On July 21, 2005 China, along with introducing a market-based exchange rate system, increased its exchange rate from around 8.28 yuan per U.S. dollar by 2.1% to 8.11%. This development had long been foreseen and has been the subject of debates following China's high trade surplus against the US. Economic analysts see this move as a strain on the economy of China. They posit that that the exchange rate is hard to sustain and would hinder China from responding easily to overheating economy. There is yet to discover on China's exchange rate policy.
Laura Alfaro; Rafael Di Tella; Ingrid Vogel
Harvard Business Review (706021-PDF-ENG)
March 02, 2006
Case questions answered:
- What are the implications of China’s exchange rate policy on doing business with and “against” China?
- 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?
- How should changes to China’s exchange rate policy be sequenced with banking sector reform and liberalization of capital controls?
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China: To Float or Not to Float? (A) Case Answers
1. What are the implications of China’s exchange rate policy on doing business with and “against” China?
China considered its fixed currency regime as critical for the country’s growth and development. It led to rapid foreign exchange reserves accumulation due to excess imports.
Implications of doing business with China before 2005’s change in policy
- Due to the fixed exchange rate, many countries preferred to do business with China as they were able to get more value from their business due to the undervalued currency. They would be able to get more products and services produced in China using less capital due to high productivity.
- Due to the fixed exchange rates, businesses were able to reduce their currency risks and also were able to better forecast their production strategies.
- Even though this favored business from other countries, it was also affecting the economies of these trade partner countries negatively in the long run. Developed economies such as the US and the EU were increasingly becoming a trade deficit with China year-on-year.
- For example, Chinese goods that were being exported to the US had an unfair advantage in the US market due to their low cost.
- The movement of many industries from developed economies like the US to China led to the closure of many home-country businesses and the loss of many jobs in these countries.
Implications of doing business with China after 2005’s change in policy
In 2005, China changed the value of the yuan to 8.11 per dollar (an appreciation of 2% from the existing rate). The peg to the US dollar was also abandoned, and instead, a basket of global currencies was used.
They also announced that they would let the yuan fluctuate 0.03% per day over the previous day’s closing. This managed float currency regime has resulted in a gradual strengthening of its currency since 2005.
- Initially, many global companies that had invested in China were unhappy with the change in exchange rate policy as they would be losing out on the investments that they had made earlier, considering the fixed cheap currency in mind.
- However, companies who also identified China as a potential market for their goods welcomed the currency regime change as they would be able to reap good profits due to the development of the Chinese market.
Implications of doing business “against” China
- The countries that compete against China in global markets, as well as within the Chinese market, would still be disadvantaged. China, with its managed float regime coupled with its strong and cheap workforce capabilities, would still be able to reap the benefits of low production costs and succeed in both global and Chinese markets.
- When compared with the floating rate currencies of developing nations in the rest of the world, China’s managed rate currency still remains an attractive business environment where the effects of currency risk are minimal.
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?
In the pre-reform period, China had fixed the yuan at an overvalued rate to subsidize imports of capital goods that the country was not able to produce internally. However, starting in 1980, the Chinese government corrected the overvalued yuan by steadily lowering its inflation-adjusted value.
In 1994, due to increasing inflation and the credit boom, the government initiated a new exchange rate regime that fixed the exchange rate at 8.28 yuan per dollar. This change led to an increase in the earnings of domestic exporters who were at a disadvantage earlier.
China was even able to maintain this rate during the Asian financial crisis when other Asian countries were devaluing their currency.
- China’s exchange rate policy of keeping its currency undervalued is mainly done to promote exports to other nations and differentiate itself as a prime destination for setting up production businesses.
- If the exchange rate continues to be undervalued, China will get more foreign currency inflows, which would keep it at a trade surplus and boost the economy.
- This is evident from the growth of China’s GDP since the 1970s. The weight of trade in GDP increased from 10% to 79%, and FDI increased from 0 to $64 billion.
- China also managed to move up along the value chain rather than just being an exporter of raw materials or basic commodities. Its position as the leader in manufacturing labor-intensive products such as electronics, auto parts, and aerospace products. This enables China to maintain a competitive advantage over other trading partners.
Having said that, China should not heavily rely on this strategy for the country’s future development. If China decides to change its exchange rate policy to move to a more flexible floating exchange rate system, it will compromise its current position as an export leader.
This will lead to the loss of many outsourced jobs across its industries. In such a scenario, it needs to focus on its large domestic market, which has huge growth potential, rather than the international market.
It may suffer from inflation initially, but with careful control of its interest rates, it may be able to overcome the void generated due to the missing trade.
3. How should changes to China’s exchange rate policy be sequenced with banking sector reform and liberalization of capital controls?
Since the establishment of the People’s Republic of China, the Chinese government, under Mao Zedong’s leadership, had taken major reforms that strived for a centrally planned economy with major communist ideology restrictions.
This proved to be detrimental to the economy. In 1978, the new Communist Party leadership, headed by General Deng Xiaoping, introduced fundamental reforms in the agricultural sector, state-owned enterprises, banking sector, international trade, and foreign investment.
After focusing on the agricultural sector initially, China later focused on state-owned enterprises (SOEs), which accounted for 78% of the industrial output and provided 19% of the total employment at that time.
These SOEs depended on the banking sector for support while carrying out central government-planned schemes and decisions. The poor performance of the SOEs impacted the banking sector adversely due to the accumulation of Non-Performing Loans (NPL).
In the ’90s, China had to undertake an aggressive program through NPL transfers and bailouts to improve the state-owned bank’s balance sheets. Even though the situation has improved, the banks still continue to accumulate NPLs in their books.
This is because of the highly regulated interest rate system preventing banks from charging higher interest rates to compensate for the high risk they take on certain loans.
Thus, allowing the banks to charge higher interest rates while requesting strict capital adequacy and reserve requirements will improve the performance of the banks. This would lead to a more effective internal credit allocation and a healthier banking system.
When it comes to controlling capital inflows, as China becomes increasingly integrated into the global economy, its capital controls are likely to become more erratic. Thus, speculative investors would be able to predict capital movements easily, which could disrupt China’s financial system.
Thus, in its journey of moving towards a market-oriented economy, China should continue to loosen controls on the outflows of capital. It should allow the movement of assets and capital abroad so that the pressure on the internal economy is reduced.
The capital inflow and outflow controls should be progressively relaxed as the country moves towards a more flexible exchange rate regime.
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