Yuan: Fixed or Float

Any consideration must start with China’s own economic and cultural history China is both a new country and an old country The last Dynasty was overthrown in 1911 Chairman Mao’s disastrous actions including the “Great Leap Forward” and the “Cultural Revolution” (1976) abolishing private property and causing terrible suffering are still very much part of China’s memory

Following Mao’s Death (1976) China’s economy was a wreck and trailed badly behind other Asian economies Deng began a series of reforms such as –Agriculture reform (more autonomy to farmers) –Reducing the scope of State Owned Enterprises –Banking reform (to improve balance sheets and remove non performing loans made to state owned enterprises) –Trade reform (encouraging exports) –Foreign investment reform (encouraging the establishment of foreign business and partner ships)

Yuan History and Controversies In the bad old days (pre reform) the Chinese followed the Soviet’s disastrous model of an over- valued currency and strict exchange rate controls After Mao’s death, China begin to devalue the Yuan In 1986 they introduced the “Dual Exchange Rate” –Foreigners could buy and sell currency at the market rate –Chinese exporters had to surrender foreign earnings at the fixed (overvalued) official rate. –Chinese firms were not happy

Yuan History and Controversies In 1994 China was suffering extreme inflation and as part of a new economic stabilization plan the exchange rate was fixed a 8.28/ dollar In 1998, the currency was fully convertible at that rate.

Yuan History and Controversies: The Asian Crises In 1997 the Thai bhat came under severe pressure and there was a rapid (and painful) devaluation. The contagion spread to a number of other Asian countries. China successfully maintained the Yuan/dollar exchange rate by buying dollars –But these dollars had to be recycled—they were used to buy U.S. financial assets (mostly treasuries). –This could have caused a great deal of inflationary pressure in China, but the purchases were “sanitized” by forcing Chinese banks to buy $100’s of billions in Yuan denominated bonds

Is the Yuan Over Valued? Not a simple question. Most try to answer the question by comparing the yuan to some measure of purchasing power. Estimates seem to range from 10% to 40% overvalued

Is the Yuan Over Valued?

What Should China Do? The Options Float the Yuan Devalue but maintain a peg Do nothing

Floating Floating the currency gives the Chinese monetary authority complete control over domestic interest rates and monetary policy. This means they can directly deal with concerns about a “bubble”. But it also means that many people and businesses will have to deal with exchange rate uncertainty. It also means there will be less discipline imposed on monetary policy

Devaluing Will remove some of the pressure to recycle dollars May help gently relieve the “bubble” (if there is a bubble) Will reduce the possibility of protectionist attacks by U.S. (e.g., may help reduce Lou Dobbs’ blood pressure).

Do Nothing Things seem to be going well in China right now. A policy of more of the same must be very attractive. It is almost impossible to overstate the challenges that China faces as it shifts from a rural, 3 rd -world economy to a modern, urban economy.