of the RMB pegged to the dollar, by buying American assets, with the money surplus they have in their current account. These are non-production “goods” and include government bonds, land and company stocks. Buying these assets does not create American jobs, and worries many Americans that foreigners are gaining too much influence in America.
It makes sense that Europe cares about China’s manipulation of the RNB rate as China is a competitor of Europe in trading with the US. Because of the low value, China is a more suitable trading partner for the US.
I think it would barely decline. Companies in the US rely heavily on Chinese products and materials for the production of their goods (just like with the example of the auto dealers). An appreciation of the RMB is the cost to pay for these companies to continue their businesses. Perhaps smaller companies would be affected the most with the higher costs.
Chinese consumers suffer from a weak currency because they have a lower purchasing power and their currency buys them less than for example the dollar can.
China invests in America’s financial sector with the dollars that the US pays for China’s exports. There is an inflow of dollars into the US keeping the supply of dollars high.
1. Since the US and China are such large world economies, their business together affects the rest of the world including Europe. If the RMB weren’t pegged to the US dollar then the depreciation of the USD would eventually balance out once American goods start to look attractive the Chinese and Americans would demand less RMB’s. This would shift the supply of USD inwards and cause the dollar to appreciate. In other words, the RMB has a lot of power against the dollar and would maintain it at a stable level in the long run. This is why Europeans don’t benefit from a fixed exchange rate; the dollar can undergo large fluctuations because the RMB won’t counteract this and will fluctuate alongside the dollar.
2. Yes. This would happen if the dollar depreciated and the RMB appreciated because demand for RMB’s is so high and therefore supply in the dollar market in China is also high. This depreciation of the dollar should cause rational American consumers to purchase domestic products before the more expensive Chinese products. However some factors may come into play, such a well-known brand China offers as opposed to some other brand elsewhere that might be cheaper but not one that is recognized by the consumers and therefore unattractive to the public. Although the rational action is to buy the cheaper product, consumers might still continue to buy the Chinese product they are used to them and have been buying their whole life. It is true that the product might cost more to produce in the US than in China because of China’s cheap labor, however, as the dollar continues to depreciate there will eventually be a noticeable difference that will result in Americans buying domestic products over Chinese goods.