Reference no: EM132293750

One of the controversial economic issues in trade today is what is referred to as the Reminbi (RMB) peg. The currency of the People’s Republic of China (China) is called the RMB or the yuan. The value of the RMB was historically pegged to the U.S. dollar. The peg has been set at different levels over time, including three, five, and most recently, about eight to the dollar. It was this value no matter what the value of the dollar. That is, if you had a U.S. dollar, you knew that it was worth 8.28 RMB. However, as of late 2005 China pegged their currency to a wider variety of currencies including the euro and the Japanese yen. The U.S. dollar, since the start of the new millennium, has been in decline relative to other currencies. Thus, an American selling something in Europe in 2000 may have been able to sell its product for $100 in the U.S. but would have to sell that product for 110 euros in Europe to get the same money back. By 2008 that same $100 product in the U.S. would sell for approximately 65 euros. This has driven U.S. exports down as U.S. products have become much cheaper to customers in Europe. (Recognize that for a tourist from the U.S. who takes his or her dollars to Europe, the effect is just the opposite—foreign travel has become much more expensive.) However, relative to China, the $100 product in 2000 held approximately the same value until 2005. If a U.S. product sold for $100 in the U.S., it would have to sell for 828 RMB in both 2000 and 2005.

The difficulty from the U.S. government’s perspective is that most countries’ currencies are allowed to float against each other. Thus, countries with strong eco- nomic policies have currencies that increase in strength, but these countries sell less and other nations in turn seek to strengthen their own industries. It is a natural balancing among international traders. However, it is estimated that if the Chinese currency were allowed to freely float, it’s worth would be up to 40 percent higher and might move back to about five RMB for one U.S. dollar. The impact of a stronger RMB would make Chinese goods more expensive outside of China. Many government officials around the world think that as a result, the explosion of Chinese exports might slow down. Thus, in the U.S., there are laws now proposed to require the Chinese to allow the free float of their currency or penalties will be imposed on their exports to the U.S. In 2008, the U.S. dollar was worth 6.87 RMB—a 17 percent decline in the value of the RMB relative to the U.S. dollar. The result has been to make the U.S. products cheaper in China and Chinese goods costlier in the U.S. However, the trade deficit with China has not changed dramatically in the U.S. In the future, it is likely that China will allow the currency to freely float. While allowing the currency of China to be more realistically valued is good for international trade, it will not affect the U.S. trade deficit significantly. The U.S. has one of the lowest savings rates and highest levels of deficit spending in the industrialized world. These factors have a far greater effect on the U.S. trade deficit than does the RMB’s value. The debate on whether the solution to the U.S. trade deficit is to be found through higher taxes or lower spending is not the goal here. However, it is clear that the excessive levels of deficit spending are not sustainable. The U.S. national debt has also doubled since the start of the new millennium and will have a significant impact on U.S. economic policy and international relations with its trading partners in the coming years. Students should realize that while a low value of the U.S. dollar may sound like a cure-all for the international trade difficulties of a nation, it is a short term and costly solution. The value of a nation’s currency decreases when other nations do not believe the government’s economic program is sufficient. A nation’s currency valuation can be conceptualized similar to a stock’s value. A stock represents what the public considers the value of the company. The currency exchange rate is the evaluation of the world as to the value a nation can produce and its economic management skills. Thus, it is not a vote of confidence in the international market when a country’s currency continues to fall.

1. In approximate terms, what do you think will be the exchange rate between the U.S. dollar and the Chinese RMB?

2. What would be the best strategy for a large multinational when faced with vast swings in the value of the U.S. dollar?

3. Why do politicians talk so positively about the dollar’s decreasing value?

4. What is the long-term outlook for the U.S. dollar?