On April 6, 2005, the U.S. Senate voted 67 to 33 to impose a 27.5% tariff on all Chinese

products entering the United States if Beijing did not agree to revalue the yuan by a like amount.

Almost two years earlier, on September 2, 2003, U.S. Treasury Secretary John Snow had traveled

to Beijing to lobby his Chinese counterparts to revalue what was then and still is widely regarded

as an undervalued yuan.

In the eyes of U.S. manufacturers and labor unions, a cheap yuan gives China's exports an

unfair price advantage over competing American products in the world market and is part of a

mercantilist strategy designed to favor Chinese industry at the expense of foreign competitors. A

consequence of this strategy is an accelerating movement of manufacturing jobs to China. One

piece of evidence of this problem was the widening U.S. trade deficit with China, which reached

$162 billion in 2004 (on about $200 billion in total imports from China). Similarly, Japan, South

Korea, and many European and other nations were pushing for China to abandon its fixed exchange

rate because a weak U.S. dollar, which automatically lowered the yuan against other currencies,

was making already inexpensive Chinese goods unfairly cheap on global markets, hurting their

own exports.

China rejected calls for it to revalue its currency and said it would maintain the stability of

the yuan. Since 1998, China has fixed its exchange rate at 8.28 yuan to the dollar. During 2004,

the dollar depreciated significantly against the euro, giving Chinese companies a competitive

advantage against European manufacturers. A massive rise in China's foreign exchange reserves

(reserves rose 47% in 2004, to reach $609.9 billion by the end of the year) is evidence that the

Chinese government had been holding its currency down artificially. Politicians and

businesspeople in the United States and elsewhere have been calling for the yuan to be revalued,

which it almost certainly would in a free market. (Economists estimated that in 2005 the yuan was

undervalued by 20% to 30% against the dollar.)

The Chinese government has resisted the clamor for yuan revaluation because of the

serious problems it faces. As the country becomes more market oriented, its money-losing stateowned

enterprises must lay off millions of workers. Only flourishing businesses can absorb this

surplus labor. The Chinese government is concerned that allowing the yuan to appreciate would

stifle the competitiveness of its exports, hurt farmers by making agricultural imports cheaper, and

imperil the country's fragile banking system, resulting in millions of unemployed and disgruntled

Chinese wandering the countryside and threatening the stability of its regime. It also justified a

weak yuan as a means of fighting the threat of deflation.

Nonetheless, keeping China's currency peg is not risk free. Foreign currency inflows are

rising as investors, many of whom are ordinary Chinese bringing overseas capital back home, bet

that China will be forced to revalue its yuan. They are betting on the yuan by purchasing Chinese

stocks, real estate, and treasury bonds. To maintain its fixed exchange rate, the People's Bank of

China (PBOC) must sell yuan to buy up all these foreign currency inflows. This intervention boosts

China's foreign exchange reserves but at the expense of a surging yuan money supply, which rose

19.6% in 2003 and 14.6% in 2004. For a time, a rising domestic money supply seemed an

appropriate response to an economy that appeared to be on the verge of deflation. More recently,

however, rapid money supply growth has threatened inflation and led to roaring asset prices,

leading to fears of a speculative bubble in real estate and excessive bank lending. The latter is

particularly problematic as Chinese banks are estimated to already have at least $500 billion in

nonperforming loans to bankrupt state companies and unprofitable property developers.

Another risk in pursuing a cheap currency policy is the possibility of stirring protectionist

measures in its trading partners. For example, ailing U.S. textile makers lobbied the Bush

administration for emergency quotas on Chinese textiles imports, while other manufacturers

sought trade sanctions if Beijing would not allow the yuan to rise. Similarly, European government

officials have spoken of retaliatory trade measures to force a revalued yuan.

Requirements: Answer the following questions.

1. The Chinese Yuan is kept depreciated deliberately against US$. What is the benefit for

Chinese economy in doing so? Support your argument with logical answers.

2. How such a policy may hurt the US economy?

3. As mentioned in the case that US government imposed higher tariffs on the Chinese products

condition to the re-valuation of her currency. With such tariff policy, will the consumers be

better off?

4. If Yuan gains its value by around 25%, considering the fact that out of total imports of US,

Chinese imports are around 10%, by how much the US$ will lose its value? Will such

appreciation benefit the US consumers or Chinese exporters?

5. Describe the direct or indirect government intervention methods, if any, used by Chinese

government to keep Yuan at undervalued level. And will there be any additional cost burden

on economy due to any such interventions?

6. China has very strict capital outflows and tight laws on currency conversions. As a Chinese it

is very difficult to convert Yuan to any FX and invest it abroad. The conversions takes place

only at government designated centers where you must justify the reason of converting Yuan

to any FX. Imagine the government of China eases such restriction, what will be your

speculative position on Chinese Yuan (will Yuan appreciate or depreciate) and will you buy

or sell Yuan in forward market? Justify.