China, float or not

? 1. What are the implications of China’s exchange rate policy on doing business with and “against” China? Since July 21, 2005, China has adopted a managed floating rate regime based on market supply and demand with reference to a basket of undisclosed currency. The daily trading price of the U. S. dollar against RMB in the foreign exchange market will be allowed to float within a band of +/->0. 3% around the central parity published by People’s Bank of China.

The signal was initially interpreted by the international market as an indication that China would embark on a gradual shift toward increased flexibility which eventually adopt a floating exchange rate regime where the RMB will appreciate much against US dollar. However, they soon realized that China was still extremely cautious in adopting a fully floating exchange rate system and provided very limited flexibility on the exchange rate system. The Chinese government and central bank was striving to maintain the RMB exchange rate at a stable and equilibrium level.

According to some studies who advocate RMB revaluation, the current RMB/USD exchange rate is undervalued by 35% based on the price level of goods and services in China compared with those of its trading partners. The current managed floating rate regime adopted by Chinese government has undoubtedly a great impact on countries and corporations doing business with China & Chinese companies and/or competing against with them in the international market.

Countries & Companies doing business/partnering with China. The “undervalued” RMB will create a competitive advantage for those who manufacture their products in China by leveraging the relatively cheaper raw material as well as labor in the China market and export them in other markets to generate greater profits. As specified in the case, Wal-Mart for example, imports from China reached $18 billion in year 2004 responsible alone for almost $10 billion of the US deficit with China.

However, the advantage is only significant to those companies who purchase majority of their raw materials and services locally in China as the “undervalued” RMB will also encroach their profits if the company heavily relies on imported goods/services for their supplies. If China were to adopt a full floating exchange rate regime, the competitive advantage stemmed from cheaper raw material and labor maybe compromised due to the appreciation of the RMB. Countries & Companies competing against China.

For those who compete against with China and Chinese enterprises in the international as well as China market by producing in their home countries and wishing to sell them in the China market, they will be penalized and disadvantaged for the “undervalued” RMB exchange rate as the production costs are significantly higher than their competitors who manufacture in China, while the Chinese companies who produce in China will enjoy the benefits of the low production costs which are denominated by RMB. FDI/hot money 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? Measured by GDP on a purchasing power parity basis, China now is world’s second largest economy. When analyzing the component of GDP, it’s evident that China is heavily relying on trade as well as FDI. The weight of trade in GDP increased from 10% to 79% (40% of which is export) and FDI increased from zero to $64 billion corresponding to 3. 3% of annual GDP. Foreign invested factories produced about half of China’s exports.

China is also moving up along the trade value chain as the country is moving away from the labor intensive products to expand the shares of technology intensive products including electronics, auto parts and aerospace products. The current managed foreign exchange rate regime enables China to maintain a competitive advantage with their trading partners as the “undervalued” RMB would support Chinese enterprises and Multinational Companies who invest heavily in China due to the lower price of the assets and manufacture the products in China to enjoy the benefits of cheaper raw material and labor.

The change in the exchange rate policy to move to a more flexible floating exchange rate system will inevitably compromise China’s current advantageous position in trading especially the export which takes a heavy weight in China’s GDP. The appreciation of RMB will deprive the Chinese enterprises of the advantage to leverage the cheap materials and labor to compete in the international market. This might be a positive indication for China’s importers who has a focus on the domestic markets rather than the international market, where the importers’ purchasing power gets enhanced if the domestic currency appreciate.

However, China is still heavily relying on export to grow their GDP at this point and a revaluation of RMB would be very dangerous for the country. Thousands of factories counting on exports might be closed and millions of workers would lose their jobs. As pointed out by Morgan Stanley Economist Andy Xie in the case, “China’s priority is stability and currency flexibility should not be allowed to conflict with this goal”. On the flip side though, a revaluation of the RMB would not necessarily change the current situation of US and EU who had a large trade deficit with China.

The reduced imports from China are unlikely to stimulate the growth of the domestic productions of those countries and most likely they will import from other low wage countries. The current managed floating rate regime adopted by Chinese government is very costly to sustain in the long term and also straining China’s own economy. As growing capital flows to China put pressure on the revaluation of RMB, Chinese government has to absorb large amounts of USD and exchange them to RMB that are subsequently released to the economy, which in turn fuel the domestic inflation and overheat the economy.

At the same time, FDI is invested in low yield US treasury bonds while used productively to develop the economy. To fight against the inflation, the government has to raise the interest rate and reserve requirements. This again attracts more capital inflow and put extra pressure on the inflation and appreciation of the currency. As such, the current managed floating rate regime is a temporary and transitional tool for Chinese government to balance the domestic growth as well as the financial stability and it is not sustainable in the long run.

3. What would be the impact for China and the U. S. of a drastic reduction in the U. S. trade balance deficit? If there would be a drastic reduction in the US trade balance deficit, it suggests that US is growing its exports or reducing its imports drastically, either way this will lead to a balance of payments which are greater than zero, and this will put an upward pressure on the USD for appreciation as there will be an increased demand for USD.

Under the flexile exchange rate regime, if the USD appreciates against RMB, China would be able to leverage on the relatively low manufacturing costs and labor therefore to gain the competitive advantage on trading, which will help China grow its exports to US. In the meantime, as RMB further depreciates against USD, this will make the assets in China cheaper, which will result in further capital inflow and FDI to China, creating more manufacturing facilities in China. At the end of the day, the drastic reduction in trade balance deficit will be adjusted through the USD appreciation when the new balance is reached where BOP equals zero.

4. How should changes to China’s exchange rate policy be sequenced with banking sector reform and liberalization of capital controls? Given the complexity and potential huge impact of the foreign exchange policy reform, Chinese government should start with banking sector reform then followed by the foreign exchange regime reform and liberalization of capital controls at the same time. As specified in the case, China’s banking sector has been impacted directly by the poor financial performance of the SOEs, as a result the NPL has accounted for 70% of the total loans by mid 90s.

Although China has embarked on an aggressive program to improve the bank’s balance sheets along with the IPO of the major banks, there were growing concerns that the newly added loans would become new NPLs considering the weak risk management practices of Chinese banks. Furthermore, the highly regulated interest rate system prevents the banks from charging higher interest rates to compensate the high risk borrowings, which stimulates the borrowings of firms and contribute to the overheating of the economy.

The banking sector reform allowing the banks charging higher interest rates while requesting strict capital adequacy and reserve requirements will significantly improve the banking sector’s performance. A healthier banking sector would enable China to perform the internal credit allocation more effectively which is imperative for a sustainable long term growth of the economy. With a healthier banking sector, China could continuously further deepen the foreign exchange policy reform and the liberalization of the capital controls at same time.

As stated previously in the case write-up, the current managed floating foreign exchange regime was a transitional tool for the Chinese government to balance the economic growth and financial stability, given the increasing high cost to maintain the regime as well as the refrain to the real economy, this managed floating system was considered not sustainable. The reform will gradually provide RMB exchange rate more flexibility and move to a more market oriented economy, in which the risks of a sudden devaluation of RMB are significantly reduced.

Actually that’s what the Chinese government is doing, the RMB gradually appreciates to USD since 2010, please refer to Figure-1 for the chart showing the upward appreciation trend between RMB and USD from June 2010 to June 2013. As a tool assisting the liberalization of the financial markets, the capital inflow and outflow controls should be progressively alleviated as the country is moving to a more flexible exchange rate regime. Figure-1 Average Monthly Yuan-Dollar Exchange Rates: June 2010-June 2013