China and the Esquel Group

Topics: Foreign exchange market, Monetary policy, Bretton Woods system Pages: 10 (1786 words) Published: April 20, 2014

China and the Esquel Group

China and the Esquel Group
In response to criticism of it pegging the Yuan to the US dollar, China recently implemented steps toward liberalizing its exchange rate policy; however, a floating Yuan has created uncertainty concerning its impact on China’s economy. While it is likely that allowing the Yuan to appreciate against the US dollar will result in undesirable impacts for China such as deflation, a reduction of foreign direct investment (FDI), and a decline in exports, we believe China will, and should, continue a tempered liberalization of its exchange rate policy. This is necessitated by the potential consequences China faces both politically and economically by not moving towards a floating rate. Politically, China will continue to absorb the majority of the blame for foreign countries’ rising trade deficits, spawning potential legislation dictating import quotas on Chinese products. Economically, a fixed exchange rate will continue to plague China by its dependence on exports and increase its risk of being able to maintain the value of its portfolio of foreign reserves, most notably the United States dollar. It is our belief that these risks outweigh the benefits of China continuing business as usual. As such, the Esquel Group should devise operational strategies that mitigate the risks of an appreciating Yuan, which include diversifying revenue streams by implementing a textile import division, pursuing growth in domestic textile sales, and exporting more service-oriented products such as design and manufacturing technologies.

If China does indeed relinquish dependence on maintaining a fixed exchange rate, it would reap several long-term benefits. The most notable of these benefits is an increase in China’s ability to react to a volatile economy by concentrating on inflation rather than exchange rates. Additionally, a pegged currency has in some instances acted as a double-edged sword for China: any appreciation of the Yuan or depreciation of the dollar will result in significant losses in the value of China’s reserves. When the dollar fluctuates, the only way China can maintain the value of its foreign reserve portfolio is by purchasing more dollars, which only further increases its risk and dependence on devaluing the Yuan. This is an expensive practice and has prevented China from being able to make deeper investments in its own economy. We believe that by moving towards a floating exchange rate, China could make these domestic investments, which when coupled with exploiting its massive workforce, including the 200 million unemployed rural populace, it will not only blossom China’s domestic economy but will also allow it to further increase its global competitiveness. China would then be able to promote price stability, thus increasing its central bank’s reputation, in turn causing foreign direct investment to return. This would increase living standards, wages, and consumption, thus boosting GDP.

While it may seem logical for China to move towards a floating interest rate sooner rather than latter, it is much easier said then done. It is our assessment that Zhou Xiaochuan was correct when he stated, “Step-by-step reform is a better way of reform.” The vast amount of China’s foreign reserves as well as its overwhelming dependence on foreign exports cannot be easily overcome. In order to avoid a global economic shock, China must commit to a tempered and transparent approach toward currency liberalization. Not only will this allow for the global economy to prepare but will also openly communicate to businesses what China’s intentions are and allow them to adjust appropriately and avoid speculation.

While a floating rate policy will have beneficial long-term effects, from the perspective of domestic-based companies, this is an unfortunate change in policy in the short term....
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