Chinas Managed Float
I think the reason Chinese government pegged the value of Yuan against US dollar is obviously to support rapid economic growth and attract foreign capital inflows. Through pegging the Yuan, its value was kept depreciated against US dollars, which helped in enhancing Chinese exports to US. The Yuan was maintained 40 undervalued, which made Chinese exports cheaper to US. The benefits for China are trade surplus, accumulation of foreign reserve, boost in local production, increase in GDP, rise in employment and standard of living. Apart from the reason that cheaper Yuan made Chinese exports cheaper in international trade, the other valid reasons for cheaper Chinese products are its lower labor cost, technological advancement, higher capital to labor ratio, good infrastructure facilities such as transport and power, and supportive government policies regarding industrialization. All of these factors summed up in making China an excellent place to set up factories and plants for production because of its overall lower production and exchange rate cost.
On the cost side, China was accumulating excess foreign exchange and was increasing Yuan money supply aggressively which might lead to price inflation. When dollar was in excess supply, the Chinese central bank used to issue additional Yuan in order to cover the shortage of Yuan against dollar. The pegging of currency actually increases the domestic money supply and it is a concern for the economy because it is not sustainable to follow aggressive expansionary monetary policy in the long run. At the point when productive capacity of economy stops expanding and the rising aggregate demand cannot be met by limited productive capacity then the excess inflation destabilizes the economy. Hence the monetary base should be expanded moderately to maintain the economic growth in the long run. Lastly, the depreciated Yuan however makes imports costly and this has hurt firms which rely on imported raw materials, machinery and supplies for its production. This exchange rate policy has hurt non exporting industries which rely on imported raw materials (Morrison Labonte, 2009).
Effects of Yuan appreciation on Foreign Firms
Many foreign firms have invested in China which takes advantage of lower production and exchange rate cost to export cheaply in world market. However, if Yuan appreciates the attractiveness of Chinese exports will definitely decline, and given the current financial crisis and decreased consumer spending worldwide, the foreign firms will experience decrease in its revenue. Moreover many foreign firms have issued bonds and stocks in Chinese stock market and have taken huge debt from Chinese banks to finance their growth projects. These firms pay dividends and interest in Yuan and if it appreciates, this will increase their cost of capital.
However Yuan appreciation will benefit those sectors in China which import raw materials from overseas for their production. This will lower the cost of their raw materials and will result in increased profit margins. Moreover appreciated Yuan will make imports of capital goods and machinery more attractive. More industrial units will be setup with advanced technology and this will increase competition for foreign firms. Moreover, as capital to labor ratio will increase, the labor productivity will rise and this will lead to increase in wages. Hence labor cost will increase and this will affect foreign firms whose primary purpose for setting up factories in China is to take advantage of lower labor cost.
Effects of Yuan appreciation on FDI flows to China
According to statistics, global financial crisis of 2008 has caused a decline in Chinas exports and FDI. Exports declined by 20.5 and FDI declined by 12.6 from January to October 2009 as compared to same period in 2008. If Chinese government adopts free floating exchange rate policy, it is likely that FDI flows to China will decrease further. Obviously, when Yuan will become costly buying Chinese assets with Yuan will be expensive hence deterring FDI. Also much of the FDI attracted by China is due to its stable exchange rate which reduces exchange rate risk for foreign investors. Letting Yuan to free float in foreign exchange market will negatively affect the FDI in China (Morrison Labonte, 2009).
Effects of Yuans free float on Chinese economy and worldwide impact
If Yuan is left to free float against US dollar, then it is likely that Yuan will appreciate in value and the result will be decreased FDI and exports of China. Estimates reveal that 20 increase in Yuans value will lead to 4 rise in the prices of Chinese exports. Given the current worldwide recession, any decrease in exports will destabilize the Chinese economy whose main revenue comes from exporting. The decrease in revenue will lead to closing of plants and factories or layoff of workers. The unemployment in China will greatly affect the conditions of people who already have low to moderate standard of living (Morrison Labonte, 2009).
However, it is not necessary that free float of Yuan will lead to its appreciation. Many manufacturing firms in China are foreign based such as US which utilizes the cheap labor of China to export their products worldwide. These firms import raw material and components in China for manufacturing and assembly mainly from East Asian countries. Hence China runs trade deficit with countries such as South Korea, Taiwan and Japan. Therefore the free float of Yuan will result in very small rise in its value because a trade surplus with US will be countered by trade deficit with East Asian countries, making Yuans value to remain unchanged. Hence the extent to which Yuans free float will affect Chinas economy is not clear (Morrison Labonte, 2009).
The excess of foreign reserves in China has led to Chinese purchase of huge amount of US assets. More than 1 trillion US securities are believed to be held by China. Any appreciation of Yuans value relative to US dollars will decrease the value of assets and securities held in dollar denomination. Hence the Chinese economy will be affected if its assets held in dollar currency depreciate due to Yuan appreciation (Morrison Labonte, 2009).
Worldwide, the countries are experiencing recession because of recent global financial crisis. The nations have experienced decreased consumer spending and business investment because of lost of confidence in the economic process. China is the only hope for taking the world out of the recession because of its lower priced exports. If China is the largest exporter, it is also one of the largest importers of goods and services. China is a source of revenue and employment for many East Asian and African nations from where it imports raw material and components. The foreign based firms in China take the returns on capital out of the China and into their respective countries, hence boosting their home economy. Thus China is the engine of economic growth for many countries worldwide. If recession hits China because of the negative effects of Yuan appreciation, then it is very difficult for the world economy to get out of the recession.
Should US force the Chinese to free float Yuan
I do not think it is beneficial for US to push China for free float of Yuan. If Yuan appreciates there will be negative repercussion for US economy. US has large trade deficit with China because Chinese firms have competitive advantage due to low exchange rate is not the complete explanation. US have long been in trade deficit and the primary reason is imbalance between domestic saving and investment rate. The US have low saving rate and the attractive US consumer market has led many countries to benefit from exporting to US. The US productive capacity is not enough to meet its growing aggregate demand. China also exports to US and then uses its excess reserve to purchase US securities and treasury bills. China is a major financier of US deficit and also brings major capital investment to US. Hence any damage caused to Chinas export by appreciating Yuan will have direct impact on US economic fundamentals such as lowering of capital investment rate which will further worsen the US deficit (Morrison Labonte, 2009).
What should China do regarding the currency policy
I think China should let the Yuan float as my research shows that Yuan will not appreciate significantly as trade surplus with US will be offset by trade deficit with East Asian countries. US is using trade barriers and duties to raise the prices of Chinese exports in US, hence the move by Chinese government to abandon the pegging completely might improve the terms of trade for China with US. Moreover the devaluation of Yuan by China leads to cycle of devaluations by other countries mainly East Asian who want their exports to China to be competitive in terms of exchange rate. Hence free float of Yuan might eliminate this cycle of currency manipulations. Moreover Chinas devalued currency hurts the exports of least developed countries in Indian subcontinent (Bangladesh, Pakistan and Burma) and Africa. Therefore China should free float its currency to give fair chance to these developing countries to increase their exports.