China: To Float or Not to Float - Case Study Example

Fixing the exchange rate by China against the US dollar has served to increase its exports to the US, while decreasing its imports, a situation that led to an increase in China’s trade surplus, at the expense of the USA (Alfaro and Tella, 12). Following this scenario, there has been increased pressure to have China revalue its quasi-fixed exchange rates, and thus make the exchange rate for its currency against those of other countries more flexible. While this move is anticipated to benefit China’s trading partners, since they will be in a position to reap the benefit of a flexible currency exchange rate, which includes increasing the value of their exports to China, there is some dissent view amongst some economists, that doing that will have a negative implication on China and consequently on its trading partners (Alfaro and Tella, 7).  

In the event that China would make its currency exchange rate more flexible, a high rate of deflation will be experienced in China, which would result in economic decline. This is because; making the exchange rate flexible would mean that the Chinese currency will lose some value relative to other currencies, such as the US dollar. This would mean that the cost of doing business in China will increase since the multinational corporations and other foreign investments in China will be forced to cater to the cost of increased inflation. This might result in having most of the foreign investments or the multinational companies moving out of the Chinese market and seeking to invest in other countries, where the cost of doing business will be relatively lower (Alfaro and Tella, 18). While it can be seen that fixing the currency exchange rate for the Chinese currencies against other currencies serves to give China a competitive advantage in business with other countries, the revaluation of the currency to make it more flexible will have negative impacts on the Chinese economy and to other foreign investors into the Chinese market.  

The Chinese economy operated under the principles of communism until reforms were introduced to make it a socialist economy, with private ownership of property and increased reforms in agriculture, state-owned enterprises, banking sector, trade, and foreign investment policies, which saw China increase its GDP growth by 9.5% annually, and increase its trade from 10% of GDP to 79% of GDP between 1978 to 2004 (Alfaro and Tella, 15). The most significant change was in foreign investment policies, where China pursued policies that allowed for high foreign investment, resulting in having 50% of China's exports being produced by foreign investors by 2004 (Alfaro and Tella, 16). China pursued foreign direct investment into its economy more than borrowing loans, an aspect that saw the FDI account for more than 70% of its capital inflow in the early 2000s.

However, the pressure of investment into china reached a position of imbalance with household consumption, prompting the Chinese government to slow down its pursuit for investment, to encourage household consumptions, so that the pressures of investment and consumption would level off. Thus, as opposed to focusing on revaluing the exchange rates, the Chinese government started focusing on domestic policies that would enhance consumption starting in 2005 (Alfaro and Tella, 22). Both the domestic policy and the exchange rate revaluation have the impact of increasing deflationary pressure while increasing the cost of doing business for foreign investors. This calls for a further adjustment to such businesses, which may include increasing their sales in China to cover up for the increased costs or shifting their businesses to other countries which have less cost of doing business.

Therefore, as much as there is an increased pressure to have China revalue its exchange rates and make it more flexible, there are both advantages and disadvantages to this move, according to economists. The advantage likely to be obtained by Chin, through making its exchange rates more flexible is that the move will enhance the movement of the Chinese economy from an investment-oriented economy to a market-oriented economy (Alfaro and Tella, 21).