Critically Analyzes & Drawbacks About Fixed and Managed Floating Exchange Rate Regime

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On top of this, the managed floating exchange regime makes Chinese firms more exposed to foreign exchange risks. Although RMB against US dollar and Yen appreciated steadily after the new regime, it has depreciated dramatically against Euro and pound from 2005 to 2007 (Bernard, 2008). The diversified changes of the exchange rate against different currencies indeed cause some problems for exported-oriented companies in China, especially for textile companies. For example, from the research conducted by Bernard (2008), in 2006, about 87% of the sample textile companies received revenue in dollars while the geographic distribution of these companies was much more divergent, which covered EU, Japan, US and other areas. The mismatch of currency settlement and actual trading destination will induce problems if RMB is going to appreciate against Japanese Yuan and Euro, however, there is a lack of effective instruments to hedge the foreign currency risk since the foreign exchange market is relatively underdeveloped in current China. Hence, for these exporting companies the foreign exchange risks cannot properly be reduced. Additionally, trade of processing industry contributes to more than 60% of China’s total export without much value added; and Chinese exporters only earn a profit margin of 1.8 percent (Zhang and Sato, 2012). Therefore the effect of exchange rate is basically neutral, and will not have a great impact on price competitiveness in this type of Chinese goods. In fact, about 82 per cent high-tech exports in China are generated by foreign invested firms in China (Xing, 2012). Therefore it is essential for the government to build effective foreign exchange market which allows these firms to use currency futures and options to hedge against the transaction exposure.

2.2 Inflation

Secondly, domestic inflation rises significantly, influencing the cost of company. According to the Purchasing Power Parity, the change of exchange rate, RMB/USD, can be reflected on the inflation differentials of the two currencies (Zhang, 2009). Under the fixed exchange rate regime, the inflation can be relatively low and stable. After the reform of exchange rate regime, although the fluctuation is limited, the daily exchange rate can give the foreign investors arbitrage opportunities by investing in RMB, and the analysis devoted by Hokroh (2013) points out that excessive capital inflow drives up the money supply which the People’s bank of China cannot serialize, therefore the CPI inflation increased from 2006 and peaked out over 8 percent at 2008 (McKinnon et.al, 2009). In addition, with the growth of inflation rate, based on fisher effect, interest rate changed accordingly. This may lay heavy burden on company, for instance, the cost of domestic financing and production will increase.

2.3 Monetary control and foreign reserves

Thirdly, it weakens the government monetary control. The transformation of exchange rate regime is gradually practiced in China allowing the government to adopts more flexible monetary policy, and to realize an entirely flexible exchange rate regime requiring a fully convertible capital account (Cappiello and Ferrucci, 2008), which is not attainable for current China. Also, the constant appreciation of RMB against US dollar during 2005-2008 leads to hot money capital inflows and accelerates the rising of foreign exchange reserves (McKinnon et al., 2009). During the same period, the monetary control of People’s Bank of China was weakened and the foreign exchange forward market was severely disrupted (Wang, 2009). According to data from the State Administration of Foreign Reserves (2013), foreign exchange reserves reach 34,496,686 million US dollars in June, and about two-thirds of them are in dollar assets. Hence if US dollar depreciated against RMB, China will suffer the exchange rate risks.

- Conclusion

Throughout above analysis, it is noted that China will move towards a more flexible exchange rate regime but government control still plays a significant role, which should largely manage the relatively underdeveloped foreign derivatives market.

Reference

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