Harvard Business Case of International Finance , China to Float or Not to Float?

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  • Topic: Monetary policy, Bretton Woods system, Central bank
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  • Published : October 29, 2011
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China: To Float or Not To Float?

International Finance

Executive Summary

On July 21, 2005, China revalued its decade-long quasi-fixed exchange rate of approximately 8.28 yuan per U.S. dollar by 2.1% to 8.11. Simultaneously, the People’s Bank of China announced that the daily trading band of 0.3% against the dollar would be maintained. Many analysts and economists believed that the real trade-weighted value of the renminbi was undervalued by up to 30% to 35%.

Companies that produce in China for the overseas market, retailers, and importers clearly benefit from an undervalued Chinese currency, as well as from the abuse of workers’ rights. On the other hand, companies actually producing in the foreign countries – whether for the domestic market or for export – face debilitating and unsustainable disadvantages from both currency manipulation and violation of workers’ right in China.

By 2004, the combined value of China’s exports and imports rose to 67% of its GDP, making China’s growth relied heavily on its international trading. The excess foreign exchange reserves resulting from the fixed yuan exchange rate was used as collateral to attract FDI inflows and support China’s development strategy – FDI brings useful technical and management skills as well as jobs to China. A sharp depreciation of renminbi will certainly reduce exports, increase unemployment, and force multinational companies with factories in China to shift production to other low-cost countries. However, the fixed exchange rate was expensive to sustain, and it also limited China’s flexibility in responding to a potentially overheating economy.

Summary of Q3

Chinese commercial banks face foreign exchange risk in three categories: banks’ capital exchange risk, asset liability net position risk, and the foreign exchange settlement risk. Yet Chinese banks’ company governance and international operation expertise are still far behind international competitors. A sudden change of foreign exchange policy such as floating exchange rate could bring huge risk to Chinese banking system. Foreign investors (or speculators) flood large amount of “hot money” into China, causing high inflation especially in property and commodity market. In order to control inflation, central bank has to issue bonds to commercial banks. As a result, the central bank’s independence is seriously challenged. Therefore, the exchange rate reform should be arranged after banking sector reform and capital control liberalization.

Q1. Implications of China’s exchange rate policy on doing business with and against China

After embarking reform in various sectors, especially trade and foreign investment reform, China has increased the total value of both imports and exports. Between 1977 and 2004, China’s share of world trade increased from 0.6% to 6.0%, and strong trade growth continued afterward. The composition of exports also changed dramatically over time. The dominant export product varies from agricultural and petroleum from the earliest year of reform, textiles in 1990s, electronics in 2000s, to automobile and aerospace products by the mid-2000s. It is clear that now China not only has spectacular trade growth, but also moves its exports up to the value-added chain.

China’s partners who buy and sell products with China or its competitors who compete Chinese goods in the international markets have expressed their dissatisfaction with the current situation, as many of them suffers trade deficit with China or attack on domestic industries due to flood of inflows of Chinese goods, particularly US. They argued, undervalued Chinese currency and a fixed exchange rate against dollar allowed Chinese goods an unfair advantage. Suppose that Chinese currency was undervalued and the cost of producing was the same globally, the fixed exchange rate system would always make Chinese product cheaper when selling in international markets. Besides, fixed exchange rate was a barrier to...
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