Should China let its currency float freely on the exchange rate markets?

Athena Zabidi 


In order to analyse the effects of China’s policy choices, we must consider the effectiveness of expansionary monetary and fiscal policy. Currently, China operates on a fixed exchange rate system, with strict capital controls. Chinese policymakers have significantly undervalued the Yuan against the US dollar, leading to a huge balance of payments surplus through cheaper exports. The principles of the Mundell-Fleming trilemma evince the inability of Chinese citizens to integrate themselves in the global market.

For clarity’s sake, we must consider a few assumptions. Firstly, we assume that China’s sole aim is to increase her output. Secondly, given the nature of China’s export sector, we will assume that China has a balance of payments surplus. We will also be using the Mundell-Fleming’s “Impossible Trinity”, where no economy can simultaneously maintain a fixed exchange rate, autonomous monetary policy, and perfect capital mobility.

If the rest of the world goes into recession, China’s economy would take a large hit from the drop in demand for Chinese exports.

Fixed exchange rates and strong capital controls have allowed China’s monetary policy to operate independently, and hence have allowed them to control domestic inflation. Under the current regime, China’s economy is shielded from fluctuations in world exchange rates and hence fluctuations in their balance of trade. If the rest of the world goes into recession, China’s economy would take a large hit from the drop in demand for Chinese exports. In The Globalisation Paradox (2011), Rodrik argues that perfect capital mobility has actually led to higher vulnerability across countries, drawing on the successes of the countries who had adopted capital controls as part of the “Washington Consensus”.

On the other hand, having capital controls in place means that there will be no inflow or outflow of capital that would alter China’s domestic interest rates. Expansionary monetary policy gives rise to higher levels of output under a floating exchange rate regime compared to a fixed exchange rate regime. Under this system, policymakers can use monetary policy for other purposes, rather than just using it to keep the exchange rate at the target level. Moreover, there is a beneficial effect of allowing the Yuan to depreciate, which would lead to a higher balance of payments surplus, and more output generation in the long run. Capital controls and floating exchange rates would allow fiscal policy to work extremely effectively, by increasing China’s output through increased investment.

Expansionary monetary policy gives rise to higher levels of output under a floating exchange rate regime compared to a fixed exchange rate regime.

China should indeed float its exchange rate. There would be extremely beneficial results of expansionary monetary and fiscal policies under a floating exchange rate system, given that capital controls are still in place. We must seek to consider other permutations of the Mundell-Fleming trinity, including considering the effects of freer capital mobility to increase output.