China's Managed Float

Feedback: Case Analysis #1

Chapter 10: The International Monetary System

Closing Case: China’s Managed Float

The closing case describes China’s exchange rate policy. For nearly a decade, China fixed its exchange rate to the dollar and bought or sold dollars to maintain the exchange rate. By early 2005 though, the country was feeling pressure both at home and abroad to let its currency, the Yuan, float freely against the dollar.

[1]Why do you think the Chinese government originally pegged the value of the Yuan against the U.S. dollar? What were the benefits of doing this to China? What were the costs?

Comments:

Most of the Chinese exports are made from dollar-denominated imported materials and energy. By pegging to the dollar, China managed its foreign exchange risk in these areas. It also mitigated the risk for investors coming into China. Also, China’s economy, through its peg to the dollar, has remained stable. It was not drawn into the Asian meltdown in 1997. One of the costs of pegging is that the Chinese government has to manage the peg. Thus, it is active in the foreign exchange markets. Another cost is that the dollar’s movement, up or down, affects the Chinese economy.

[2]Over the last decade, many foreign firms have invested in China, and used their Chinese factories to produce goods for export. If the Yuan is allowed to float freely against the U.S. dollar on the foreign exchange markets, and appreciates in value, how might this affect the fortunes of those enterprises?

Comments:

Since they are moving raw materials into China, using Chinese labor, and then exporting, their production costs will rise in China (Yuan strengthening against the dollar) in dollar terms.