“For the past 8 years, the Chinese yuan has maintained its fixed value against the US dollar. Of late, China has come under heavy pressure to revalue the yuan because the USA felt it was undervalued.” What factors might have contributed to the undervaluation of the yuan? [8 marks]

Chapter: Foreign exchange

Identify the contributing factors affecting the demand and supply of the Chinese Yuan currency, which will influence the value of the Yuan. By doing so, it will be more effective in assessing the possible reasons in explaining the under-valuation of the Yuan with respect to the American dollar.

   07 August 2018

economics tuition notes definition

The Chinese Yuan is considered to be undervalued as her exchange rate under the current fixed exchange is lower than the exchange rate if it is allowed to float under the flexible exchange rate system. To understand why the rate is undervalued, there is need to examine why there is a higher demand for the currency and the lower supply of the currency if it is not pegged under s fixed exchange rate.

One factor is the high export demand. high demand for export will increase the demand for Yuan and this will mean that the exchange rate is likely to be higher if it is allowed to float. It is probable that demand for export will increase, as the Chinese good is cheap as the Chinese firms’ cost of production is lower due to lower cost of labour cost and cheaper raw material. Furthermore, the importing countries’ income must be higher and this will induce them to purchase more Chinese goods.

The second factor is the rise in capital inflow. A rise in capital inflow will lead to an increase in demand for Yuan. The rise in capital for inflow is due to an influx of higher level of foreign direct investment as the expected rate of return on investment is higher in China. Rise in national income in China means a rising market with higher purchasing power and great eagerness to buy more consumer goods. With higher expected revenue and a lower cost of production, profitability will be higher, leading to a rise in influx of investment from other countries.

The third factor is lower import demand. A lower demand for import will mean that there will be a decrease in the supply of Yuan, leading to an appreciation of the exchange rate if is allowed to float under the flexible exchange rate system. China is likely to experience a lower import demand as she increases her utilization of her own resources in the country when the country accelerates the development of the inner part of the country. Besides this, as China’s product becomes cheaper and improves her quality, there will be greater import substitution leading to a fall in imports and rise in local production.

Finally, the fourth factor is lower level of capital outflow. A lower level of capital outflow will also lead to a reduction in supply of Yuan in the foreign exchange market, leading to an appreciation exchange rate if is allowed to float. China is likely not to have a high capital outflow as her investment to abroad is low due to greater profitable investment in the country, which is likely to discourage from investing abroad. Furthermore, lack of international exposure for international investment will undermine her willingness to invest abroad. Consequently, a low level of capital outflow will mean a low supply of money and a higher value of exchange rate.

In conclusion, the above factors explained why the exchange rate is higher than it will be under a fixed exchange rate system and thus explain why the exchange rate is undervalued.