Global Economic Crisis

Since the collapse of Bretton Woods, a critical question facing governments, particular emerging economies, is the choice of exchange rate regimes. While most OECD economies have floating rates and capital mobility or are in the Eurozone, emerging countries have generally selected different exchange rate regimes. Many emerging economies have a “fear of floating,” a resistance to allowing market for to freely determine their exchange rate since they fear that speculation or overvaluation may lead to excessive volatility that could contribute to financial crises and discourage trade and investment. Lack of transparency, thin markets, poor policy, low institutional credibility, and sometimes distrust of perfectly free markets have fueled their reluctance to float.

China, along with other emerging economies in East Asia and the Gulf region, 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.

Positive economic fundamentals, including rapid productivity growth, high investment, and enormous growth potential, resulted in capital inflows, massive trade surpluses, and pressure for the exchange rate to appreciate. 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 (POBC, the central 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. After vocal complaints by U.S. manufacturers, union leaders, and politicians of both parties, and under pressure from the Obama Administration, 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.

Questions

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?
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?