Critically Analyzes & Drawbacks About Fixed and Managed Floating Exchange Rate Regime

Critically analyzes merits and drawbacks about fixed and managed floating exchange rate regime

Nowadays, the effects of exchange rate policy are growing with deepen globalization. In particular, it can affect not only the balance of payment, but also price level and stability. In 1994, China fixed the exchange rate at 8.28 RMB per US dollar, and the pegging of RMB/USD falls strictly in the region of 8.20~8.30; from 2005, China implemented managed floating exchange rate regime which allows RMB/USD can fluctuate within ±0.3% around the closing rate of the previous trading day (Sau-leung, 2011), and RMB is no longer pegged to US dollar but a basket of currencies (Duttagupta et al., 2005).  This paper will mainly focus on the advantages and disadvantages of fixed exchange rate regime and floating exchange rate regime with China’s case. This section will critically discuss and analyze advantages and disadvantages of fixed and managed floating exchange rate regime through the trade, inflation, monetary policy and foreign reserves.

1. Fixed exchange rate regime

1. Trade  

The fixed exchange rate regime can promote trade and generate a more favorable balance of payment, which is more effective if a country fix its exchange rate underneath the equilibrium level. Since adopting this regime,        China’s exports volume increased  substantially  (as shown in Figure 1); even during  the period of  Asian financial crisis, China still  stands  out from  other  Asian countries as their currency  have  gone  through substantial devaluations  (IMF, 2003).        The world market witnesses the steady increase in China’s share of total export (from 0.77% to 5.03%), while the market share of US decreased by 3.6% from 1970 to 2002 (as shown in Figure 2). Admittedly, the fixed exchange rate regime of China contributes to better exports performances. However, Adams (2004) argues that China’s export competitive power also depends on the coincidence of several factors, such as the low wages and the encouraging policy.  

[pic 1]

Figure 1

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Figure 2

1.2 Inflation

Another crucial reason to choose pegged exchange rate system might be that countries could enjoy much lower inflation rate. Theoretically, fixed exchange rate regime makes a highly visible and tangible commitment and therefore increases the political cost of abolishing the pegged regime (McKinnon, 2006). Thereby, its prominent currency credibility can enhance the demand for the national currency and reduce the probability of inflation. For example, during 1994 to 2005, the consumer price inflation in China dropped approximately 1% to 2% (McKinnon, 2006). However, Aghevli et al. (1991) note that lacking appropriate fiscal policies leads to the fact that a great number of nations under the fixed exchange rate regime can go through high level of inflation, while many of the countries with more flexible regime  enjoy  lower rates of  inflation through implementing prudent fiscal policies. Klau (1998) demonstrates that the effects of exchange rate regime and the level of inflation are also determined by some national fiscal, monetary policy and the influences of supply shocks.  

1.3 Monetary Policy

A country might take advantage of fixed exchange rate, but these advantages come at a high price. Firstly, the inflexibility of fixed exchange rate regime might place a hard constraint on monetary policy therefore macroeconomics fluctuations cannot be regulated effectively. According to impossible trinity theory (Obstefeld, 2005), for an economy it is impossible to have independent monetary policy, fixed exchange rate, and free capital movement at the same time. This means if the central bank chooses to adopt pegged regime and free capital flow, thus it has to give up the ability to set interest rates independently. For example, in 2003-2004, foreign direct investments was pouring into China and the national price level accelerating, the People’ Bank of China was reluctant to increase national lending rates to a certain extent since higher interest rates would attract more capital inflows, despite capital controls  (Goldstein and Lardy, 2006). Consequently, the real rate of interest to corporate borrowers was going down from 8% in 2002 before the investment boom and even reached to –4% in 2004, which leads to an excess demand for loans (Kenen, 2007). It is reinforced by Xu (2006) that the monetary policy of the PBC has little influence on the national price level.  

1.4 Foreign Reserves

Countries under pegged exchange regime are requiring large amounts of reserves to maintain the fixed exchange rate. Although foreign exchange reserves may gain credibility and maintain the stability of RMB, the accumulation of a great number of reserves can generate stress for the RMB to appreciate, meanwhile, the appreciation may lead to both the economic losses and the unsteadiness of the currency. For example, Chinese foreign exchange reserve reached $400 billion in 2003 (Zheng and Yi, 2007). However, excessive foreign exchange reserves may result in some problems.  With the growth of foreign exchange reserves, RMB has a short-term appreciation expectation at that time, which creates an arbitrage opportunity and attracts capital inflows, further strengthens the pressure of appreciation. Xia (2006) points out that 22% of foreign reserves increase in 2005 were caused by expectations concerning the appreciation of RMB. In addition, Fankel (2006) has demonstrated that the return of huge foreign exchange reserves is much lower than the return of inward investment and foreign investment. Therefore it is necessary for the country to maintain foreign reserves in a moderate level.

1.  Managed floating exchange rate regime

By contrast, floating exchange rate refers to the currency value that can fluctuate in accordance with the foreign exchange market, which normally let market demand and supply of currency decide the exchange rate. However, to avoid damages brought by the extreme appreciation or depreciation of one currency, central bank may use managed floating to adjust and control the fluctuation to stabilize the economy. The following section will critically analyze its advantages and disadvantages of applying floating exchange rate in China.

2.1 Trade  

Firstly, the revaluation of RMB against US dollar to some extent relieves external pressure of reducing China’s large trade surplus. The effect of this policy was that RMB has appreciated from 2005 to 2008 against US dollar in an annual rate 6% generally (McKinnon and Schnabl, 2012). Also, with the appreciation of RMB, the price of imports can be relatively lower and domestic consumers’ real purchasing power is strengthened. Nevertheless, under the same circumstance, companies which produce in domestic market and sell to foreign market facing increasing cost, therefore if companies still want to keep the same profit margin as before they have to raise price, leading to the decrease of foreign demand; and to some extent to weaken the comparative  advantage  of Chinese  goods. Cheung et al. (2007) illustrate that the appreciation of RMB does not affect China’s exports to the US but increases US exports to China, and this was refuted by Cline (2010) that in the current account surplus, a 10 percent real effective appreciation of RMB will lead to 0.45% GDP decrease in China.