Question

China has resurrected an exchange rate regime called Bretton Woods II, where these economies peg to the dollar. China pegged at Yuan8.28/$ from 1995 to 2005. (http://www.tradingeconomics.com/china/currency). On July 21, 2005, the People's Bank of China announced a revaluation of the Yuan (from Yuan8.28 to Yuan8.11 to the dollar) and a reform of the exchange rate regime. Under the reform., the People’s Bank of China linked its currency to a reference basket of currencies, heavily weighted toward the U.S. dollar. Over the next three years, under this crawling peg system, the yuan gradually appreciated against the dollar. With the advent of the global economic crisis, China reestablished the yuan's fixed peg to the dollar, at Yuan6.84/$ and maintained it for the next two years. China rolled out a new currency policy on June 20, 2010, that allowed the yuan to once again float upward, within limits, against the dollar; de facto, however, the Bretton Woods II regime remains intact and the currency pegged to the U.S. dollar. The Chinese central bank has managed this peg with widespread capital controls through quantitative limits on both inflows and outflows. The objectives of the controls have evolved over time, and include (i) facilitating monetary independence, (ii) helping channel external savings to desired uses; (iii) preventing firms and financial institutions from taking excessive external risks; (iv) maintaining balance of payments equilibrium and exchange rate stability; and (v) insulating the domestic economy from foreign financial crises.

Recently, the government has started to gradually liberalize capital flows and globally integrate China's capital markets in order to eventually establish Shanghai as a leading financial center. It remains unclear, however, whether China will yield more on monetary independence or exchange rate stability. Chinese authorities fear floating exchange rates, since they want to avoid a rapid and large appreciation of the yuan. This could have serious effects on employment and profits of multinationals in their export sector.

1. By how much did the yuan appreciate against the dollar on July 21,2005?

2. How has the yuan’s appreciation since July 21,2005 affected the U.S. trade deficit with China? Check the trade deficit with China over time at https://www.census.gov/foreign-trade/balance/c5700.html

3. How did the crawling-peg system in place from 2005 to 2008 likely affect inflows of hot money to China?

4. What is the likely reason for the Chinese government again fixing the yuan to the dollar upon the outbreak of the global economic crisis?

5. Why has China adopted capital controls?

Answer 1

1. Yuan appreciated 0.17 against the dollar on July 21,2005.

2. Yuan's appreciation since July 21,2005 has affected the U.S. trade deficit with China over time. Since July 21,2005, the U.S. trade deficit with China had increased at an increasing rate upto October, 2005. Since November,2005, the trade deficit had shown a declining figure.  

3. The crawling-peg system in place from 2005 to 2008 helped Yuan gradually appreciate against dollar. Such currency appreciation has helped in gaining the confidence of investors in favour of Chinese economy and this has led to inflow of hot money to China.

4. The reason for the Chinese government again fixing the Yuan to the dollar upon the outbreak of the global economic crisis is full fledged. Reasons such as Facilitating monetary independence in the Chinese economy and channelising external savings to desired uses has been focused by the Chinese government. Along with this, preventing firms and financial institutions from taking excessive external risks was emphasised. Maintaining balance of payment equilibrium and exchange rate stability along with insulating the domestic economy from financial crisis was given much importance.

5. China has basically adopted capital controls through quantitative limits on both inflows and outflows in order to manage this peg and appreciate Yuan against dollar in the foreign exchange market and kept the Bretton Woods II regime intact.