In this essay I am going to talk about floating and fixed exchange rates and then state why Chinas unadjusted Yuan threatens western industries. The US are having a floating exchange rate, this means that the central bank has a reduced need for holding large reserves of gold and foreign currency to use for intervening in the markets, as there is no exchange rate target. According to economists, floating-exchange rates can be a useful instrument of macroeconomic adjustment, as depreciation will most likely provide a strong increase in national export demand and therefore stimulate growth.
This is why many economies inside the Euro Zone may now be in suspense of a more competitive exchange rate in order to create an injection of demand into their slow-growing economies.
Furthermore floating exchange rates provide a certain level of adjustment when the balance of payments is in a strong disequilibrium, as a large trade deficit puts pressure on the exchange rate, which aids national export and should help controlling the demand for imports as they become relatively expensive.
Also the risk of currency speculation is reduced as speculators often target an exchange rate which they suppose to be strongly over-or-undervalued.
Moreover short term interest rates cannot be set in order to help stabilising growth or controlling inflation if an exchange rate target exists.
However, a fixed exchange rate, like China's, can help to encourage trade and investment due to a lower currency risk.
Furthermore businesses, within a state that has a fixed exchange rate, have to spend less on currency "hedging" if they know that the currency will hold its value in the foreign exchange markets. Firms from the US for example (floating exchange rate) need to buy the currency they need in the forward currency markets, as one can never predict what will happen to the market value of a currency. This so-called "hedging" involves risk.
Why is it problematic for western economies if China has a fixed exchange rate?
This becomes quite clear, if one has a look at the issue stated in the article. China has a tremendous trade surplus with the US and has also fixed its exchange rate against the US dollar.
In the past the exchange rate between the Chinese currency and the dollar has been in place for several years, however, most estimates already indicated that the Yuan is undervalued against the dollar.
This made Chinese products and services cheaper than they would have normally been and has therefore caused a rush in import penetration from China into the economy of the United States.
This has led to an outcry by US firms as they wanted the Chinese to switch to a floating exchange rate or at least to adjust the Yuan by appreciating against the dollar.
What can be done about it?
The fixed exchange rate of course benefited China's economy. However, a sudden adjustment of the Yuan against the dollar would mean, that Chinese products would rapidly lose economic attractiveness as they would become more expensive.
This would result in a higher unemployment rate, as firms would need to fire workers. Furthermore the Chinese dollar-reserves would lose value.
The US could threaten the Chinese government by retaliation. This means, that they could put tariffs on certain Chinese goods or impose quotas.
Tariffs:
As one can see the US could produce QE amount of a certain good at PE-price without foreign-import interference. However this product is sold at Pc-price by Chinese firms. Therefore US-firms could only sell 0 to Q1 and Chinese firms sold Q1 to Q2. The US could therefore impose a tariff on this imported good, so that domestic producers would sell 0 to Q3 and Chinese producers would sell Q3 to Q4. The blue area represents the revenue the government makes with the imposed tariff.
Quotas:
As one can see the US could produce QE amount of a certain good at PE-price without foreign-import interference. However this product is sold at Pc-price by Chinese firms. Therefore US-firms could only sell 0 to Q1 and Chinese firms sold Q1 to Q2. The US could therefore impose a quota of Q1 to Q3, this will cause an excess in demand of Q3 to Q2 and the price will probably rise to Pc + Q. At this price Q4 of the product is supplied, where domestic producers supply 0 to Q3 and Chinese producers supply Q3 to Q4.
I personally think that China should adjust its currency to the dollar little by little, as the feared consequences - being a drop in national export - then would be evened. Therefore a certain western understanding will be necessary if this issue should be solved without vast diplomatic conflicts. On the other-hand there will be no other option besides retaliation if China continues to be stubborn, as this inequity must not continue much longer.
