Question

According to some U.S. Treasury officials, China’s currency, yuan, is considered significantly undervalued. Assuming it is true, explain what Chinese government needs to do in order to maintain their currently undervalued official exchange rate. Also, explain the effect of keeping yuan undervalued on the Chinese money supply and inflation.

Answer 1

U.S. Treasury officials accused Chinese government on undervaluing the yuan to make its exports more attractive and artificially gain the competitiveness. In China the People's Bank of China until mid-2005 established the fixed exchange rate among the currency and the dollar, at 8.28 yuan per dollar. The yuan is not traded freely and regulation by government limits currency movement against the US dollar. The PBOC unlike other central banks is not independent and when big transactions occur it faces claims of interference. The central bank of China pushed its yuan to its lowest rate against the US dollar in to deal with easing growth for supporting the market-reforms

A weaker Chinese currency makes it's exports more cheaper or competitive to buy with foreign currencies. From the perspective of some U.S. Treasury officials it was an attempt to offset the impact of higher tariffs on imports from China coming into U.S. The weaker Chinese currency will make imports into China more costly, potentially increasing the inflation; and leading to strains in a slowing economy and pushing holders of yuan to invest in other assets. The undervalued currency faces the risk of capital flight with citizens transferring wealth overseas for providing a protection on the real value of their saving. Furthermore lack of supply would put upward pressure on relative prices, reversing the real depreciation over time that pushes back the economy to its original point