China: to Float or Not to Float

Question 1: What are the implications of China’s exchange rate policy on doing business with and “against” China? Figure 1. China’s exchange rate in government manipulation and expectation 2004-2009 The fact that China made two renminbi (RMB, also called yuan) revaluation in 2005 and 2010, but in the limit of case study, we may just focus on the first one as shown in Fig. 1. On July 21, 2005, China announced a 2. 1 percent appreciation of the RMB against the US dollar, from 8. 28 to 8. 11, a move to a managed float, and a number of other “reforms” such as in agricultural, state-owned enterprise, banking sector and trade reform, etc.

Those were already mentioned in the case, as Prof required, we don’t repeat any more. The effects of China’s exchange rate are a prominent topic in both policy debate and analytical discussion. In policy circles, the questions include whether China should allow its currency to depreciation – that is, a change in Chinese currency policy would have a significant impact on growth of U. S. output and employment. As we know, China exports a wide range of final goods.

Similarly, China is increasingly important as a source of parts and components for manufacturing in other countries. •Depreciation Reduced Imports A country’s exchange rate cannot be a concern for it alone, since it must also affect its trading partners. But this is particularly true for big economies. So, whether China likes it or not, its heavily managing exchange rate regime is a legitimate concern of its trading partners. Whenever RMB was kept at such low rate, the U. S. companies still faced to the big barriers to entrance to the biggest market of the world.

•Depreciation Reduced Investment Abroad Besides, depreciation also reduced investment abroad especially in developing countries such as Vietnam, Lao, Myanmar, etc. The China companies had to consider more whether they go to invest in low labor cost countries with more risks or stay in China with low cost of labor and also low production cost and maybe low tax. That why China’s government had still kept the low rate for quite long time which was out range of the expectation of an appreciation value (Fig. 1). Question 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? The depreciation of RMB really worked well with the government development strategy in the aspect of attracting more investors to stimulate exports. •Attract more Foreign Direct Investment (FDI) First take a look to the FDI before the depreciation in 2005. In some moments, the actual FDI was much lower than a half of the expectation. Figure 2. FDI expectation and actual growth in 1989-2004 However, those were changed when PBC’s informed about their rate adjustment on RMB exchange rate dropped to 8. 11 (Fig. 3).

Almost right after the release announcement of PBC, the flow of FDI in following years increased quickly at 4-5 times until 2007, then greatly continuous enhanced to more than 10 times. Top countries investing in China were who had a lot of number of oversea Chinese as Hong Kong, and regions those had a long historical trading with China as Japan, South Korea (Fig. 4). Figure 3. FDI growth in 1982-2010 Figure 4. FDI Top 10 countries investing in China. •Depreciation Stimulates Domestic Production As a basic, low labor cost and low production cost will keep Chinese companies to stay and invest in their own cities.

Those effects could help to solve the problem of unemployment which was at high rate at that moment ~10%. We also can see the effects in the reform of agriculture which increased farming productivity and rural incomes. •Depreciation Stimulates Exports Low value of RMB meant the supply demand correspondence low (as mentioned in theory of exchange rate in chapter 9 textbook), so Chinese companies tended to export their goods to other countries, in the cheap prices, as developing countries in neighbor area like Vietnam, Philippine…The low price of their goods was a great advantages to compete with local products.

•Negative Impact of Yuan Depreciation Increasing exports will not fundamentally improve peoples’ lives. On the contrary, it will consume more natural resources and worsen the already damaged environment. The quality of life deteriorates and the natural resources that belong to future generations are forcibly damaged and consumed. This will eventually have a deadly impact on the continuing development of China’s economy. The depreciation can push for an increase in exports and thus relieve domestic unemployment pressures because the Chinese economy is heavily dependent on exports.

Unfortunately, globally, the devaluation of the RMB worsens the tension that comes from the trade imbalance with the United States as well as global economic crisis. Question 3: How should changes to China’s exchange rate policy be sequenced with banking sector reform and liberalization of capital controls? As mentioned in the case, because the poor financial performance of SOEs directly impacted China’s banking sector, Chinese government tried to improve the balance sheets of four state banks through transfers and bailouts. Those activities did help in some ways, e. g. low interest rate convinced firms to invest more.

However, these trials were not enough to help banking sector become more commercially oriented. As we can observe from Exhibit 12a and 12b, Chinese government imposed a very tight control in capital to make sure the value of RMB always undervalued. Nonresidents almost were not allowed in purchase capitals, derivatives or direct investments. In a similar way, whenever residents wanted to purchase or invest abroad, they must get the SAFE review/approvals. Why Chinese government did like that? The reason could be to help state banks to cover the losses due to depreciation of RMB.