The Foreign Exchange Reform in China and Hedging Currency Risk by Chinese Firms

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1. Introduction

China, one of the large emerging markets, with the implementation of its “reform and opening up policy” made in 1978. China has successfully transformed itself from an inflexible centrally-planned economy to an open and market-oriented economy, and accomplished remarkable progress in trade market. China has maintained high and stable growth rates for over two decades. Since China is becoming an increasingly important member in the world’s economic scene, the movements of the foreign exchange rate could be an important issue for Chinese firms. On 19 of June 2010, China’s central bank declared that it will further implement the reform of foreign exchange and enhance the flexibility of RMB exchange rate (Money for life guide, 2010). In the recent financial crisis, it has shown that China’s exchange rate policy is a substantial international issue (Zhang, 2001). However, China’s central bank is in dilemma because of the effects of the foreign exchange reform and the currency risk to the Chinese companies. In the influences of the foreign exchange reform to Chinese enterprises, Anderson, UBS’s chief Asia economist, stated that the impact of importation should be better than the impact of exportation for Chinese firms. However, in the external business competitions, Chinese firms engage in importing machinery and raw materials from other countries, are definitely affected by the foreign exchange reform. Their selling prices are down right now because of losing the competitive advantage from exchange rate reform. But Woetzel, director of McKinsey & Company's Greater China Office, argued that the exchange rate reform will bring Chinese enterprises to the international market, and the effect of the whole foreign exchange reform process will allow Chinese companies to meet the international standards (Let the world feel a bright future of China's economy, 2005).

This essay is organized as follows: Section 1, review the process of China’s foreign exchange rate reform and the new Renminbi (RMB) exchange policy and its impact on China’s balance of trade and the economic development. Section 2, briefly discuss about the impacts of foreign exchange reform in China and the risk to Chinese firms. Section 3, focus on the currency risk affecting the multinational companies in China, examines the relationship between foreign exchange rate arrangements, and states the solution to hedge the currency risk during the foreign exchange reform. Section 4 concludes the paper.

2. The Foreign Exchange Reform in China

Renminbi (RMB) has become a national currency in 1949, but it has been invariable and inconvertible. Consequently, RMB was limited to be an accounting instrument and a capital for allocating company’s resource. With its market isolation from outside world, RMB could not athletically take action to the unpredictable foreign exchange rate, nor make appropriate adjustment that based on the change supply and demand of foreign exchange immediately. Zhang (2001) explained that this situation is essentially related to the monopoly condition of China’s foreign trade policy, only dozen of authorized import and export corporations could cooperate with foreign firms under the import and export contract. Furthermore, these foreign trade corporations (FTCs) had to relinquish the earnings from foreign trading because they had to exchange the currency from the Bank of China at the official exchange rate, and normally the rate is not reasonable. Obviously, there were no incentives for traders under this business circumstances, the changes in the official exchange rate would definitely affect the multinational firms’ financial profits.

In order to improve incentives and promote export performance, China has endeavoured at least four times to reform and loosen its foreign trade management system since 1978 (Zhang, 1997). The main progress of the reform was launched in the last two decades, it proposed to fracture the...
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