INTERNATIONAL ECONOMICS

Fixed Exchange Rate Regime



Fixed Exchange Rate Regime

Introduction

Fixed Exchange Rate

The maintenance of currency pegs by fast-growing emerging markets has become a flash point in discussions of economic policy. Not a few observers concerned for the stability of the international economic and monetary system argue that international balance could be better maintained, and global financial stability enhanced if emerging markets like China abandoned their pegs in favor of regimes of greater flexibility. In addition, more flexible exchange rates would give emerging markets greater ability to tailor policy to domestic conditions. Where growth is strong and inflation is a problem, currency appreciation would help damp down inflationary pressures, and avoid asset bubbles, and overheating (Steven, 2008).

It would facilitate efforts in these countries to rebalance away from exports in favor of domestic spending. It would give them a supplementary instrument - a more flexible exchange rate -with, which to cope, with volatile capital flows as the capital account of the balance of payments becomes more open. Greater flexibility on the part of countries like China, implying less foreign exchange market intervention, would also slow the accumulation of reserves in the form of U.S. treasury and other advanced-country securities. It would help the China grow its exports. Insofar as exchange rates fixed at inappropriate levels contributed to global imbalances and thereby helped to plant the seeds for the global financial crisis, this is an issue of not just national but international significance. Thus, not only the IMF but high officials in both the United States and Europe regularly make the case for greater exchange-rate flexibility to emerging markets like China.

Discussion

For nearly a decade, China has fixed its exchange rate to the dollar and bought or sold dollars to maintain the exchange rate. By early 2005, though, the country feels pressure both at home and abroad to let its currency, the Yuan, float freely against the dollar.

China's decision to peg its currency to the U.S. dollar provided for a more stable currency for China because it meant that the Yuan moved in lockstep with the value of the dollar - a currency that would be far more stable than the Yuan. However, the decision led to a situation that was not popular with the United States or other developed nations, as, over the next decade, the Yuan became undervalued by as much as 40 percent. This trend allowed China to increase its exports dramatically, while at the same time making it more difficult for foreign exporters to sell their products to China. Foreign companies manufacturing in China were able to capitalize on the undervalued Yuan, and reap the benefits of “cheap” exports. Recently, after years of rapid economic growth stimulating by exports, and amassing a stockpile of dollars valued at more than $700 billion, China faced significant pressure for currency revaluation (Shambaugh, 2004).

Many people will probably agree that a stronger Yuan would probably result in a situation in which companies that currently export from China see some slowdown in their exports or a lower ...