PRESIDENT BARACK OBAMA, on his first visit to China this week, urged the government to allow its currency to rise. President Hu Jintao politely chose to ignore him. In recent weeks Jean-Claude Trichet, the president of the European Central Bank, and Dominique Strauss-Kahn, the managing director of the International Monetary Fund, have also called for a stronger yuan. But China will adjust its currency only when it sees fit, not in response to foreign pressure.
China allowed the yuan to rise by 21% against the dollar in the three years to July 2008, but since then it has more or less kept the rate fixed. As a result, the yuan's trade-weighted value has been dragged down this year by the sickly dollar, while many other currencies have soared. Since March the Brazilian real and the South Korean won have gained 42% and 36% respectively against the yuan, seriously eroding those countries' competitiveness.
Speculation about a change in China's currency policy increased in the week before Mr Obama's visit, after the People's Bank of China tweaked the usual wording in its quarterly monetary-policy report. It dropped a phrase about keeping the yuan "basically stable" and added that foreign-exchange policy would take into account "international capital flows and changes in major currencies". But exchange-rate policy is decided by the State Council, not the central bank. And many policymakers, notably in the Ministry of Commerce, do not favour a revaluation right now.
Indeed, Chinese officials have become bolder in standing up to America. "We don't think that it's good for the world economic recovery that you ask others to appreciate while you depreciate your own currency...It's also unfair," said a spokesman for the Ministry of Commerce on November 16th. The previous day Liu Mingkang, China's chief banking regulator, blasted America for its low interest rates and for the falling dollar, which, he suggested, might be encouraging a dollar carry trade and, in turn, global asset-price bubbles. He strangely ignored the fact that China's own overly lax monetary policy, partly the result of its fixed exchange rate, risks fuelling bubbles in its domestic property and equity markets.
Foreigners argue that a stronger yuan would not only help reduce global imbalances, such as America's trade deficit, but would also benefit China. It would help China regain control of its monetary policy. By pegging to the dollar, it is, in effect, importing America's monetary policy, which is too loose for China's fast-growing economy. A stronger yuan would also help rebalance China's economy, making it less dependent on exports, putting future growth on a more sustainable path.
If a stronger exchange rate is in China's own interest, why does it resist? Beijing rejects the accusation that its exchange-rate policy has given it an unfair advantage. It is true that other emerging-market currencies have risen sharply this year, but this ignores the full picture. Last year China held its currency steady against the dollar throughout the global financial crisis, while others tumbled. Since the start of 2008, the yuan has actually risen against every currency except the yen (see chart).
China also argues that it has done a lot to help global rebalancing. Thanks to its monetary and fiscal stimulus, domestic demand has contributed an remarkable 12 percentage points to GDP growth this year, while net exports subtracted almost four percentage points. Its current-account sur has fallen by almost half, to around 6% of GDP from 11% in 2007. Chinese policymakers accept that the yuan needs to appreciate over the longer term, but say now is the wrong time, because Chinese exports are still falling, by 14% over the past 12 months.
Another reason for hesitation is that the theory that revaluing the yuan will allow Beijing to tighten its monetary policy is too simplistic. China's experience since 2005 shows that a gradual rise encourages investors to bet on further appreciation; hot-money inflows then swell domestic liquidity. A large one-off increase might work, as it would stem expectations of a further rise. But the sort of increase required�perhaps 25%�is politically unacceptable because it would put many exporters out of business overnight.
Some Chinese economists warn that the benefits to America from yuan revaluation are much exaggerated. In particular, a stronger yuan would not significantly reduce America's trade deficit. There is little overlap between American and Chinese production, so American goods could not simply replace Chinese imports. Instead, consumers might end up paying more for imports from either China or other producers, such as Vietnam. This would be like imposing a tax on American consumers.
These arguments help explain why China is dragging its feet. Nevertheless, in the long run, a stronger yuan would benefit China's economy�and the world's�by helping shift growth from investment and exports towards consumption. It would boost consumers' purchasing power and squeeze corporate profits, which have accounted for most of the increase in China's excessive domestic saving in recent years. China will probably allow the yuan to start rising again early next year. This will not be the result of foreign lobbying�indeed, China is more likely to change its policy if foreign policymakers shut up. But by early next year China's exports should be growing again, its year-on-year GDP growth could be close to 10% and its inflation rate will have turned positive. The arguments in favour of revaluation will then loom much larger.
Though China has achieved remarkable developments in its economy, the stronger competition has caused in recent months the US governments to intensify their demands for an appreciation in the Chinese Yuan exchange rate. An appreciation, it is expected, would raise the cost of China's production exports, and would thus somewhat mitigate the threat that China poses to one of its major trading partners. China's official position on the issue, however, is that a stable currency rate is not just desirable for China, but for the world economy as well. Yet, from the perspective of China's rapidly expanding market, maintaining a stable currency rate in relation to a single currency such as the dollar will lead, in the long run, to the increase of the burden upon the real economy. A gradual appreciation of the currency, in other words, would be to China's benefit.
In terms of China's international revenue and expenditure, both its current balance and its capital balance have increased. While under normal circumstances, the flood of dollar-based investments would lead to a rise in the Yuan, because China has adopted a foreign currency intensive management system, the central bank is buying dollars and selling Yuan on a daily basis. As a result, the foreign currency reserves managed by the central bank are rapidly increasing.
The Exchange Rate (ER) of a currency is its external value, that is, its price expressed in other currencies.
Eg. 1 American Dollar = 6.82 Chinese Yuan or 1 Chinese Yuan = 0.146 American Dollars
The Exchange Rate of the Yuan is its price in other currencies: a price is determined by the demand for it and the supply of it. Demand for the Yuan is based on non-Chinese residents who wish to buy Chinese goods and services. Non-Chinese who wish to invest in Chinese assets and speculators who believe that the Yuan will rise. Seeing that the market for Chinese counterfeited products in the US is very popular and that "China's experience since 2005 shows that a gradual rise encourages investors to bet on further appreciation" demand for the Yuan will most likely increase.
The diagram above shows the effect of a rise in demand for Chinese goods and services abroad on the ER of the Yuan. From the graph, ER is raised to ER1. This raises the quantity from Q to Q1. This increase in demand has caused an increase in equilibrium quantity.
There are two types of exchange rate systems: floating or fixed. Floating ERs are allowed to find their own level without any intervention by the authorities. Manage flotation occurs when the currency flows but the authorities intervene as of when they decide that the ER has fallen/risen too far/too fast.
Afixed exchange rate, in this case called apegged exchange rate, is a type ofexchange rate regime wherein acurrency's value is matched to the value of another single currency. A fixed exchange rate is usually used to stabilize the value of a currency, against the currency it is pegged to. This makes trade and investments between the two countries easier and more predictable.
In extreme situations such as political unrest, terrorist attacks or natural disasters a country's currency may experience a period of heavy selling that causes it to depreciate in value. The country's central bank may intervene in order to restore the value of the currency. A central bank regime that routinely intervenes would use the term "managed float". Sometimes, the central bank may set upper and lower bounds known as price ceilings and floors, respectively, and intervene whenever those bounds are reached. Central banks influence the supply and demand of their country's currency through control of interest rates or though intervention actions.
A central bank can affect the demand for other countries currency as well. If the bank (Chinese Central Bank) feels that its reserve amount of a particular country's currency (Euro) is too low then it will engage in the foreign exchange market and buy that currency. This change in the composition of the Chinese Central Bank's reserves, will lead to an increase in demand of the Euro since it is being bought, and the Euro's appreciation.
 Is a term that encompasses the notion of individuals and firms striving for a greater share of a market to sell or buy goods and services.
 The increase or rise in the value of property, goods, services, etc.
 Are the foreign currency deposits and bonds held by central banks and monetary authorities.
 A floating exchange rate is one in which a currency's value is determined by market forces.
 A fixed exchange rate matches the value of the currency to: one currency, several currencies or even to a fixed amount of a commodity
Source: ChinaStones - http://china-stones.info/free-essays/business/yuan-sided-argument.php