Why does China still have a managed peg exchange rate system?

20 Feb

During China’s reform era foreign trade was used to drive industrialisation as part of the Chinese government’s policy objective to sustain economic growth, with minimal disruption to society. Trade allowed China to import more of the key industrial inputs and technology which it could not produce.  When China joined the World Trade Organisation and opened up to free trade on 11th December 2001 it agreed to ‘liberalize its regime in order to better integrate in the world economy and offer a more predictable environment for trade and foreign investment’ (WTO, 2001). However, it is argued that China has ‘an unfair competitive advantage to Chinese producers and exporters’ (Morrison and Labonte, 2013). China’s progressive move to market liberalisation involves the move away from a fixed-peg mechanism. This leads to the question why today does China still have a managed peg exchange rate?

The yuan or renminbi is the currency of China, meaning the “people’s currency” (Qing, 2012). The People’s Bank of China and therefore the Chinese government manages the value of the renminbi (RNB) by fixing the rate on each trading day for trade flows in and out of China (ECR Research, 2014). The RNB is therefore now calculated by market supply and demand. The basket to which China fixes the RNB contains 11 currencies; the US dollar, euro, British pound, Japanese yen, Russian rouble, Australian dollar, Canadian dollar, South Korean won, Malaysia ringgit, Singapore dollar and Thailand baht. Although since 2005 China has discontinued a fixed exchange rate to the dollar, the weights given to each currency are not made public. The People’s Bank of China therefore still has incentive to give a greater weight to the dollar, the U.S. being China’s main trading partner.

The main reason China does not have a floating exchange rate is due to the economic benefits of an undervalued currency. A weaker currency means that imports are relatively expensive and exports are relatively cheaper. A managed peg system therefore allows China to achieve a higher export-led growth rate since Chinese goods are more appealing to foreign firms and consumers (Morrison and Labonte, 2013); which in turn provides more jobs for Chinese workers. This therefore supports China’s market oriented development strategy and reflects why the RNB still follows a similar trend to the dollar today. Secondly a managed peg exchange rate system is beneficial for China as a developing economy because it will ‘give rise to lower inflation and facilitate more investment’ (Yi, 2013); necessary conditions for gradualist reform. FDI is also crucial because it provides access to foreign ‘technology and know-how’ (Morrison and Labonte, 2013). The exchange rate and China’s four macroeconomic performance indications are interlinked; a fluctuating exchange rate impacts growth, unemployment, inflation and the balance of payments. China therefore must continue a gradual move away from a fixed peg system in order to maintain economic stability and achieve ‘a relatively balanced balance of payments account’ (Yi, 2013).

Since July 2005 the RMB has appreciated 34% on a nominal basis against the U.S. dollar (Morrison and Labonte, 2013) reflecting that today market forces have a more dominant role, as central bank intervention begins to decrease. It is argued that a stronger currency within China could decrease global imbalances. By fixing to the dollar China is effectively importing America’s monetary policy (The Economist, 2009). A stronger currency could therefore not only decrease America’s trade deficit but allow China to implement monetary policy more suited to its rapidly growing economy. It would also help to ‘avoid the resource misallocation caused by exchange rate distortions’ (Yi, 2013) and today benefit China as import levels are increasing. Yet the economic benefits of a managed peg system reflect why ‘China is dragging its feet’ (The Economist, 2009). It becomes clear that whilst China still aspires to become the next global superpower it will not appreciate its currency completely until the fuel of Chinese growth shifts from exports to consumption; a pattern which is unlikely to occur in the near future.

Amy Warwick

 

References

ECR Research, 2014. China’s exchange rate policy. Available from: http://www.ecrresearch.com/chinas-exchange-rate-policy [Accessed 19/02/14].

Koh Gui Qing, 2012. Timeline: China’s reforms of yuan exchange rate. Available from: http://www.reuters.com/article/2012/04/14/us-china-yuan-timeline-idUSBRE83D03820120414 [Accessed 20/02/14].

Morrison, M.W. and Labonte, M. (2013) China’s Currency Policy: An Analysis of the Economic Issues. CRS Report for Congress, Congressional Research Service, RS21625.

The Economist, 2009. A yuan-sided argument, Nov 19th 2009. Available from: http://www.economist.com/node/14921327 [Accessed 19/02/14].

WTO News, 2001. WTO successfully concludes negotiations on China’s entry. 2001 Press Release.  Available : http://www.wto.org/english/news_e/pres01_e/pr243_e.htm [Accessed 20/02/14].

Yi, G. (2013) Exchange Rate Arrangement: Flexible and Fixed Exchange Rate Debate Revisited. International Monetary Fund, 16th April 2013.

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