China has experienced dramatic economic growth and development over the last 30 years, multiplying GDP by nearly 1,600 per cent. In earlier years, the export of manufacturing goods at competitive prices was the absolute driver of GDP growth. To sustain this cost advantage in international trade, exchange rate control has always been an important consideration, since it impacts very significantly on the pricing of Chinese exports.
China also became a magnet for foreign investment as companies sought to enjoy the aggressive cost advantages offered by industry and the potential of the large, though still immature, domestic marketplace. Yet others have targeted China looking for quick investment returns, generating highly speculative flows of “hot money”.
In order to benefit trade, and to prevent speculative shocks that come about through surges in foreign currency inflows, China adopted a policy of pegging the RMB to US Dollar. The practice was abandoned in 2005, but China still maintains one of the strictest monetary policies in the world; post the Global Financial Crisis, it appears to have adopted a new RMB regime based on a quasi ‘hard-peg’ to the US Dollar between September 2008 to February 2009, an opinion shared by many economists.
Why Internationalise?
China is actively trying to internationalise the RMB, on one hand trying to sustain the competitiveness of Chinese goods with a depreciated currency, whilst on the other loosening monetary control to facilitate the inflow of investment, cheapen the cost of trade and especially to reduce Chinese exposure to foreign currency risk (read: USD). Internationalisation is happening. Bilateral agreements between China and other developing countries, such as Malaysia, Indonesia and Argentina, allow their respective central banks to buy RMB for use in international trade support. These agreements already total USD95 bn to date.
Such treaties are fundamental to facilitating the international flows of RMB, but also work as a strategy to fight inflationary pressure in the Chinese domestic market due to excess liquidity created by buoyant economic growth and a trade balance surplus built up over past decades.
As result of the enormous surplus created in the trade balance in the last 15 years, China now holds the largest foreign-exchange reserves in the world, valued at USD2.1 trillion. With the depreciation of the US Dollar by roughly 25 per cent to the price of gold in the last 12 months, Chinese reserves have lost significant value; so the challenge is to avoid risk of further and future collapse in value, which is driving the Government’s argument that perhaps we should reconsider the role of the US Dollar as the dominant, global reserve currency.
Part II of this article is available at: http://www.bizchina-update.com/content/view/2750/44/
This article is contributed by Capital Eight - an investment banking advisory firm headquartered in Shanghai. The company specialises in Mergers & Acquisitions and Structured Finance, advising companies active in China. The team combines more than forty-five years of deal-making expertise in Asia, Europe and North America. For more information please contact
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