Question

 

If you were elected to choose between a fixed, freely floating or dirty floating exchange rate system, which would you choose for your home country? Why? China has a fixed exchange rate for the yuan (the currency they use for foreign trade). Many people argue that the yuan is overvalued. What impact does this have for US trade with China.

Answer 1

If, I would be elected to choose an exchnage rate system for my country then, I would have recommended the dirty floating system or the managed float system. This is because my home country being India and is a huge importer of goods. And as the imports have been higher than exports over past years there has been more outflow of INR in form of foreign currency than foreign currency's inflow. In such cases if exchange rates are completely market determined then this leads to consistent depreciation of domestic currency, which is being witnessed by India over past few years. Major import commodity is oil and oil prices highly affect it.

If its managed float system for India then government might intervene a little into markets and can manipulate the exchange rates a bit to put a cap on this forever depreciating currency. This also highly affects the internal monetary policies of country and inflation as well. Goverment can somehow manage with the capital accounts or might increase the FDI to increase the inflow of foreign currency in order to manage the exchange rates, so I think some of government intervention is essential for regulation of exchange rates.

Yes, china has fixed exchange rate regime and this is due to type of goverment there. China has been following the fixed exchange rate since past 20 years and has recently liberalised a little to allow the movements to take place as per the markets. But china has dominated a lot in global markets. Moreover China is also a huge exporter to global markets, and hence it has enough reserves as well to manipulate its exchange rates against other countries. This is the reason why some people say yuan is overvalued as Chinese government manipulates its exchange rate to keep yuan strong against other countries and would not let China to suffer even if global economy suffers due to any reasons.

For USA, China is the largest bond holder of USA and has highest reserves of dollars in the world. So whatsoever is the exchange rate status with US, China can easily manipulate its Yuan in order to mainatain a desired exchange rate with US, either appreciating Yuan by selling dollars and depreciating(devaluating) it by buying dollars. Now this affects US in context of trade, as the value of dollar would be affected internationally but Yuan stays as it is. Suppose if USD depreciates at a global level then US would have to pay much more to china for its imports as compared to other nations due to fixed exchange rate system of China. This can also be related in context of the US-China trade war going on currenty.