Running head: Reminbi Peg and Its Impact on World Trade

Reminbi Peg and Its Impact on World Trade

Roger “Chip” Browne

Stevens-Henager College
 Abstract

In this paper, I explain the exchange rate between the U.S. dollar and the Chinese RMB?

I then explain what I believe to be the best strategy for a large multinational company when

faced with the vast swings in the value of the U.S. dollar. I explain why some politicians talk

positively about the U.S. dollar’s decreasing value, and I give my analysis of the long-term

outlook for the U.S. dollar. I conclude by summarizing this information and providing my

predictions for the United States economy.

Every nation has a supply of money called its currency. This currency is made up of

coins and bank notes and bank deposits which, in the past, were backed up by assets and reserves

held by the government. This system facilitates the exchange of goods and services between

individuals where the government becomes a third-party of all transactions. The currency is the

medium of exchange, providing a means whereby an individual can consume the product or

service from another individual without requiring the “providing” individual to consume the

product or service of the “consuming” individual. Necessarily, the two individuals agree on a

valuation of the currency in order to consummate the transaction. The currency of a nation,

therefore, becomes its own product having a value of its own which also can fluctuate. The

products and services of an individual are denominated in the national currency where they are

produced. When trade occurs between individuals (or companies) in two different countries,

there becomes an additional rate of exchange when the two currencies are compared in value.

Normally the valuations of national currencies are determined by the ratio of assets, held

by the nation, to the amount of money in circulation. After the Second World War, a system

similar to a gold standard and sometimes described as a "gold exchange standard" was

established by the Bretton Woods Agreements. Under this system, countries fixed their exchange

rates relative to the U.S. dollar. The U.S. promised to fix the price of gold at approximately $35

per ounce. Implicitly, then, all currencies pegged to the dollar also had a fixed value in terms of

gold (Lipsey, 1975). President Richard Nixon ended the direct convertibility of the dollar to gold

in 1971, resulting in the breakdown of the Bretton Woods Agreements and the adoption of full

fiat money which is inconvertible paper money made legal tender by government decree.
 US dollar vs. Chinese Yuan Exchange Rate

Since 1971, China has maintained a fixed currency exchange rate with the United States.

The “peg” has been set at different levels over time, including three, five, and most recently,

8.28 RMB to the dollar (Chinese Yuan). On 21 July 2005, China replaced the peg against the

U.S. dollar by a link to a basket of currencies (the U.S. dollar, the euro, the Japanese yen and the

Korean won), but the exchange rate was simultaneously set within a narrow band around

Rmb8.11:US$1, representing a far smaller appreciation than had been called for by the United

States and other trading partners. In the following three years, however, a further gentle

appreciation against the U.S. currency has occurred. By end-October 2008, the renminbi had

risen to nearly 6.8 to the U.S. dollar. Since then, the renminbi has been held stable as the

Chinese government considers how best to respond to the global economic crisis. In June 2010,

the temporary dollar peg was again abandoned, after the renminbi had risen some 16% against

the euro following the onset of the Greek fiscal crisis (Chinability, 2009)”.

Figure 1 Google Finance USD-CNY Exchange Rate

During the post-World War II period when the Bretton Woods was in effect, the major

trading currencies were pegged to the U.S. dollar, and the U.S. dollar was pegged to gold at $35

per ounce. As a result of this, the U.S. dollar became the world's reserve currency. After the end

of the Bretton Woods Agreements, major currencies went to free-floating, and in 1978 the

International Monetary Fund mandated that all currencies of IMF member nations be free-

floating. Multinational companies that are headquartered in the United States must develop a

strategy for the large swings in the valuation of the U.S. dollar. These strategies pertain if the

company is selling a product or service that is denominated in U.S. dollars or if they hold assets

that are denominated in foreign currencies other than the U.S. dollar. The valuation of a product

or service in U.S. dollars is directly vulnerable to the swings in valuation of its currency. A

sophisticated method for offsetting the decrease in value is to balance the cash balances of a

company with denominations of currencies that move opposite to the U.S. dollar. The most

popular strategy for protecting foreign currency assets and liabilities from adverse moves in

foreign currency rates is to do what is called Forex hedging. “The Forex hedge’s change in value

is opposite to the change in value of the foreign currency exposure (hedged item). These two

amounts offset each other to obtain cost certainty or revenue certainty” in the Fair Market Value

(FMV) of the assets (Oanda , 1996).

Figure 2 Forex Hedging

Ironically, some politicians are optimistic when the currency of the United States decreases

in value. Although there are reasons that these politicians are pleased, not all politicians share the

same perspective when the dollar decreases in value. Probably the greatest reason that

politicians would be pleased is that a decrease in the value of the dollar will increase exports and

decrease imports, causing net exports to rise. A rise in net exports serves to reduce trade deficits

that exist between the United States and other countries. In addition, as a country exports its

goods and services, it serves to create employment for the producers who are involved with the

company and its suppliers. This increase in employment is favorable to the constituents of

politicians.

Besides increasing exports, a decreased dollar value will also serve to devalue the deficit of

the United States government. This, however, has a negative effect upon the citizens of the

country as well because their buying power is reduced accordingly, not making politicians

happy.
Figure 3 Purchasing Power of U.S. dollar
 Long-term Outlook for the U.S. Dollar

Peter Schiff is an American economist and the renowned author of the bestseller Crash

Proof: How to Profit from the Coming Economic Collapse. He is a commentator and a popular

video blogger. I personally met and listened to Peter two months ago at a gathering of

conservative folks in Utah. Peter spoke about the economy, stock markets, politics and gold. He

believes that the U.S. dollar will continue to decline "for a long time as long as the Fed

Chairman continues to deny that the inflation that he has created exists”. [Schiff believes] it`s

going to keep on falling as long as the [Federal Reserve] prints money as they do quantitative

easing. Schiff states that he does not believe that inflation is going to come to an end in the

summer, and he doesn’t believe the Fed believes it either (Schiff, 2011).

The United States is the world's largest debtor fighting a losing battle against both trade

and financial deficits that are growing daily and being caused by fundamental flaws in the

policies of the United States which are now irreversible. Less than one month ago on April 25,

Standard & Poor's, one of the three main agencies that rate the ability of companies and

sovereign nations to repay their debts, lowered its outlook for America's long-term credit rating

to "negative" from "stable." The change means that there is a one-in-three chance that S&P could

downgrade the nation's "AAA" credit rating within two years. That would make it harder for the

U.S. government to borrow money to fund its activities (Rooney, 2011). These predictions and

factors persuade me to believe that the long-term outlook for the U.S. dollar is very unstable,

and I predict that the U.S. government will become insolvent under the weight of its debt.

Conclusion

The stability of a nation’s economy is portrayed by the stability of its currency. After

World War II, the world economies adopted the Bretton Woods Agreements which pegged
foreign currency to the U.S. dollar and which pegged the U.S. dollar to gold. This agreement

failed in 1971. The country of China continued to peg its currency - the reminbi - to the U.S.

dollar and is gradually allowing its currency to fluctuate against the U.S. dollar. Having free

floating currencies is now a requirement of the International Monetary Fund and brings with it

swings in valuation of the U.S. dollar when compared to other currencies. One of the best

strategies for protecting the values of products, cash and assets during these swings in valuation

of the U.S. dollar is to invest in currencies that move contrary to the U.S. dollar using Forex

hedging. Some politicians are optimistic about the decreasing value of the dollar because exports

from the United States are less costly to foreign importers; more exports means more jobs. The

long-term outlook for the U.S. dollar is, in my opinion, unstable. I believe that due to the burden

of the spending deficit and trade deficits, the U.S. government will become insolvent under the

weight of these burdens.

Chinability. (2009). Renminbi (Chinese yuan) exchange rates 1969-201. Retrieved May 14,

2011, from Chinability: [Link]

Lipsey, R. G. (1975). An introduction to positive economics (fourth ed.). In R. G. Lipsey, An

introduction to positive economics (fourth ed.) (pp. 683–702). Weidenfeld & Nicolson.

Oanda . (1996). Hedging Basics: What’s Forex Hedging? Retrieved May 14, 2011, from Oanda

fxConsulting: [Link]

Rooney, B. (2011, April 19). U.S. credit rating outlook lowered by S&P. Retrieved May 14,

2011, from CNN Money:

[Link]

[Link]

Schiff, P. (2011, April 8). Gold Will Reach 2000 USD An Ounce. Retrieved May 14, 2011, from

Peter Schiff Blog: [Link]

[Link]
Figure

Figure 1 Google Finance USD-CNY Exchange Rate.....................................................................4