Currency analysis of US dollar and RMB free essay sample

Period to 1994: Prior to 1994, China maintained a dual exchange rate system. This consisted of an official fixed exchange rate system, which was used by the government, and a relatively market-based exchange rate system that was used by importers and exporters in â€Å"swap markets†. The two exchange rates differed significantly. For example, the official exchange rate with the dollar in 1993 was 5. 77 Yuan versus 8. 70 Yuan in the swap markets. The foreign exchange was highly restricted in order to limit imports, resulting in a large black market for foreign exchange. From 1994 to 2005: In 1994, the Chinese government unified the two exchange rate systems at an initial rate of 8. 70 Yuan to the dollar, which eventually was allowed to rise to 8. 28 by 1997 and was then kept relatively constant until July 2005. From 1994 until July 2005, China maintained a policy of pegging the RMB to the U. S. dollar at an exchange rate of roughly 8. 28 Yuan to the dollar and Chinese central bank maintained this peg by buying (or selling) as many dollar-denominated assets in exchange for newly printed Yuan as needed to eliminate excess demand (supply) for the Yuan. The peg appears to have been largely intended to promote a relatively stable environment for foreign trade and investment in China. From 2005 to 2008: From 2005, Chinese government started to reform the peg. The Chinese government modified its currency policy on July 21, 2005 and the exchange rate of the U. S. dollar against the RMB would be adjusted from 8. 28 Yuan to 8. 11, an appreciation of 2. 1%. The government announced that the RMB’s exchange rate would become â€Å"adjustable, based on market supply and demand with reference to exchange rate movements of currencies in a basket†. The situation in the next three years would be described into â€Å" management float† which is the market forces determined the general 1 1 direction of the RMB’s movement. As we know that from July 21, 2005 to July 21, 2008 the dollar-RMB exchange rate went from 8. 11 to 6. 83, an appreciation of 18. 7%. From 2008 to 2010: China halted its currency appreciation policy around mid-July 2008, mainly because of declining global demand for Chinese products that resulted from the effects of the global financial crisis. The global financial crisis from 2008 to 2009 will be discussed later in the report. The Chinese government intervened to prevent any further appreciation of the RMB to the dollar because of the declining exports and the huge unemployment rate in 2009. The RMB/dollar exchange rate was held relatively constant at 6. 83 through around mid-June 2010. From 2010 to now: On June 19, 2010, the People’s Bank of China (PBC), stated that, it had decided to â€Å"proceed further with reform of the RMB exchange rate regime and to enhance the RMB exchange rate flexibility â€Å"and â€Å"it is important to avoid any sharp and massive fluctuations of the RMB exchange rate†. After that, the RMB’s exchange rate with the dollar has gone up and down since RMB appreciation was resumed, but overall, it has appreciated. From June 19, 2010, to July 10, 2013, the Yuan/dollar exchange rate went from 6. 83 to 6. 17, an appreciation of 10. 7%. Most of the appreciation occurred in 2010 and 2011. From January 1, 2012, to July 10, 2013, the RMB appreciated by only 2. 1% against the dollar. Analysis Factors that affect currency Aside from factors such as interest rate and inflation, the exchange rate is one of the most important determinants of a countrys relative level of economic health. Exchange rates play a vital role in a countrys level of trade, which is critical to most every free market economy in the world. For this reason, exchange rates are among the most watched analyzed and governmentally manipulated economic measures. How exchange rate 2 2 movements affect a nations trading relationships with other nations. A higher currency makes a countrys exports more expensive and imports cheaper in foreign markets; a lower currency makes a countrys exports cheaper and its imports more expensive in foreign markets. A higher exchange rate can be expected to lower the countrys balance of trade, while a lower exchange rate would increase it. The exchange rate between the U. S. dollar and the Chinese Yuan has been a matter of contention between the two governments for quite some time. Put simply, the U. S. accuses China of manipulating the currency exchange rate. Strictly speaking, that is exactly right, as it must be for unilaterally fixed exchange rates. In practice, the USD/CNY currency rate trades at a rate higher where it would be in a free-floating market, making Chinas exports cheaper than they would otherwise be and making imports into China correspondingly more expensive. The U. S. has tried many different ways to get China to adjust its position on the currency issue such as negotiations, threats and trying to line up allies in the fight. Most recently, the Senate passed a bill aimed squarely at the Chinese though officially targeting any country with a fundamentally misaligned currency that would empower the government to impose import tariffs on Chinese goods if the exchange rate is not changed. Although the bill does not seem likely to get through the House or signed into law, the Chinese have not surprisingly responded with a fair bit of anger. Included in this has been the requisite warning that such a move violates World Trade Organization rules and could prompt retaliation and ultimately a trade war. Thats not all. China added a bit of heft to its words this time. After the bill passed, the Chinese reset the exchange rate to the USD to 6. 3598, an increase of 116 pips. A 0. 116% move is not exactly a world-changer, but it does reverse the trend in the exchange rate. The meaning of the move is lost on no one. This is not a large move, and it is not going to dramatically alter any trade flows or business. Moreover, the impact of this move is likely 3 3 being magnified by the fact that the currency markets are nervous, risk-averse and news-starved right now. In such a market, any turbulence can get blown out of proportion quite quickly. There is another meaning, though, and its more significant. This moves reemphasizes that China will not be jawboned or pushed around by the U. S. when it comes to matters of economic policy. Perhaps more so than any other major economic power today, China is hypersensitive to any perceived slight or infringement on its national sovereignty. This is a byproduct of being pushed around by Western powers not all that long ago. While Japan tolerated the railings of U. S. politicians against its unfair trade practices with little public reaction, Chinas fuse is cut much shorter. Along those lines, this currency move reminds investors that China can be a major destabilizing force in the global economy if and when it wants to do so. While U. S. and European political and financial heads try to triage the Greece situation, China stands by with the ammunition to cause yet another global credit crisis if it so chooses to do so (leaving aside that China has much to lose from it as well). How It Will Impact U. S. Businesses and Investors: Assuming that China is simply making a political point and does not intend to force a new trend of Yuan depreciation, the impact of this particular move will be minimal. Its a tiny change to almost anyone who isnt a highly levered currency trader. With the G20 summit coming on in early November, it is likely that China will want to be seen as powerful but sensible. Thus far, the G20 has been reluctant to support the U. S. position on Chinas currency exchange rate, and China needs that to continue. Longer term, there are certainly ramifications from this currency policy and a potential trade war. Those politicians advocating a new tariff on Chinese imports might want to look up Smoot Hawley and see how well that all worked out. Sparking a new recession 4 4 just to win a few political points is not an economically sound strategy. At the same time, it is worth remembering that China is not the sole source of the U. S. s economic problems. China did not force U. S. banks to loan money to less credit worthy borrowers, it did not allow Medicare and Medicaid to become hydra-like monsters, and it did not force the U. S. to rack up huge debts and deficits to simultaneously fund wars and tax cuts. Consumers and investors also need to realize that a compliant China has costs as well. A stronger Chinese currency will mean that Chinese imports are more expensive. That means more pain at the store. In theory, some of the manufacturing that was off shored to China will come back, but in practice it is more likely that it would just be moved on to a cheaper country like Vietnam with no net improvement in U. S. jobs. This would also result in more expensive goods for U. S. shoppers. At the same time, this policy costs China as well. China has an inflation problem that is exacerbated by its artificial currency exchange rate. The exchange rate, and the position of the U. S. dollar as a global reserve currency, allows us to effectively export inflation. Likewise, Chinas currency policy is essentially a subsidy to its manufacturing sector and subsidies tend to have familiar consequences. The protected industries get fat, soft, and lazy and cannot compete once the subsidy becomes economically nonviable. The Effects of Financial Crisis from 2008 to 2009 As the U. S. subprime mortgage crisis evolved into a global financial crisis, there was a significant slowdown in the appreciation of the RMB exchange rate. Obviously, the financial crisis impact on the exchange rate is unprecedented in breadth and depth. In the previous period, the central bank of China allowed the RMB to appreciate against the dollar by about 21%. However, once the effects of the global economic crisis began to become apparent, the U. S. dollar, a safe haven currency, was no longer safe, and investors 5 5 exchanged their U. S. dollar for British pounds and Euros. As a result, the U. S. dollar plunged relative to those currencies. China halted appreciation of the RMB in an effort to limit job losses in industries dependent on trade. There are several main factors influenced the exchange rate, include China’s economic growth conditions, foreign exchange reserves position, the existing price level and inflation, moreover, outside of China, the United States exerted pressure on RMB appreciation and the appreciation of non-dollar currency trade pressure on China. During the financial crisis, the United States, the euro area and Japan, the three major economies, their own economic recession, resulting in shrinking external demand to China, in November 2008 the highest negative growth rate hit a decade -9%. The GDP measured in RMB, one third from exports, so the reduction in exports makes the whole year GDP growth dropped to 9%. If the sharp appreciation of the Yuan continues, it would bring negative impacts to exports ; so in this stage of the financial crisis, RMB necessary to maintain a relatively stable. In addition, the U. S response to the 2008-2009 credit crisis by taking some measures, such as write-offs by holders of bad debt, government purchase of debt securities, and government capital injections to support liquidity. From the second half of 2009, there was a significant recovery in the global economy. As a result of improved external demand, Chinas export growth rate from December 2009 onwards from negative to positive, and in the first half of 2010, the average monthly growth rate reached 36%. In June 2010 the exchange rate reform is restarted. Purchasing Power Parity (PPP) In China a Big Mac costs Yuan 16 (local currency), while in the United States the same Big Mac costs $4. 56. The actual spot exchange rate was Yuan 6. 13/$ at this time. The price of a Big Mac in China in U. S. dollar terms was therefore Price of Big Mac in China In Yuan = Yuan 16 Yuan/$ spot rate Yuan 6. 13/$ 6 = $2. 61 6 Then calculate the implied purchasing power parity rate of exchange using the actual price the Big Mac in China over the price of the Big Mac in the United States in U. S. dollars Price of Big Mac in China in Yuan = Yuan 16 = Yuan 3. 51/$ Price of Big Mac in the U. S. in $ $4. 56 Now comparing this implied PPP rate of exchange, Yuan 3. 51/$, with the actual market rate of exchange at that time. Yuan 6. 13/$, the degree to which the Yuan is wither undervalued or overvalued versus the dollar Implied Rate – Actual Rate = Yuan3. 51/$ Yuan 6. 13/$ = -42. 8% Actual Rate Yuan 6. 13/$ There is a chart that is a history of Big Mac Index between US and China. (See Exhibits 1. ) A forward rate is an exchange rate quoted today for settlement data some future date. F(Yuan/$ 90) = S(Yuan/$)* [1+(i(yuan)*90/360)] [1+(i$*90/360)] =6. 13* [1+(0. 06*1/4)] [1+(0. 0025*1/4)] =6. 13* 1. 015 1. 000625 =6. 13*1. 0144 =Yuan 6. 22/$ Example of CIA. (See exhibit 2). Forecast Fundamental Analysis: ? Economic Growth. (See exhibit 3) ? Financial markets. (See exhibit 3) Current spot rate: S;=; 6. 13/$ 7 7 ? Purchasing Power Parity Forecast: Yuan/U. S. dollar in one year S1= ;6. 13/$ * [1+(2. 83%)] = ;6. 1648/$ [1+(2. 25%)] ? International Fischer Forecasts: forecast the following future spot exchange rates using the government bonds rates for respective country currencies. S1= ;6. 13/$ * [1+(6%)] = ;6. 4816/$ [1+(0. 25%)] ? Political and social infrastructure: 1. The U. S. government was shut down on Oct. 1, 2013. After 11 business days, the U. S. Federal reopened on Oct. 16. The CNY/USD rate decreased rapidly from ;6. 122/$ to ;6. 0813/$ on Oct. 23. It leads to appreciate CNY. Since the U. S. government was shutdown, the CPI sample of October will be incomplete, this affects the veracity; it will appear deviation, and it will affect the next seven months CPI. 2. The CNY will be interfered by the market. In other words, the CNY/USD rate will be appreciated. Facing financial crisis, U. S. government will issue much more government bonds to raise the money. However, U. S. government will decrease the liability though appreciating other currency. In this case, the CNY/USD will appreciate. Chinese government will control the exchange rate in order to maintain the balance of export. Technical Analysis: Historical Exchange Rate Summary: CNY/USD (see exhibit 4) â€Å" The Chinese Yuan exchange rate for August 2013 averaged 6. 121 CNY to USD. Thats 0. 014 points lower than the July, 2013 rate of 6. 135, and 23. 8 basis points lower than the August, 2012 rate of 6. 359. The minor movement in the CNY/USD exchange rate from July to August provides evidence that the short-term trend in CNY/USD is relatively flat. 8 8 † If that trend continues in the currency market, we should see an average daily rate in December 2013 that is close to 6. 20. The average CNY/USD rate over the last 12 months was 6. 20. The average rate over the last 10 years was 7. 22. A lower Chinese Yuan to US Dollars exchange rate over the last 12 months compared to the average currency rates over the last 10 years serve as an indicator that the long-term rate trend in CNY/USD is down (weakening US Dollar against the Chinese Yuan). The highest currency rate for CNY/USD over the last 12 months was 6. 32. The lowest was 6. 12. The market high was attained in September 2012. The market low was achieved in August 2013. Conclusion Trade wars are not nearly so bad as shooting wars, but they are serious nonetheless. Ultimately, the U. S. and China have to learn how to play together in the same sandbox. In the meantime, China is doing what every other country does – playing its strongest card. After all, the U. S. prints money to advance its politico-economic needs, the Japanese keep their interest rates incredibly low and the Russians periodically shut off the gas lines to Europe. Ultimately, China will find that the cost of an artificial exchange rate is too much to bear. In the meantime, U. S. investors should realize that apart from adding a little jolt to an already-shaky market, the real consequences are likely to be less than feared. A consumer price index (CPI) measures in the price level of a market basket of consumer goods and prices purchased by households. CPI shows the change of the inflation rate. So the forecast of the currency will be influenced. Additionally, based on fundamental analysis and technical analysis, the CNY/USD rate will appreciate in the short-term. Then, CNY will depreciate; the exchange rate will get new balance around the ;6. 20/$. 9 9 Exhibit 1 10 10 Exhibit 2 Example of CIA Assume that an investor has $1,000,000 and several alternative but comparable CNY monetary investments. If the investor chooses to invest in a dollar money market instrument, the investor would earn the dollar rate of interest. Start $1,000,000 S=Yuan6. 13/$ 11 i=. 25% per annual End *1. 000625% $1,000,625 $1,000,313. 5 90 Days F90=Yuan6. 22/$ 11 i=6% per annual Yuan6, 130,000 *1. 015% Yuan6,221,950 This exhibit shows investor may, however, choose to invest in a US money market instrument of identical risk and maturity for the same period. This action would require the investor invest the US dollar in a money market instrument. Exhibit 3 ? Economic Growth: ? Financial markets: 12 12 Country China United Stated Country China United Stated Exports 185644. 00 189221. 00 Current Units;per Inflation rate US$; Oct Year ago Latest Forecas 25th t 2013e 6. 13 6. 31 2. 6% 2. 83% 1. 00 1. 00 1. 5% 2. 25% Foreign direct investment 886. 00 37869. 00 Interest rate GDP 1-Yr Govt Latest 6. 0% 0. 25% Annual Growth rate 2. 2% 1. 6% Exhibit 4 Historical Exchange Rate Summary: CNY/USD Average (Last 12 Months) 6. 20 Average (Last 10 Years) 7. 22 High (Last 12 Months) 6. 32 (September, 2012) Low (Last 12 Months) 6. 12 (August, 2013) High (Since January, 1981) 8. 73 (April, 1994) Low (Since January, 1981) 1. 55 (January, 1981)