Sample Term Paper
To keep its exchange rate hooked to the dollar, China was the biggest buyer of American Treasury bonds over the past year. In the first six months of 2005, its foreign-exchange reserves improved by more than $100 billion, to $711 billion, of which about three-quarters are in dollars. This has also reserved capital costs artificially low. The effect of a Chinese revaluation on the overall U.S. current account, however, is likely to be much larger than the influence on the bilateral trade balance alone. The reason is that China may be the key to a general realignment of Asian currencies. (The Economist) The cumulative effect on the overall U.S. current account deficit of such a general realignment of Asian currencies in response to a 20 percent revaluation of the yuan would be several times the $10 billion estimated reduction in the U.S. bilateral trade deficit with China. However experts argue that revaluing of Chinese currency will not be as effective as thought according to Bottelier (2003):
The root cause of the US trade and current account deficit problem is the low domestic savings rate, definitely not China’s exchange rate. The US savings shortfall is compensated by foreign capital inflows, especially from Japan and China. An undervalued nominal exchange rate does usually not remain undervalued for very long, because sustained large balance of payments surpluses usually lead to higher inflation in the surplus country which drives up its real exchange rate which is the rate that matters most in international competition.
In my view in spite of the pegged currency, China is a force to be reckoned with, and its huge export industry is formidable. In addition, if the pegged currency becomes free floating it may decrease the trade deficit; however, United States’ reliance on Chinese goods will not diminish, instead it is bound to increase.