China's Fixed Exchange Rates

Fixed or pegged exchange rates are exchange rates that are held constant or allowed to vary within a very narrow margin (Madura 2008, p.154). The Chinese government re-instituted its Yuan peg during the global financial crisis in July 2008 after de-pegging in July 2005. The current USD/CNY and EUR/CNY rates of 6.52 and 9.46 respectively have been criticised as being too low, especially by the U.S.

In fixing the exchange rates, central bank trades domestic and foreign exchange reserves to adjust the money supply such that the domestic interest rate equals the foreign interest rate. Since the Chinese’s foreign exchange reserves mainly compose only of US government and institutional bond, most of our analysis will relate more on the impact of the U.S. economy. The central bank would have a choice to use the monetary policy or fiscal policy to alter the money supply.

In both policies, when the domestic currency (suppose the dollar) appreciates higher than its fixed level, the central bank will enter the foreign exchange market and purchase foreign assets. This causes an increase in domestic money supply, leading to a fall in dollar interest rate in the short run. A fall in domestic exchange rate makes return on dollar deposits lower than foreign currency deposits. In turn, investors will exchange their dollars for foreign currency, depreciating the dollar to its fixed level. The reverse happens when the dollar depreciates lower than desired.

Policy makers from US and all over the world have argued that the Yuan is highly undervalued by around 40% (Morrison and Labonte 2008, p.2). This statement is further supported by China’s foreign reserves exceeding $3 Trillion, which indicates the government’s intervention in keeping th...

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