Question one.

Case assignments must be completed with a written 2-page study on the assigned case questions in the textbook. The format requested for these assignments is based on elaborating and including two basic parts in the essay: 1) in a bullet presentation style (one phrase each bullet), list a summary of the key issues, situations, problems, opportunities and threats you may identify as relevant; 2) answer all the questions listed in each case in two or three sound paragraphs. Use the APA style for these assignments.

Do Yuan to Buy some Renminbi?

On November 30, 2015, the International Monetary Fund announced that the Chinese yuan, also known as the renminbi (RMB or "people's currency"), would finally join the U.S. dollar, the euro, the British pound, and the yen in the basket of reserve currencies also known as SDRs or Special Drawing Rights. Although this will not become effective until October 2016, the recognition of the yuan is due to China's increasing dominance in the global economy and its moves in recent years to liberalize its financial markets. However, what does all of this mean to China and the rest of the world, and will China continue down the road to the liberalization of its currency and other financial markets?

In the currency markets, the sign for the yuan is (the same symbol used for the Japanese yen) and the code is CNY. On January 7, 1994, the Chinese government, after debating what to do with its currency, decided to fix the value to the U.S. dollar at a rate of 8.690 per dollar.25 This was easy to do, given that currency trading was controlled by the Chinese government and not allowed offshore. In 2004, Hong Kong residents were allowed to exchange local Hong Kong dollars for yuan in a first move to allow some limited trading offshore. By early 2005, the yuan was trading at a fixed rate of 8.2665 per dollar. But pressure began to build in 2005 as both the European Union and the United States faced strong competition from imports from China as well as from Chinese exports to developing markets. When China fixed the value of its currency in 1994, the country was not considered a major economic powerhouse. Then things began to change. By 1999, China was the largest country in the world in population, and in 2003 it was the seventh-largest in the world in GNI, exceeded only by the United States, Japan, Germany, the United Kingdom, France, and Italy. It was also growing faster than any of the top six countries. In the decade of the 1990s, China grew by an annual average of 9.5 percent and was above 8 percent every year in the first half of the 2000s. Because of China's low manufacturing wages, it was exporting far more to the United States than it was importing. In 2004, it had a trade surplus of $155 billion with the United States, compared with a surplus of only $86 billion with the EU. However, between 2002 and 2004, China's surplus with the EU doubled, while growing by a little over one-half with the United States. Also during that time, there were capital controls on the flow of yuan in and out of China, so there was a tremendous inflow of yuan into the banking sector in China with no real way to move the money offshore. That meant that banks could lend money at very low-interest rates, fueling a real estate boom. Also, China had to do something with its building reserves. Initially it invested huge sums of money in U.S. treasury bills, helping to fund the growing U.S. budget deficit. Then it began encouraging foreign direct investment, especially in natural resources around the world. However, the competitive pressure of China in Asia was not the same. Because most Asian currencies were also locked onto the dollar, the yuan traded in a narrow range against those currencies. Most of the Asian countries were using China as a new market for their products, and they were not anxious to have anything upset the Chinese economy and reduce demand for their products. Critics from the United States and EU argued that the yuan was undervalued by 15 to 40 percent and the Chinese government needed to free the currency and allow it to seek a market level. The pressures for and against change were both political and economic. The U.S. government had been working with the Chinese for an extended period of time to get them to revalue their currency, but the Chinese government had found plenty of excuses not to do that.

China had its own political pressures. For one thing, a lot of people had been moving currency there in anticipation of a revaluation of the yuan, which was creating inflationary pressures. The Chinese government was forced to buy the dollars and issue yuan-denominated bonds as a way of "sterilizing" the currencytaking it off the market to reduce the pressures. The government was not very excited about revaluing the yuan and rewarding the speculators, so it kept saying it would not announce if, when, or how much the revaluation would be. It also did not want to revalue under pressure from foreign governments lest it appear to be bowing under pressure from abroad. Finally, China has serious problems with employment. Even though its billion-plus population grows at only 1 percent annually, it adds the equivalent of a new country the size of Ecuador or Guatemala every year. China needs to add enough jobs to keep up with its population growth and displaced workers from its agricultural sector and state-owned firms. That means adding 15 to 20 million new jobs per year, or about 1.25 million per month.

Given these pressures, China took a historic step on July 21, 2005, and de-linked the yuan from its decade-old peg to the U.S. dollar in favor of a currency basket. Although the dollar has been the dominant currency in determining the value of the yuan, there are periods of time when some Asian currencies have also shown themselves to be influential. So the currency basket was largely denominated by the dollar, the euro, the yen, and the South Korean won currencies that were selected because of their impact on China's foreign trade, investment, and foreign debt. Even when the basket grew to 11 currencies, these 4 dominated. The People's Bank of China (PBOC, the country's central bank) decides a central parity rate daily and then allows a trading band on either side of the decision point. The move to the currency basket increased the yuan-to-dollar rate by 2.1 percent. Before the peg was de-linked, the yuan was kept around 8.2665; immediately afterward, it rose to 8.1011, an increase of 2 percent. The PBOC responded to the pressures by the international community to strengthen the yuan by widening the trading band on May 18, 2007, from 0.3 percent to 0.5 percent on either side of the fixed rate. Obviously, that small difference allowed little room for traders.

Until the yuan began its ascent against the U.S. dollar, it was very easy to deal in foreign exchange in China because the rate was fixed against the dollar. It doesn't take a lot of judgment for a trader to operate in a fixed-rate world. The exchange rate is managed by the State Administration of Foreign Exchange (SAFE), which is closely linked to the PBOC. SAFE is responsible for establishing the new foreign-exchange trading guidelines as well as for managing China's foreign-exchange reserves. A major concern of the PBOC is that China's financial infrastructure might be capable of trading foreign exchange in a free market. SAFE was moving to change that. When the PBOC made the decision to loosen up the value of the yuan in 2005, it opted to allow banks in Shanghai to trade and quote prices in eight currency pairs, including the dollar-sterling and Euroyen. Prior to that, licensed banks were only allowed to trade the yuan against four currencies: the U.S. dollar, the Hong Kong dollar, the euro, and the yen. Shanghai was being positioned as the financial center of China, hopefully by 2020. However, all the trades were at fixed rates, and they did not involve trades in non-yuan currency pairs. SAFE also decided to open up trading to seven international banks (HSBC, Citigroup, Deutsche Bank, ABN AMRO, ING, Royal Bank of Scotland, and Bank of Montreal) and two domestic banks (Bank of China and CITIC Industrial Bank).

However, the global financial crisis forced the Chinese government to return the yuan to a peg against the U.S. dollar from July 2008 until June 2010, during which time the United States and China were embroiled in a war of words over the value of the currency. The United States wanted the Chinese to allow their currency to continue to rise to help solve the trade imbalance, and the Chinese wanted the United States to get its economy under control and stabilize the value of the dollar, which had been falling in value against most other currencies. China was even calling for the creation of a new reserve asset to take the place of the dollar in the global economy. Why was China so worried about the dollar's value? Because of most of its reservesthe largest in the world at more than $3 trillion, fed largely by its huge trade surplus are in U.S. dollars. The last thing China wanted was to have all of its dollar reserves losing value in the global economy.

By the end of 2010, not only had China replaced Japan as the second-largest country in the world in terms of GDP, it was closing fast on the United States. In addition, China surpassed Germany and the United States as the largest exporter in the world, which meant that it was continuing to generate large foreign-exchange assets that were exposed to losses in value as the dollar fell against other world currencies. China, however, had its own set of problems, irrespective of what was going on in the West. When it decided to let the yuan gradually rise against the dollar in June 2010, the result was a 3.6 percent rise in the yuan's value against the dollar by the end of 2010. However, inflation was rising in China faster than in the United States, so Chinese exports were becoming increasingly expensive. The rise in the currency compounded the loss in competitive position brought on by the rise in inflation. Powerful Chinese exporters were very upset with the idea that the government might free up the currency and speed up their competitive challenges. Because of inflation, Chinese workers were increasingly unhappy with their working conditions, and they began to demonstrate, sometimes violently. As workers pushed for higher wages, manufacturers faced even greater cost pressures. With general inflation, higher wages, and the possibility of an even more expensive yuan, manufacturers were being forced to move further inland to find cheaper labor or even move abroad. Many U.S. manufacturers began moving to manufacture back to the United States or to cheaper Asian countries.

In the meantime, the PBOC announced in 2009 that it was going to allow companies in Shanghai and four other major cities to settle foreign trade in yuan instead of dollars. If Chinese companies can get more exporters and importers to settle their obligations in yuan instead of dollars, they can save a lot of transaction fees and the yuan will gradually increase in importance. Even though China wants to make Shanghai its future financial center, a lot of yuan transactions occur in Hong Kong. For a while, it was the only place outside of mainland China allowed to set up yuan bank accounts. Hong Kong is China's testing ground for the liberalization of currency trading. However, Singapore is also being considered as a place for yuan transactions, and it also trades about the same as Hong Kong in foreign exchange. The PBOC permitted HSBC and the Bank of East Asia to issue yuan-denominated bonds in Hong Kong in 2007, allowing Hong Kong to increase in importance as an offshore financial center for yuan trading. As banks and companies issue bonds and securities in yuan, the amount of yuan in circulation outside China will steadily grow. In October 2010, ICAP PLC and Thomson Reuters began to trade yuan on their electronic-trading platforms and announced that they were working with banks in the United States and Europe to use their platforms to trade yuan. Before this, banks in Hong Kong were trading yuan with each other OTC or through brokers. The use of the electronic platform promises to increase transparency and traffic. In spite of these moves, the onshore market in mainland China still dwarfs the offshore trading, and the fixed exchange rate set by SAFE will be the most important rate. The onshore market in mainland China is far more tightly controlled. Even though major money center banks such as HSBC are allowed to trade currency in China, their volume dwarfs that of the large Chinese banks. As those banks gain greater expertise in global trades, they will become even more significant outside of China. And as China and Singapore explore the possibility of Singapore joining Hong Kong as another location for yuan trades, the international banks will ramp up their yuan trading competencies in both locations. As capital controls in China are loosened, the international banks will also have to ramp up their presence there to compete with the huge Chinese banks that are now starting to get involved in the global foreign-exchange trading game.

Questions

9-3. Why is it important for the Chinese yuan to become a major world currency? What are the risks for China?

9-4. What role do foreign banks like HSBC and electronic platforms like Thomson Reuters and ICAP play in helping the yuan move closer to becoming a global currency?

9-5. Why is the yuan being used more widely in global business transactions? Do you think it will ever replace the dollar or the euro? Why or why not?