Sample Essay Paper on The Determinants of the Chinese Yuan to US Dollar Exchange Rate

Since the establishment of an industrialized China through many phases of massive development, the renminbi (or yuan) exchange rate method, which used a static system of exchange rate unwaveringly shifted towards a managed floating system for its exchange rates. In the days when China adopted the fixed exchange method, the yuan fluctuation against other currencies was more based on the economic policies and this largely influenced the yuan exchange determinants. Nonetheless, policies regarding the exchange rate of the yuan have been subjected to many empirical researches. These studies have mostly concentrated on the analysis of the real value of renminbi exchange rate comparative to the equilibrium value that has been impacted by many fundamental factors. Moreover, since Chin abolished the decade-long dollar method to determine the value of its currency, several studies have exposed major undervaluation of the yuan. The Chinese growing trade surplus, especially with the USA, has resulted to numerous scholars and even politicians in the US to allege that China seems to enjoy some an unfair form of competitive advantage because of the intentional policy by China to keep its currency undervalued. Many studies have majorly attempted to address this critical subject by scrutinizing the equilibrium actual exchange rate between the US dollar and the yuan.

Nevertheless, researches that analyze a bilateral equilibrium nominal of yuan versus the dollar exchange rates appears to be very limited and there is little consensus among these studies. For this essay, it aims to establish the determinants of the Chinese yuan against the USA dollar exchange rate. In this essay, various factors that determine the exchange rate between the yuan and dollar shall be discussed. These are interest rate differential, money supply, trade balance, GDP differential, inflation rate differential, exchange rate reserve, and government spending. The reason for completing this paper has been vastly motivated by the significant consequences for the China’s yuan exchange rate policy against the dollar in the competitive world economy.

In the bid to establish the principal aim of this essay, it is fundamental to understand the China’s currency policy and various concepts of currency exchange rate through some relevant pieces of literature. This is very critical since it shall set the platform for understanding the key determinants of the yuan against the US dollar through the literature that assesses the concept of currency exchange rate in any economy.

China’s Currency Policy

The keystone of the China’s economic policy is to manage the renminbi exchange rate effectively in a bid to benefit the country’s export. In a quick look, studies have revealed that China did not possess the floating exchange rate policy that is established by the market forces, as seen in many developed economies. However, the yuan was pegged to the US dollar. In fact, the renminbi was pegged at 8.28 to the US dollar for over ten years from 1994. It was just in 2005, due to the growing pressure from the main trading partners of China that the renminbi was allowed to appreciate by just 2.1 percent against the US dollar. In addition, the yuan was also shifted to the more managed float policy against some major currencies in the world, though this essay predominantly focuses on the determinants of yuan against the US dollar and shall not indulge to other currencies. Three years after the introduction of the new exchange rate policy, Renminbi was permitted to appreciate against the US dollar by approximately 21 percent to the level of 6.83. However, during the worldwide financial crisis that affected many countries including advanced economies, China in 2008 scraped the renminbi appreciation as the global demand for the Chinese goods drastically declined. After few year, and that is 2010, China brought back its currency policy of progressively moving the renminbi up and by 2013, its currency cumulatively appreciated by approximately 12 percent to 6.11.

Primarily, the actual value of the renminbi is tough to establish since many researches over a longer period indicate a broad range of undervaluation with some stating as low as 3 percent to higher ends of 50 percent but the commonly agreeable fact is that the yuan currency is considerably undervalued. Through the process of keeping the value of yuan at artificially lower levels in the market, China has been able to put its exports at a very competitive place in the world market and even against the US dollar. More importantly, China attains this by primarily pegging the renminbi to the US dollar at the daily reference exchange rate directed by the central bank, People’s Bank of China and permitting the currency to fluctuate within the fixed rate set at 1 percent by January 2014. The Renminbi may appreciate substantially against the US dollar if permitted to float freely. Subsequently, China caps the rise of the yuan by buying the US dollar then selling the yuan. In fact, this inexorable accumulation of the US dollar resulted to foreign exchange reserves of China increase to a world record of US dollar 3.82 trillion as of 2014.

Theoretical Concepts of Currency Exchange Rate

Purchasing Power Parity Theory

The purchasing power parity (PPP) theory has an extended economic history. The idea of money and the foreign exchange rates was first published in 1914 in a bid to expand the knowledge of foreign exchange rate based on PPP. The key notion behind PPP concepts is that a bilateral currency exchange level is dictated by the ratio of various price levels present in two nations. In some periods, the value of two currencies can defined by the comparisons of buying power of such currencies, which can also be utilized to indicate both price levels in two countries. If the reciprocal of an overall price index denotes a corresponding to the monetary purchasing power, then it becomes clear that both currencies under comparison may depend on the overall price levels. In this regard, the relative PPP can be described as the comparative change to the purchasing power of currency between the nations and it becomes the determinant factor of foreign exchange rates. It is regarded as the principal aspect of foreign rate changes and the comparative change of the commodity price or the currency purchasing power. In a situation where two nations purchasing fraction change, then the foreign rate changes between the two states shall have to adjust to the situation. The comparative PPP often represents some period of exchange rates and considers the inflation situation of the country. This concept thus shades more light on the study topic and give insights how foreign exchange rate takes place.

Keynesianism’s Theory of Foreign Exchange Rate

This theory just denotes that foreign exchange rate is merely a type of a market price decided by the supply as well as demands power between two nations. The demand and supply of a given currency is largely determined by the nature of balances that exist in the international payments, particularly the payments of services and goods. Hence, an exchange rate relies on the balance of international payments; especially the existing balance of accounts of payments, which itself depends on a nation’s domestic income. This theory is essential, in understanding the determinants of the yuan against the US dollar because these are two huge economic powerhouses with varied currencies.

The New Keynesianism’s Theory of Foreign Exchange Rate

This theory is somewhat difference to the Keynesianism’s concept and states that the foreign exchange rate is largely influenced by the supply as well as the demand of the two currencies and that the current account is the principal aspect to establish the demand as well as the supply of the foreign currency. This concept regarded that the current account balance is influenced by the domestic income, various price levels in two nations, and the exchange rate bands itself. The effect of the domestic exports hugely depends on the relative price levels present in countries, the exchange rate, and the foreign nation’s income. This concept is also fundamental to the understanding of how the foreign exchange between two nations is influenced.

Key Determinants of the Chinese Yuan to US Dollar Exchange Rate

According to Coudert et al. (94), the exchange rate gives an essential macroeconomic correlation between the national economy and the foreign nations that occur through goods as well as the asset markets. Moreover, the exchange rate becomes so vital since it aids to converts a nation’s currency to other currency of different countries. Consequently, international trades like the purchase of services and goods or the transfer of funds especially among states can be attained. The exchange rate is also applied when it comes to price comparisons of same products in other nations, thereby making it an essential aspect that influences the competitiveness of businesses. The exchange rate contributes significantly to any economy of a country, and its shifts can affect a country’s domestic economy as well as foreign trade, or even an entirely international economy. Studies show that a deficit in trade may create a situation where a currency depreciates and lower the national income, or even result in decreased aggregate demand. For instance, in a case of import and export competing industries, the depreciations in the domestic currency may give rise to a windfall profit (Coudert et al., 94). Further studies have also suggested that a currency appreciation may also affect the state of the stock markets, especially in the export-oriented nations in a negative manner while it may affect the stock market of an import-overriding nation in a very positive manner. For instance, the J-curve concept suggests that balance in trade depreciates after a while but shall also improve in the long run especially after situation of exchange rate amelioration. The key determinants of yuan to dollar exchange rate are discussed below.

Money Supply

Money supply is a key factor in foreign exchange rates and has been regarded as a leading indicator of a value of currency. Primarily, equilibrium in the exchange rate is established as the phase where the demand, as well as the supply of foreign money, equates the foreign exchange marketplace (Coudert et al., 97). Furthermore, Coudert et al. (94) established that money supply could make exchange rate volatility. Zhang et al. (360) also tested the performance of an unhampered monetary system as well as the random walk system of the US dollar against the Chinese yuan and found out that excess supply of the dollar shall have great impacts on the yuan as well as the dollar itself. In such a scenario, more supply of the dollar shall see its value depreciate while the value of renminbi appreciates. Being there is no equilibrium in the demand and supply of the currency, then the value of dollar shall somewhat depreciate compared to that of the yuan (Coudert et al., 97).

Interest Rate Differential

In recent studies, Frankel (246) explored the correlations between the interest rate and that of the foreign exchange rate in China and its currency as well as the US dollar. The study established that a more increased interest rate should make the local nation’s currency to appreciate. Buckley et al. (499) also found that a higher interest rate differential in the US dollar compared to Chinese yuan in China should make the value of the dollar to appreciate significantly and become much stronger than the yuan. The bottom line here is that an increase in the interest rate of a local country would make it stronger. The value of yuan against the dollar is too affected the interest rate differential. Cheung et al. (231) also found that higher interest rate affects the value of the currency in the country where such a policy has been enforced. Furthermore, the coefficient in studies about interest rate differential, particularly between the yuan and US dollar has been found to be significant, showing that the exchange rate relationship between the two currencies does exist. This infers that the interest rate influences the value of the yuan against the dollar. Therefore, the interest rate is a key determinant is predicting the exchange rate of the Chinese Renminbi against the dollar. The negative correlation of foreign currency rate infers that an increase in interest rate between the US and China results in less yuan exchange for one US dollar, thereby making the value of the Chinese currency to appreciate.

Trade Balance

The trade balance often points to the product traded between nations, which thus form a critical indicator of a macroeconomic situation. Trade balance also forms an essential indicator of underlying analysis of the foreign exchange transactions. The impact of the exchange rate on trade balances turns out to be one of the important studies in an economic literature since depreciation in the exchange rate is assumed to cause positive impacts on the output as well as trade balance (Cheung et al., 231). In addition, Frankel (246) found positive correlations between the exchange rate and the export, as well as negative associations with the imports. The study also revealed that an increase in the total trade balance should appreciate the actual exchange rate. In some cases, the trade balance may not largely influence the foreign exchange rate between the two currencies. This may be similar to the situation of the Gross Domestic Product (GDP) differential. The change in a trade balance might not straightly influence the exchange rate because when there is trade surplus or even deficit, the various monetary plans shall determine the exchange rate in another way (Frankel, 246).

Foreign Exchange Reserves

The foreign exchange reserve forms an essential factor in the foreign exchange rates analysis and the key functions of this element is to maintain the stability of foreign rates market. In fact, whether a nation’s currency is deemed stable or not relies on the extent of the exchange rate liquidity of the currency reserves. Coudert et al. (94) in his studies found significant correlations between the foreign currency reserve and the exchange rates in China. The study thus suggested that the coefficient of the foreign exchange reserves could be negatively connected to the nominal foreign exchange rates. Significantly, estimates points that an increase in the comparative balance of the foreign currency reserve may lower the nominal exchange rates. In the Chinese currency reserve, there exist relations to the dollar. In this scenario, the foreign exchange reserve can be substantially connected to the yuan exchange rate. This infers that the foreign exchange reserve shall be an important determinant in predicting the Chinese yuan against the US dollar exchange rates. Therefore, an increase in the foreign exchange reserve within China shall result to less Chinese yuan exchange rate for one dollar thereby making the value of yuan to appreciate (Frankel, 246).

Inflation Rate Differential

From the PPP concept, the exchange rate can be described as the ratio of various price levels between two nations. In some period, the two currencies can be determined by the dissimilarities between the level of purchasing power existing in the two currencies as well as the buying power may also be used to denote the price levels in the two countries. The relative PPP indicates the period of the exchange rate by considering the inflation levels. Cheung et al. (231) exposed that a higher rate of inflation in the local currency results in the depreciation of that particular currency. Primarily, the inflation rates in China and in the US is very different, and thus the foreign exchange reserves shall largely be significant concerning the exchange of the Chinese yuan against the US dollar. This means that an inflation rate differential shall be one of the key determinants in predicting the exchange rate of the renminbi. To bring this into perspective, the increase in the inflation rate differential between the US and China results in more yuan exchange against the dollar thereby making the value of the yuan to depreciate.

Government spending

The correlation between the exchange rate and the fiscal balance is so interesting since it encompasses on of the main constituents of national savings. According to Frankel (250), higher government spending balances expand the savings and grow the balance of the current accounts. Coudert et al. (97) established that a higher government spending to that of the GDP ratio should result in the appreciation of the actual exchange rate. Furthermore, an increase in the government expenditure comparative to the GDP also leads to the appreciation of the exchange rate. In addition, this factor determines the value of the yuan in the exchange rate market against the dollar. Although it is not a principal factor that can peg the value of the yuan against the dollar in exchange rates. This is possible because when there is less or more government expenditure, then the government can use the various monetary policies to affect the exchange rate.

GDP differential

In this circumstance, the GDP differential may mean the increase in the GDP rate variances between the US and China at a given period. The GDP between some period may mean the value of every final services or good in the area or country that often considered as the key measure of the national economic situations. The stronger the economic growth is about the chief trading partners; the lower would current accounts be. Buckley et al. (499) found that the GDP differential, as well as the exchange rate, is related through the reexamination of the PPP theory. This infers that the GDP different between the US and China are not that may substantially correlate to the renminbi exchange rate. This is sensible since the differences in the exchange rate may also be pegged on other monetary policy of the country.

Conclusion

This paper successfully establishes the key determinants of the Chinese yuan to US dollar exchange rate. First, China is a nation that largely has strict currency policies, and thus its currency is often observed at close range by the relevant agencies to ensure it remains stable. From the historical developments on Chinese has been subjected to many developments. Many studies have also tried to address the exchange rate concept of the Chinese yuan against the dollar. Critical theories that are related to the idea of exchange rate have been discussed. The PPP concept, the new Keynesianism’s theory, and the Keynesianism’s have been unfolded and expanded on how they relate to the exchange rate. From the findings of this essay, the key determinants of yuan exchange rate against the dollar can help the Chinese government and interested parties identify the factors influencing the renminbi exchange rate. Furthermore, the findings of this paper may also aid financial institutions as well as multinational corporations to lower the foreign exchange rate uncertainty.

 The determinants in the paper are foreign exchange reserve, interest rate differential, money supply, government spending, and inflation rate that influence the exchange rate of yuan against the dollar. The interest rate differential has been found to be significantly related to the yuan and dollar exchange rate. An increase in interest rate, especially between China and the US, causes less yuan exchange against the US dollar, hence making the value of the Chinese yuan to appreciate. The foreign exchange reserve has also been found to relate exchange rates of the two currencies. The paper asserts that an increase in the foreign exchange reserve in China can result to less Chinese yuan exchange rate against the dollar hence making the value of yuan to appreciate. In addition, the inflation rate differential is key determinants just as discussed in the paper. Hence, an increase in the inflation rate differential between the US and China may cause more yuan exchange against one dollar thereby making the value of the yuan to depreciate. The Chinese government may apply the foreign currency reserve, interest rates as well as other key determinants to maintain the stability of the renminbi exchange rate. Lastly, various multinational firms through the grasp of the shift in the level of exchange reserve as well as other changes in interest rate in US and China can help determine the trend of yuan exchange rate and put proper measures to lower the losses caused by the shifts in the exchange rate.

Works Cited

Buckley, Peter J., et al. “The determinants of Chinese outward foreign direct investment.” Journal of international business studies 38.4 (2007): 499-518.

Cheung, Yin-Wong, Menzie D. Chinn, and Eiji Fujii. “China’s current account and exchange rate.” China’s Growing Role in World Trade. University of Chicago Press, 2010. 231-271.

Coudert, Virginie, and Cécile Couharde. “Real Equilibrium Exchange Rate in China. Is the Renminbi Undervalued?.” Exchange Rates and Macroeconomic Dynamics. Palgrave Macmillan UK, 2008. 94-112.

Frankel, Jeffrey. “On the yuan: The choice between adjustment under a fixed exchange rate and adjustment under a flexible rate.” CESifo Economic Studies 52.2 (2006): 246-275.

Zhang, Fan, and P. A. N. Zuohong. “Determination of China’s long-run nominal exchange rate and official intervention.” China Economic Review 15.3 (2004): 360-365.