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April 28th 2005

The economics behind China’s exchange rate crisis

Jeffrey Frankel, a professor of economics at Harvard University, believes the laws of economics Will eventually force the Yuan to rise against the dollar, in real terms at least. China’s economy is growing exponentially, and the Chinese government seems either unwilling or unable to cool it off. As the demand for Chinese goods continues to skyrocket, so too must prices. According to Frankel, the extent of the rise will be such that in a decade, the Chinese Yuan will be fairly valued against the USD, in real terms. While nominally, one USD would be worth 8.28 Yuan, the inflated costs of Chinese goods would ensure equilibrium. Such a situation would be disastrous for China, however. It would be in China’s best interest to slowly appreciate the Yuan against the Dollar, through the use of a crawling peg exchange rate regime. If China waits to long, warns Frankel, the results could be catastrophic. Reuters reports:

"The alternative of waiting for a time of balance-of-payments deficit often turns out to mean exiting the peg under strong downward speculative pressure, with the result that confidence is undermined and the national balance sheet is weak," Frankel says.

Read More: Yuan undervalued at least 35 pct

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Posted by Adam Kritzer | in Chinese Yuan (RMB) | 1 Comment »

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One Review of “The economics behind China’s exchange rate crisis”

  1. Ryan Pitylak Says:

    This revaluation will be negative for the United States, but the negative impact of this revaluation of the Yuan vis-à-vis the dollar will be almost negligible. The revaluation will be beneficial for China for several reasons. First, the flexible exchange rate will help to protect it from macroeconomic volatility. Second, it will allow China to cool the over lending that has occurred with its new ability to raise interest rates. Before the revaluation, there was a fear that large capital inflows would result from higher interest rates. Chinese authorities are not against a gradual revaluation, but they want to make sure that the revaluation happens slowly (such as the recent 2.1% revaluation). China’s financial market is weak and it needs time to become better equipped to handle the large capital outflows that are expected to occur after a complete capital market liberalization.

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