Question

Foreign countries have been pressing China’s government to alter its exchange rate policy to allow more flexibility, presumably so that the yuan will appreciate by a substantial amount. What have been and are China’s policies toward the foreign exchange market?

From the point of view of China’s government and the well-being of the Chinese economy and people, what are the main reasons for the Chinese government to allow more flexibility and (probably) substantial yuan appreciation?

What are the main reasons for China’s government to maintain its current exchange rate policy?

What do you think will actually happen in the next three to five years?

Answer 1

Foreign Countries across the globe, have been demanding that the Chinese government create a flexible exchange rate system, whereby, the value of its currency changes over a period of time. The Trump administration in particular has been vocal about the fact that the Chinese Yuan is currently undervalued and it allows for them to gain from exports and imports as well. Due to undervaluation of the currency, exports bring in more money in local currency than they actually would if the rates were higher.

The Chinese Government directly controls the exchange rate which is pegged to the US dollar. The country operates in a command style economy wherein all decisions regarding what to produce, how much to produce and for whom to produce are undertaken by the Central Administration.

This policy system is known as a fixed rate exchange system, wherein the currency and its value get tied to another currency, and then the price or the exchange rates remain the same over a period of time, The country manages to do so, as it has huge reserves of dollars and it even buys dollars in the international markets to maintain exchange rate levels and gain from trade as described above.

The core benefit, which having this policy gives is exporters gain huge from trade. This is because the prices remain stable over the years, and domestically generate higher number of yuan’s than they ideally would if the exchange rate was not fixed.

Floating exchange rate change over a period of time, and thus a contract done for an amount of dollars could change in value if the currency exchange rates also changed. Businesses in China are well protected through this system, and do not face any fluctuations and can gain big from both the undervaluation of the currency as well as lack of any speculation.

For example, if a producer from China entered into a contract with a United States company, he would be aware that the exchange rate would remain relatively stable over the coming months. This would mean he would be in a position wherein the profits would remain stable even when other countries may face tight situations due to currency hikes or declines coming into picture. The added advantage, makes the country increasingly likely for trade.

The core reason thus, for the government to maintain this currency system is that it allows for certainty of profits and business owners gain from exports and import prices also remain stable over the years. However, in the next 3 to 5 years, due to the added international pressure which is there on the country, it is estimated that it would have to shift to a floating rate wherein the currency rates will be determined by the forces of demand and supply. Which is if exports increase, price would increase and vice versa.

Please feel free to ask your doubts in the comments section.