China has a fixed currency system which is also known as pegged currency system. In this type of currency system, the value of currency is fixed to the value of another currency or basket of currencies.
Till 2005, Renminbi was pegged against US dollar at 8.28 Renminbi/USD. To keep the Renminbi at pegged level, Chinese central bank had to supply Renminbi and demand dollars in foreign-exchange markets. This pegged system created a severe problem for US markets as US producers have to compete with Chinese cheap products due to undervalued Renminbi. To prevent this in US markets, a tariff of 27.5 percent was announced on Chinese imports until China adjusted the value of its currency.
In July 2005, China announced that it would move in the direction of a floating exchange rate. As per this new policy, it still intervenes in foreign-exchange markets to prevent large and sudden movements in the exchange rate, but it also permits gradual changes. This measure resulted in 20% appreciation of Renminbi against USD in three years.
Since mid-2008, Renminbi barely moved against the Dollar as Chinese exporter's sales overseas had dropped sharply because of the global economic downturn. It was almost certain that Chinese central bank returned to the policy of controlled exchange rate.
Objective: To know the reasons why China is keeping the currency stable and its relative consequences both visible and invisible.
Why did China resort to undervaluation?
Export driven employment 出口带动就业
China is the No.1 exporter in the globe and its exports contribute the most to its GDP (about 40%). During recession, the Chinese government had implemented a 4 trillion dollar stimulus package, of which the biggest bites were given to large state-owned enterprises which were all capital-intensive firms. So, although the output figures were soaring high it lead to more unemployment in the country and because of this, the Chinese policy-makers had to make sure that the export industry was growing as it was the largest and the most labour intensive sector which was the answer to china's rising unemployment rates. An appreciating Renminbi would only make exports expensive which is not desired by china evident from the graph above.
FDI generated employment 外商直接投资产生就业
Devaluating currency also attracts many foreign investors which strengthens the foreign reserves and generates more employment in China. In fact, almost 60 percent of Chinese exports to the United States are produced by firms owned by foreign companies, many of them American. These firms have moved operations overseas in response to competitive pressures to lower production costs and thereby offer better prices to consumers and higher returns to shareholders. The implication is that foreigners who invest in productive facilities in China are doing so solely because of cheap labor and cheap currency evident from graph moving up in the starting of 2009.
On top of the existing 103 million urban migrants, Chinese cities will face an influx of another 243 million migrants by 2025, taking the urban population up to nearly 1 billion people. In the medium and large cities, about half the population will be migrants, which is almost three times the current level. This adds to employment woes.
China's economic statistics are based on recorded production activity, rather than being a measure of expenditure growth. As a result of stimulus the SOEs capital intensiveness made them produce huge amount of goods which added to the GDP but people savings were high. Thus consumption lagged behind production. The idle stock lying unsold can only be tackled by way of increasing exports.