How Is China's Exchange Rate Policy Linked to Its Economic Development Strategy?

[pic 1][pic 2][pic 3][pic 4]

Question I:  Do a brief summary of the major even of case (max 300 words) focusing on what happened on July, 21st 2005.

        On July 21, 2005 China revalued its decade-long quasi-fixed exchange rate of approximately 8.28 yuan per U.S. dollar by 2.1% to 8.11 and, at the same time, introduced a more market-based exchange rate system. A basket of currencies the main ones being the U.S dollar, euro, Japanese yen, and South korean won serves as the yuan exchange rate reference. This move came after China faced pressure from countries such as USA, Brazil, and the european union to have a more flexible exchange rate regime wherein the renminbi could be valued at it’s actual price against the dollar and not be undervalued by 30% to 35% .Supporters of  the flexible exchange rate regime argued that the quasi-fixed exchange rate  gave  China an unfair advantage in trade and threatened to impose tariffs. This move of  revaluing the yuan by 2.1% and the shift to peg the yuan against a  basket of currencies was initially considered as an indication that the country was embarking  on a sustained gradual shift toward increased flexibility wherein the yuan would even appreciate against the US dollar but eventually this change was considered too small to small domestic and international trade balances. Not only was the exchange rate expensive to sustain, but it contributed to--as well as limited China's flexibility in responding to--a potentially overheating economy. Attempts such as increasing interest rates , increasing reserve requirement to offset inflation which occured  as a result of buying back the renminbi to decrease appreciation of the renminbi against the dollar seemed to not solve the problem

Question II: How is China's exchange rate policy linked to its economic development strategy?

        China’s exchange rate policy has always been strongly linked to economic strategy line since Deng came to power after Mao’s death. During that period around the 1980’s, focus was on import of capital goods that could not be produced in the country. The Yuan was hence overvalued to make imports cheaper for them compared to foreign countries. The imbalance between excess demand for the Yuan compared to the supply forced the authorities to keep a strong control on the currency though.

        The second part of the process was to fit China’s new export policy. Indeed, between 1977 and 2004, China’s part in global trade went from 0.6% to 6.0%. Such a new target compelled the government to devaluate the Yuan to be more competitive. The first move was to act on inflation by slowly lowering it.         A few years after (1986), a dual exchange rate was also created: while the Renminbi was a fix exchange rate, limited foreign exchange was allowed using a parallel currency (FEC : foreign exchange certificate).

        Then, facing more than 20% inflation rate and a credit boom, some decisions were taken regarding exchange rate policy here again. It was decided of a development of the Renminbi, abolishing the FEC and fixing the market rate to 8.28 yuan per dollar. Later, the CNH appeared, which was fully convertible and permitted foreign importers to pay Chinese firms on a free market. These tools permitted to reach an acceptable level of inflation in the end.

        Another huge side of China’s economy is Foreign Direct Investments (FDI). Indeed, China became by 2004 the first largest recipient of FDI (annual inflow of $64 billion, cumulative total balance of $564 billion). Such a situation put pressure on the exchange rate as excess demand for Renminbi threatened the currency of a dangerous upward move. In order to prevent it and keep a competitive currency, the government exchanged incoming dollars for renminbi and bought US Treasuries using dollars (which made China one of the largest US Teasuries holder).

        Hence exchange rate policy has always been in line with exporting strategy China developed since the 1980’s, coupled with some techniques to overcome conjectural difficulties.

Question III: Why China moved to another exchange rate system? Compare the risks of keeping the same exchange rate policy and changing it.

             For the past years, china has captured the world’s attention as its economy has grown unprecedentedly at an average of 10.1% a year. China has not only outperformed emerging economies, it has become the world largest economy superpower surpassing the USA for the first time. While china’s climb has been extraordinary, it has been plagued with controversy especially around their exchange rate regime. China in the only economy of its size to utilize a fixed exchange rate, as we know floating exchange rates are based on equilibrium, asset and output markets, therefore, floating exchange rates can fluctuate greatly and these fluctuations can influence GDP and the nation’s economy. In July 2005, and following a year of intense discussion, the chineese government has announced that it was revaluing the currency by 2.1% and switching from the dollar peg to a basket - The People’s Bank of China also provided additional information on the composition of the reference basket, specifying that it includes not just the dollar, the euro and the yen and the Korean won but also the Malaysian ringget, the Russian ruble, the Australian dollar, the Thai baht, the Canadian dollar and the British pound. The governor of the people’s Bank did not however reveal the weights on the constituent currencies -. and allowing the currency to float more freely. [pic 5]

Risks of changing/keeping the exchange rate:

The floating exchange rates don’t depend on the central bank but on the market. Any differences in the supply and demand will be reflected automatically. If the demand for a certain currency is low, its value will decrease which results in imported goods being more expensive and thus driving demand for local goods and services. In other words, if China would allow their currency to strengthen again the US dollar, their exports would more expensive than other countries, so it would decrease demand of their exports which leads to fewer production in the factories and would obviously slow down the Chinese economy. A 100% floating rate will impact foreign investment in China and would worry about other developing countries such as India or Latin America’s nations which they have a labor advantage.

On the other hand, keeping the same system would have impacted the international relations of China, and might have a direct impact on the huge amount of exports that has been an important factor in the Chinese GDP. Moreover, a pegged RMB, unlike a floating one, will no isolate china from external shocks, and will not allow china to address its own domestic economy issues. And more importantly, large reserves made in order to keep the pegged system can spark higher inflation, which causes prices to rise and create stability problems in the country. Some economists are stating out the fact that china is a net exporter of capital and its credit stock is mostly denominated in domestic currency.  In addition, pegging to the U.S. dollar will be risky in terms of further appreciation since the US has continuous fiscal and current account deficits and China is expected to continue economic growth.