2010 CJC Prelim, CSQ 2

China’s Trade Surpluses & its Exchange Rate

Suggested answers

(a) (i) Using Figure 3, describe the trend of US trade balance with China. [2]

US was experiencing a trade deficit [1]

The deficit was increasing up to 2008 before the trend was reversed. [1]

(ii)(i(ii) Using demand and supply diagram, explain how China “manipulates” its
exchange rate. [4]

The Chinese government is deliberately undervaluing the yuan by setting it below the free market
rate[1]. This can be done by the selling of Yuan (and buying of USD by the Chinese central bank) in
the foreign exchange market).(1m) This increases the supply of yuan in the foreign exchange mkt
(1m). 1 diagram (1m). The ss for yuan curve will shift to the right, causing the value of yuan in terms
of USD will to fall [1]

Will accept answer that explains central bank seeking to appreciate the yuan..
Also accept the use of interest rate to influence exchange rate

(iii) Assess the effects of a change in the value of Chinese yuan on US trade [8]
balance with China.

When the yuan appreciates against the US$ (a given qty of yuan is worth more US$), it implies that
the US$ is depreciating. Prices of USA exports will be cheaper while its imports are more expensive.
USA goods will be cheaper in China market while imported goods from China will be more expensive
in USA market. Assume the demand for both exports and imports are price elastic. The quantity
demanded for USA exports will rise proportionately more than its price fall, and the Qd of imports to
US will fall proportionately more than its price rise.  export revenue of USA will rise & import
expenditure of USA will fall  hence reducing the trade deficit US had with China.
According to the Marshall-Lerner condition (where the sum of the price elasticity of dd for exports and
imports exceeds one), depreciation will improve the trade balance. When exports and imports are
price elastic, the sum of their Ped exceeds 2, satisfying the Marshall Lerner condition.
However the Marshall Lerner condition is likely to be satisfied in the long run rather than the SR. This
means that the trade deficit is likely to worsen before it improves (J-curve effect). Fig 3 seems to
show the J-curve effect as the depreciation of US$ after 2005 led to a widening trade deficit up to
2008 before it improved.

It is possible for US trade balance with China to be influenced by other factors like the rising income of
USA, improved productivity of China’s exports, China export of more higher value added products like
mobile phones & DVD players (Extract 6, 2nd last para). So, the widening trade deficit observed in fig 3
could be due to rising income in USA that led it to import more, and the improvement in the trade
deficit could be due to global crisis that reduces its income.

Conclusion: A change in the exchange rate is just one factor affecting the trade balance. Fig 3
showed that the change in the exchange rate had limited impact on the USA trade balance. This could
be due to the small change in the exchange rate or there could be other factors at work.

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L1 1-3 Making simple description of how value of Chinese yuan will affect US trade balance.
Not conceptual in explaining the effects, e.g. not stating assumption of M-L condition.
L2 4-6 Able to give conceptual explanation of how Chinese yuan will affect US trade balance,
and provide for alternative views on effects of Chinese yuan on US trade balance (e.g.
M-L condition may not be met; other factors affecting Chinese exports to US and/or
US imports to China).
L3 7-8 Able to evaluate the effects with justification. Make use of Fig 3.

(b) Explain two possible effects FDIs have on China’s balance of payments [4]

Capital and financial account

- comprises of direct investment, portfolio investment and other investment.
- FDI comes under direct investment and it is a credit item (currency inflow to China) Improves BOP

Current account
– record trade in goods, services, income flows and transfers
When profits are made by the foreign firms, the money could be sent out to their parent company
abroad. This comes under factor income sent out (debit item)
If the FDI made use of imported inputs for production, money is sent out of China (debit item)
If the FDI is export oriented, then, there will be an increased in China’s exports, resulting in revenue
earned from abroad (credit item)

Combined effects on BOP: If the sum of the credit items exceeds the sum of the debit items, there will
be an improvement in the BOP.

(c Using Table 2, identify the trend of exchange rate of Singapore dollar and
Chinese yuan between 2005 and 2009. [2]
)

Suggested Answer:
The exchange rate of S$ in Yuan remained relatively stable [1] with the S$ appreciating slightly
against the yuan in 2006 compared to 2005. [1]

Exchange rate of yuan was the highest in 2008 (exchange rate of S$ was the lowest in 2008) [1]

(d Assess whether China’s growth is a threat or benefit to the Singapore

economy. [10]
)

Suggested Answer:
Interpretation of China’s growth in
- income
- exports
- employment opportunities
- foreign direct investments

Benefits to Singapore
- China presents a big and growing market for Singapore export oriented economy. Extract 6
mentioned that consumption level in China is rising and some of these will be in the form of
imports (exports from S’pore). Singapore can export goods and services (e.g. medical

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 services, education, refined oil, tourism) that she has comparative advantage in. There could
also be intra- industry trade to satisfy consumers’ varying tastes and preferences.
- Extract 6, para 3 mentioned that ‘China export machine…. has sucked in vast quantities of
parts and components for final assembly from other parts of Asia. This means that Singapore
will be able to provide the inputs for China to process and assemble (para 3, page 6). China’s
fast export growth is not at the expense of other countries in Asia due to differing comparative
advantages.
- Table 1 also suggested that S’pore’s balance of trade with China did improved from a trade
deficit to a trade surplus between 2008 and 2009.

- Extract 6, para 3 indicates that investment in ‘ASEAN countries hit a record of $37b in 2005.
China’s growth had not diverted FDI away from ASEAN countries in which Singapore is a
member. Foreigners invest outside China as a hedge against some unforeseen circumstances
in China. Singapore does have certain advantages over China like protection of intellectual
property rights, clear rule of law for businesses and developed infrastructure.

The above is about rising net exports and investment. This will raise aggregate demand, shifting the
AD curve upwards. 1 graph. The results are rising income and employment, assuming Singapore has
not reached full employment. These are benefits to Singapore as they contribute to the meeting 2
macro-economic goals. In addition, net exports and FDI contribute to the improvement in Singapore’s
balance of payments as Singapore is receiving money from the rest of the world.

Singapore has been quite dependent on the developed nations like EU and USA for its export market.
The rise of China provides Singapore with a market to diversify to reduce risk. For e.g. if USA
economy is slowing down, she still have the China market to sell to, thereby reducing the impact of a
fall in exports and foreign investment.

Others if time permits

- China’s growth and need for FDI act as an attractive destination for investment by S’pore
firms. Income sent back from China adds to Singaporer GNP.

- Increased number of foreign workers from China supplements her limited local labour ss. This
raises productive capacity and AS , contributing to a slower rise in prices when AD rises

Threats
- Cheap imports (e.g. shoes, handbags) from China compete with similar domestic product. The
goods are cheap because China has abundant ss of labour, giving it comparative advantage in
labour intensive products over Singapore. Firms unable to compete close down. Some
relocate to China. This causes structural unemployment.
- China is moving up to produce higher value-added products like desktop computers, mobile
phones. Some of these products compete directly with Singapore. If Singapore loses its
comparative advantage in the products we compete with, then, there will be structural
unemployment.

- As China continues to grow, it will provide its citizens with better job prospects. The inflow of
foreign workers from China could reverse. If this happens, it will reduce the availability of FOP
for our production, leading to fall in AS and potential economic growth.

Conclusion: Threat or benefit?

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So far, China’s rise has been a benefit rather than a threat as it has contributed to providing a cheap
source of food products and inputs as Singapore lacks natural resources. China growth has also
contributed to rising AD that increases growth and employment. The structural unemployment can be
reduced with education and training to move workers to expanding industries Whether in future China
will be a threat or benefit depends on Singapore’s ability to find niche areas where she excels in and
its ability to equip the workers with the appropriate skills and education in this changing world. This is
a challenge for Singapore.

Level Descriptors Marks

L1 Explanation of China’s economic growth on Singapore economy using little or no 1–3
economic analysis.
L2 Able to use economic analysis to explain the impact of China’s growth in general 4–6
to Singapore economy.
L3 Able to explain the nature of China’s economic growth in depth (eg, export 7–8
growth, employment opportunities, income increases & FDI growth) and analyse
the impact on Singapore economy, citing both threats and benefits.

E1 Able to make a conclusive stand with justification 1–2