China's Exchange Rate

China’s Exchange Rate: Issues and Policies

by

Maria DaCosta

Department of Economics

University of Wisconsin-Eau Claire

Eau Claire WI 54702-4004

dacostmn@uwec.edu

Eastern Economic Association

Annual Meeting

Washington D.C.

February 20-22, 2004

Introduction

China has been under increasing pressure to revalue its currency -- the yuan. China's exchange rate has been pegged to the dollar since 1994 and as China's trade and economic position has strengthened, such policy has come under attack. How important has China's exchange rate policy been to the success of China's economic reform? Should China revalue its currency? What would the effects of such revaluation be on China's economy? Should China allow the currency to float? These are the questions addressed in this study.

This paper is structured as follows. In the first part we provide an overview of alternative exchange rate regimes and China’s exchange rate policy. Then we examine the impact of exchange rate fluctuations on three economic areas: inflation, the external sector, and financial stability. The connections between inflation and exchange rate, namely the so-called pass-through effect, are discussed in part two. Part three investigates the impact of the exchange rate on the external sector by examining the issues of competitiveness and openness. In part four, we address the exchange rate’s impact on financial stability. Policy recommendations are discussed and concluding remarks offered in part five.

1. Overview

Generally speaking there are three exchange rate regimes: fixed, floating (free) and managed float. It has been suggested in the literature that countries generally float their currencies if their GDP is large, if there is a relatively low level of openness, a high inflation differential with other countries, a high degree of integration in international capital markets, and substantial diversification in...