The Chinese Yuan: The Revaluation Dilemma

Abstract

With China coming to occupy a central place in the global economy, the country's economic policies are attracting significant international attention. The Chinese government has indicated that it intends to liberalize capital controls.

Meanwhile, the Yuan has been pegged to the dollar for a decade. There is a widespread belief that the Yuan has become significantly undervalued. But senior Chinese politicians believe that China cannot let its exchange rate move more freely before it fixes its weak banking system. Otherwise, there will be a large outflow of capital.

China seems intent on relaxing capital controls before setting its exchange rate free. Is China better off moving cautiously in liberalizing its capital account, and moving more rapidly towards greater exchange-rate flexibility? What should China do?

INTRODUCTION

With China coming to occupy a central place in the global economy, the country's economic policies were attracting significant international attention. In early 2005, the Chinese government indicated that it intended to liberalize capital controls. Having already eased some controls on capital outflows, in the past one year, Chinese officials mentioned that they would open up the capital account further during 2005.

For example, firms would have more incentive to hedge foreign-exchange risk. This would encourage the development of suitable financial instruments including derivatives. The experience of greater exchange-rate flexibility would also help the economy over time, to prepare for a full opening of the capital account. If capital controls shielded the economy from volatile flows, China would have time for reforms to strengthen the banking system.

Chinese policy makers faced a dilemma. What should they do first - liberalize capital flows or allow the Yuan to float? The dilemma was further accentuated by pressure on China from many western countries, especially the US, to revalue the Yuan.

BACKGROUND NOTE

Only a few years ago, when "the world economy" was discussed, China would at best get a brief mention. But in 2005, China was too big to ignore. Since 1978, when Deng Xiaoping first set his country on a path of economic reform, its GDP had grown by an average of 9.5% a year, faster than in any other economy in the world.

China had the highest income per head and was the technological leader. But then it suddenly turned its back on the world, imposing restrictions on international trade and use of technology.Measured by GDP per person, China was overtaken by Europe by 1500, but it remained the world's biggest economy for long thereafter.

In 1820 it still accounted for 30% of world GDP. However, by 1950, after a century of anarchy, warlordism, foreign suppression, civil war and conflict with Japan, its share of world output had fallen to less than 5% .

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        Case Code   ECOA132
   Case Length    16 Pages
              Period    -
 Organization     -
        Pub Date     2005
Teaching Note    Not Available
     Countries    China
      Industry    -

Issues                 -

China, The Yuan, Pegged to the dollar, China's Economic Policies, Chinese Government, Liberalizing capital controls, Weak banking system, Relaxing capital controls and Greater exchange-rate flexibility.

Please note:

This case study was compiled from published sources, and is intended to be used as a basis for class discussion. It is not intended to illustrate either effective or ineffective handling of a management situation. Nor is it a primary information source.