China's Managed Float

Throughout the 1990s, China was highly successful at maintaining a currency peg using a government monopoly over all currency conversion between the Yuan and other currencies. This policy was praised during the Asian financial crisis of 1998 as it prevented a round of competitive devaluations. (Wilson, 2010). In order to improve the competiveness of Chinese exports, China in the 1980s devalued the Yuan. The peg lifted on July 2005 was not long-lived as it was unofficially reinstituted when the financial crisis hit: "Under intense pressure from Washington, China took small steps to allow its currency to strengthen for three years starting in July 2005. But China "re-pegged" its currency to the dollar as the financial crisis intensified in July 2008." (Robb, 2010). In June 2010 China stated that it would increase the Yuan exchange rate flexibility and move to a managed floating exchange rate based on market supply and demand with reference to a basket of foreign currencies (Chan, 2010). However, the country is being pressured from both home and abroad to let the Yuan float freely against the dollar.

The critics of the pegged currency state that China is going against the basic principle of market economics by holding its currency at artificially low prices. Why? Pegging the value of the Yuan against the US dollar gives China a competitive advantage by making its products cheaper in the US markets, thus allowing Chinese firms to acquire market share and seize jobs away from US manufacturers. Pegging also allowed China to protect domestic markets from imports and create a steady atmosphere for foreign investment as the investor were able to gauge the value of his/her investments and not be concerned about daily exchange rate fluctuations. (Chan, 2010).

The damaging implication of the peg is that while exporters benefit with an undervalued currency, importers face high costs of importing parts, machinery and materials to China. This may hamper the optimal...