Yen for Yuan China Is Case Study

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One could expect a dollar depreciation of 2.5%. Because the 25% appreciation in the yuan represents the amount it is currently undervalued against the dollar, one can expect a significant drop in the demand for China's goods. However, the appetite for foreign goods in general will still be strong as the U.S. turns to China's competitors such as Europe, South Korea and Japan.

China relies on a fixed exchange rate rather than letting market forces invoke needed exchange rate adjustments. To maintain its fixed exchange rate, the Bank of China has had to issue more yuan to buy up dollars that are flowing into the country. This has meant a dramatic increase in China's money supply which as risen from 19.6% in 2003 to 14.6% in 2004. As a result, inflation has now displaced deflation as the main economic policy concern with the government worrying about the outfall of the asset bubbles inflation has created, particularly since banks already have $500 billion in nonperforming loans from state companies and property developers.

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As a solution, China might consider some yuan appreciation or develop policies to encourage capital outflows that would decrease pressures for expanding the money supply to buy up dollars.

Yes, undervalued currency does come at a cost. Chinese consumers have to pay higher prices for foreign goods and consumers. It is more difficult for Chinese businesses and investors to expand into foreign markets. and, Chinese tourists have to pay more when they are traveling abroad.

The percentage gain to a dollar investor would be 65.6% as shown by the following calculations:

China currently has its exchange rate at 8.28 yuan to the dollar. The value of the yuan increases from $0.1208 (1/8.28) to $0.20 (1/5).

Thus, the increase in the dollar value is (0.20-0.1208) / 0.1208 which equals 65.6%.

Relaxing currency controls and restraints on capital outflows would increase capital outflows and increase the demand for foreign currency. These factors should, in turn, decrease the pressure on the yuan to revalue. Further, the yuan might actually experience depreciation if.....

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