China: To Float or Not

China: To Float or Not to Float? CASE SUBMISSION - INTERNATIONAL FINANCE

SUBMITTED BY – Himanshu Arora - 12122 Pratik Dugar - 12140 Tripta Kaur Bath- 12159 Lalit Jain – 12524 Mayank Jhawar - 12527

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.