Himanshu Arora - 12122

Pratik Dugar - 12140

Tripta Kaur Bath- 12159

Lalit Jain – 12524

Mayank Jhawar - 12527

China: To Float or Not to Float?

Case submission - INternationAl Finance

SUBMITTED BY –

1. What are the implications of China’s exchange rate policy on doing business with and

“against” China?

China has certain advantages and disadvantages to its fixed exchange rate policy. Countries

globally would have a deep impact of china’s undervalued exchanged rate. Analyst and

economist have estimated that the extent of undervaluation of Chinese currency (Yuan)

could be about 35%. The prime reason for this was to keep Yuan cheap in exchange with

USD which was the strongest in the global market. The benefits out of this would have been

that it would boost exports as the cost turned out to be very cheap and constrain import

because of undervalued local currency. They were trying to hedge in such a way that the

movement of USD in either way would benefit the Chinese economy as a whole. By doing

that, China was able to keep a competitive advantage over other countries such as the US.

Their products were sold for a cheaper price compared to the US products hence a global

center for low cost product & services thus a planned and structured boost to their economy.

Although the exports was favored by the depreciated currency but at the same time Chinese

import restrictions and other trade policies made it very difficult for foreign exporters to sell

their products to China. The managed floating rate regime adopted by Chinese government

who were extra cautious about adopting a fully floating exchange rate system has

undoubtedly a great impact on countries and corporations doing business with/against China

& Chinese companies in the international market arena.

Doing business with China

The countries trying to export goods and services to china were not being favored due to the

stringent import policies, trade mechanism developed and a highly undervalued currency.

Thus raising the burden on cost of exports for other countries made it very difficult for foreign

exporters to sell their products to China. Due to currency undervaluation countries were

highly active to import from china and get goods and services at a very reasonable price by

reducing the cost drastically and raising china to be a low cost center for major products.

This resulted in a sustainable competitive advantage not explained by the law of supply and

demand on financial markets but directly managed by the currency play.

Doing business ‘against’ China

With such volume investment in low cost product which is the resultant of their enhanced

trade policies and undervalued currency might hamper the economic stability of the country

going against China. It would be very difficult to facilitate business against china, as they’ll

ruin the competition by their lower price and complete control over currency which further

plays an important role in trade and commerce controlling a major chunk of low cost export

for major countries in the world.

2. How is China’s exchange rate policy linked to its development strategy? How would

changes in exchange rate policy impact growth in China as well as the rest of the world?

The development strategy of China is based on the following - Agricultural Reforms, State

Owned Enterprise Reforms, Banking Sector Reforms, Trade Reforms and Foreign

Investment Reforms. It has focused on manufacturing industries with the help of its

exchange rate policy. The FDI in manufacturing sector is largely due to its investor friendly

policy. China’s undervalued currency made Chinese products cheaper and thus helped in

improving exports hugely. The policy has also helped China to utilize its labor force for

production of goods and services which can be exported. By opening up the Banking sector

to the foreign investors, it expects major positive changes which would contribute to its

development as its currency is undervalued. Any change in the exchange rate policy will

impact the trade (import and export). The trade surplus may be reduced. An adverse change

may lead to a situation where China is no longer attractive for goods and services. The

overheated Chinese economy may suffer from instability, deflation and zero interest rate

liquidity trap. The unemployment in China may increase and there may be a decline in FDI

and foreign exchange reserves. Thus, the growth would be negatively impacted.

There can be a decline in trade deficit of US and EU due to change in exchange rate policy

of China. Exchange rate policy changes may also lead to India and other Asian countries

being more attractive for goods, services and investments. So, the exchange rate policy of

China would not only impact domestic trade, economic stability and growth of China but also

the rest of the world due to its integration with the world economy.

3. How should changes to China’s exchange rate policy be sequenced with banking

sector reform and liberalization of capital controls?

Chinas banking sector was directly impacted by poor financial performance of SOEs. Banks

financed SOEs and other risky projects despite their poor repaying ability. SOE loans ended

up forming more than 70% of total loans given by banks in China and in due course, became

NPLs. Even by 2005, unofficial estimates of NPLs were very high. Efforts to reduce NPAs

were aggressive since the nineties and a large amount of funds were injected to carry out

bailouts and transfers. A lot of money was transferred in AMCs in return for bonds.

As of now the banking sector in china is dependent on huge capital pumped in by the

government, if exchange rate policy changes positively then the banking industry as a whole

should strengthen up since the banking sector depends highly on these bond interest rates

denominated in dollars. Changes in exchange rate policy should also factor in money going

into bailouts and transfers. Exchange rates should be as less volatile as possible and

banking industry as a whole needs to grow and meet global standards and practices.