The document discusses China's yuan exchange rate and bilateral trade with the US and Japan from 2002-2007. It notes that China's exports grew rapidly during this period, especially to the US, leading the US to pressure China to revalue its currency. In 2005, China moved to a managed float of the yuan based on a basket of currencies and revalued it by around 20% against the dollar by 2007. The revaluation reduced China's exports to the US but did not significantly impact exports to Japan. The document examines the two-way relationship between bilateral trade and exchange rates using economic models and China's trade data.

1. A CASE STUDY
ON
THE CHINESE YUAN: BE CAREFUL OF THE DRAGON’S TAIL
SUBMITTED TO:
PROF. DR. MAYUR SHAH
PREPARED BY:
JITENDRA DARJI (117680592014)
ANKUR AGRAWAL (117680592017)
RAMAKANT SONI (117680592018)
PUNIT SHAH (117680592030)
CHINMAY ACHARYA (117680592032)

2. Introduction1
After China acceded to the WTO in 2001, China’s exports increased dramatically.
Theannual export growth rate was 20.1% during 2002-2007. China’s exports to Japan
andthe United States, the two largest trading economies in the world, also grew very
quickly.
Specially, China’s exports to the U.S. increased from US$53.2 billion to $232.7 billion,a
29.5% annual growth rate during this period. By way of comparison, China’s exports
toJapan increased from US$48.4 billion to $102.0 billion, a 14.9% annual growth rate
duringthis period.
Simultaneously, the exchange rate of Chinese Yuan (RMB) against U.S. dollarchanged
by around 20% during this period due to revaluation.
The RMB’s revaluation against U.S. dollar in 2005, the proportion of China’s exports
tothe U.S. compared with China’s overall export volume followed a downward trend
whereasthat of China’s exports to Japan continued to decrease. It is therefore interesting
to askwhether the revaluation of the RMB is reduced bilateral trade among China,Japan
and the U.S.

3. The increase in RMB valuation against the U.S.dollar resulted in more expensiveChinese
exports to the U.S., which in turn decreased China’s exports to the U.S.However, there is
a more fundamental mechanism underlyingthis conventional wisdom: the bilateral
exchange rate is not exogenous itself.
SurgingChinese exports could result in strong pressure to protect markets raised by the
import-competing special interest groups in the importing country. Accordingly, the
governmentin the importing country would push the exporting country to revalue its
exchange rate.Put another way, exports have a reverse causality on bilateral exchange
rates. Ignoringthis fact may make estimation results imprecise.
Previous studies have paid little attention to this two-way causality. Most only
mentionone of the two causal connections. Some works focus on the impact of the
bilateralexchange rate on bilateral trade, especially through the pass-through effect of
theexchangerate (Goldberg and Knetter, 1997)

4. When the nominal bilateral exchange rate is changed,it has a pass-through effect on the
price of the imports, which in turn would affect bilateraltrade.
Previous studies likeFeenstra (1989) find empirical evidence that the effect of thebilateral
exchange rate on bilateral trade is like that of a tariff. Bergin and Feenstra (2008)also
explored how a change in the share of U.S. imports from a country with a fixedexchange
rate like China could affect the pass-through of the exchange rate to importprices in the
U.S.
On the other hand, a variety of papers consider the determinants of thebilateral
exchangerate (Meese and Rose, 1991). Bilateral trade, among others, is one of themost
importantdeterminants. As mentioned above, in considering the endogenous
nexusbetween these two variables, studies on a one-way causality would lead to
simultaneousbias.
It is understood that an identical change of exchange rate could have different effects
onindustry-specific bilateral exports.
The economic rationale is as follows. Some industriesin China (e.g., manufacture of
special purpose machinery) may have higher productivityand hence enjoy a larger profit
margin when they access to the foreign markets. WhenRMB appreciates, such industries
can still earn positive profits.
In contrast, some otherindustries (e.g., manufacture of apparel, footwear & caps) only
have slight profit margins when they entry to the export markets (Yu, 2008). Many firms
within such industrieswould die and exit from the export market (Melitz, 2003).
Therefore, an identical revaluation of RMB would induce different effects on bilateral
exports across industries. Inspiredby the theoreticalindustry-specific gravity model
presented in Yu (2009), I am able touse the gravity model to capture the effect of bilateral
exchange rate on industry-specificbilateral trade.
Therefore the bidirectional causality between the bilateral exchange rate andbilateral
trade using data from China, Japan and the U.S. during the period 2002-2007. First
estimation equation in the system is the bilateral export equation. Since thegravity model
is successful in explaining the growing trade volume since World War II(Feenstra, 2003),
The revaluation of the RMB against the U.S. dollar reduces China’sexports to the United
State whereas there is no significant impact on China’s exports toJapan. Simultaneously,
the effect of exports on the bilateral exchange rate is insignificantfor both the Sino-U.S.
and the Sino-Japan case
China’s Exchange Rate and Trade
According to China’s Statistical Yearbook (2008), the bilateral trade between China
andJapan increased dramatically since 2002. After China acceded to the WTO in
2001,the bilateral trade volume (i.e., exports plus imports) between China and Japan
reachedUS$101.9 billion, with a 16.1% annual growth. Japan was China’s largest

5. trading partnerin 2002: the bilateral trade volume accounted for 16.5% of China’s overall
trade volume,which was higher than 12.9% with the U.S.
Since then, the average growth rate of Sino-Japanese bilateral trade has been about 25%.
In 2006, bilateral trade between Chinaand Japan reached US$207.4 billion, which
accounted for 11.7% of China’s overall tradevolume. This volume is smaller than the
Sino-U.S. trade volume, worth US$262.7 billion,making Japan China’s second largest
trading partner in the world since 2004.
In the overall whole trade volume, Japan has maintained a modest trade surplus
withChina in the new century. The bilateral trade imbalance was US$5 billion in 2002.
Chinathen became Japan’s largest source for imports for a share of 18.3% of Japan’s
total importvolume, which is higher than 17.1% from the U.S. The imbalance gap has
widened over4 times.
In 2006, China had a trade deficit with Japan worth US$24 billion, which accountedfor
around 12% of the overall bilateral trade volume.
According to reports by China’s General Administration of Customs and the Department
of Commerce in the U.S., Sino-U.S. bilateral trade also increased rapidly after
Chinaacceded to the WTO.
Simultaneously, China maintained a huge bilateral trade surpluswith the U.S. In 2004, the
bilateral trade was worth US$161 billion. More importantly,the Multi-Fiber Agreements,
which set an upper bound for textile exports from China tothe U.S. in the Uruguay round
of the GATT, were automatically terminated in January2005.
Accordingly, China’s textile exports to the U.S. increased dramatically soon afterthat. In
2005, the trade imbalance gap widened to around US$200 billion. Due in partto
appreciation of the RMB China’s bilateral trade surplus with the U.S. reduced
fromUS$232 billion in 2006 to US$213 billion in 2007. In 2008, the Sino-U.S. trade
volume didnot increase by very much because of the stronger RMB and the shrinking
demand in theUnited States caused by the financial crisis. However, China still
maintained a US$170billion trade surplus with the United States, accounting for 57.8
percent of China’s totaltrade surplus.
Due to the surge in the Sino-U.S. bilateral trade, special interest groups, such as
laborunions, in the United States appealed to the U.S. government by arguing that
Chinahad manipulated its currency at an unreasonable level. They argued that China had
aserious real exchange rate misalignment such that China could maintain a huge
bilateraltrade surplus.
In response to the demand by special interest groups, the U.S. congressthreatened to
impose trade sanctions on China if China did not "voluntarily" restrain itsexports to the
U.S., or revalue the RMB. To avoid a possible trade war, China adjustedits fixed
exchange rate against the U.S. dollar, which had been adopted for one decade.
In July 2005, the RMB against the dollar was revalued by 2%. It was no longer
solelypegged to U.S. dollar but it was pegged a basket of currencies including, among
others,the U.S. dollar and the Japanese Yen. Since then, the RMB was continuously
revalued.
In the next three years, the RMB against the dollar was revalued by around 20% from
8.3to 6.8 RMB per dollar.

6. Review of Related Theory
This section species the bilateral trade equation, the exchange rate equation, and thesimultaneous
bilateral export and exchange rate equations.
The Determinants of Bilateral Trade
Feenstra (2003) highlighted three reasons that explain the growing bilateral trade
sinceWorld War II: growing GDP, declining transportation costs, and trade liberalization.
Thegravity model is expected to be the only successful model to explain the growing
tradevolume.
It is easy to understand that the GDP growth of two trading partners plays a significant
role in determining their bilateral trade. The gravity model suggests that largercountries

7. trade more since they produce more commodities.1 Also, two countries trade1Though not
inspired by theoretical literature, it may be worthwhile to include trading
partners.GDPper capita in the gravity equation (Carrère, 2006).more if the sizes of their
economies are similar (Helpman, 1987).
Later, Anderson andvan Wincoop (2003) provided a solid theoretical micro-foundation
for the typical gravitymodel by carefully introducing the "multilateral trade resistance"
term, which specifiesthe implicit price indices in the gravity equation.
Traditional wisdom suggests that international trade agreements foster internationaltrade.
After a 15-year long march, China successfully acceded to the World Trade Organization
(WTO) as its 143rd member in 2001. The impact of WTO accession on theChinese
economy has been substantial. Some researchers like Woo (2001) argued thatWTO
accession was a key component to reconstruct the Chinese economy. At the veryleast, the
accession to WTO helped China enjoy a larger foreign market, which in turnfostered
exports.
Besides multilateral trade agreements, trade liberalization, such as tariff reductionand
non-tariff barriers, is important to bilateral trade growth. Shortly after it began
itseconomic reforms, China set up a whole system of tariffs in the 1980s. After the
Uruguay
Round of the WTO, China experienced huge tariff reductions due, in large part, to
itseagerness for WTO accession. China cut its tariffs from 35% in 1994 to around 17%
in1997. In 2001, China further cut its average tariff rate from 16.4% to 15.3%.Equally
importantly, the bilateral exchange rate plays another key role in bilateraltrade.
Previous studies like Feenstra (1989) argued that there is a symmetric responseof import
prices to changes in an import tariffs and the bilateral exchange rates. Thishypothesis is
supported by Japanese and the U.S. industrial data.
The economic rationalefor the effect of the exchange rate on bilateral trade seems
straightforward. A change in thenominal bilateral exchange rate has a pass-through effect
on import prices. Accordingly,both of these changes affect the bilateral trade. Put another
way, an appreciation in the real exchange rate, which is defined as an increase in the
relative price of tradable tonon-tradable goods, would lead to a decrease in bilateral trade.
The effect of movements in China’s exchangerate on its bilateral trade with two other
giants: Japan and the U.S.was sufficient enough to describe the main economical scenario
of China.
The Determinants of the Exchange Rate
As summarized by Meese and Rose (1991), there are five models to explain the
determinants of nominal exchange rates:
o a flexible-price monetary model
o two sticky-price models
o two Lucas-type (1982) models
In all of these models, the bilateral spot exchange rateis determined, at least, by both-
o The nominal domestic (i.e., China) money supply relative to foreign money
supply.
o Domestic industrial production relative tothe foreign industrial production.
These common variables gain special theoretical support in Lucas’s (1982) model of a
two-good, two-country, pure exchange economy.

8. Shortlyafter that, Hodrick (1988) extended Lucas’s (1982) and Svensson’s (1985)models
the inclusion of various bilateral geographic variables did not change estimation results
since suchvariables will be dropped automatically in the two-way fixed-effects
estimations.
To include the change in the relative money growth rate in the model to capture
thetimingof money market transactions the other three models have different extensions
to the benchmark setup introducedby Lucas (1982).
In particular, the flexible-price monetary model includes a nominalinterest differential
since it assumes that the purchasing power parity (PPP) still holdswhen the home country
faces an exogenous real exchange rate shock.
In contrast, thetwo sticky-price-type models emphasize that the adjustment of goods
prices is lower thanthat of asset prices. Therefore, one of the sticky-price-type models
assumes that thereal interest differential, measured by the difference between interest
rates and inflation,is included in the estimation.
Previous research on real exchange rates takes special interest in the extent of
itsmisalignment. It is usually believed that there exists an equilibrium exchange rate
inwhich both internal and external balances are achieved. The gap between the
estimatedequilibrium and the actual exchange rate is the so-called real exchange rate
misalignment(Williamson, 1994).
There are two major approaches to identifying the misalignment(Zhang, 2001).
o One of them is based on the idea that the equilibrium concept is derivedfrom the
macroeconomic balance. Based on this, the misalignment is measured either
byPPP or the black market exchange rate.
o Another approach is the so-called BehavioralEquilibrium Exchange Rate (BEER):
the equilibrium exchange rate is determined by avariety of explanatory variables
of economic fundamentals.
Political pressures
1. A lot of people had been moving currency into China in anticipation of a revolution of
the Yuan, which was creating inflationary situation in China.
2. At that time The Chinese government was forced to buy the dollars and issue Yuan
denominated bonds as a way of “sterilizing” the currency.
3. The silent kept by the government of China in order to maintain the secrecy, because
government was not in favor of revalue the Yuan.
4. According to their population size they had also a problem of employment, so at that time
China’s 1.3 bn population is growing at only 1% a year.
5. China needs to add enough jobs as well displaced workers from its agricultural sector and
state-owned firms.
6. In figures, China had to add 15 to 20 mn new jobs per year. In comparison, The USA
created 275000 new jobs in April 2005, where as China needed to create at least 1.25 mn
new jobs per month to keep with its demand.
7. In order to keep the balance if China had focused on the inflation in check, It needed to
have a strong export sector otherwise it might create complex situations for China.

9. The currency basket issues
1. In July 21, 2005 China delinked the Yuan from its decade-old peg to the U.S. dollar in
favor of a currency basket. The basket was largely dominated bt the dollar, the euro, the
yen, and the won because these currencies had a great impact on China’s foreign trade,
investments, and foreign debt.
2. The Yuan was also influenced by other currencies of other countries like Singapore,
Britain, Malaysia, Russia, Australia, Thailand, and Canada.
3. Because of the settings in the currency basket Yuan was increased by 2.1%, which leads
Yuan at the price of 8.11$ from 8.28$.
4. In 2006, the Yuan appreciated by 5.68% which leads to deficit in U.S. trade and this
deficit increase and continued the pressure on the China.
5. In 2007, Central bank of China thought widening the trading band of the Yuan, but in that
debate with the U.S. treasury department the China got punitive steps by the U.S. senate.
Taking SAFE steps:
1. Fixed exchange rate against dollar
2. Trading and Quoting prices in 8 currency pairs
3. Neglect trade involvement in non-Yuancurrencies
4. Opened up trade with international banks
5. Foreign exchange rate guidelines
Options
1. Widening the trading band:
a. Consistence performance of Yuan
b. +/- 2.25% of range in trade of currencies
c. Complexity of situation of China leads to late decision
2. Pegging the Yuan to a bigger basket:
a. Made Yuan free from the U.S. dollar as its main peg
b. Lesser volatility
c. Choosing four main currencies as major trading partners
d. Challenges:
i. Picking the currencies to include in the basket
ii. Weight these currencies
iii. Determination of flotation of Yuan against the basket
3. Letting the Yuan float:
a. Uncertainty of Yuan against dollar
b. Risk to political, economical and social factors
c. Foreign trade might disturbed

10. Q.1 Evaluate the three choices that China faces in determining what to do with its currency
value. Which choice would you choose, why?
Answer:
According to three options available with the China widening the trade band should be the best
option.
Reasons:
(1) Consistence performance of Yuan
In 2002, Yuan was trading within the 0.3% band of around US$ 8.277, but by 2005,
the band was not implemented and the Yuan was trading at a fixed 8.2765
(2) +/- 2.25% of range in trade of currencies
a. IMF decided a range of 2.25% at both the levels of trading the currencies so it would
be a barrier for the China
(3) Complexity of situation of China leads to late decision
a. At the time of deciding the step China was facing the problems regarding
international pressure and internal factors so it led China to late decision
(4) While pegging the Yuan at bigger basket it may faces some challenges like
a. Challenges:
i. Picking the currencies to include in the basket
ii. Weight these currencies
iii. Determination of flotation of Yuan against the basket
b. Hence it may lead to any situation in world market and also create a pressure against
other currencies.
These reasons proves the better option as to choose the widening the trading band.
Q.2 on July 23, 2005 China revalued the Yuan by 2.1%. Given that the exchange rate was
8.2725 prior to the revaluation, look at the exchange rate today. How much has the Yuan
revalued against the dollar since then? Do you think this is enough to take the pressure off
China? Why or why not?
Answer:
Current exchange rate of Chinese Yuan is 6.2845
So according to simple calculation the Chinese Yuan appreciate by approx. 24 %(base year
2005).
According to the case there are mainly two reasons for the pressure on the China

11. 1. Unemployment rate
a. China’s urban unemployment rate is 4.1% which was 4.4% in 2004-2005.
Average unemployment rate is 4.2% (source:
www.tradingeconomics.com/china/unemployment-rate)
2. Exports
a. China’s export is good $177.97 bn, but it can’t balance the factor of
unemployment rate with proportion to the population increase in China.
SO, in spite of having good appreciation in Yuan these factors may increase political as well as
social pressure on the Chinese government
Q.3 Using the table 10.1, which exchange rate arrangement is China using now?
Answer:
Crawling pegs:2
o In this, the country maintains the value of the currency within a very tight margin,
but it changes the value of currency as needed. Thus, tries to maintain the value of
currency but does not hold rigidity to that value as economic condition change.
The currency is maintained within a bandwidth around a central rate, which is adjusted
periodically at a fixed pace or in response to changes in selective quantitative indicators.
Maintaining the exchange rate within the band imposes constraints on monetary policy
with the degree of policy independence being a function of the bandwidth.
Q.4 Assume you are a Chinese exporter. Would you prefer a Chinese export tariff on
selected garment and textiles export as a way to release the pressure against the Yuan or a
revaluation of the currency? Why?
Answer:
China Exports
In 2010, China exports totaled $1.194 trillion, down from $1.429 trillion in 2008. Its
main exports are electrical goods and other machinery, including data processing
equipment, apparel, textiles, iron and steel, optical and medical equipment.
China’s textile exports to the U.S. increased dramatically soon after that. In 2005, the
trade imbalance gap widened to around US$200 billion. Due in part to appreciation of the
RMB China’s bilateral trade surplus with the U.S. reduced from US $232 billion in 2006
to US$213 billion in 2007. In 2008, the Sino-U.S. trade volume did not increase by very
much because of the stronger RMB and the shrinking demand in theUnited States caused

12. by the financial crisis. However, China still maintained a US$170 billion trade surplus
with the United States, accounting for 57.8 percent of China’s total trade surplus.
China's main export partners are US (17.7%), Hong Kong (13.3%), Japan (8.1%), South
Korea (5.2%) and Germany (4.1%)
China exports were worth 177.97 Billion USD in August of 2012. Historically, from
1990 until 2012, China Exports averaged 49.8 Billion USD reaching an all time high of
181.1 Billion USD in May of 2012 and a record low of 2.8 Billion USD in January of
1990. Export growth has continued to be a major component supporting China's rapid
economic growth. Exports of goods and services constitute 39.7% of its GDP. China
major exports are: office machines & data processing equipment, telecommunications
equipment, electrical machinery and apparel & clothing.
Textile exporter would prefer a revaluation of the currency. This is because broad
devaluation would likely result in only little strengthening of the Yuan while a targeted
export tariff would result in a much greater loss of competitiveness.
China’s one of the main export industry is textile so if textile export tariff were imposed
it would create the internal pressure on Chinese government as well as it will affect the
China’s export. So the balance between the Yuan and Export will be damaged which will
affect the Chinese economy.
So, Export tariffs on textile are not preferred as a textile exporter.

13. 1
Miaojie Yu (2006), Revaluation of the Chinese Yuan and Triad Trade: AGravity
Assessment,China Center for Economic Research (CCER), pp. 1-8.
2
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