Introduction
The exchange rate has become an integral component of modern economics. Its role stems from its far-reaching effects on the economy of a country, investments, the profitability of firms, and personal finances. Countries have become even more interdependent due to the rapid advancement in communication technologies and the expansion of global trade, which have significantly reduced the geographical distance between both individuals and countries. However, since nations use a broad range of domestic currencies with different values, trading partners must, therefore, rely on currency conversion methods to facilitate global transactions. This paper explores the importance of exchange rate and the factors affecting exchange rate movements. It also examines the impact of exchange rate on the economy of China and the U.S.
The meaning of exchange rate
The exchange rate permits the expression of local currencies in terms of an equivalent value of foreign currencies to ease trade and other financial transactions. Krugman and Obstfeld (2000) define exchange rate as the foreign currency per unit of domestic currency or vice versa. For instance, a rate of $1 = 6.73 Yuan means that an individual will spend 6.73 Yuan to buy one U.S. dollar. Thus, the exchange rate allows trading partners to denominate the price or cost of commodities in a common currency. Exchange rates can be either nominal or real. A nominal exchange rate refers to the unadjusted value of the currency of a country relative to other currencies. It is usually expressed in monetary terms. Factors such as the price of goods and services do not affect it. Nominal exchange rates often function in foreign exchange markets and largely depend on the forces of demand and supply. The foreign exchange (forex) market has many participants including central banks, private firms, individuals, commercial banks, and non-bank financial institutions. These agents can buy or sell currencies at either the spot rate or forward rates. Spot rates refer to the exchange rates for currency transactions that take place in the present while forward rates are for those transactions that will take place at some predetermined future date (Krugman & Obstfeld, 2000). On the other hand, a real exchange rate refers to a nominal exchange rate that has been adjusted for inflation (Piana, 2001). It measures the purchasing power of currencies – the number of goods and services they can buy – at the current exchange rates and prices prevailing in the market. Thus, real exchange rates provide a more realistic view of prevailing economic conditions between countries because if factors in the price differentials that can either raise or lower the purchasing power of currencies.
The International Monetary Fund (IMF) gives states the discretion of adopting whichever exchange rate regime they prefer. Three types of systems exist in modern economies. The freely floating system allows the exchange rate to fluctuate freely in the market based on the forces of demand and supply (Piana, 2001). Most major currencies existing today such as the U.S. dollar use this regime given its widespread use in global trade transactions by most countries. A rise in the exchange rate of a country implies a depreciation – a drop in the value of the domestic currency relative to a foreign currency (Krugman & Obstfeld, 2000). A depreciated currency is less expensive and can be exchanged for a smaller number of foreign currency, thus purchases fewer commodities from abroad (imports < exports). Conversely, a fall in the exchange rate implies an appreciation. An appreciated currency buys a larger number of foreign currency, hence purchases more foreign commodities (imports > exports). The managed float regime allows the exchange rate to fluctuate within a specified band determined by the central bank of a country. China uses this system where the Renminbi (RMB) can rise or fall by only 2% from the official rate. Finally, the fixed exchange rate regime does not permit exchange rate fluctuations. The government sets the official rate and can either raise or lower it depending on the economic situation in the country. When it raises the exchange rate, devaluation occurs, which reduces the value of the domestic currency in relation a foreign one. Devaluation makes imports more expensive than locally produced goods and services. On the contrary, the government can lower the exchange rate – revaluation – to increase the value of the domestic currency.
Importance of exchange rate
The knowledge of exchange rate mechanism is essential to the country, investors, multinational corporations, and individuals for various reasons. First, it enables countries to evaluate their economic performance and facilitate comparisons with other nations. Countries rely on exchange rate fluctuations to determine whether their economies are growing or decelerating as these movements determine their level of imports and exports, which significantly affect the GDP. A rise in the exchange rate in a country means that the domestic currency has depreciated. It becomes expensive for locals to purchase foreign goods, leading to a fall in imports relative to exports. This change creates a favorable balance of trade through the creation of a trade surplus, thereby boosting the GDP. The government can channel the surplus into various industries through subsidies to promote domestic production and exports. Conversely, an appreciation of the local currency means imports become cheaper than locally produced commodities, leading to an increase in importation activities. An unfavorable balance of trade results that can create current account deficits in the long-run. Deficits chip away at the GDP, thereby reducing the amount of subsidies that government can channel into local industries. Deficits also have debt implications for the government since it will borrow funds to finance development projects. Thus, exchange rates indicate the relative performance of countries at any given time and inform macroeconomic interventions.
Second, exchange rates inform the investment decisions of investors, both traders, and lenders. Firms that deal with exports and imports can find their commodities prohibitively expensive or competitive in foreign markets depending on the fluctuations of the exchange rate. A currency depreciation that makes imports expensive will increase the production cost of a firm that depends on foreign raw materials to manufacture its products. Higher costs translate into higher prices and low, profit margins. For exporters, depreciation is an economic boon because they can sell more of their products cheaply in overseas markets, therefore boosting their profit margins. In contrast, an appreciation makes exports more expensive in foreign markets, thus reducing both sales and profit for exporting firms. Importers benefit from currency appreciations because imports become cheap. The businesses can source more raw materials at lower prices, which lowers their production costs significantly while increasing domestic sales and revenues.
Third, foreign lenders and investors will only hold those securities denominated in strong, stable currencies. A depreciating foreign currency will mean a decline in the value of their foreign holdings and capital since exchange rates have a direct effect on the return on investment portfolios. Thus, foreign lenders and investors will follow exchange rate movements to determine whether to advance loans or invest in the securities of another country. Fourth, multinational corporations depend on exchange rate movements to determine when to repatriate revenues to their country of origin. Sending funds when the domestic currency has depreciated will mean lower profits and capital outflows because they will spend more local currency to purchase foreign currency. Hence, it is more prudent to repatriate funds when the local currency appreciates since the profits and capital outflows will be substantial. Lastly, the exchange rate is important to individuals since it affects their personal finances. Travelers such as tourists and business persons rely on exchange rates when planning their travels to foreign destinations. Exchange rates affect how much they will spend overseas. For instance, if the dollar is strong relative to the Yuan, American tourists visiting China will find it cheaper to purchase Chinese products and hotel accommodations. However, when the dollar is weak relative to the Yuan, Chinese commodities and hotel accommodations become expensive for American tourists. Thus, individuals can undertake their journeys during those periods when their currencies are stronger than those of the destination nations. Exchange rates also impact the lives of individuals by influencing the cost of living. When the local currency is stable, imports become cheap thereby easing the excess demand in the economy. As a result, the inflation rate and cost of living drop, and consumers can purchase more products with the same income or save more.
A recent trend in outsourcing by companies as an effect of exchange rate movements threatens the source of livelihood of many people, especially those in developed countries of the West such as the United States. When the dollar is strong, U.S. exports become relatively expensive in other nations such as China while Chinese products become relatively cheaper in the U.S. market. This imbalance prompts many American companies to relocate their manufacturing facilities to overseas to countries in which the production costs are low. In such countries, the cost of labor is low given their relatively weaker currencies vis-à-vis the dollar. While outsourcing benefits companies in terms of cost minimization, it has a detrimental effect on employment in the U.S. since many workers formerly engaged in production lose their jobs, leading to massive unemployment. The casualties suffer income losses, reducing their standard of living. Thus, by observing exchange rate trends, employees can make appropriate career decisions or job switches in time before their employers initiate downsizing efforts.
Factors affecting exchange rate
Several factors affect the exchange rate. They include inflation, income level, government control, interest rates, the expectations about future exchange rates, public debt, current account deficits, and political stability. Inflation refers to persistently high prices in an economy. High inflation causes currency depreciation since domestic goods become more expensive than foreign goods. The demand for foreign goods increases while exports fall, leading to current account deficit. Inflation also causes foreign investors and lenders to offload their portfolio holdings denominated in the local currency fearing losses in their investments. The fall in demand for the currency in the market also contributes to depreciation. In contrast, a country with a lower inflation rate will experience a drop in the exchange rate as its currency appreciates. Second, income affects exchange rates through its effect on the consumption spending. If the income of one country increases relative to the income of a foreign country, its people tend to buy more commodities and increase their investments in the foreign country. The result is a rise in imports that causes currency depreciation.
Third, government intervention affects causes changes in exchange rates through policies relating to trade and the economy. Macroeconomic policies that affect interest rate, inflation, and income level also affect the exchange rate. Usually, the government intervenes during adverse economic conditions such as inflation or depression to stabilize the economy. During the period of inflation when imports exceed exports, the government may impose trade barriers such as import duties to restrict imports and reduce the current account deficit. As a result, the currency to appreciate. Fourth, expectations about the future movements of exchange rates also affect the current rates in the market. Speculations about a possible high inflation or interest rate cause individuals to sell their holdings denominated in the local currency or buy such holdings respectively. Fifth, changes in interest rates influence exchange rates through their effect on the return on investments. When the interest rate rises, the rate of return on capital also increases. Higher return will attract foreign capital, causing a surge in demand for the domestic currency. The result will be a fall in the exchange rate.
Sixth, current account deficits have debt implications for countries. The current account indicates the balance of trade between countries that shows all payments for commodities, dividends, and interest (Tafa, 2015). A deficit implies that the imports exceed exports, meaning that more money is spent on foreign trade than the country is earning through exports. This imbalance forces the government to borrow funds from foreign lenders, causing the demand for foreign currency to rise. Consequently, the exchange rate between the two countries will fall (i.e. the foreign currency appreciates) until the domestic products and services become cheap enough for foreigners to afford, and foreign assets become too expensive for locals to purchase. Eventually, imports will decline, and the current account deficit will fall. The seventh factor is public debt. If the government expenditure exceeds its revenue, a budget shortfall will ensue. Deficit financing efforts to fill this gap encourage inflation that may cause a depreciation of the domestic currency. Lastly, political stability affects the confidence of investors in currency. If a nation experiences political turmoil such as a civil war, foreign investors lose confidence in its currency causing them to move their capital to other countries whose currencies are more stable. Massive capital outflows cause a fall in demand for the local currency, causing it to depreciate.
Impact of exchange rate on China and the United States
The exchange rate between China and the U.S. has had substantial changes in both economies over the years. For China, these changes have been more positive than negative. China used a dual exchange rate system before 1994 consisting of a fixed exchange rate and a semi market-based system (Yu, 2013). The central bank sets the official fixed rate under which the government undertook its transactions. The semi market-based exchange rate had some window of fluctuation based on market forces of demand and supply. Importers and exporters used this regime to conduct trade activities. However, after 1994, the Chinese government combined the two systems to form a managed float system, in which the RMB was pegged to the American dollar. At that time, the rate was set at 8.70 Yuan per dollar but later devalued to 8.28 Yuan in 1997 (Yu, 2013). In 2008, China attempted to allow its currency to fluctuate at a slow pace, but the dramatic appreciation of the RMB by 20.8% from 6.83 to 6.22 Yuan in 2013 caused China to halt the fluctuation of its currency (Yu, 2013). As a result, the RMB is grossly undervalued causing Chinese exports to become cheaper than U.S. exports. American citizens find it cheaper to buy Chinese commodities through imports while Chinese locals find American products (imports) expensive. For this reason, the U.S. imports greater volume of products from China to meet internal demand whereas it is unable to export an equivalent amount of its products to China.
For the U.S., the imbalance caused a trade deficit that continues to rise exponentially. It took only a decade for the U.S. trade deficit with China to rise dramatically from $124 billion in 2003 to $290.6 billion in 2013 (Yu, 2013). The deficit stood at $344 billion in 2014 (Morrison, 2015). The deficit contributes to the enormous foreign debt that the country maintains today since the federal government is forced to borrow funds from foreign investors to make up for the gap. In the long run, the massive debt will deter investors from advancing lines of credit to the U.S. fearing a possible default. To induce them into advancing loans, the government will have to issue Treasury securities at higher interest rates, which raises future interest payments and eventually limit the funds available for economic development. Undervaluation of the RMB against the dollar makes domestic products and services in the U.S. expensive, thus reducing consumption demand, sales, and production. Since American companies face small, profit margins in the country, some of them opt to outsource their manufacturing capabilities to China where the cost of production is relatively low. Furthermore, the cost of labor in China is lower than that in the U.S. because a dollar translates into a larger amount of Yuan currency. Consequently, many Americans previously employed in the manufacturing sector lose their jobs due to downsizing efforts by firms. Recent statistics indicate that more than 2.7 million jobs were displaced in the country due to outsourcing to China (Yu, 2013).
For China, the persistently high exchange rate makes its products cheaper both in the U.S. and in the global market. Thus, it exports more locally produced commodities than it imports from the U.S., creating a huge trade surplus that has financed its economic growth over the years. The Chinese government, through the efforts of the People’s Bank of China, often intervenes in the forex market to prevent the RMB from appreciating beyond the 2% fluctuation band. The bank either buys currency by issuing government securities to absorb excess supply or sells such securities in the forex market to ease excess demand. So far, the country has accumulated about $1.26 trillion of official foreign reserves (Morrison, 2015). Over the years, China has used such reserves and trade surpluses to subsidize its local industries. Subsidies reduce the overhead costs of these industries substantially, making it hard for foreign companies to operate in China. It also increases production that further boosts exports and multiplies the surpluses. Currently, China is the largest merchandise exporter in the world, accounting for about 10% of all global exports (Yu, 2013). Furthermore, the Republic was also the second largest economy in the world in 2010.
On the downside, the RMB undervaluation has generated conflicts between China and the United States that threaten trade relationships between the two nations. American politicians and economists are concerned about the rising trade deficit with China owing to currency manipulation. They maintain that the pegged currency regime in no longer needed given the huge economic success that the economy has attained. These sentiments stem from accusations that China deliberately undervalues the RMB below its actual value. According to the exchange rate theory, it is theoretically and practically impossible for a country to continuously enjoy massive capital inflows and surplus simultaneously without government intervention (Herrmann, 2009). In contrast, the RMB would appreciate under a floating exchange rate regime until the balance of payment between the US and China equalize. This rise in exchange rate does not necessarily mean a deficit since the dollar will appreciate in the long-run due to increased demand for American exports in China, thus offsetting part of the decline in Chinese surplus.
The strained trade relations between the two countries has escalated in the last few years, with the US Congress calling for the enactment of legislations that allow the federal government to impose countervailing import duties on Chinese commodities to restrict imports, and reduce the trade deficit. However, some economists argue that such a move would result in a currency war whereby China might retaliate by offloading its dollar reserves in the global market, causing drastic depreciation of the dollar, and thus, harm the US economy. Ultimately, both countries stand to lose if a currency war occurs because their economic ties are even more entwined than in the past. The trading volume between them stood at approximately $591 billion in 2014 compared to a mere $2 billion in 1979 (Morrison, 2015). Statistics released in 2015 show that China is the second largest US trading partner and its biggest source of imports (Morrison, 2015). Hence, China cannot afford to lose a crucial trading partner such as the US while the latter cannot risk a depreciation in its currency. A more serious debate and deliberation is, therefore, the key to unlocking the impasse between the two nations and creating fair trade relations. On one hand, China has the right to use the managed float regime since the International Monetary Fund permits countries to do so. Nevertheless, it has a responsibility to treat its trading partners with fairness for long-term trade partnerships. On the other hand, the U.S. should file formal complaints with the IMF for an official inquiry into allegations of currency manipulation by China, rather than using threats.
Conclusion
In summary, the exchange rate plays a vital role in determining the economic performance of countries, which informs policy-making by governments. Investors and lenders rely on exchange rates to determine the return on their investments while traders use the rates to make decisions regarding the volume of imports and exports they trade in. On an individual level, exchange rate influence tourism and traveling decisions, the cost of living, and job turnover related to the relocation of firms overseas. Several factors affect exchange rates, including interest rates, income level, inflation, current account deficits, public debt, and government control among others. Depending on the type of exchange rate regime or nature of exchange rate fluctuations, trading countries can either enjoy surpluses (e.g. China) or suffer deficits (e.g. U.S.). China’s managed float system has generated high unemployment rate in the U.S. due to the outsourcing of jobs overseas. In contrast, it receives large capital inflows that finance the development of its economy. If this trend persists in the coming years, the trade relations between the two nations is likely to worsen. Thus, the two governments need to engage in a productive dialogue from which both parties will benefit.
References
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