I believe that China pegged the value of its currency, the yuan, to the U.S. dollar in 1994 because at that time the United States was the world's number economy and its currency is considered a highly reliable financial instrument. The benefits of pegging the value of the yuan against the dollar include more control in regulating money supply, and managing exchange rate. Costs include that higher chance of the economy blowing up in a costly currency collapse (Goldstein, 2002, p. 3), an example of which is the managed float currencies during the Asian crisis.
Given the level of foreign investments in China and that their investments produce goods primarily for export, allowing the yuan to float freely vis-a-vis the U.S. dollar and other foreign currencies in the foreign exchange markets and to appreciate in value could mean a significant decrease in the fortunes, and thence values of these enterprises. If yuan is to freely appreciate would lead to lower export growth (Sharma, 2006, p. 59) and even significant decrease in demand for Chinese-made products.
Given than the foreign direct investments that have been flowing into China were invested primarily invested in factories producing goods for foreign markets, and that a freely floating yuan would result to currency appreciation and significant decrease in the demand for Chinese exports, foreign direct investments would decline over time. FDIs like any other investments are return driven and as the return on their investments in China decreases, investors would look for alternative investment vehicles with higher returns.
A freely floating yuan could mean a sharp increase in the value of China's currency and lower demand for export. Lower demand could mean lower jobs and thus higher unemployment. Higher unemployment could lead to domestic unrest and if not controlled to economic destabilization.
Moreover, an appreciating yuan could mean that it...
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