Read the case study “China’s Pegged Currency” on p. 701 in Chapter 22 of International Economics Theory and Practice.

According to published reports, China today manufactures more goods for global consumption than any other nation. As a result, its foreign currency reserve as of January 7, 2016 stands at $3.4 trillion (IMF) compared to $118 billion for the United States. According to this metric, China ranks number one while the US ranks number 18.  Most analysts attribute China’s massive accumulation of reserves to the pegging of its currency to the US dollar as discussed in the case.  Critics call this currency manipulation on the part of China.

Analyze in a minimum of 1,050 words, using this case study as the basis, the impact of currency manipulation on cross-border trade and investment activities.

Cite a minimum of 3 peer-reviewed references from the University Library.

Format assignment consistent with APA guidelines.

CASE STUDY: China’s Pegged Currency

Over the first decade of the 2000s, China developed a substantial overall current account surplus and a large bilateral trade surplus with the United States. In 2006, the current account surplus reached $239 billion, or 9.1 percent of China’s output, and the bilateral surplus with the United States, at $233 billion, was of similar size. A good part of China’s exports to the United States consists of reassembled components imported from elsewhere in Asia, a factor that reduces other Asian countries’ exports to the United States and increases China’s. Nonetheless, trade frictions between the United States and China have escalated, with American critics focusing on China’s intervention in currency markets to prevent an abrupt appreciation of its currency, the yuan renminbi, against the U.S. dollar.

Figure 22-2 shows how China fixed the exchange rate at 8.28 yuan per dollar between the Asian crisis period and 2005. Facing the threat of trade sanctions by the U.S. Congress, China carried out a 2.1 percent revaluation of its currency in July 2005, created a narrow currency band for the exchange rate, and allowed the currency to appreciate at a steady, slow rate. By January 2008, the cumulative appreciation from the initial 8.28 yuan-per-dollar rate was about 13 percent—well below the 20 percent or more undervaluation alleged by trade hawks in Congress. Early in the summer of 2008, in the midst of the financial crisis, China pegged its exchange rate once again, this time at roughly 6.83 yuan to the dollar. In response to renewed foreign pressure, China in June 2010 announced it was adopting a “managed float” exchange rate regime, and under this arrangement, the yuan had appreciated to about 6.12 per dollar by the fall of 2013—a further appreciation of about 10 percent.

FIGURE 22-2 Yuan/Dollar Exchange Rate, 1998-2013 (see attachment 1)

China’s yuan was fixed in value against the U.S. dollar for several years before July 2005. After a 2.1 percent initial revaluation, the currency has appreciated gradually against the dollar.

China’s government has moved so slowly because of fears that it would lose export competitiveness and redistribute income domesically by allowing a large exchange rate change. Many economists outside of China believe, however, that a further appreciation of the yuan would be in China’s best interest. For one thing, the large reserve increases associated with China’s currency peg have caused inflationary pressures in the Chinese economy. Foreign exchange reserves have grown quickly not only because of China’s current account surplus, but also because of speculative inflows of money betting on a substantial currency revaluation. To avoid attracting further financial inflows through its porous capital controls, China has hesitated to raise interest rates and choke off inflation. In the past, however, high inflation in China has been associated with significant social unrest.

What policy mix makes sense for China? Figure 22-3 shows the position of China’s economy, using the diagram developed earlier in this book as Figure 19-2. In the early 2010s, China was at a point such as 1 in Figure 22-3, with an external surplus and growing inflation pressures—but with a strong reluctance to raise unemployment and thereby slow the movement of labor from the relatively backward countryside into industry. The policy package that moves the economy to both internal and external balance at Figure 22-3’s point 2 is a rise in absorption, coupled with currency appreciation. The appreciation works to switch expenditure toward imports and lower inflationary pressures; the absorption increase works directly to lower the export surplus, at the same time preventing the emergence of unemployment that a stand-alone currency appreciation would bring.

FIGURE 22-3 Rebalancing China’s Economy ( see attachment 2)

China faces a current account surplus and inflationary pressures. It can fix both without raising unemployment by expanding absorption and revaluing its currency.

Economists argue further that China should focus on raising both private and government consumption.19 China’s savers put aside more than 45 percent of GNP every year, a staggering number. Saving is so high in part because of a widespread lack of basic services that the government earlier supplied, such as health care. The resulting uncertainty leads people to save in a precautionary manner against the possibility of future misfortunes. By providing a better social safety net, the government would raise private and government consumption at the same time. In addition, there is a strong need for expanded government spending on items such as environmental cleanup, investment in cleaner energy sources, and so on.20

While China’s leaders have publicly agreed with the needs to raise consumption and appreciate the currency, they have moved very cautiously so far, accelerating their reforms only when external political pressures (such as the threat of trade sanctions) become severe. Whether this pace of change will satisfy external critics, as well as the demands of the majority of Chinese people for higher security and living standards, remains to be seen.