Download China Revalues the Yuan and Moves to a Managed Float Regime

Case Study: China Revalues the Yuan and Moves to a Managed
Float Regime, July 2005
Since early 1997, the Chinese government had pegged its currency, the yuan (or
renminbi), to the U.S. dollar at a rate of Yuan8.28/$. The Chinese government
had maintained this peg even through the difficult Asian currency crisis later in
that year, when many emerging Asian countries were forced to abandon their
pegs.
China argued for years that a fixed and stable currency was critical for the
development and growth of its economy. Pegging its currency would remove
currency risk (regarding the U.S. dollar) and could encourage the development of
both Chinese exports and foreign direct investment into the country. The
success of the Chinese economy during the pegged period was indeed
remarkable, growing in real GDP terms at over 10% per year.
As China’s external trade grew, especially its surplus with the United States,
increasing pressure was applied to the Chinese government, especially from
Washington, to revalue the currency. The U.S. argued that its increasing trade
deficit with China was the result of a significantly undervalued yuan. China
argued that the trade deficit was the result of their competitive cost position.
While China continued to resist Washington’s calls for revaluation, they did
acknowledge that maintaining the peg at 8.28 was becoming very costly in terms
of buying U.S. dollars that were flowing into the country from trade and
investment. In addition, speculative flows into the country, in anticipation of an
eventual yuan revaluation, also required the central bank to purchase dollars and
other hard currencies. By early 2005, China’s foreign exchange reserves
exceeded $700 billion and they were the holders of $190 billion in U.S.
government bonds.
On July 21, 2005, the Chinese government officially changed the value of the
yuan and announced that they were abandoning the peg to the U.S. dollar in
favor of a basket of currencies. On that day, the yuan was allowed to move to
Yuan8.11/$, which represented an appreciation of the currency of slightly over
2%. The Chinese government also announced that they would let the value of
the yuan fluctuate 0.03% per day over the previous day’s closing from July 21st
forward.
China’s new currency regime is consistent with a managed float and although the
government did not announce which currencies are in the new basket, it is
presumed that the euro and yen play important roles in the government’s daily
management. The managed float has resulted in a gradual strengthening of the
currency against the U.S. dollar since July 2005 (see chart).
Implications for Global Companies
Not all global companies welcomed the move to a managed float. Many global
companies had invested in China for the purpose of manufacturing products.
These companies desire a stable and relative cheap currency (i.e., undervalued
yuan and thus overvalued U.S. dollar) for this purpose.
Matttel, as one example, sources more than 70% of its toys from production in
China. For Mattel, a strengthening yuan would result in an increase in the U.S.
dollar cost of producing those toys and unless prices could be raised in Mattel’s
major buyer markets (e.g., in the United States), profit margins would fall.
On the other hand, some companies welcomed the currency regime change,
especially if it resulted in continuing strengthening of the yuan. As the yuan
strengthened, companies selling into China could benefit. Boeing, as one
example, uses dollar based pricing for its exports. A strengthening yuan would
increase the purchasing power of their potential Chinese customers and could
lead to increased sales.