How Is China’s Exchange Rate Policy Linked To Its Development Strategy?

765 words - 4 pages

2. How is China’s exchange rate policy linked to its development strategy? How would changes in exchange rate policy impact growth in China as well as the rest of the world? Is the current exchange rate policy sustainable in the long run?

China’s exchange rate policy is linked to its development strategy as China’s gradual transition from a centrally planned economy to a “socialist market economy” was accompanied with major changes in the exchange rate regime. Before the reforms, the Yuan was fixed at an overvalued rate in order to subsidize imports of capital good that could not be produced internally. Then, in 1986, a dual exchange rate system appeared: the official exchange rate was ...view middle of the document...

By 2004, China was the world’s largest recipient of FDI and even became the world’s third largest trading nation (trade increased from 10% of GDP in 1978 to 79% in 2004).

At the beginning of 2005, exports increased 32% over the same period in 2004 while the imports increased by only 14%. The large move of the exports up the value-added chain leads to tensions with China’s trade partners, especially the US. The fixed exchange rate regime also had a major impact on foreign investment. Moreover, China tried to offset inflationary pressures that would overheat the economy by increasing interest rates and by a sterilization program (loans to commercial banks were reduced, reserve requirements increased, Yuan denominated bond issued to absorb liquidity). By 2005 China faced many pressures to revalue its currency, which, according to the US was devaluated. Moreover, it was getting harder for China to keep the fixed exchange rate regime (for example, for the Central Bank, with more and more capital inflows, it was difficult to keep sterilizing monetary base growth). So the fixed exchange rate policy does not seem to be sustainable in the long run.

In 2005, China changed its exchange rate to 8.11 Yuan per...

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