International Economics: the Chinese Yuan and the US $

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International Economics: the Chinese Yuan and the US $
Abstract
Currency crises have been on the increase in the global markets. The various fiscal and monetary policies used by the world economies generate different kinds of fluctuations in the global currency markets. The crises that the US dollar has encountered in the past years have triggered proposals that another currency should be introduced as the reserve currency. The Yuan is one of the currencies that the global community proposes for a reserve currency. This paper has discussed the historical background of the dollar and the Yuan. The comparison of these currencies on the basis of market stability has been made. Models that are mainly used by fiscal policy makers to evaluate the regimes of currency exchange rates have also been discussed. The Mundell-Fleming model has shown that flexible exchange rate system is the best in maintaining balance in the global currency markets. This paper has concluded that the dollar is still the choice of many, since the Yuan has hugely been affected by the fixed rate system in China.
Introduction
The frequent economic declines and recessions in the world economies have triggered the establishment of various financial policies and economic initiatives. The last few decades have seen difficult economic times in many countries. The money markets have encountered numerous challenges during economic recessions. There is an overwhelming prospect of the American dollar losing grip in most of the world’s money markets. This is because there has emerged various stable currencies in the large economies, such as the European Euro and the Chinese Yuan. Crises have been experienced due to the consequent fluctuation of the US dollar, and the world may be headed for a change in the reserve currency situation. Perhaps, the Yuan might replace the US dollar as the world’s recognized reserve currency. However, this possibility is worth intensive evaluation so that economists and financial analysts can convince the world that this would be a sound move. This paper seeks to explore the impacts that would be generated by replacing the US dollar for Chinese Yuan, in terms of stabilizing the global currency markets to avoid economic crises that have occurred in the past.
The global currency markets are very sensitive to economic malpractices. Stock markets are some of the platforms that are hugely affected by fluctuations in foreign currencies, such as the reserve currency. Trade deficits have often resulted to a wobbling monetary situation in the United States, and the 2006 deficit of more than $700 billion can show the imminent possibility of the collapse of the dollar (Hagee, 2010, p.99). The unfavorable conditions that have occurred in the money markets as a result of trade deficits include deflation-inflation extremes and inadequacies in debt settling. These are notably the most likely factors that would lead to the decline of the US dollar as the prime reserve currency in the world markets (Hagee, 2010, p.99). The weakening of the dollar may even render the American economy unable to offset the deficits. However, the adoption of a new world reserve currency would pose acute challenges to the financial agencies. Many economies would rather prefer the implementation of the Special Drawing Rights, stipulated by the IMF (Hagee, 2010, p.100).
The history of Yuan since 1970
The use of the Chinese Yuan as a unit of currency can be dated back to the late periods of the nineteenth century. The Yuan currency was first developed in china to serve as an exchange unit with the Mexican silver coins in the nineteenth century (Rojas, 2010, p.151). In the years before 1970s, the financial systems in china were relatively weak due to the instability of the Yuan in the domestic currency markets. There were adverse cases of inflationary surges in the Chinese economy. However, the government engaged in regulatory measures to address the fiscal failures that had resulted to the faltering of the Yuan. In 1970, through its central bank, the Chinese government effaced the earlier Yuan currencies and introduced the Renminbi Yuan (Rojas, 2010, p.152). This national replacement was done at the prevalent market rate of 10000 former currencies to 1 Renminbi (Rojas, 2010, p.152). The government saw this as the best attempt to improve the value of the Chinese Yuan in the domestic and foreign currency markets. However, the government introduced another series of the Yuan in 1988 in an attempt to preserve nationhood from foreign influence (Rojas, 2010, p.154).
The government, surprisingly, displayed the year 1980 as the issuing date in the 1988 currency notes and coins (Rojas, 2010, p.154). This was declared as the common look of the Yuan, and its value maintained stability in the domestic and foreign markets. In the year 2004, another series of the Yuan was introduced into circulation, and it came to be known as the Sans Wall (Rojas, 2010, p.154). Due to the positive growth in the Chinese economy over the last two decades, the government has effectively developed measures to stabilize the value of the currency by stockpiling the foreign currencies into its national monetary reserves (Rojas, 2010, p.154). It is estimated that in the year 2010, the foreign capital in china had accumulated to more than two trillion US dollars (Rojas, 2010, p.154). The Chinese Yuan has attracted much criticism from the American society, since it is seen to give China an unhealthy advantage in the global trade activities.
China established the rate of 8.3 Yuan per dollar in 1994, which has been termed by the US as gross manipulation of the global currency markets (Ferrington, 2006, p. 8). This currency system remained in operation until in 2005, when the Chinese government bowed to the international pressure to let the Yuan respond to the free currency market. Despite these calls, the Chinese government instead raised the value of the Yuan by only a scanty 2 percent (Ferrington, 2006, p. 8). This meant that the value of the Yuan could not entirely be determined by the money markets, since the government did not let the currency out of its control. The value of the Chinese Yuan that is set by the government has been estimated to be around 40 percent less the actual value that the currency market would place on the Yuan (Ferrington, 2006, p. 8). To keep the Yuan stable to the dollar, the Chinese government largely trades with commodities whose value is payable by the Yuan in exchange of dollars.
The history of the US Dollar since 1940
Economists have pointed out that the value of the dollar has hugely depreciated since the year 1940, during the World War 11 (Cornish, 2004, p.138). The value of the dollar suffered heavily during the Great depression in 1929, since the fiscal markets were adversely affected across the world. (Aliber, 2005, p. 22)Despite these setbacks in the financial markets, the dollar has remained as the prime reserve currency in the world. This is because most of the other major currencies have proved to be more unstable than the US dollar. The value of the US dollar has devalued by around 90 percent since the year 1940 (Cornish, 2004, p.138). Since the last fifty years, the dollar has been noted to be headed for an imminent downfall, due to its deterioration as a reserve currency (Whalen R & Whalen C, 2010, p.341). The loss of value of the dollar since the mid twentieth century has led to the decline in the USA exports to the world markets. This is because most of the large economies have protected their currencies from foreign influence in the money markets (Whalen R & Whalen C, 2010, p.341).
The US has had an acute problem with the Chinese Yuan, since the Chinese government has pegged the value of the Yuan at a lower value against the dollar. In 1970s, the dollar lost value against the German and Japanese currencies as a result of inflation (Aliber, 2005, p. 15). The dollar increased its value after the Paul Volcker, the then chairman to the Federal Reserve Bank, established new policies in the to curb market problems in 1979 (Aliber, 2005, p. 15). The dollar’s value improved by more than 60 percent in the following few years. The 1980s saw the value of the dollar grow steadily because of the influence from the Tokyo money market (Aliber, 2005, p. 15). The dollar was effectively appreciated by the USA-Japan ties, and most of the Japanese financial agencies had opened branches in the US (Aliber, 2005, p. 15). Another factor that led to the increase in the dollar value was that more international traders bought dollar securities, rather than the Yuan and the European currencies (Aliber, 2005, p. 22)
The dollar has served as the world’s reserve currency since the world war 11, when the international community declared the dollar as the most stable currency. However, due to the loss in the dollars value, there has been an urge to replace the dollar as the reserve currency. The G8 meeting in 2009 proposed the replacement of the dollar by another stable currency, probably the Yuan or the Euro in order to strengthen the global currency markets (Hagee, 2010, p.99). The dollar experienced a rise in the global reserves from 2001 to 2003, hitting a high of 72 percent (Hilbert, 2007, p. 12). Since 2000, the global inflationary surges have led to the decline in the value of the dollar. The trade deficits in the USA have seen the drastic fall of the dollar value, such as the 2006 and 2009 trade deficits (Hagee, 2010, p.99).
Comparison between the Yuan and the US dollar
The Yuan portrays various differences from the US dollar. For example, the Yuan is not floated in the currency markets. China uses pegging policies, whereby the value of the Yuan is set by the central bank (Walden & Thoms, 2007, p.53). The value of the Yuan is thus kept at a fixed rate against the US dollar, usually at 8.3 (Walden & Thoms, 2007, p.54). The value of US dollar is set by the world currency markets, thus it is highly flexible. The market forces such as global demand and supply are the prime regulators of the dollar (Walden & Thoms, 2007, p.54). The Yuan is kept at a constant value against a host of other currencies (Walden & Thoms, 2007, p.54). The government trades mainly with dollar-related commodities in order to reduce the Yuan circulation if the domestic supply increases to unwanted levels.
The dollar maintains international trade balances, unlike the Chinese Yuan. This is because the value of the US dollar is determined by the market forces, thus the global trade is fairly controlled (Ferrington, 2006, p. 9). The Yuan causes trade imbalances in trading operations. China gains more income from its exports, and it imports goods from other countries at relatively cheaper prices (Ferrington, 2006, p. 9). This results to unfair trade relations and many countries are planning to introduce special tariffs against the Chinese goods (Ferrington, 2006, p. 9). For example, the USA has proposed a 27 percent tax increase on Chinese goods to ensure that the Yuan does not cause imbalances in the US markets due to its devaluation (Ferrington, 2006, p. 9).
Reserve Currency
The reserve currency is defined as a currency which is held by the global society as the main legal tender in the international markets (Bartholomew, 2010, p.25). The IMF has outlined the Special Drawing Rights (SDRs) that are applied for a currency to become the global reserve currency (Bartholomew, 2010, p.25). In most cases, the reserve currency’s value is controlled by the global market forces, such as the dollar value. In most central banks, the reserve currencies are held in terms of precious stones such as gold. Every country has a reserve currency in the domestic fiscal markets, in addition to the US dollar. This ensures that the global collapses of the fiscal markets do not adversely affect the domestic currency markets.
A reserve currency must be able to pay an interest if it issued as a bond in the stock markets (Bartholomew, 2010, p.25).The reserve currency has various functions in the international market, apart from being the common legal tender. It is used to measure the inflationary effects in the world economies (Bartholomew, 2010, p.25). Thus, it serves as the sole indicator of the market trends in the free market, according to the fluctuation of the market forces. Foreign exchange trade is also an important avenue in which the reserve currency is used by the world economies. Import debts are settled using the reserve currency, and the export revenue generation is measured in terms of this currency (Bartholomew, 2010, p.25). The reserve currency serves as a domestic currency to the mother country, thus investments in such a country, like the USA, are valued in terms of the reserve currency.
The reserve currency is used as the global medium payment, and the major treasury bonds in the international community are issued in terms of the US dollar, since it is the world’s reserve currency. The IMF uses the reserve currency to determine the worth of the SDRs (Bartholomew, 2010, p.25). The SDRs are then used by this international body as a medium of exchange with various other countries. The reserve currency is used by the international community to stock the official share reserves in the world markets (Bartholomew, 2010, p.25). This is because the value of the reserve currency is controlled by the market forces. The US dollar is used largely as the currency reserve since it can be easily liquidated in the international markets (Bartholomew, 2010, p.25). The reserve currency is responsible for the adequate controlling of the currency markets, since its supply influences trading activities.
A reserve currency must be able to deal with large and complex trade activities. For example, the US dollar is the main medium of exchange in the oil transactions in the world (Murphy & Yuan, 2009, p. 3). The oil trade activities can heavily influence the world markets, since the industrial sectors in most countries depend on petroleum energy. Thus, the reserve currency prevents any currency frailties, since it helps trading partners to meet financial obligations (Whalen R & Whalen C, 2010, p.341). A reserve currency is held by world economies as the safest medium of exchange, especially in transnational trade relations (Bouchard & Koch, 2009, p.49). Trading blocks use the reserve currency to settle payments, and to invest in various sectors across the world.
Pegging model
Owing to the massive importance of determining the best reserve currency, economists have developed models that can be used to analyze foreign exchange rates. In the crawling and basket peg model, the government imposes a constant level of the currency value, so that the domestic currency is not affected by the global market changes. However, the government introduces an appropriate stochastic error, by which the currency may be allowed to be driven by the market forces (Moosa, 2008, p. 24). In the Chinese economy, the foreign exchange rates follow a pegged mechanism, whereby the stochastic error was introduced as 0.3 percent in 2005 by the government (Moosa, 2008, p. 24). Due to the rapid growth in China’s trade activities, studies on the peg model have proved to be vital. China has introduced a basket peg on its monetary systems, which means that it has pegged the price of the Yuan against a host of other major currencies in the world (Moosa, 2008, p. 24).
In the crawling peg model, the government establishes the relevant devaluations that are required for the currency to trade fairly in the monetary market (Moosa, 2008, p. 24). However, the devaluations are made such that they vary in time, according to the performance of the currency markets (Moosa, 2008, p. 24). In most cases, the crawling pegging fails and the economies largely use the basket pegging schemes. The foreign exchange rates are widely affected by the pegged currencies, since they are seen to be selective. For example, a country can impose harmful devaluations of its currency against another currency in order to disrupt trading activities in such countries. This is because the crawling pegs are usually designed to deal with a one currency, instead of a block of currencies (Moosa, 2008, p. 27). The base currency in a country that sets a pegging regime is often prone to criticism by the bilateral partner, since the government does not give a bigger room for the fluctuation of the currency depending on the international situations. However, this model can be used to promote bilateral trade to greater levels if it is fixed at the relevant valuation levels (Moosa, 2008, p. 27).
As Moosa write, the rate of the base currency against one anchor currency can be determined by the prevalent rates between the specific anchor currency and the rest of the group or basket (Moosa, 2008, p. 27). This is done by calculating the different weights given to each currency in the basket, so that the true value of the various currencies in the basket can be altered appropriately. Time series models are preferred in determining the forecasted rates in the currency rates, in order to improve the reliability of the peg models (Moosa, 2008, p. 27). The Chinese Yuan trades against a basket of eleven currencies, including the strong world currencies such as the US dollar and the pound (Moosa, 2008, p. 27). A country forms a peg system with the countries which are its large trade partners so as to attract fair trading relations. However, the relati...