Effect of China’s New Trade Settlement Policy on the Value of Dollar

Abstract

While swap agreements greatly relieves two trading nations of the shortage of international liquidity, they have several implications for the countries issuing an international currency. Such agreements, by lowering the demand for an international currency, lower its relative price and, thereby, change the balance of payments and the real income of the nation issuing the currency. Since, the U.S. dollar dominates all other international currencies in trade settlement and in reserve composition of sovereign states, such swap agreements are expected to affect U.S. dollar’s exchange rate, and, thereby, the U.S. balance of payments and real income. This study, therefore, attempts to evaluate the impact of China’s swap agreements with Indonesia on U.S. dollar’s exchange rate with Indonesian rupiah, which has never been done before. In this study, we have developed a model in which the exchange rate of the U.S. dollar is a function of a number of variables, such as, the natural logs of the U.S. real GDP, Indonesian real GDP, U.S. money supply, and Indonesian money supply plus one-period lagged value of the dependent variable and a swap dummy. Our study found that China’s swap agreement with Indonesia has no effect on the exchange rate (value) of U.S. dollar. One explanation of this finding can be the amount of swap agreement being relatively too small compared to the volume of Indonesia’s annual trade volume to influence the value of the dollar. Also, the swap amount is meant to settle bilateral trade over several years rather than one year, which makes the swap amount a much smaller percentage of Indonesia’s annual trade volume making the swap agreement ineffective in changing the exchange rate (relative value) of U.S. dollar with respect to rupiah.