International Business

Week Three – Case Study:

China’s Managed Float

1- Why did China originally peg the US Dollar? What are the Pros? What are the cons?

In 1994 the US Dollar was the dominant world currency and for China a target export nation. Only 20 years earlier based on the Bretton Woods agreement all exchange rates were fixed on the US dollar. (Actually, they were fixed on gold, but the US dollar was the only currency that could be changed for gold.) Many of the small countries pegged their currency to the US Dollar once Bretton Woods broke down even though the breakdown was caused by US policy (Hill p.359). By stabilizing the exchange rate between the US and China, they were reducing the risk of foreign investment and economic exposure. This reduced risk gave the US and others who would be marketing to the US through China a stable means of converting money. It effectively reduces the risks associated with volatility of foreign direct investment.

When China pegged the US Dollar many advantages for the global economy as well as China itself were seen. First off, the global economy has seen advantages by eliminating competitive devaluations and forcing China to hold stringent economic policies to reduce inflation (Hill p.358). Additionally, China has benefited from very low inflation rates until recently and strict economic policies that have protected their monetary system. This protection from inflation and the trade surplus have actually made the Yuan undervalued. This gives them a significant advantage when exporting to the US or any other nation that allows their currency to float freely.

There are also some negative effects of the pegged Yuan. According to BloggingStocks.com as the dollar depreciates the costs of consumer goods in China rises, especially imported goods. This means inflation beyond the protection of the dollar. Now that the dollar is depreciating, so are any currencies that are pegged (or managed) to them.

2- If China floats the Yuan, what will happen to foreign enterprise doing business in China?

Firms doing business in China will have one significant problem to deal with. There was once a pegged dollar and the Chinese costs could be held constant according to their home (if they were US based) or the market. Now if the Yuan were to float freely, by some estimates, it could revalue at 40% higher despite a 20% change since 2005, which translates to a 40% increase in operation cost in China (Wikipedia). That estimate may be extreme but the cost for operations would increase significantly enough that the advantages of manufacturing in China will be severely reduced. Strategies would need to be re-evaluated and maybe China as a market may come as a new focus.

3- How would a floated Yuan effect future FDI?

In the short term, foreign direct investment would decrease because of the large amount of inflation that would happen rather rapidly. This would make the rational for manufacturing in China to be less reliant on low cost labor. Companies would take their money to a different global location where the future was more predictable until China was able to give substantial reasoning for continued investment.

Long term may have different outcome if the Yuan were allowed to freely float. The market would be changed more closely to a free market where efficiency was sought. This efficiency would force China to find their niche and focus on what they do best. When regions or nations are able to specialize in what they do well, they can put all their energy into doing that one thing better. These efficiency gains make them more desirable when evaluating where to invest.

4- What circumstances, if the Yuan were floated, would China destabilize? What are Implications?

In 2005 China allowed their currency to start slow revaluation, based on a “basket” of other currencies (Washington Post). Since that time it has risen about 20% and continues to rise against the dollar (Wikipedia). The change in valuation has more to do with the inflation of the dollar than China actually revaluing.

The destabilization of China could happen if the revaluation were to take place very rapidly. Nearly all economists agree that they need to revalue, but how quickly and to what extent is what is still in contention (NPR). If it were instantaneous all Chinese firms that have export capabilities would be hurting for profits and would ultimately loose business. This quick loss of business could cause a downward spiral of the entire economy if there was no intervention by the Chinese government. This means that the government should be slowly easing its way into the free float market so that market efficiency could be improved on the global scene.

5- Should the US push China to float the Yuan? Why?

The US should push China to revalue. We must use very cautious and diplomatic means to avoid putting our economy (or theirs) into a tailspin. We are currently in a precarious position economically, and I believe that now is not the time to press China into the revaluation process. The non-US dollar pegged currency is a good first step as well as allowing 0.5% change each day. These are the slow methodic means of transforming the global economy into an efficient one with competition, free trade and commonly valued monetary systems that are not controlled by governments.

6- What should the Chinese government do with currency value?

I believe that most governments are looking out for the best interest of the company in the long run (although looking at the US government and the current presidential race, I might disagree). China would be better off in the long run to slowly make steps to revalue its monetary instruments. These steps may include modifying the “basket” of currencies it is pegged to until they believe it is close enough to the free market cost. Once it is near free market value they can plan to change it to float freely. If they can stretch this over the next 5-10 years they will be able to make it through the process and not be solely known as a low labor cost country but be developing an efficient, specialized niche where they can be successful on a level playing field.

BlogginStocks.com. China learned that Yuan-dollar peg is a two-edged sword. Retrieved May 30, 2008 from: http://www.bloggingstocks.com/2008/01/07/china-learned-that-yuan-dollar-peg-is-a-two-edged-sword/

Hill, Charles (2008). International Business: competing in the global marketplace, e7. New York: McGraw-Hill Irwin.

NPR. Q &A: How China’s currency policy effects you. Retrieved May 31, 2008 form: http://www.npr.org/templates/story/story.php?storyId=5353313

Washington Post, China end fixed-rate currency. Retrieved May 30, 2008 from: http://www.washingtonpost.com/wp-dyn/content/article/2005/07/21/AR2005072100351_2.html

Wikipedia. Renminbi. Retrieved May 30, 2008 from: http://en.wikipedia.org/wiki/Renminbi