Case 1 Assignment

CHINA: TO FLOAT OR NOT TO FLOAT?

Submitted by: Abhinav Sinha 12201 Deepro Dutta 12214 Pritish Prabhu 12339 Divyesh Pai 12515 Radhika Sharma 12540

Q1) What are the implications of China’s exchange rate policy on doing business with and “against” China? Many analysts believed that the Chinese currency was undervalued and that China kept a its currency pegged against the dollar at a higher exchange rate. Now this policy of China to keep its currency weak against the dollar had following implications w.r.t doing business with and against China: 1) Increase in Exports: The “undervalued” Chinese currency will help create a competitive advantage for the manufactures in China to price their products lower by leveraging the relatively cheap raw material and labor in the Chinese market and export them in market of other countries. 2) Decrease in Imports: With the integration of economy the devaluation of the Chinese currency definitely will have an impact on its trading partners. The currency being undervalued, the companies in the U.S will find it difficult to enter the Chinese market. 3) Increase in trade deficit: Above 2 points, led to increase in the trade deficit (the gap between the imports and exports) 4) Reduce in investments aborad: When the currency is devalued the investment in the countries aborad is also reduced. The Chinese companies would not be able to capitalize on the low labor cost available in the emerging markets of developing or underdeveloped countries. They need to consider the larger impact of risk associated with these countries.

Q2)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? China keeps it exchange rate fixed against the U.S dollar. Fixed exchange rate helps China to devalue its currency even when there is an surplus of exports. Devaluation of Yuan increases exports, foreign investment and the GDP. Thus there is a positive effect on China‟s economy. This acts as an incentive for China to promote exports and take advantage of its manufacturing prowess. China keeps its currency devalued which allows it to be competitive in its exports. Because of this it is able to keep the prices of the consumer goods very low and thus have a large surplus of exports over imports generating huge foreign reserves in the process. Because of this policy, countries like the US are in debt and have hence put pressure on China to stop manipulating its currency and institute more flexibility and move to a floating rate regime. 1|Page

China can modify its current exchange rate in three ways. By appreciating the Yuan, by depreciating it, or by keeping it stable. If they appreciate the Yuan, China will lose its competitive advantage in trades. Factories will move to countries with cheaper labour. This could provide opportunities in export for emerging markets but would have a negative impact on companies in China that are dependent on the advantages provided to them by a cheap renminbi. The United-States think that an appreciation of the money would increase their exportation and solve their unemployment issues, accusing China to “undercut American workers” with low-cost labour; and yet job losses in the US are probably more related to internal problems. It seems that an appreciation of China's currency will not balance the U.S. trade and create more jobs because other low-wage countries might easily take China's place. If China depreciates the Yuan, This would be good for Chinese companies dependent on exports, as the cheaper the currency, the bigger is the advantage for exporters. Foreign factories will outsource their manufacturing and production in China, which will help developed economies to reduce costs and enjoy better profit margins. But in the meantime, it would increase the idea of an unfair competitive advantage in trade for China and unemployment in developed countries might increase. Moreover, inflation in the country would increase, reducing the purchasing power of its citizens even further. Citizens with debts won‟t be able to pay them out, as the value of their holdings will decrease. Another disadvantage of sticking to the current fixed exchange rate policy is that China won‟t be able to manage the economic and financial shocks hitting it as it cannot control its interest rates. Indeed, if it increases its interest rates, more capital owners will want to invest in the country which will ultimately make the value of the renminbi rise, jeopardizing China‟s quasifixed exchange rate policy.

Q3) How should changes to China’s exchange rate policy be sequenced with banking sector reform and liberalization of capital controls? Full autonomy should be given to the banks in their decision of funding projects wether it is a state owned enterprise or foreign enterprise. Project viability and cost of capital or lending rate should be the sole deciding factor in giving commercial loans. Then the lending rate should also be variable and decided on the basis of the riskiness of the project and the tenure of the project and size of the firm. In this way NPA in the banks‟ balance sheet will be improved and banking system will be more profitable and attractive to foreign investors. Also the flow of money into the system will be more driven by the market forces enabling the exchange rate to be market driven. 2|Page

The savings rate of the banks should be decided by the banks themselves allowing them to attract low cost funds from the general population for lending to the business; this in turn will allow the banks to lend at attractive and competitive rates boosting the overall economy. It might also happen that credit-deposit is not growing at par with the deposit growth because the banks have flexibility to invest only in profitable projects and if they don‟t find it they can park the funds in low investing government bonds. The state should also remove the cap on sector wise lending quota allowing the banks to invest in only profitable projects irrespective of the sector in which it is investing. Since the banks are state owned they ultimately going to make the state balance sheet stronger. Then the banks should also be encouraged to fund projects abroad in developing countries earning profits in foreign currency and thus balance the volatility of exchange rate through market forces. Moreover Chinese home grown firms which are investing abroad should be provided loans at attractive rates which will result in capital outflow and will help in stabilizing the currency; also the investment should be made in strategic assets such as oil and natural gas because it will reduce the dependency on imports and when the exchange rate becomes more free floating then it will result in more capital outflow due to the appreciation of renmibi further reducing the import bill and thus will help in maintaining a positive Balance of Current Account. Moreover the interest rate of the commercial banks should be increased to prevent enterprise to take loans at cheaper rates and end up as non-performing assets. This can be done by having a constant Net Interest Margin of few hundred basis points. So as the gross NPAs increases the deposit rate could be increased which in turn would increase the lending rate discouraging lending and thus „deposit rate‟ could act as a policy signaling rate. As a result the savings component of the following equation would increase : (S – I) + (T - G) = BCA (Balance of Current Account). This in turn will allow the state to have a surplus and prevent downward pressure on the currency because the government can spend from the domestic borrowings only if there is a budget deficit. The foreign currency holdings of Chinese households and firms should be taxed if they are converted into renmibi or vice versa depending on the volatitlity of the exchange rate of renmibi against foreign currency; this way they will be able to control the upward/downward pressure on the domestic currency. This decision should taken by the Chinese central bank and can be executed through the commercial banks in which this foreign currency holdings lies. Moreover the FDI in China should be routed through a Chinese bank where it can only be converted into renmibi if it has corresponding domestic order payment proof; thus giving

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the central bank more control in the capital flow and indirect control in the exchange rate and thus reducing the volatility in it. Lastly the money market and overnight lending rate should be subject to periodic review to change the interest rate so that it indicrectly controls the money flow into the overall economic system which in turn will stabilize the exchange rate in volatile market as per the requirement.

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