Chinas Exchange Rate And The Influence On Its Developing Economy

China’s Exchange Rate And The Influence on it’s Developing Economy

Introduction:

China is a country in the Asian sub-continent with one of the world’s largest populations. It has one of the world’s highest economic growth rates and it is expected that by the year 2030 china might be the world’s largest economy if the growth rate continues at the current levels. China has had an average economic growth rate of more than 7% for the last decade and it has been classified as one of the Asian tigers alongside Singapore South Korea and Taiwan.

China was more of a socialist command economy since the period of the onset of world war one but social and economic reforms effectively took root in 1989 to turn china into a market economy. Although china has tried its best to be an ideal market economy many regulations still exist that make it more of a mixed economy.

Such regulations exist on the domestic currency (Renminbi), the main topic of this paper. Due to this growth china has become one of the worlds best investment locations. In addition Chinas exports into the world economy are on the increase year in and year out.

In trying to analyze the reasons why the Chinese government does not want an immediate change into a floating currency we shall also look at issues like the advantages of a fixed currency or pegged currency against a floating currency.

CHINESE CURRENCY: RENMINBI (RMB)

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China’s Exchange Rate And The Influence on it’s Developing Economy

For many years the Chinese currency has been a fixed currency but since 1994 it has been more of a managed floating currency. The Chinese government has usually set a 0.3 percentage per day fluctuation limit on either side based on a central parity basis. In July 2005 the Chinese government introduced new economic reforms. In these reforms the currency was to be affected as follows.

Firstly the Renminbi was not to be pegged on the United States dollar anymore but instead was to be pegged on a basket of currencies and secondly the renminbi was to be made more flexible by having its price value being determined by market forces of demand and supply. In the same July of 2005 the Chinese government announced a 2.1 percent appreciation of the renminbi to the dollar. This was meant to be an indication of better things to come of a floating renminbi but the road to a complete floating currency has been long and problematic. The process has been very slow and indeed the Chinese currency still seems very much pegged on the United States dollar in international transactions. The United States dollar being one of the most favored hard currencies seems many countries want to peg their currencies on it. This is because pegging a currency on the U.S dollar guarantees some level of stability in international trade and the countries involved in the act are not highly affected by market forces. This has been evidenced by acts of countries adopting partial (semi-official) dollarization of their currencies including Iraq, Somalia and southern Sudan.

WHY CHINA IS ADJUSTING IT`S EXCHANGE RATE SLOWLY:

For a long time now the Chinese economy has been experiencing a substantial current account surplus of sometimes up to six percent of the gross domestic product. In addition to this net capital inflows into the Chinese economies industrial sector are continually on the increase, could this be the reason why the Chinese government wants a gradual shift into a floating currency. This can be analyzed in detail using the underlying balance approach.

Thus we could assume that the Chinese renminbi is economically and intentionally under valued. If it is true that the currency is undervalued then the Chinese government will have to

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China’s Exchange Rate And The Influence on it’s Developing Economy

allow a gradual shift towards a floating currency since direct adoption of a floating currency will mean that the currency will automatically appreciate to a market equilibrium point within a short period probably even a couple of weeks.

This would mean that all of a sudden Chinese exports would become proportionally more expensive and imports would necessarily become cheaper by the same proportion. This can be evidenced by scenes from many developing countries which had to adopt structural adjustment programs. In the case of these states most of them in Asia Latin America and Africa their case was the entire opposite. According to the structural adjustment programs they had to float their currencies. In the case of these states their currencies depreciated highly and ended up with their exports becoming cheap and imports becoming more expensive. This is the reason that many sub-Saharan Africa states have current account deficits up to 30% of their Gross domestic products, since they are entirely dependent on industrial exports. Applying this scenario to the case of china then the current account surplus that china has been experiencing over the last couple of years would certainly come to an end and probably end up being a current account deficit. In addition the economic growth rate would certainly come to an end. This would be as a result of reduced productivity that would lead to massive loss of jobs, an increasing or rising consumer price index, and a massive decline in foreign domestic investments as investors seek more profitable locations like India, Malaysia and Singapore.

HOW THE EXCHANGE RATE INFLUENCES THE WHOLE COUNTRY`S ECONOMY AND TRADING WITH OTHERS:

The current state of a managed floating currency has its own advantages and demerits at the same time both domestically and also on the global economy.

Advantages:

On the domestic economic status the managed float has had many positive effects. Firstly by having a managed float producers of not only industrial but also consumer goods are guaranteed a fixed amount of return on their exports. This security guaranteed by a pegged currency on the dollar has boosted production capacities within the Chinese economy and thus

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China’s Exchange Rate And The Influence on it’s Developing Economy

boosted export potential as well as improving on the current account balance.

In addition by having the currency pegged on a value that is in economic terms under valued, this has in turn reduced the value of imports coming into the domestic economy. This has had the effect of reducing currency outflows within the Chinese economy. In addition since exports are in excess of imports the net balance of trade has meant that the Chinese government is increasing stocks of foreign currency.

On a global perspective increased competitiveness within the Chinese industrial sector has led to reduced global prices especially of goods that are mass produced like toys and electronic goods and devices. In addition the undervalued currency has led to massive increases in net capital inflows portfolios largely lured in by market expectations of appreciation.

Disadvantages of the current currency regime:

A fixed currency pegged currency or a managed float usually have some negative policy implications for an economy. In the case of china the managed float has had the following negative effects both on the domestic economy and the global economy.

On a purely domestic perspective the managed float has limited the independence of Chinas monetary policies and the macro-economic environment in the following ways. Firstly it has limited the central bank from increasing domestic lending rates even in times of investment booms and accelerating price inflation, since even with controls the central bank feared increased capital inflows that would subsequently lead to an excess of demand for industrial loans over available supply.

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China’s Exchange Rate And The Influence on it’s Developing Economy

If this was to happen then the central bank would be forced to introduce lending ceilings that are economically problematic since they affect the continued development of a credit culture within the Chinese economy.

In addition the Chinese government has invested heavily in overseas countries as well as emerging as a development partner to many African countries. In terms of financing the government has signed many contracts especially in the field of oil explorations in the Falk land islands and the east African coast. All these and many more contracts could end up being more expensive if the Renminbi was to significantly change in value.

Further more the excessively under valued currency, leads to excess investment in tradable goods. This increased investment in tradable goods will cause the real exchange rate to appreciate within the domestic economy. Once the real exchange rate appreciates it lowers the profitability in the tradable goods industry sending shock waves throughout the economy especially in the financial services sector where it most adversely affect commercial and investment banks.

Besides the mentioned demerits the managed float also causes a massive potential capital loss. In this field the loss is self-inflicted. This arises due to the fact that as china accumulates excess financial capital reserves in the form of foreign exchange reserves it is bracing itself up for potential losses if it was to revalue its currency to a basket of world hard currencies. In addition the prolonged intervention in the foreign exchange market has started to cause for protectionist measures especially within its major trade partners like the United States and the European Union.

If this was to happen on a global perspective then china might find itself faced with many tariff barriers from its trade partners. A significant protectionist measure in the U.S is the Schumer-Graham bill in the US Senate, which could lead to a 27.5 percent tariff imposition on

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China’s Exchange Rate And The Influence on it’s Developing Economy

Chinese imports into the United  States.

Another protectionist measure is the congressional action subjecting the Chinese National Offshore Oil Corporations’ intended purchase Of a U.S Company Unocal, to a review by congress. Due to the fact that over half of all Chinese exports go to Europe, United States, and Japan then china needs to be afraid of such protectionist measures.

In addition since china is a major trading partner of the world’s largest economy, the United States, its inflexible currency complicate the issue of global imbalances and thus increases the risk of a hard-landing for the United States economy as well as the United States currency compounded by probable non-adjustable spillover effects for the global economy.

Conclusion:

Although china is willing to eventually have a floating currency the immediate achievement of this is problematic. some of the issues that make it quite difficult include; a fragile banking sector-although efforts are being made to resolve this, like overwriting debts of national banks and listing them on the stock exchange, like it did with the industrial commercial and development bank of china, the banking sector is still precarious.

Although ultimately a floating renminbi is good for the global economy immediate adjustment might be more costly than expected. Thus the ultimate decision will have to be made by the Chinese authorities based on their views of potential gains and or losses for both the Chinese and the global economy.

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China’s Exchange Rate And The Influence on it’s Developing Economy

REFERENCE:

Morris Goldstein and Nicholas Lardy, “China’s Exchange Rate Policy Dilemma” (PDF), Institute for International Economics. Available at: www.aeaweb.org/annual_mtg_papers/2006/0107_10 15_1301.pdf

Marko Škreb and Mario I. Bléjer (1999) Balance of Payments, Exchange Rates, and Competitiveness in Transition Economies, Springer, U.K

Eugene F. Brigham and Michael C. Ehrhardt (2005) Financial Management: Theory and Practice, Thomson South-Western.

Yun-Wing Sung (1991) The China-Hong Kong Connection: The Key to China’s Open-door Policy, Cambridge University Press, Cambridge.

Nicholas R. Lardy (1992) Foreign Trade and Economic Reform in China, Cambridge University Press, Cambridge.