China F/X China Faces a Tough Decision

China F/X

China faces a tough decision with respect to floating the yuan or not. Ultimately, a float will severely limit China's ability to control the value of its currency. At present, this will be a significant problem because the yuan would likely rise in value. This would be to the detriment of the country's export industries, which are the drivers of the economy and employment. Further, the country may be tempted to continue to hold down the yuan's value, which will be much more difficult under floating rate conditions. Another issue is that China will have start publishing accurate economic information, which will pose a challenge for the country's officials, who are unaccustomed to things like transparency. The country would almost certainly need to undertake banking reform in order to float the yuan as well, posing additional structural challenges. Overcoming all of these challenges will take time.

There are advantages, however. Right now, China is spending a lot of money to hold down the value of the yuan, money it could put to other uses. Further, the country may benefit from having a currency that can be freely traded. It is much easier to attract foreign investment when you have free floating currency, an absence of currency controls (necessary to maintain the fixed rate regime) and a modernized banking system. These advantages are more theoretical than the risks, which the average PRC politician seems to understand more acutely.

In its history, China has moved towards a more market economy. The first steps of this focused on allowing private enterprise and setting up a banking system with banks that specialize in different sectors, so as to encourage investment in these different sectors (industrial, agricultural, construction etc.). China then opened up the country's borders to trade, a move that culminated in its ascension to the World Trade Organization, illustrating its commitment to removing trade barriers. Lastly, China wanted to grow its economy by bringing in foreign capital. By attracting foreign investment capital, China had a means by which its banks could fund domestic projects, and additionally along with foreign capital came foreign expertise and knowledge, which have proven valuable in helping China's manufacturing industries become world leaders, as opposed to just making low grade goods.

China has always felt that improving the economy was a pressing domestic issue. Officials have long been wary of the risks associated with having such a large population of poor, up to the possibility of rebellion. This driving fear encourages officials to pursue economic development as a means of prolonging their power, and most Chinese policy is focused on the economy as a result. There have been some concerns about the environment lately, in particular as it has to do with the long-term sustainability of the country's drive to improve its economy. Water is the key environmental issue. The country also makes a fuss about corruption.

Internationally, China can't help but get involved regionally, rattling sabers with Korea, Japan, Taiwan and Vietnam in particular. China is a major backer of North Korea. But the country is also beginning to expand its international presence, using trade and its economic clout to gain access to materials from around the world. China is also dependent on trade, in particular exporting, so China has also focused energy on building its trade footprint around the world.