China, float or not
Since July 21, 2005, China has adopted a managed floating rate regime based on market supply and demand with reference to a basket of undisclosed currency. The daily trading price of the U.S. dollar against RMB in the foreign exchange market will be allowed to float within a band of +/->0.3% around the central parity published by People’s Bank of China. The signal was initially interpreted by the international market as an indication that China would embark on a gradual shift toward increased flexibility which eventually adopt a floating exchange rate regime where the RMB will appreciate much against US dollar. However, they soon …show more content…
As growing capital flows to China put pressure on the revaluation of RMB, Chinese government has to absorb large amounts of USD and exchange them to RMB that are subsequently released to the economy, which in turn fuel the domestic inflation and overheat the economy. At the same time, FDI is invested in low yield US treasury bonds while used productively to develop the economy. To fight against the inflation, the government has to raise the interest rate and reserve requirements. This again attracts more capital inflow and put extra pressure on the inflation and appreciation of the currency. As such, the current managed floating rate regime is a temporary and transitional tool for Chinese government to balance the domestic growth as well as the financial stability and it is not sustainable in the long run.
3. What would be the impact for China and the U.S. of a drastic reduction in the U.S. trade balance deficit?
If there would be a drastic reduction in the US trade balance deficit, it suggests that US is growing its exports or reducing its imports drastically, either way this will lead to a balance of payments which are greater than zero, and this will put an upward pressure on the USD for appreciation as there will be an increased demand for USD. Under the flexile exchange rate regime, if the USD appreciates against RMB, China would be able to