China: To Float or Not To Float

Introduction

In 1976, China decided to abolish its centrally planned economy that failed to spur efficient economic growth. China’s new leadership decided to introduce fundamental reform in its agriculture sector, state-owned enterprises (SOEs), banking sector, international trade and foreign investment to gradually expand the role of markets. Reforms in these sectors were at the core of China’s economic development plan. By the year 2004, China’s gross domestic product (GDP) grew at an average 9.5% annual rate, foreign direct investments (FDI) increased from zero to $64 billion annually and trade increased from 10% of GDP to 79% of GDP. China’s long-sustained economic growth is attributed to a surge in export that was fueled by the excess of cheap labor and a foreign currency exchange regime that provided economic stability, created a price advantage to its exports and invited foreign capital in-flows to rapidly build its manufacturing base.

Problem Identification

China’s development strategy hinges on its ability to continue to manipulate the yuan to advantage in the world market economy. A long-standing debate over China’s exchange rate system offered no impetus to China to move to revalue the renminbi. Economists waxed poetic over the perceived unfair competitive advantage China purportedly gained with an exchange rate of 8.28 yuan to the U.S. dollar. Neither the threat of impending tariffs, an overheating economy, nor the potential risk of collapsing the global financial system moved China beyond taking baby steps in revaluing its currency. The country blithely continued to make only incremental changes and pegged the yuan to a basket of undisclosed currencies as a reference and to the U.S. dollar. China’s quasi-fixed rate, artificially held low, stimulated wealth in the form of exports and allowed China to amass trade surpluses in comparison to the United States rising trade deficit. Thus the question to float or not to float, or to allow the market to determine the value of the yuan, becomes a critical question in light of how China’s economy will be impacted.

Analysis

Prior to 1994, the inflation rate in China reached a staggering 20% due to earlier devaluation of the yuan. The 20% inflation, combined with a credit boom, led China to adopt a new foreign exchange regime that fixed the exchange-rate against the dollar at 8.28 yuan per dollar and within two years the currency became fully convertible for current account transactions – no restriction on importers to purchase foreign currency and allowing exporters to retain all export earnings.

The fixed foreign-exchange policy created a stable economic environment that protected the economy against currency fluctuations and encouraged foreign investments in the Chinese economy by neutralizing risks from currency fluctuations that