1

International Finance

What policy should China adopt to stabilize the

economy while real appreciation happens -

Measures of Chinese government to the appreciation

Winnie Wu, Vinzer Hsieh, Blair Chang, Novia Chang , Harold Lu

July, 2012

2

Framework

1.0 Introduction

2.0 Literature Review

2.1 The undervalue of RMB

2.2 The effect of RMB’s appreciation

2.3 Chinese Government’s Policy

2.4 The connection between Taiwan, Japan and China

2.5 Japan’s mistakes

2.6 NTD Appreciation

3.0 Methodology

3.1 Research Framework

3.2 Mundell-Fleming Parity

3.3 Covered Interest Rate Parity

4.0 Conclusion and Future Prospect

5.0 Reference

3

1.0 Introduction

1.1 Motivation and Background

Since the 1980s, China has started its high-speed industrialization development and has caused a huge

influence on the economic market. In 2005, WTO indicated that the trade amount of China had reached

1.42 trillion. According to the China State Administration of Foreign Exchange, China’s foreign reserve

reached 1.96 trillion in 2006, which exceeded Japan to become the biggest foreign reserve-holding

country. The record was one of the most remarkable milestones in economic history throughout the world

due to the tremendous effect. Analyzing the trend of RMB became a hot issue in the currency market.

In our paper, we use the Big Mac Index and the Purchasing Power Parity Theory to elaborate the status of

RMB. Due to the fact that China is holding a large amount of the foreign reserve and having a trade

surplus to the United States, we are assure that the RMB is under the pressure of appreciating and the

appreciation will happen sooner or later.

We want to discuss whether the Chinese government is making the right moves. The monetary and

fiscal policies are two important government strategies to stabilize the economy. We notice that Japan and

Taiwan used to face the same pressure of currency appreciation back in the late 1980s. From their

experiences, we found that Japan had made a few mistakes when making the decision while Taiwan

successfully prevented the economy from bubbling. Therefore, the policies that government undertakes

are fairly vital. In the research, we analyze the current monetary policy and fiscal policy which China is

taking right now, and try to look into the future economic status of China.

4

2.0 Literature Review

2.1 The undervalued RMB

In the past decades, the RMB exchange rate has been seriously underestimated, accompanied by large

trade surplus and vast-accumulated foreign exchange reserves in China, the underestimated RMB

depresses the GDP growth of major countries and makes trade circumstances unfair. However, China

insists to control the exchange rate which (chart 1) has made the International trade unfair, caused the

dumping of cheap Chinese-made products to other countries and resulted in trade deficit.

Figure I

RMB exchange rates, 1 RMB to US dollar by year since 1981

2.1-1 The Big Mac Index

In our essay, we will use the Big Mac theory as one of the index to prove the underestimation of RMB.

The economists’ Big Mac index is based on the theory of purchasing-power parity: in the long run,

exchange rates should be adjusted to equal to the price of a basket of goods and services in different

countries. Take the big Mac hamburger as an example, it costs＄4.2 in the USA while it only costs 15.4

5

RMB in China. According to ―burgernomics‖, the RMB is approximately 42% undervalued.

Because the implicit exchange rate is 3.67 RMB to one US dollar while the actual exchange rate is 6.32

RMB to one dollar on January 11th, 2012; we are not sure how much is the RMB undervalued ,but we

know the RMB holds great potential to appreciate.

Figure II

Big Mac Index of different kinds of currencies over the world

2.1-2 China’s currency intervention

The People's Bank of China (PBOC, China's central bank) has continued to intervene in the foreign

6

exchange market at a massive scale, buying as much as $500 billion per year (equivalent to its

balance-of-payments surplus) to maintain the yuan's exchange rate against the U.S. dollar. Consequently,

China's foreign reserves reached $3.3 trillion in March 2012, which is the world’s biggest.

China's massive intervention in the foreign exchange markets has made an undervalued currency that

subsidized all Chinese exports by at least 20 percent and protects all Chinese imports by at least 20

percent. The U.S. global trade deficit is by $50 billion to $100 billion higher than other countries and

resulted in high unemployment rate in these countries. Moreover, China's actions have unleashed

worldwide currency conflicts that threaten to replicate the spiral of competitive devaluations that

deepened the Great Depression in the 1930s.

2.2 The effect of RMB’s appreciation

As we know that the RMB undervaluation may cause an inevitable appreciation, looking into the

effects that the appreciation will bring to China’s economy is quite important for our study.

2.2-1 The advantages for China if RMB appreciates

A moderate appreciation of RMB can benefit China as following:

(1) Creating competitivity: the appreciation of RMB allows Chinese enterprises to use less RMB when

investing overseas. This will create an international competitiveness for Chinese corporations.

(2) Improving the foreign investing environment: once the RMB appreciates, the foreign companies who

have invested in China will be benefited. This encourages them to reinvest in the financial market, thus

makes China’s economy better off.

(3) Eliminating trade conflicts: the United Stated and Japan are currently the two biggest exporting

7

countries of China. Due to the undervalued of RMB, China has a comparative advantage to those two

countries which hurts their local industries. The appreciation of RMB may diminish the effect of this

feature and, therefore, reduce the trade conflicts between those countries.

(4) Enhancing the domestic consumption: the appreciation makes the RMB more valuable, meaning that

the import goods are relatively cheaper. Therefore, it enables China to purchase the high-technology

products and equipments which they lack of at a lower cost, thus eventually stimulates the domestic

consumption.

2.2-2 The disadvantages for China if RMB appreciates

A sharp appreciation might cause the following damages to Chinese economy as well:

(1) Increasing the cost for foreign investment. The appreciation makes RMB more expensive, thus it

increases the cost for foreign investments to come into China.

(2) Breaking down the exchange rates in East Asia. RMB is the key to stabilize the exchange rates in East

Asia. If China lets RMB appreciate, the hot money will flow into China and cause an economic instability.

Also, due to the collective fluctuation of the exchange rates in East Asia, the currency value of the

countries in East Asia might variant as RMB appreciates.

(3) Damaging the financial market. Once a sharp appreciation occurs, a large amount of hot money in

China will evacuate as soon as the investors getting their profits. This will harm the financial market in

China.

(4) Damaging the labor-intensive industries. Appreciation of RMB weakens China’s export products and

results a reduction in export-oriented and labor-intensive industries, ultimately increases the

8

unemployment rate in China.

(5) Ruining the industrialization. A sharp appreciation may ruin the industrialization in some areas and

result a large amounts of funds outflow.

2.3 Chinese Government Policy

Since the late 1990s, China has been adopting a conservative point of view towards the RMB variation.

They gradually formed a moderate monetary policy. The key point of this policy is to stable the currency

value while maintaining a moderate growth in money supply and a rapid growth in national economy.

The graph below shows the exchange rate of RMB against the USD from 1991 to 2011:

Figure III

The historic exchange rate of RMB

We can see from the curve in the graph, the exchange rate has been well controlled since 1994 when

the managed floating rate policy was adopted. Even though the RMB started to appreciate in 2005, the

4.5

5

5.5

6

6.5

7

7.5

8

8.5

9EX (RMB/USD)

1994, Mana

ged floating

rate policy

2005, RMB

appreciated

9

exchange rate declines smoothly.

This year, early in 2012, Chinese government had announced to maintain the moderate monetary policy

and positive fiscal policy. Their point is to ease the restraint of RMB appreciation slightly and let it

appreciate steadily and smoothly. The government has announced to broaden the floating range of the

RMB against the USD from 0.5% to 1%, means that the scale of RMB appreciation or depreciation has

been doubled.

2.4 The Connection between Taiwan, Japan, and China

Back in the late 1980s, Taiwan and Japan both experienced a rapid economic growth. The economy

boomed promptly and turned themselves into export-oriented countries. However, the success brought to

a problem - monetary appreciation. Back then, Taiwan and Japan both had a trade surplus to the United

States, which made the US forced them to appreciate their currencies. Nevertheless, they settled the

problem differently and acquired distinct outcomes, which we will explain the details later.

China, on the other hand, shares the similar situation. China’s economy boom rapidly as well, and is

facing the appreciation pressure just like Taiwan and Japan were. Here are a few reasons: First, China as

just replaced Japan to be the largest foreign reserve holding country in 2006. Second, China also has a

trade surplus to the United States. And third, the RMB is undervalued. Due to these reasons, China is

facing a pressure of RMB appreciation from the European Union, Japan, and especially the United States.

In later paragraph, we will study the policies Taiwan and Japan took when they confronted the pressure,

and how the policies influence the economies. Investigating Taiwan and Japan’s monetary and fiscal

policies helps us analyze whether Chinese government’s currently monetary policy and fiscal policy is

10

suitable for the problems at this present.

2.5 Japan’s Mistake

We think there were three mistakes after the Plaza Agreement that caused the bubble economy. Before

discussing about the three mistakes, we need to know about the background which is Plaza Agreement.

2.5-1 Plaza agreement

The Plaza Agreement was signed between the United States, Germany, the United Kingdom, France

and Japan on September 22, 1985. In order to devalue the US dollar to alleviate the trade deficit, these

countries sold their foreign reserves and intervened in the currency markets and therefore successfully

boomed the export of American goods and services.

2.5-2 The effect of the Plaza Agreement to Japan

However, the Plaza Agreement failed to accomplish its primary objective of alleviating the trade deficit

for Japan. During 1980 to 1984, the United States was the world’s biggest debtor country, while Japan

was the biggest creditor country. Therefore, many countries bought in a large amount of Yen because of

the expectation that Yen would appreciate right after the agreement was signed. But only ends up with

the time of Bubble Economic from1986 to 1991.

2.5-3 The first mistake

In 1986 ,there was a small recessionary which was caused by the strong appreciation against US dollar,

but it was just an adjustment of the market, and it then soon came back to stable economy in the end of

1986. But after the recessionary, the Japan government feared that the recessionary would occur again. So

11

they wanted to use the easing monetary policy to spur the economy by lowering the discount rate. They

lowered the discount rate from 5 percent to 2.5 percent in just one year, from 1986 to 1987.

2.5-4 The second mistake

The world economy boomed in the autumn of 1987.To prevent the inflation in the near future, the US

and German government both raised their discount rate. The US government suggested Japan not to raise

their discount rate because US was afraid that if Japan did so, the money wouldn’t flow back to western

countries. At the same time, Japan was implementing the policy to increase the domestic demand, which

needed the lower discount rate to attract more investment. And Japan also feared raising discount rate

would make more money flow into Japan, which caused the appreciation, then finally stopped the

economy from growing. In this circumstance, Japan stuck to the easing monetary policy. The discount

rate remained at 2.5% until 1989. The easing monetary policy made the market full of too much fund, and

the long-term low interest rate further pushed the money into stock market and real estate.

Figure IV

Japanese Nikkei Index and Japan’s Official Discount Rate

12

(From the chart above, we can see that the discount rate fell from 5 percent to 2.5 percent, from 1986 to

1987. And then it went up from 2.5 percent to 6 percent in 1989. After the discount rate fell down in 1986,

the stock price soared dramatically, which reached the peak in 1990.)

Figure V

Residential Urban Land Price Index

(The land price also soared with so much fund flowing into real estate market.)

2.5-5 The third mistake

In 1989, the Japan government realized the price had soared dramatically so they decided to alter the

monetary policy to the tightening one. From May 1989 to August 1990, Japan raised the discount rate 5

times, from 2.5 percent to 6.0 percent. After the sudden increase, the Japan market collapsed.

To sum up, the first mistake was happened in 1986, because of the fear that the recessionary might

occur again, they lowered the discount rate in just one year. And the second mistake was happened in

1987, when it was an appropriate time for Japan government to slowly raise their discount rate, however

they didn’t. And the third mistake was happened in 1989, Japan government changed their policy too

suddenly, the market couldn’t adjust itself yet, and the whole Japan market collapsed.

13

2.6 Taiwan’s Right Choice

Taiwan and Japan faced the same condition that China is facing right now. However Taiwan

government took totally opposite options to Japan’s. Japan’s economic disaster explained its wrong

decisions. What came to our mind is if we can see what right policies Taiwanese government

implemented, we’ll be able to suggest Chinese government, even other countries, to make the right

choice.

2.6-1 About Exchange Rate

Exchange rate is an important factor to affect the appreciation of currency. Here we can separate them

into three different dimensions:

Fixed Exchange Rate

A country’s exchange rate is fixed or it can only fluctuate in an extremely small range. The central bank

must interfere with the foreign exchange market or implements foreign exchange control to maintain the

exchange rate.

Managed floating rate

The exchange rates fluctuate from day to day, but central banks attempt to influence

their countries' exchange rates by buying and selling currencies. It is also known as a dirty float.

Freely floating rate

It’s a type of exchange rate where a currency's value is allowed to fluctuate according to foreign

exchange markets.

2.6-2 History of Exchange Rate in Taiwan

14

1949-1978: Taiwanese government implemented fixed exchange rate regime.

1978-Now: Taiwanese government implemented managed floating rate regime.

2.6-3 Period of Fixed exchange rate

In 1949, the exchange rate was NTD＄5 to USD＄1. Later in 1951, the government of Taiwan set the

rate to USD＄1 to NTD＄10.35, which was applicable to produce equipment, raw material, and essentials

exchange settlement of import. In 1963, the government implemented the single ed exchange rate, USD＄

1 to NTD＄4.

2.6-4 Period of managed floating rate

In 1978, the government eliminated fixed exchange rate, Taiwan adjusted the rate of 1:38 to 1:36.

Exchange rate was decided by exchange market. In 1990, Taiwan entered the time of exchange rate

liberalization. But the central bank still got the power to interfere with the NTD exchange rate.

2.6-5 Total Effect of Exchange Rate Regime in Taiwan

To summarize the history and transformation, the government has to consider the whole environment

to maintain the domestic economic growth.

Before 1970, Taiwan was pegged to USD (like other members in IMF). The domestic economy

developed to export trade. The Balance of Payments revealed that the unfavorable balance of trade and

foreign exchange reserves are not enough. After 1970, to prevent the monetary supply increased rapidly

and led to the inflation, the government changed the fixed exchange rate into managed exchange rate

regime. After the 1980s, in response to the pressure from the USA, NTD was forced to appreciate. The

regime of exchange rate became freer and deregulation. After 1990s, Central Bank’s target was to hold the

15

exchange rate, and it also interfered with the rate occasionally.

2.6-6 Appreciation of NTD

Although the appreciation was harmful to export, and the GDP didn’t grow substantially, the condition

was still under control. Due to the favorable balance of trade gets higher, Taiwan became more

internationalized. Taiwanese government also decreased the tariff. The appreciation enhanced the

purchasing power and made people take more foreign traveling and foreign investments. At that time, the

money supply substantially increased, hot money rushed into Taiwan, and the price of real estate and real

equity were raised. In 1989, Taiwan sensed the situation and implemented the deflation policy. If the

government didn’t make the right decision, it could be like Japan’s bubble economy.

3.0 Methodology

3.1 Research framework

3.2 Mundell-Fleming Model

Trade surplus is the root cause of the pressure for RMB appreciation. By adopting the appropriate policy,

the appreciation of RMB could exist along with the stability of the economy. Mundell-Fleming model has

been described as ―the dominant policy paradigm for studying open-economy monetary and fiscal policy.‖

Therefore, we want to take advantage of this model and further understand the relationship among

Other Economic Indicators

Interest and Exchange Rate

Foreign Investment Monetary and Fiscal Policy

16

government policy, trade policy and exchange rate, fiscal and monetary policy especially, to see how the

RMB appreciation will have influences on the economy.

3.3 Covered interest rate parity

When the difference between the domestic interest rate and the foreign one is equal to the domestic

forward currency discount (premium), the countries then enter forward foreign exchange contracts in

order to achieve the purpose of hedging the exchange rate risk. If Chinese government let RMB

appreciate appropriately, it will then eliminate the potential for covered interest arbitrage profits.

4.0 Conclusion and Future Prospect

After we understood what policies did Taiwan and Japan took in 1980s,we analyze the monetary and

fiscal policies that China is applying right now.

4.1 Monetary policy - Maintain the interest rate

While Japan’s easing monetary policy was taken to lower down the discount rate from 1985 to 1989 in

order to maintain the value of Japanese Yuan ,China’s government learned it won’t be a wise decision to

do the same thing as Japan, because as the chart below has shown, while Japan realize its booming

economy was unable to be hold , it raised the discount rate from 2.5％ to 6％ in one year ,which caused

the lost ten years in the following decade.

17

Figure VI

The Discount Rates taken in Japan

What China’s government do is to maintain the low discount rate in between 2 to 4 percents, even though

the interest rate is low ,the trend of foreigner investment doesn’t seem to decrease, we assume that is

because the foreigner investor still consider China a potential market to grow and they believe that RMB

will be appreciate in the future.

Figure VII

The Discount Rates taken in China

0

1

2

3

4

5

6

7

1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995

0

1

2

3

4

5

6

7

8

9

10

1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007

TThhee ssttaabbllee

ddiissccoouunntt rraattee

18

But the stable discount rate will result in the appreciation in RMB, which could be harmful to the export

market, so the fiscal policy ,12th

-5 plan is applied to enlarge the domestic market that can make up the

loss from export market.

Figure VIII

Current account balance

(shows that China’s export market is cutting back because the appreciation of RMB)

4.2 Fiscal policy- Enlarge the domestic market

We might prove that China’s domestic market is stably increase because the growth rate of the market

maintain at 4 to 6 percents, on the other hand, the growth rate of export market is unstable and even

reached -3.6 percents in 2009, the main reasons are the launch of 12th

5 plan in 2008 and the

sub-mortgage crisis happened in 2008 made the whole investing environment a disaster.

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

China 17.40 35.42 45.87 68.65 134.1 232.8 353.9 412.4 261 305.3 201

0

50

100

150

200

250

300

350

400

450

U.S

. do

llars

(bill

ion

s)

Current account Balance

19

Figure IX

The growth rate of net export vs. domestic market consumption

So, the conclusion is if China wants to stable its economy while real appreciation happens, it can’t follow

Japan’s policy, but it could view Taiwan as a great example, manage the exchange rate and also

encourage the domestic market to consume. The monetary and fiscal policies that China is taking right

now seem effective to reach its economic growth goal - 8 percents per year. But since the appreciation

could do lots of damage to its original low-cost characteristic, The People's Bank of China might want to

apply the policy wisely in order to stable the economy in the future.

5.0 Reference

1.陳建雄 (Jul 2004),「日本經濟四大訓」,香港商務印書館

2.陳添壽 (Sep 2006),「台灣經濟發展史略」,立得出版社

3.泥仁傳 (2001),―釘住匯率的抉擇—以人民幣釘住美元為例」中國文化大學經濟學研究所博士論文

4.王振鎖、李鋼哲主編 (2002),「東亞經濟區域合作:中國與日本」,天津人民出版社

5. Hong Kong Monetary Authority (2004), ―RMB appreciation on global imbalances and the impact of

intra-regional trade‖ Hong Kong Monetary Authority quarterly journal.

-6

-4

-2

0

2

4

6

8

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

growth rate of net export

growth rate of domestic market consumption

20

6.Ching-Chang, Lai (2004), ―Macroeconomics‖ second edition, Taipei: 195-256.

7.Lawrence J.Lau, ―The Use of Purchasing-Power-Parity Exchange Rate in Economic Modeling: An

Expository Note‖, Department of Economics Stanford University

8. Iwami Toru (1995), ―Japan in International Financial System’’, MacMillian Press, New York

9. Wood (1992), ―The Bubble Economic‖, Sidgwick & Jackson, London

10. Julee Blackburn (2008), ―Globalization and the Mundell-Fleming model- Free Flows of Capital and

the Mundell-Fleming Model‖

11. Mankiw, N. Gregory (2010), ―The Open Economy Revisited: The Mundell-Fleming Model and the

Exchange-Rate Regime‖ In Macroeconomics, sixth edition, ed. 334–367. New York: Worth Publishers.

12. Morris Goldstein; Nicholas R. Lardy (Mar 2005), China's Role in the Revived Bretton Woods System:

A Case of Mistaken Identity

13. University of Macedonia, Department of Economics, Applied Economics and Finance. (Aug 2009),

The Purchase Power Parity (PPP) Hypothesis

14. Fu Yong (May 2008), The conditions of Interest Rate Parity in China

15. Alan M. Taylor; Mark P. Taylor (2004), The Purchasing Power Parity debate. The Journal of

Economic Perspectives, Vol. 18, No. 4.