CASE ANALYSIS- INTERNATIONAL FINANCE

CHINA: TO FLOAT or NOT TO FLOAT? DATE: 09.10.2015

GROUP 5:

1) SANTOSH PRASAD M (14B116)

2) DHIRAJ BAID (14B109)

3) AMIT KUMAR SINGH (14B104)

4) VISWESWARAN (14B123)

1. What are the implications of China’s exchange rate policy on doing business with and “against” China? China follows quasi-fixed exchange rate pegged to US dollar, which was recently revalued by 2.1% but was supposed to be revalued by 35% as per the estimates. Countries globally would have a deep impact of china’s undervalued exchanged rate. The prime reason for this was to keep Yuan cheap in exchange with USD which was the strongest in the global market. The benefits out of this would have been that it would boost exports as the cost turned out to be very cheap and constrain import because of undervalued local currency. Chinese central bank intervened by exchanging incoming dollars and buying dollar assets – U.S. Treasuries. The possible inflationary pressure due to release of RENMINBI is offset through reducing loans to commercial banks, increasing reserve requirements thereby controlling the capital leakage. Their products were sold for a cheaper price compared to the US products hence became a global centre for low cost product & services thus a planned and structured boost to their economy. The exports was favoured by the depreciated currency thereby leading to excessive reserves. At the same time Chinese import restrictions and other trade policies made it very difficult for foreign exporters to sell their products to China. The managed floating rate regime adopted by Chinese government has following impact in doing business with/against China:

a. Doing business with China - Control of Imports: The countries trying to export goods and services to china were

not being favoured due to the stringent import policies, trade mechanism developed and a highly undervalued currency. Thus raising the burden on cost of exports for other countries made it very difficult for foreign exporters to sell their products to China.

- Promotion of Exports: Due to currency undervaluation countries were highly active to import from china and get goods and services at a very reasonable price by reducing the cost drastically and raising china to be a low cost centre for major products.

- Result: This resulted in a sustainable competitive advantage of Chinese products directly managed by quasi-fixed interest rates and capital control measures. b. Doing business ‘against’ China China’s strategy of pegging and maintaining fixed exchange with strongest global currency US dollar, enables it operate with volume investment in LOW COST products and efforts to go against will only lead to economic instability of the country’s trade. Due to sustainable competitive advantage and low cost of capital, the countries going against China will end up in high losses as the competition will be ruined by their lower price and complete control over currency.

2. How is China’s exchange rate policy linked to its development strategy? How would changes in exchange rate policy impact growth in China as well as the rest of the world? Transition of China from centrally planned economy to socialist market economy, brought about growth in annual GDP (9%), FDI reserves ($64b) and trade as % of GDP (79%). This development is obtained by introducing fundamental reforms in the agricultural, SOE’s, banking, international trade and foreign investment. In brief it has focused on manufacturing industries with the help of its exchange rate policy promoted by its quasi fixed approach.

- The FDI in manufacturing sector is largely due to its investor friendly policy. China’s undervalued currency made Chinese products competitive and thus helped in improving exports hugely.

- SOE’s accounted for 78% of industrial output and the exchange rate policy enabled to introduce market based incentives thereby improving the productivity of larger SOE’s.

- The policy has also helped China to utilize its labour force (71%) for production of goods and services which were exported.

- By opening up the Banking sector to the foreign investors, it expected major positive changes which would contribute to its development as its currency is undervalued.

IMPACT OF CHANGE IN EXCHANGE RATE POLICY:

- Appreciation of Yuan: Any change in the exchange rate policy will directly impact the trade (import and export). Due to currency appreciation, trade surplus may be reduced. An adverse change may lead to a situation where China will no longer have sustainable competitive advantage. The overheated Chinese economy may suffer from instability, deflation and zero interest rate liquidity trap. The unemployment in China may increase and there may be a decline in FDI and foreign exchange reserves. Thus, the growth would be negatively impacted.

- Devaluation of Yuan: If China devaluates the currency further, it should actually lead to increase in exports and thereby increasing trade surplus. But it won’t be as expected because the investors will be reluctant to invest under high financial instability. It would lead to “hot money” contributing to economic crisis under anticipation of possible devaluation by the investors.

There can be a decline in trade deficit of US and EU due to change in exchange rate policy of China. Exchange rate policy changes may also lead to India and other Asian countries being more attractive for goods, services and investments. So, the exchange rate policy of China would not only impact domestic trade, economic stability and growth of China but also the rest of the world due to its integration with the world economy.

3. How should changes to China’s exchange rate policy be sequenced with banking sector reform and liberalization of capital controls? China’s banking sector was directly impacted by poor financial performance of SOEs. Banks financed SOEs and other risky projects despite their poor repaying ability. SOE loans ended up forming more than 70% of total loans given by banks in China and in due course, became NPLs. China engaged in an aggressive program to improve bank balance sheets and reduce the stock of NPL’s through transfers and bailouts. But those measures only lead to losses of AMC’s and the NPL’s continued in future years. Desired Changes: 1. Impact of positive changes in exchange rate policy on Banking Sector reforms: - The banking sector performance in China is dependent on huge capital pumped in by

the government. Due to positive changes in exchange rate policy, the banking industry as a whole should strengthen up since the banking sector depends highly on these bond interest rates denominated in dollars.

- Changes in exchange rate policy should also factor in money going into bailouts and transfers. Exchange rates should be as less volatile as possible in order to reduce the amounts pooled in banks to meet the capital requirements.

2. Impact of changes in exchange rates on liberalization of capital controls: - While tightening control on inflows, the Chinese authorities loosened controls on

outflows of capital. - Due to controlled change in the exchange rates, the environment should be conducive

for both investors investing in offshore portfolios and allowing Chinese emigrants abroad to transfer personal assets with them. This would in turn ease up the building pressure on RENMINBI (caused by “hot money”)

Conclusion:

As a conclusion, the liberalization of the banking sector should happen after the progressive switching to a floating exchange regime. Only after the full switch of the exchange regime that the liberalization of capital controls should take stage. Otherwise, China could be led to a financial crisis if it abandons its controls before the full switching, as market forces would not have had the time to expand and play their part in balancing and controlling.