China Foreign Exchange Market
China exchange market has undergone massive development through various phases. The primary currency, renminbi or yuan is used in the foreign exchange market, and for many years, the static system was favored over the new managed floating system (Yuqing, 2006). Historically, the days when the exchange method was pegged on the fixed exchange rate, the renminbi changed against other currencies based on various fiscal policies (Xiangqian et al., 2005). In an attempt to determine the key objective of the paper, it is vital to comprehend the China currency policy. It is essential to understand this concept since it helps in identifying the factors that influence the changes in the foreign exchange rate in China (Xiangqian et al., 2005). Factors that affect the China exchange rate encompass interest rate differential, inflation rate differential, exchange rate reserve, and money supply. Thus, China foreign exchange market forms the central theme of this discussion.
China’s Currency Policy
The foundation of China’s foreign fiscal policy is to address the yuan exchange rate efficiently to manage the economy. Reports have shown that China did not have the free foreign change policy that most developed nations have (Yuqing, 2006). Nonetheless, the renminbi was pegged to the United States dollar at a figure of 8.28 for ten years right from 1994 (Xiangqian et al., 2005). Pressure from different trade partners made the renminbi to strengthen by 2.1 percent in 2005. This made the yuan in the foreign exchange market to shift to a more floated system against the US dollar. During the global financial crisis that ravaged many countries, China lowered the yuan appreciation in 2008 due to reduced global demand for their products (Xiangqian et al., 2005). Primarily, the real value of the yuan is tough to determine because many scholars indicate an array of undervaluation where some people value it at 3 percent while others value it to extreme ends of 45 percent (Xiangqian et al., 2005). However, the real value of yuan is undervalued. Importantly, China achieves this value by pegging the yuan to the United States dollar at daily reference rate regulated by the People’s Bank of China, which is the central bank in the country (Yuqing, 2006). Yuan may hugely appreciate against the dollar when left to float uncontrolled (Xiangqian et al., 2005). In the short run, China caps the appreciation by buying the US dollar then sells the renminbi. This short- term inexorable accretion of the United States dollar results to increased foreign exchange reserve.
Changes in the Exchange Rate
The foreign exchange rate contributes considerably to an economy of a nation, and its fluctuation can influence a country’s economy and foreign trade, or solely international economy. A gap in trade creates a scenario where the value of the currency depreciates then it lowers both national income and aggregate demand (Xiangqian et al., 2005). Various pieces of literature have suggested that a currency fall may affect the state of the stock markets, predominantly in the export-based nations in an adverse manner (Yuqing, 2006). It may affect the stock market of the import-overriding country in a positive trend. For instance, the J-curve model is instrumental and shows that the balance exhibited in trade depreciates shortly, but shall increase in the long run, mainly after the situation of exchange rate enhancement (Xiangqian et al., 2005). Changes in the foreign currency rate are brought by these factors discussed below.
China’s Foreign Exchange Reserve
Source: People’s Bank of China
Money supply in a vital factor that hugely influences the value of a currency when inappropriately managed. Majorly, equilibrium within the exchange rate is reached when the demand and the supply of the foreign money equals the foreign currency rate. Also, money supply may make the foreign currency rate more volatile (Xiangqian et al., 2005). In this case, increased supply of the dollar makes the dollar itself to depreciate whereas the value of renminbi tends to appreciate in this kind of the scenario. When no equilibrium is attained in the supply and demand of the particular currency, the value of the U.S dollar will slightly depreciate (Xiangqian et al., 2005). Thus, money supply is a key factor that hugely determines the value of yuan against other major world currency in the foreign exchange market. China works around the clock to regulate money supply in a bid to strengthen the economy and makes the value of renminbi stronger (Chinn 2006).
Interest Rate Differential
In the recent years, Chinn (2006) explored the relationships between U.S dollar rate and yuan exchange rate based on various interest rates executed by the government. The report showed that higher interest rates lead to the appreciation of the local currency rate. The banking industry contributes hugely to economic growth of any country. A considerable increase in interest rates allow the banks to offer people loans and other individuals can also take loans to start up small business, which shall strengthens the economy and makes the value of the yuan to grow stronger (Xiangqian et al., 2005). Low-interest rates make the banks and other financial institutions to dismiss the loan process, and the economy may experience a recession that shall make the value of the yuan to depreciate (Yuqing, 2006). In conformity with the studies highlighted in Chinn (2006), higher interest rates make the domestic currency to strengthen against the U.S dollar (Xiangqian et al., 2005). The key premise here is that interest rates differential affects the value of yuan against the dollar. Thus, interest rate differential is a key determinant that changes the value of the yuan against other world major currencies. Subsequently, a higher interest rate between the United States and China leads to reduced yuan exchange against the dollar hence the value of yuan appreciates (Xiangqian et al., 2005).
Foreign Exchange Reserves
The Foreign reserve is another key factor that changes the value of yuan in the foreign exchange market. Foreign reserve forms a vital aspect of the currency market analysis as well maintaining the stability of the currency in the economy (Xiangqian et al., 2005). Largely, a currency either is deemed stable or not by gauging the magnitude of the liquidity of that particular currency reserve. In China, there exist a significant association between foreign reserve and the exchange rate (Xiangqian et al., 2005). Thus, a surge in the comparative balance of foreign exchange reserve might reduce the standard currency exchange rates. This depicts that foreign reserve is a vital factor in predicting the value of yuan against the dollar and other major currency in China foreign exchange market (Yuqing, 2006). In perspective, a higher foreign reserve balance China results to reduced exchange of yuan against the dollar and this makes the value of the renminbi to appreciate (Yuqing, 2006). The government is often vigilant with maintaining the foreign exchange reserves at adequate levels in a bid to monitor the value of yuan against the dollar.
Inflation Rate Differential
From the purchasing power parity (PPP) model, an exchange rate refers to the ratio of numerous price levels between nations for instance, the U.S and China when compared. In a some scenario, the value of yuan and U.S dollar can be established by considerable differences that occur between the purchasing power of both currencies. In addition, the buying power can also show the price ranges in both nations. Comparative PPP denotes foreign exchange rate by regarding various inflation figures. Precisely, higher inflation rates lead to a significant depreciation of a given currency (Chinn 2006). This infers that an inflation rate is a key determinant in predicting the value of the renminbi against the U.S dollar and other major world currencies in China foreign exchange market. In perspective, higher inflation rate differential in both nations leads to more yuan exchange against the U.S dollar hence depreciating the value of the yuan (Chinn 2006).
This paper successfully discusses the fundamental thesis of this study about China foreign exchange market China has strict fiscal policy that ensures the foreign exchange market remains strong. From the historical developments, China has enacted numerous fiscal changes in its foreign exchange market in the bid to strengthen the yuan against the dollar and another major world currency. Furthermore, stronger yuan in the foreign exchange market assists the financial institutions and various multinational firms to reduce the foreign exchange rate improbability. China employs short-term measures such as buying the dollar and selling the yuan to help maintain the exchange the rate. Finally, the changes in the foreign exchange rate are brought by interest rate differential, money supply, and currency reserve.
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