Swap Exchange Rate Market - Essay Example

From 1980 onwards the Chinese government built Special Economic Zones (SEZ’s) in the costal area. The SEZ’s attracted a lot of FDI (Zhang; 1999). Experiencing rapid growth, these companies needed a lot of foreign exchange. In 1986 The Chinese government established Foreign Exchange Adjustment Centres (FEAC), also called swap centres. The dual exchange rate system emerged again in China, one was the swap exchange and the other was the official exchange rate. Lin and Schram (2003) explain that companies can bid and ask in the swap centre.

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This was the first time in China that the exchange rate was determined by the forces of market supply and demand. This swap centre was different from that in developed countries. This swap market was a place where foreign fund enterprises and domestic companies sold their retained foreign exchange for domestic currency. Zhang (1999) indicates that because the official exchange rate was fixed at that period, the fluctuating swap market exchange rate became the effective exchange rate.

In 1988 the Chinese government also adopted some policies to deepen the reform of the exchange rate system. The trader could then hold a higher portion of retention and the price were liberalised. Zhang (2001) claims that although the swap market was a milestone in China’s foreign exchange reform it had its own problems. He mentions that the swap market exchange rate was very volatile, because some large FTC gathered a lot of retention “quotas”.

This large amount of “quotas” in and out of the swap market resulted in large fluctuations which could result in serious problems and this problem clearly indicated the need for unification of the different exchange rates. The dual-exchange rate regime was unified into a single market-based official exchange rate. After China uniformed the exchange rate in 1994, the government started to adopt a managed floating exchange rate with a narrow band (Huang and Wang; 2004).

In 1994, the RMB equalled to 8.7 Yuan per 1 USD and the value could be adjusted within in  0. 25 percent of its previous market exchange. From 1995, the RMB started to have a little appreciation, in 1995, it reached 8. 3 per USD and in 1995, it was 8. 3 per USD. Although the government announced to the IMF to have a managed floating exchange rate system from the 1994, actually the exchange rate was de facto pegged to the USD since 1994. From 1994 until July 2005, the policy on currency has been to peg informally the value of the Yuan against the value of the United States dollar.

This policy was praised during the Asian financial crisis of 1998 as it prevented a round of competitive devaluations. Although China’s previous currency regime was commonly referred to as a peg to the US dollar, China actually maintained a version of a managed float against the dollar: Since 1994, the Yuan was allowed to fluctuate within a narrow band. In July 2005 China announced a switch in its exchange rate regime whereby its currency, until then effectively pegged to the US dollar, would instead be pegged to a ‘basket’ of foreign currencies.

The following month, the 11 currencies comprising this basket were revealed, namely U. S. dollar, euro, Japanese yen, Singapore dollar, Malaysian ringitt and South Korean won, with a smaller proportion made up of the British pound, Thai baht and Russian ruble. Their weighting, however, and the frequency with which these weights might be altered were not disclosed. It was also announced that the Yuan would trade within a narrow 0. 3 percent band against the basket.

As such, the Yuan may fluctuate 0.3 percent above or below the previous day’s closing exchange rate-but the value will be determined by referring to a basket of currencies, not just the dollar. In August 2005, PBOC Governor Zhou Xiaochuan named four factors that China takes into consideration to determine the currencies and their weights in the basket for the RMB’s exchange rate: the currency’s share of trade in goods and services; the currency structure of China’s foreign debt; sources of foreign direct investment for China; and current transfer items under the current account.

Zhou noted that the bulk of currencies in the basket are those of China’s biggest trade partners: the United States, the Eurozone, Japan, and South Korea. The currencies of other significant trade partners, including Singapore, the United Kingdom, Malaysia, Russia, Australia, Canada, and Thailand, are also taken into account. Unlike a true floating exchange rate, the yuan would (according to the Chinese government) be allowed to fluctuate by 0. 3% on a daily basis against the basket.

Since July 2005, China has allowed the yuan to appreciate steadily but very slowly. It has continued to accumulate foreign reserves at a rapid pace, which suggests that if the yuan were allowed to freely float it would appreciate much more rapidly. The current situation might be best described as a “managed float” – market forces are determining the general direction of the yuan’s movement, but the government is retarding its rate of appreciation through market intervention.