Impact of China Fixing the USD / Cny Exchange Rate Term Paper

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Markets

USD/CNY Currency Exchange Relationship

The amount of money passing through a foreign exchange market was pegged at $4.0 trillion per day in April 2010 (Bank for International Settlements, 2010). Among the many currencies traded on the open market, the U.S. dollar (USD) continued to lead the pack by a wide margin; a full 84.9% of all trades involved the USD. By comparison, the Chinese currency (CNY) increased its share of the global FX market from 0.1 to 0.9% between April of 20004 and 2010. To better understand how trade with China impacts the exchange rate this essay will examine monetary policy for both countries.

USD/CNY Foreign Exchange Market

The sum of the current (CA) and capital (CAP) accounts will theoretically be zero if the exchange rate between two currencies is flexible (MacDonald, 2007, p. 7). Since M = R + D, where M. is the base money supply, R is the reserves (CA + CAP), and D. The domestic credit issued by the central bank, then a flexible exchange rate theoretically permits monetary policy to function independently of foreign currency exchange rates. This is the case in the United States, but not in China (ECR Research, 2014). The central bank of China, the People's Bank of China (PBoC), controls the value of the yuan (renminbi) by pegging it to the most commonly traded currency, the USD. This practice of pegging the exchange rate keeps the currency value low, thereby increasing attractiveness of Chinese goods and services internationally and providing stability for importers and exporters.

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A pegged CNY exchange rate, however, precludes PBoC from keeping CA and CAP independent of monetary policy (ECR Research, 2014). China has become a major economic force in the global economy, with a current account balance of 2.4% of GDP in 2014 (The World Bank, 2014). The bulk of this surplus is due to trade exports, although China continues to receive returns on foreign investments and income in the form of foreign aid. Since there continues to be a strong demand for Chinese goods and services, the amount of yuan exchanged for foreign currency remains high (ECR Research, 2014). This places a strong upward pressure on the value of the yuan, so the PBoC must purchase U.S. dollars and Treasuries to maintain a favorable exchange rate. This is problematic because the yield on these instruments is typically low and the amount of yuan being dumped on the open market increases the domestic money supply and inflationary pressures.

Figure 1

. USD/CNY balance of payments. Between 2005 and 2010 the USD/CNY exchange rate increased from about 0.124 to almost 0.147 dollars per yuan (Figure 1). This increase correlated with a sizeable increase in the volume of dollars flowing into the international currency markets (compare FX0 to FX1), due to U.S. consumers purchasing yuan to buy Chinese goods and services. The increased demand for yuan increased its value, so it cost more dollars….....

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