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China To Float Or Not To Float

2675 words - 11 pages

Summarize and evaluate the arguments presented in the (A) case for and against the revaluation of the Renminbi. Provide your own assessment of the projected future direction of the RMB/USD exchange rate (using info provided in the case). China’s decision to release its currency from the decade long peg (approx. 8.28 Yuan per USD) raised multiple concerns within the global economic community. Many economists welcomed the decision while still others questioned it. Below is a brief description of the various arguments presented on the topic. Political: With the value of the Dollar decreasing over the recent years, the western governments are less pleased with China maintaining its currency at ...view middle of the document...

This increased forex reserve is putting a strain on the already overheated economy. An increasing inflationary pressure can be offset by increasing the borrowing interest rates, which thereby slows down the economic growth. Chinese officials though, controlled the pressure through sterilization methods where State banks were made to purchase bonds at higher prices. By keeping the governments costs low at the expense of the banks, China’s financial stability is at a serious threat. A counteracting solution to this problem would be to allow the Yuan to float, hence steadily allowing the market forces to increase the interest rates and release the pressure from State banks.


 

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Arguably, even with the fixed exchange rate, China still managed to hold autonomy over its monetary policy through capital controls. The effective segmentation of onshore and offshore markets could provide an example for domestic interest rate adjustments to help achieve a desirable internal and external policy. Social: With the FDI inflow mainly being locked in to China’s Forex reserve, little or no money is being spent on developing the Chinese economy. By keeping their currency low to provide low cost goods, the officials are “punishing” the minimum wage workers. Over the years the Chinese people have been vocal about calling for a revaluation that would ultimately increase their purchasing power and hence create a demand for goods locally. On the contrary, some economists believe that as China deals with an urbanizing economy with over 300 million surplus workers, it’s main focus must be on creating stability in the market before subjected itself to any currency volatility. Technical: China’s rapidly growing economy will find it hard in the near future to keep its money inside. The large share of the country’s reserve tied up in US debt poses a huge threat on the currency. The US market is still picking itself back up from the recent crisis and the tides could turn at any time. Revaluing the Yuan when there is a positive push would be crucial to the economy rather than having to deal with a sudden drop in investment inflow. At the same time, analysts say that had the popular expectation of 20 to 25 percent revaluation been heeded to, it would have had a catastrophic effect on the economy. China should continue to maintain its fixed exchange rate so as not to fall into a downward pressure situation that could result in deflation and ultimately a ‘zero interest’ liquidity trap. Assessment: The Chinese government’s decision to float the currency in 2005 by about 2.1% within a band of 0.3% was a positive step for the global economy. China’s adoption of a crawling peg policy will soon see its self converting into a fully floating exchange rate in a few years as market forces come into play. A floating exchange rate will help counteract the cyclical ups and downs faced by the economy, allowing it to self rectify over time and become more stable. The RMB has...

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