Session 7 Global Foreign Exchange Markets and The Determination of Exchange Rates
Completed reading assignment: Chapter 9 and Chapter 10
Written assignment:
1) Questions 9-3 and 9-5 of Chapter 9 Closing Case
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**This week’s case is based on past events but is important to work through for present circumstances and context. Online and library references and
research would be helpful in understanding some of the case ideas.
Case Do Yuan to Buy some Renminbi?
On November 30, 2015, the International Monetary Fund announced that the Chinese yuan, also known as the renminbi (RMB or “people’s currency”), would
finally join the U.S. dollar, the euro, the British pound, and the yen in the basket of reserve currencies also known as SDRs or Special Drawing Rights. Although
this will not become effective until October 2016, the recognition of the yuan is due to China’s increasing dominance in the global economy and its moves in
recent years to liberalize its financial markets. However, what does all of this mean to China and the rest of the world, and will China continue down the road
to the liberalization of its currency and other financial markets?
A Little History In the currency markets, the sign for the yuan is ¥ (the same
the symbol used for the Japanese yen) and the code is CNY. On January 7, 1994, the Chinese government, after debating what to do with its currency,
decided to fix the value to the U.S. dollar at a rate of ¥8.690 per dollar.25 This was easy to do, given that currency trading was controlled by the Chinese
government and not allowed offshore. In 2004, Hong Kong residents were allowed to exchange local Hong Kong dollars for yuan in a first move to allow
some limited trading offshore. By early 2005, the yuan was trading at a fixed rate of ¥8.2665 per dollar. But pressure began to build in 2005 as both the
European Union and the United States faced strong competition from imports from China as well as from Chinese exports to developing markets. When
China fixed the value of its currency in 1994, the
country was not considered a major economic powerhouse. Then things began to change. By 1999, China was the largest country in the world in population,
and in 2003 it was the seventh-largest in the world in GNI, exceeded only by the United States, Japan, Germany, the United Kingdom, France, and Italy. It was
also growing faster than any of the top six countries. In the decade of the 1990s, China grew by an annual average of 9.5 percent and was above 8 percent
every year in the first half of the 2000s. Because of China’s low manufacturing wages, it was exporting far more to the United States than it was importing. In
2004, it had a trade surplus of $155 billion with the United States, compared with a surplus of only $86 billion with the EU. However, between 2002 and 2004,
China’s surplus with the EU doubled, while growing by a little over one-half with the United States. Also during that time, there were capital controls on the
flow of yuan in and out of China, so there was a tremendous inflow of yuan into the banking sector in China with no real way to move the money offshore.
That meant that banks could lend money at very low-interest rates, fueling a
real estate boom. Also, China had to do something with its building reserves. Initially, it invested huge sums of money in U.S. treasury bills, helping to fund
the growing U.S. budget deficit. Then it began encouraging foreign direct investment, especially in natural resources around the world. However, the
competitive pressure of China in Asia was not the same. Because most Asian currencies were also locked onto the dollar, the yuan traded in a narrow range
against those currencies. Most of the Asian countries were using China as a new market for their products, and they were not anxious to have anything upset
the Chinese economy and reduce demand for their products. Critics from the United States and EU argued that the yuan was undervalued by 15 to 40 percent
and the Chinese government needed to free the currency and allow it to seek a market level. The pressures for and against change were both political and
economic. The U.S. government had been working with the Chinese for an extended period of time to get them to revalue their currency, but the Chinese
government had found plenty of excuses not to do that.
Political Pressures in China
China had its own political pressures. For one thing, a lot of people had been moving currency there in anticipation of a revaluation of the yuan, which was
creating inflationary pressures. The Chinese government was forced to buy the dollars and issue yuan-denominated bonds as a way of “sterilizing” the
currency—taking it off the market to reduce the pressures. The government was not very excited about revaluing the yuan and rewarding the speculators, so
it kept saying it would not announce if, when, or how much the revaluation would be. It also did not want to revalue under pressure from foreign governments
lest it appears to be bowing under pressure from abroad. Finally, China has serious problems with employment. Even though its billion-plus population grows
at only 1 percent annually, it adds the equivalent of a new country the size of Ecuador or Guatemala every year. China needs to add enough jobs to keep up
with its population growth and displaced workers from its agricultural sector and state-owned firms. That means adding 15 to 20 million new jobs per year, or
about 1.25 million per month.
The Advent of the Currency Basket
Given these pressures, China took a historic step on July 21, 2005, and de-linked the yuan from its decade-old peg to the U.S. dollar in favor of a currency
basket. Although the dollar has been the dominant currency in determining the value of the yuan, there are periods of time when some Asian currencies have
also shown themselves to be influential. So the currency basket was largely denominated by the dollar, the euro, the yen, and the South Korean won—
currencies that were selected because of their impact on China’s foreign trade, investment, and foreign debt. Even when the basket grew to 11 currencies,
these 4 dominated. The People’s Bank of China (PBOC, the country’s central bank) decides a central parity rate daily and then allows a trading band on either
side of the decision point. The move to the currency basket increased the yuan-to-dollar rate by 2.1 percent. Before the peg was de-linked, the yuan was kept
around ¥8.2665; immediately afterward, it rose to ¥8.1011, an increase of 2 percent. The PBOC responded to the pressures by the international community to
strengthen the yuan by widening the trading band on May 18, 2007, from 0.3 percent to 0.5 percent on either side of the fixed rate. Obviously, that small
difference allowed little room for traders.
Playing it Safe
Until the yuan began its ascent against the U.S. dollar, it was very easy to deal in foreign exchange in China because the rate was fixed against the dollar. It
doesn’t take a lot of judgment for a trader to operate in a fixed-rate world. The exchange rate is managed by the State Administration of Foreign Exchange
(SAFE), which is closely linked to the PBOC. SAFE is responsible for establishing the new foreign-exchange trading guidelines as well as for managing China’s
foreign-exchange reserves. A major concern of the PBOC is that China’s financial infrastructure might be capable of trading foreign exchange in a free
market. SAFE was moving to change that. When the PBOC made the decision to loosen up the value of the yuan in 2005, it opted to allow banks in Shanghai
to trade and quote prices in eight currency pairs, including the dollar-sterling and euro-yen. Prior to that, licensed banks were only allowed to trade the yuan
against four currencies: the U.S. dollar, the Hong Kong dollar, the euro, and the yen. Shanghai was being positioned as the financial center of China, hopefully
by 2020. However, all the trades were at fixed rates, and they did not involve trades in non-yuan currency pairs. SAFE also decided to open up trading to seven
international banks (HSBC, Citigroup, Deutsche Bank, ABN AMRO, ING, Royal Bank of Scotland, and Bank of Montreal) and two domestic banks (Bank of
China and CITIC Industrial Bank).
Fast-Forward
However, the global financial crisis forced the Chinese government to return the yuan to a peg against the U.S. dollar from July 2008 until June 2010, during
which time the United States and China were embroiled in a war of words over the value of the currency. The United States wanted the Chinese to allow their
currency to continue to rise to help solve the
trade imbalance, and the Chinese wanted the United States to get its economy under control and stabilize the value of the dollar, which had been falling in
value against most other currencies. China was even calling for the creation of a new reserve asset to take the place of the dollar in the global economy. Why
was China so worried about the dollar’s value? Because most of its reserves—the largest in the world at more than $3 trillion, fed largely by its huge trade
surplus—are in U.S. dollars. The last thing China wanted was to have all of its dollar reserves losing value in the global economy.
China’s Economic Challenges
By the end of 2010, not only had China replaced Japan as the second-largest country in the world in terms of GDP, it was closing fast on the United States. In
addition, China surpassed Germany and the United States as the largest exporter in the world, which meant that it was continuing to generate large foreignexchange assets that were exposed to losses in value as the dollar fell against other world currencies. China, however, had its own set of problems,
irrespective of what was going on in the West. When it decided to let the yuan gradually rise against the dollar in June 2010, the result was a 3.6 percent rise
in the yuan’s value against the dollar by the end of 2010. However, inflation was rising in China faster than in the United States, so Chinese exports were
becoming increasingly expensive. The rise in the currency compounded the loss in competitive position brought on by the rise in inflation. Powerful Chinese
exporters were very upset with the idea that the government might free up the currency and speed up their competitive challenges. Because of inflation,
Chinese workers were increasingly unhappy with their working conditions, and they began to demonstrate, sometimes violently. As workers pushed for higher
wages, manufacturers faced even greater cost pressures. With general inflation, higher wages, and the possibility of an even more expensive yuan,
manufacturers were being forced to move further inland to find cheaper labor, or even move abroad. Many U.S. manufacturers began moving to manufacture
back to the United States or to cheaper Asian countries.
Improvement of the Trading Infrastructure In the meantime, the PBOC announced in 2009 that it was
going to allow companies in Shanghai and four other major cities to settle foreign trade in yuan instead of dollars. If Chinese companies can get more
exporters and importers to settle their obligations in yuan instead of dollars, they can save a lot of transaction fees and the yuan will gradually increase in
importance. Even though China wants to make Shanghai its future financial center, a lot of yuan transactions occur in Hong Kong. For a while, it was the only
place outside of mainland China allowed to set up yuan bank accounts. Hong Kong is China’s testing ground for the liberalization of currency trading.
However, Singapore is also being considered as a place for yuan transactions, and it also trades about the same as Hong Kong in foreign exchange. The
PBOC permitted HSBC and the Bank of East Asia
to issue yuan-denominated bonds in Hong Kong in 2007, allowing Hong Kong to increase in importance as an offshore financial center for yuan trading. As
banks and companies issue bonds and securities in yuan, the amount of yuan in circulation outside China will steadily grow. In October 2010, ICAP PLC and
Thomson Reuters began to trade yuan on their electronic trading platforms and announced that they were working with banks in the United States and
Europe to use their platforms to trade yuan. Before this, banks in Hong Kong were trading yuan with each other OTC or through brokers. The use of the
electronic platform promises to increase transparency and traffic. In spite of these moves, the onshore market in mainland China still dwarfs offshore
trading, and the fixed exchange rate set by SAFE will be the most important rate. The onshore market in mainland China is far more tightly controlled. Even
though major money center banks such as HSBC are allowed to trade currency in China, their volume dwarfs that of the large Chinese banks. As those banks
gain greater expertise in global trades they will become even more significant outside of China And as China and Singapore explore the possibility of