China: Is the Chinese Currency Undervalued

Part C: Undervalued Exchange Rates

  A. It is often said that a currency is undervalued. What does that mean?

A currency can be described as “undervalued” if that currency costs less to buy with another currency than its worth in goods (or is priced “too low" relative to the currency of another country). Therefore, the value of the currency on the exchange market is lower than is believed to be sustainable in a sense that its officially fixed value and/or nominal exchange rate is less than its fundamental value and/or real exchange rate. This may be due to a pegged or managed rate that is below the market-clearing rate, or, under a floating rate, it may be due to speculative capital outflows (also see our Book, page 67xx). The monetary fund regards a currency as substantially undervalued if it is more than 20 percent below its fair market value (according to Keith Bradsher, “Spotlight Complicates China's Currency Stance” in New York Times, published March 14, 2010)

  B. What are the consequences for trade between two countries if a currency is undervalued?

An undervalued currency in general facilitates one country’s exports into another country which, in turn, makes a trade surplus in the exporting country more likely while reducing unemployment there, at the same time possibly increasing a trade deficit as well as unemployment in the importing country. For this reason, countries following the approach of holding their exchange rates artificially low are often accused of stealing jobs and causing their trade partners to run huge trade deficits (according to “China economy review and analysis”, March 24th, 2010 in   StockMarketsreview). For example, if one country A is undervaluing its currency relative to its trade partner country B, this usually results in more sales of country A into country B since any exchange rate induced discount represents a very attractive opportunity for the buyers of country B. However, it is doubtful if country A benefits...