This paper examines China's managed exchange rate policy, beginning with the 1994 decision to peg the yuan to the US dollar. It explores the motivations behind that decision, including capital reserve accumulation and export-led growth, alongside the costs of sustained trade surpluses and global economic imbalances. The paper then considers how a freely floating yuan would affect foreign firms operating in China, foreign direct investment flows, and the stability of the Chinese economy. It concludes with a policy recommendation that China should allow the yuan to float freely in order to prevent long-term trade imbalances, reduce the risk of a domestic economic bubble, and avoid an escalating global trade war.
The Chinese government pegged the value of the yuan against the US dollar in order to help spur economic growth. This occurred in 1994, after the country had completed a series of economic reforms and was seeking to expand into international markets. By fixing the exchange rate, China created a stable and predictable environment for trade and investment that would support its broader development goals (Hill, 2008, p. 371).
Understanding why China adopted this policy — and what it ultimately cost the global economy — requires examining the peg's benefits and drawbacks, as well as the long-term consequences of maintaining or abandoning it. The renminbi (yuan) and its exchange rate management have been central to debates about global trade imbalances for decades.
The benefits of pegging the yuan to the US dollar were significant for China. Most importantly, the policy allowed the country to build up its foreign currency reserves and created a period of unprecedented export-led economic growth. By keeping the yuan undervalued relative to the dollar, Chinese exports remained competitively priced in global markets, attracting foreign buyers and manufacturing investment alike.
However, the costs of this policy were equally notable. The arrangement gave the appearance — and the practical effect — of China gaining economic advantage at the expense of its trading partners. China ran persistent and large trade surpluses while those partners accumulated corresponding deficits. Over time, these dynamics created significant imbalances in the world economy, generating political and financial tension between China and its major trading partners (Hill, 2008, p. 371).
Over the past several decades, many foreign firms invested in China and used their Chinese factories to produce goods for export. If the yuan were allowed to float freely against the US dollar on foreign exchange markets and subsequently appreciated in value, this would affect those enterprises in a notable way.
Allowing the yuan to float and appreciate would likely increase the overall profits of foreign companies operating in China. Because these firms produce goods at relatively low cost in China and export them to other countries at established markups, an appreciation of the yuan — which raises the dollar value of their Chinese-produced goods — would expand their profit margins. The cost advantage embedded in Chinese manufacturing would translate into higher returns when revenues are converted back to the firms' home currencies (Hill, 2008, p. 371).
"Free float shifts FDI toward domestic Chinese consumers"
"External tariff pressure could trigger global depression"
"Yuan should float to prevent trade war"
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