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9 -3 2 0 -0 3 9
NOVEMBER 19, 2019

LAURA ALFARO

SARAH JEONG

Floating the Exchange Rate: In Pursuit of the

Chinese Dream

“To realize the Chinese road, we must spread the Chinese spirit, which combines the spirit of the nation with
patriotism as the core and the spirit of the time with reform and innovation as the core."

– President Xi Jingping, March 2013 1

In 2005, China adjusted its exchange rate regime toward a more market-based system. Initially,
China’s central bank allowed only minor movement in the yuan’s value. It remained uncertain what
would happen to the yuan, especially because the currency was undervalued. The next 15 years saw
dramatic revaluations in exchange rates and increased exchange rate flexibility. China also opened to
currency trading and became the largest holder of foreign currency reserves. Over this period, the
country faced significant financial challenges, with inflation spiraling upwards and China’s economy
stagnating in the wake of the Global Financial Crisis. The country’s leaders took an interventionist
approach to weather the storm, controlling capital and exchange rates. These actions raised criticism
from other nations, and in 2017 the U.S. initiated the U.S.-China Trade Wars, which enforced tariffs
and requirements for increased transparency. As implications of the trade wars remained uncertain,
many wondered whether the central bank would introduce further discreet steps to change the yuan.
Would China’s currency appreciate as substantially against the U.S. dollar as predicted by economists?
And when would further change occur? The stakes were high; a freer yuan float would impact groups
within and outside of China very differently. Would China’s currency then be allowed to depreciate or
appreciate if fundamentals required it?

Floating the exchange rate

When China opened its economy in the 1970s and 1980s, the central bank kept the yuan artificially
low to allow its export industry to compete against Asian rivals. The combination of controlling the
currency and keeping out foreign investors allowed China to weather the 1998 Asian Financial Crisis. 2
Every day, the central bank set a “band” and limited the value of the yuan from moving further than
2% away from the band. Additionally, the PBOC determined how the amount of reserve cash for
Chinese Banks.

Professor Laura Alfaro and Research Associate Sarah Jeong prepared this case. This case was developed from published sources. Funding for the
development of this case was provided by Harvard Business School and not by the company. HBS cases are developed solely as the basis for class
discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management.

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320-039 Floating the Exchange Rate: In Pursuit of the Chinese Dream

Similar to the U.S., China’s central bank set interest rates, which could also alter the value of the
currency. The central bank was different from the U.S., however, in that the PBOC and Communist
Party had significant overlap. In fact, the Chinese Communist party appointed a number of central
bank leaders, including party secretary Guo Shuqing and bank governor Yi Gang. 3 The central bank
intervened through state-owned banks or by dipping into its foreign currency reserves to prop up the
yuan.

For years, the world had pushed for China to increase flexibility of its exchange rates. Before 2005,
the IMF classified the PBOC's policy as a conventional peg to the U.S. dollar. 4 In July 2005, after more
than a decade of strictly pegging 8.28 yuan to the U.S. dollar, China’s central bank revalued its exchange
rate 2.1%, or 8.11 yuan to a dollar. Simultaneously, the bank announced that a basket of currencies
would serve as the yuan exchange rate reference and that it would maintain a daily trading band of
0.3% against the dollar. 5 This decision was significant because it signaled China’s willingness to open
the country to other currencies.

China’s central bank took further steps to ease currency swaps in the following months. The PBOC
announced that domestic banks and foreign banks in mainland China could apply to engage in
currency forwards and swaps. Previously, only China’s four state banks and three of China’s joint-
stock commercial banks had been allowed to engage in these transactions. 6 The PBOC also moved to
allow the yuan to fluctuate against the reference basket of currencies by ±3% per day, compared to the
previous ±1.5%. The exception to this was the U.S. dollar, which remained at a daily band of ±0.3%
yuan against the dollar. 7 China’s central bank also announced changes liberalizing bank foreign
exchange dealings, such as widening the spread between the selling and buying prices of foreign
currencies quoted by banks to their customers.

The changes were not enough. The Group of Seven (G-7), consisting of finance ministers and central
bank governors, pressured China for further exchange rate flexibility. In a communiqué issued at the
conclusion of the December 2005 meetings, the G-7 announced that “we expect that further flexible
implementation of China's currency system would improve the functioning and stability of the global
economy and the international monetary system.” 8

In response, China introduced an over-the-counter (OTC) operations and a market-maker system

for the interbank foreign exchange market. 9 The central bank then authorized the China Foreign
Exchange Trading System to announce the central parity of China’s yuan against the dollar, euro, yen,
and Hong Kong dollar at 9:15 a.m. each day (instead of taking the closing price as the midpoint for
trading in the following session). These measures made trading the yuan easier and could provide the
technical basis for an eventual more market-based system. 10 By the end of 2005, China’s trade surplus
had more than tripled to $102 billion in 2005. 11 China’s reserves had also reached $818.9 billion, almost
matching Japan as the world’s largest reserve holder of $846.9 billion. 12

A glut of foreign reserves

As China’s exports and trade skyrocketed, the country’s success raised concerns from other
countries. From 2005 onwards, as the nation opened to foreign currency, the central bank took
measures to curb inflation and manage its world-leading supply of reserves. The bank took an
interventionist approach, manipulating exchange rates, interest rates, lending rates, and reserve
requirements. At the same time, the nation poured trillions into infrastructure and controlled the
property market through taxes and minimum payment requirements.

While China maintained the highest stock of foreign currency reserves in this period, it was not
unique in stockpiling reserves. Indeed, the management of exchange rates despite increased capital

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Floating the Exchange Rate: In Pursuit of the Chinese Dream 320-039

mobility marked the period between 2003-2013 as very unique. Ever since the IMF was established in
1945, no period had seen such a large surge in the stock of reserves held by central banks. 13

The accumulation of foreign exchange reserves came about through the central bank's intervention
in the foreign exchange market to keep financial inflows from driving up the external value of the
yuan. 14 Intervening with the exchange rate provided several advantages. First, it ensured China's
export goods remained competitive in international markets. Second, a tightly managed exchange rate
could keep down inflation expectations, though this was offset by the evident inflation during that
period. Third, a stock of reserves could buffer against international financial crises, a particularly
salient priority as the economy struggled to recover from the Global Financial Crisis. 15 Some suggested
that countries rely heavily on foreign exchange reserves and interest rate policies to achieve goals of
limiting exchange rate fluctuations and reliance on capital controls. 16 In China’s era of monetary
controls, debates arose about whether these restrictions overall benefited or harmed the country’s
economy. Regardless of the outcome for China, one result was uncontested – that China’s decisions
had a large impact on the global economy.

Groups such as the G-7 continued to push China and other emerging market countries that had
trade surpluses to increase exchange rate flexibility. 17 In August 2006, the Chicago Mercantile Exchange
began trading of futures and options contracts of the yuan, making it the first U.S. exchange to list
futures China’s equity market. 18 In May 2007, the PBOC agreed to widen the trading band to ±0.5%
from ±0.3% in an effort to cool the economy. 19

In September 2006, China’s State Administration of Foreign Exchange allowed trials of foreign
exchange reforms in Binhai. These regulations allowed banks to develop offshore finance, imposed no
limit on the amount of foreign exchange that could be transformed between headquarters and
branches, and lowered the threshold for individuals to hold shares in foreign listed companies. These
changes were intended to ease the pressure of China’s $900 billion U.S. reserves, which were the largest
in the world. 20

By January 2007, China’s foreign currency reserves had passed $1 trillion. This represented more
than a 30% increase from the previous year. 21 The central bank continued measures to tackle its massive
stock of foreign reserves. It eased controls on foreign exchange purchases by individuals, raising the
annual quota from $20,000 to $50,000 in February 2007. 22 The bank also created a new fund called the
China Investment Corporation to pursue higher returns on reserves. 23 Until that point, reserves had
been mostly in U.S. Treasury bonds and other securities. The shift from long-term bills to short-term
bills was dramatic, and by 2008, short-term bills accounted for almost two-thirds of Treasury
purchases. 24 Whether China had accumulated massive U.S. debt through forced acceptance or by active
attempts to “buy out” U.S. markets was a debatable issue. Objectively, China owned more U.S. debt
than any other foreign country, which could serve as strong leverage if the country ever decided to
retaliate against the U.S. and dump the Treasury bills.

China opens to global trade

From its entry to the World Trade Organization in 2001, China quickly grew to become the world's
largest exporting country by 2009. China agreed to strict trade rules in terms of tariff and subsidy limits
and transparency. For example, in November 2005 the U.S. and China signed a trade deal limiting the
growth of Chinese exports to the United States in 34 categories of textiles. For most categories, growth
was limited to 8%–10% in 2006, 12.5% in 2007, and 15%–16% in 2008. 25

Although the trade rules were stringent compared to other countries, the new legislation was poorly
enforced. 26 Despite initiatives such as the Qualified Domestic Institutional Investor (QDII) scheme,

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320-039 Floating the Exchange Rate: In Pursuit of the Chinese Dream

which allowed domestic firms to invest in foreign financial products, the IMF reported in 2014 that
China still had restrictions on 14 out of 15 capital inflows and 15 out of 16 outflow categories. 27

In March 2007, the U.S. imposed tariffs on Chinese products. For more than 20 years, the U.S. trade
policy had been to refrain from imposing duties on non-market economies, so this was a significant
decision. 28 This changed when the U.S. posted a record $232.5 billion trade deficit with China in 2006. 29
The initial tariffs ranged from 10.9% to 20.4% on glossy paper. 30 In its June 2007 semiannual review of
foreign currencies, the U.S. Treasury demanded further trade action against China, and criticized its
excess of foreign reserves. 31

At the start of 2008, China increased banks’ reserve requirement ratio to 15% as part of its "tight"
monetary policy. As record trade surplus of $262.2 billion compounded the cash issue, the risk of excess
liquidity resulting in asset bubbles increased. 32

Concerns about rising inflation

The period of 2006-2007 also saw efforts to slow inflation. The PBOC raised the benchmark one-year
interest rates five times in under two years, from 5.58% in April 2006 to an eventual 7.29% in September
2007 (see Exhibit 1). The aim was to curb inflation by steering bank credit, especially because the trade
surplus had rocketed 67% since the previous year and the money supply had jumped 18.5%. 33 The
government reported its concerns over asset prices when inflation reached an 11-year high in August
(see Exhibit 2). 34

Near the end of 2007, the yuan appreciated 0.6% for the week, its biggest weekly gain since the
revaluation (see Exhibits 3 and 4). Two days earlier, the Chinese central bank’s third quarter monetary
policy report revealed that the government would “strengthen the coordinated use of interest rates and
the exchange rate to help stabilize expectations of inflation,” a change in stance from the past of
emphasizing the use of other monetary tools, such as bank reserves, to fight inflation. 35 Zhou
Xiaochuan, China’s central bank governor, announced that China's goal was to bring inflation down
to 4.8% in 2008 using domestic policies rather than exchange rate reforms. 36

By April 2008, the yuan had strengthened beyond 7.00 to the dollar for the first time in over a
decade. U.S. Treasury Secretary Paulson noted that China had made “very material progress” and that
the yuan’s strength would help to combat rising inflation. 37 China’s reserves, fed by investors,
continued to increase to reach $1.8 trillion by the end of June. The country enacted policies to lessen
the pressure on the yuan to appreciate. For example, China’s domestic companies could keep their
foreign exchange income offshore without needing to seek approval for outward foreign direct
investments.

From 2005-2008, the renminbi had appreciated, a policy that the IMF classified as a crawling peg to
the U.S. dollar. 38 This changed with the Global Financial Crisis. In July 2008, the PBOC stabilized the
renminbi around 6.83 to the dollar in response to a slowing of the economy. 39

The Global Financial Crisis: early recovery efforts

On September 15, 2008, U.S. investment bank Lehman Brothers filed for the largest bankruptcy in
history, and the global economy fell into turmoil. In September 2008, the central bank cut the one-year
benchmark lending rate for the first time in six years. The central bank lowered the lending rate by
0.27% to 7.20% (see Exhibit 1) and reduced smaller domestic banks’ reserve requirement ratios by 1.0%
to 16.5%. The collapse of Lehman Brothers outweighed the rate cut, and the benchmark Shanghai
Composite Index tumbled 4.5% (see Exhibit 5). President Hu Jintao described global conditions as

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Floating the Exchange Rate: In Pursuit of the Chinese Dream 320-039

"grim", and China's premier, Wen Jiabao, declared that 2008 would be "the worst in recent times". 40 On
October 8, 2008, the PBOC joined other central banks in a coordinated rate cut to help address unstable
global financial markets. In doing so, China lowered its one-year lending rate a second time by 0.27%
to 7.2%. 41

In November 2008, China revealed a four trillion-yuan stimulus package, or 6% of the country’s
GDP, to combat slowing growth. The funding would be spent over two years to finance programs in
ten major industries such as railway projects, transport, and social housing. 42 26% of the funding was
allocated to recovery from the May 2008 earthquake that hit Sichuan province and killed tens of
thousands. 43 Approximately 30% of the package was offered by the central government, while the
remaining 70% was supplied by local governments and the private sector. 44

In addition to lending rate cuts and stimulus packages, China attempted to combat the effects of the
Crisis by cutting the benchmark one-year interest rate five times in four months. The third reduction
of 1.08% represented the biggest interest rate cut in 11 years. 45

On December 1, 2008, the yuan hit the bottom of its daily trading band limit for the first time. The
currency fell 0.7% to close at 6.885 against the dollar, a record one-day loss since the 2005 revaluation,
amid rising speculation that the PBOC would adjust its exchange rate policy and allow the yuan to
depreciate to help stimulate the economy. 46 After two days without improvement, the central bank
sold U.S. dollars to unfreeze the forex market. The U.S. Treasury Secretary Geithner and other G-7 top
economic officials commended China for its efforts to stabilize the global economic crisis and
“continued commitment to move to a more flexible exchange rate.” 47

At the World Economic Forum in January 2009, Wen Jiabao said China was targeting an 8% growth
rate for 2009, compared to the 9% growth experienced in 2008. Although the global financial crisis had
“a rather big impact” on China’s economy, Wen emphasized that the nation would focus on expanding
domestic consumer demand to drive growth. 48

Attempts to cool inflation

In an attempt to battle inflation, China's central bank raised interest rates. Between February 1 and
February 8, 2011, China’s one-year interest-rate swaps jumped to the highest level since July 2008. The
economy had grown faster than was forecasted, fueling speculation. 49 The central bank responded by
raising borrowing costs and increasing the bank reserve requirement ratio by 0.5 percentage points for
the second time in the year. 50 This gave qualified approval to international scrutiny of China's much-
criticized exchange rate policy Saturday after years of resistance. 51 In July 2011, despite a slight slowing
in economic growth, the central bank rose interest rates for a third time that year to curb inflation. 52

The bank also took steps to shut down speculation. In June 2011, the central bank tightened controls
on offshore yuan deals to curb speculation in the currency. Under the new rules, offshore banks that
settled trade in the Chinese currency were required to tighten checks on clients' yuan transactions to
ensure any buying or selling of the currency was backed by "real" trade or business needs. 53 The central
bank also attempted to curb speculative housing investments by restricting credit to banks. 54 The
Chinese State Council trialed property taxes in the business capital, Shanghai, and in the large city of
Chongqing. 55 By early 2013, several cities had restricted access to housing loans by increasing
minimum borrowing requirements and capping maximum loan size. Home prices had grown 1% in
the first month of the year, which represented the largest monthly gain in two years. 56

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320-039 Floating the Exchange Rate: In Pursuit of the Chinese Dream

A decision to raise interest rates indicated that the attempts to slow inflation had slowed growth at
an unexpectedly rapid pace. In addition to stepping back on interest rates, In July 2012, China cut
interest rates a second time in a month, indicating that growth was unexpectedly slow. 57

Increasing global access to the renminbi

At the same time that China attempted to slow inflation, the government established a series of
changes to reduce the renminbi’s dependence on the U.S. dollar. In July 2009, China held nearly $2
trillion in foreign reserves in the form of dollar-denominated assets. 58 China launched a pilot program
that allowed select banks to settle payments for imports and exports using renminbi. Consumer credit
increased exponentially, with banks lending 7.73 trillion renminbi in the first seven months of 2009, or
triple the amount reached at that point of the year in 2008. 59 In June 2010, China announced another
facet to the plan to reduce China’s reliance on USD – a flexible currency regime that would replace the
renminbi’s fixed peg to the U.S. dollar. 60

China's altering of exchange rates had long received international pushback, but the central bank's
actions to slow inflation and speculation provided newfound fodder for accusations of manipulating
currency. On October 11, 2011, the U.S. Senate passed a bill that would allow sanctions on countries
with misaligned exchange rates, and U.S. Treasury Secretary Timothy F. Geithner said that China must
move more quickly to allow its currency to appreciate. 61 The very next day, the yuan sank 1.1 percent
to 6.546 per dollar in Hong Kong. This was a record 2.4 percent discount to the prevailing Shanghai
rate, indicating that the yuan might be overvalued. 62

China made slow changes to internationalize its currency. In March 2012, the country widened
settlement rules to allow domestic firms to pay for cross-border transactions in yuan, in the hopes that
the renminbi would be fully convertible by 2015. 63 In April 2012, China widened the yuan’s trading
band against the dollar for the first time since 2007. The band, which was centered on a rate set by the
central bank, increased from 0.5% to 1%. 64 While the U.S. Treasury recognized this liberalization of
capital controls, it stressed in in its November semiannual report on global exchange rates that the
PBOC had not gone far enough in allowing flexibility of the exchange rate. 65

The next few months saw noteworthy leaps in renminbi trading. At the end of November 2012,
China Construction Bank became the first Chinese bank to issue a renminbi-denominated bond in
London, raising hopes that London would one day become an offshore hub for renminbi trading. 66

By February, the renminbi had become the world’s thirteenth-most-used currency for payments,
even passing the Russian ruble for global transactions. The growth was largely driven by offshore
financial centers in Hong Kong, London and Singapore. 67 Brazil and the U.K. signed currency swaps
with China, worth 190 and 200 billion renminbi, respectively. 68 In April 2013, Australia became the
third country to allow a direct currency exchange with the renminbi. Previously, companies and
investors had to use U.S. dollars or Japanese yen as intermediary conversion currencies. 69 Along with
establishing currency swaps, China increased offshore trading hubs. In May 2013, Highland Capital
Management received support from the Yunnan government to launch China’s first privately managed
offshore renminbi fund. 70 China’s premier Li reaffirmed the country’s commitment to reform, stating
that the government intended to “gradually achieve full convertibility of the renminbi under the capital
account.” 71

In July 2013, the PBOC took one of the most significant steps toward shrinking the state’s role in the
economy. 72 The PBOC allowed banks to set their own lending rates rather than be required to adhere

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Floating the Exchange Rate: In Pursuit of the Chinese Dream 320-039

to a floor set by the central bank. 73 By September, the renminbi had become the world’s ninth most-
traded currency. 74

Boosting China’s stagnating economy

In September 2013, the State Council trialed vague rules for the Shanghai free-trade zone (FTZ). The
State Council stated that the objective of the free-trade zone was to “promote the opening up of the
service sector and to reform the management of foreign investment.” 75 After initial success with
Shanghai, the government approved 12 more FTZs. 76

China experienced weak economic performance in the first quarter of 2014, leading to a series of
government decisions to boost the economy. 77 One tactic was to allow private lending. In March 2014,
the government announced plans to pilot private lending in Tianjin, Shanghai, Guangdong, and
Zhejiang. The ten companies involved in the pilot program were large firms, including Alibaba and
Tencent, and were required to focus on lending to smaller companies. 78 Another strategy for boosting
the economy involved initiating capital-account-opening schemes. November 2014 saw the launch of
the Shanghai-Hong Kong Stock Connect, which reduced restrictions for international investors to
access shares that were targeted domestically. In 2015, the Mutual Fund Connect allowed an exchange
of qualified funds between China and Hong Kong. Along with FTZs, these initiatives wrought a
liberalization of financial institutions and capital transactions. 79

In June 2014, the PBOC cut the reserve requirement for select small banks by 0.5%. 80 Additionally,
the PBOC introduced the Medium-Term Lending Facility (MLF), a monetary tool to increase bank
liquidity. In September and October, the PBOC supplied 769.5 billion yuan ($126 billion) to domestic
financial institutions at an interest rate of 3.5%, with the hopes that the policy would affect “mid-term
interest rates while providing liquidity to guide commercial banks to lower their lending rates and
overall social-financing costs.” 81 The PBOC cut the benchmark 1-year lending rate for the first time
since 2012, and lowered the 1-year deposit rate to 2.75%. Banks could also pay customers on their
deposits up to 120% of the benchmark, compared to the previous 110% cap. 82 Despite these measures,
China’s economic growth continued to stagnate. 2014 ended with an overall growth of 7.4%, the
slowest pace in 24 years. 83

The beginning of 2015 continued with interventionist actions by the PBOC to bolster China’s
economy. The government lowered China’s economic growth target to 7% for 2015. The government
also set a consumer inflation target at 3%, down from 3.5%. 84 The new target reflected the government’s
agenda to transition the economy toward slower but more sustainable growth. One of the interventions
targeted the struggling property market, which made up 23% of GDP. The PBOC reduced the
minimum down-payment requirement on second-home purchases from 50-60% to 40%. 85

In February, the PBOC cut the bank reserve requirement by 50 basis points to 19.5%. 86 The PBOC
also announced it would expand its Standing Lending Facility nationwide after a successful pilot
program in 10 regions. 87 Unexpectedly, the PBOC also lowered the 1-year lending rate to 5.35% and
the 1-year deposit rate to 2.5%. 88 Analysts interpreted this second rate cut in less than four months as
a sign that PBOC was growing more aggressive in addressing the slowdown in economic growth.

In August 2015, the central bank allowed the renminbi to devalue, claiming that this would better
align with market forces. 89 The depreciation led to China's forex reserves falling by $513 billion in six
months - the largest decline on record. China used $500 billion of its foreign currency to boost the yuan
in 2015; in December alone, Beijing spent a record $108 billion of foreign currency stockpile to buy yuan
and halt the rapid devaluation of their currency. 90

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320-039 Floating the Exchange Rate: In Pursuit of the Chinese Dream

From 2005 to 2015, China's exchange rate was classified as a crawl-like arrangement. According to
the IMF, for this kind of arrangement, an exchange rate must be within a small margin of 2 percent
relative to a six-month trend, but with a rate of change greater than for a stabilized, peg-like
arrangement. 91 On August 24, 2016, China's exchange rate classification switched from a crawl-like to
stabilized arrangement. 92 This classification meant that the value of the renminbi was stabilized against
a basket of currencies. In 2017, China created the Financial Stability and Development Committee,
giving the agency a higher political ranking than other ministries that were already responsible for
financial oversight. The committee had the authority to supervise financial regulators and local
governments. 93

U.S. – China Trade Wars

President Xi Jinping took office and pledged a commitment to free markets, resulting in a number
of market-oriented reforms in 2015. Alongside interest rate cuts and tighter financial market regulation,
one of the monetary policy tools employed by the People’s Bank of China (PBOC) included currency
devaluation. In August 2015, the central bank devalued the yuan by 1.9%, representing the largest one-
day drop since 1994. 94

The IMF acknowledged this move as a sign that China was opening its markets, and welcomed the
yuan to be included in the IMF’s special drawing rights basket of reserve currencies in September
2015. 95 As members, China would be allowed to purchase the yuan in foreign exchange markets to
maintain exchange rates. Despite the IMF’s positive response, many still doubted China’s commitment
to free markets and believed the devaluation to reflect instead a “managed float”, or another attempt
to boost exports and stimulate China’s slow economic growth. 96

The weakened Chinese currency had potent and widespread implications. As the world’s largest
exporter and second-largest economy, China’s decision to devalue the yuan created significant
macroeconomic repercussions for small- to medium-sized export nations, such as Vietnam and
Indonesia. India was also greatly affected, with the rupee plunging and Chinese companies
undercutting Indian manufacturers. Authorities imposed new capital controls to prevent the weakened
yuan from leaving China. They enforced scrutiny of cross-border payments, instructed banks to ensure
that payments balanced, and placed strict limits on cash withdrawals from ATMs. 97 These restrictions
to outflows hurt business investment, and overseas acquisitions by Chinese companies fell by 64% at
the start of 2017. 98

More challenges were on the horizon, with the election of U.S. President Donald Trump. Within a
year of coming into office in early 2017, Trump had ordered tariffs on a wide range of imported
products, from washing machines to steel. 99 In April 2018, China imposed tariffs on 128 U.S. imports.
Thus began what was dubbed “The Trade Wars”. For several months, retaliatory plans for tariffs were
announced on both sides of the Pacific. This eventually culminated in a 10% tariff on $200B of Chinese
imports and a range of tax rates on $60B of U.S. products, both of which took effect in September
2018. 100 During this period, China filed a World Trade Organization case against the U.S. for the tariffs,
claiming they would damage China’s trade interests. 101 Both sides of the Pacific launched threats of
additional tariffs throughout 2018.

In December 2018, the U.S. and China agreed to a 90-day halt on new tariffs. Months of trade talks
between the two countries did little to improve the U.S.-China trade relationship. On May 28th, 2019,
the U.S. Treasury released a report listing China as one of nine countries described as having exchange-
rate policies that required close attention. At that time, the renminbi had weakened against the U.S.
dollar by 3.8% since July 2018 due to the tariffs and other sanctions imposed by the U.S. 102

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Floating the Exchange Rate: In Pursuit of the Chinese Dream 320-039

In subsequent months, tensions between the U.S. and China continued to build. U.S. lawmakers
from both parties introduced a bill that required Chinese companies listed on American stock
exchanges to provide access to audits. 103 China protested allowing overseas regulators to inspect their
accounting firms, citing concerns for national security.

China weakens the yuan again

On August 1, 2019, Trump announced further tariffs of 10% on $300B additional Chinese products,
to be effective September 1st. 104 Four days later, China responded by dropping the yuan below seven
per dollar for the first time in over a decade. The last time the yuan had dropped as low as seven to a
dollar was in May 2008, during the Global Financial Crisis. 105 Weakening the currency would give an
advantage to China’s exporters and undermine Trump’s tariffs; for example, if the renminbi weakened
by 10%, a 25% tariff on Chinese goods would only equate to 15%. Following China’s action, the U.S.
Treasury stated that China was manipulating its currency – an accusation that had not been made since
1984. 106

By September 2019, it appeared unlikely that any trade deal would be made before the 2020 U.S.
election. The role of tariffs depended in part on China’s purchase of U.S. agriculture, and it remained
to be seen how the trade disputes would be settled. 107 The Trump administration threatened to delist
Chinese companies from the U.S. stock exchange as part of a broader effort to limit U.S. investment in
Chinese companies. 108 This seemed a dangerous decision, as U.S. debt had hit a record high of $22
trillion in February and the main purchaser of that debt by far was China. Questions continued to arise
– should China open its capital accounts first, or let exchange rates continue to float? With projections
of a continued weakening of the renminbi and the possibility of tighter controls over capital outflows,
people watched China’s next move with bated breath.

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320-039 Floating the Exchange Rate: In Pursuit of the Chinese Dream

Exhibits

Exhibit 1 People's Bank of China's Benchmark One-Year Lending Rate (%)

Source: Created by casewriter using data from Bloomberg, [Link] November 2019.

Exhibit 2 China's Consumer Price Index (% Change, y-o-y)

Source: Created by casewriter using data from the Federal Reserve, [Link]
November 2019.

10

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Floating the Exchange Rate: In Pursuit of the Chinese Dream 320-039

Exhibit 3 Chinese Renminbi-U.S. Dollar Exchange Rate, 2000-present

Source: Created by casewriter using data from the Federal Reserve, [Link] November
2019.

Exhibit 4 Chinese Renminbi Exchange (Relative Performance, August 1, 2005=100)

Source: Created by casewriter using data from Bloomberg, [Link] November 2019.

Note: Exchange rate defined as Renminbi per 1 Euro, Renminbi per 1 U.S. Dollar, and Renminbi per 100 Yen, respectively.

11

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320-039 Floating the Exchange Rate: In Pursuit of the Chinese Dream

Exhibit 5 China's Stock Markets: Shanghai and Shenzhen Composite Indices (Closing price, Rmb)

Source: Created by casewriter using data from Bloomberg, [Link] November 2019.

Exhibit 6 National Income Accounts

Source: [Link] November 2019.

12

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Floating the Exchange Rate: In Pursuit of the Chinese Dream 320-039

Exhibit 7 Components of GDP

Source: [Link] November 2019.

13

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320-039 Floating the Exchange Rate: In Pursuit of the Chinese Dream

Endnotes

1 “What does Xi Jinping's China Dream mean?,” BBC News, [Link] 6,

2013.
2 “This is how China controls its currency,” CNN Business, [Link]
yuan-rmb/[Link]. August 16, 2018.
3 Gabriel Wildau and Tom Mitchell, “China asserts Communist party control over PBoC,” Financial Times,
[Link] March 25, 2018.
4 "China's Exchange Rate Policies and U.S. Financial Markets," Federal Reserve Bank of San Francisco,
[Link]
financial-markets/. October 2, 2017.
5 Mark Spiegel, “A Look at China’s New Exchange Rate Regime,” Federal Reserve Bank of San Francisco,
[Link]
rate-regime/. September 9, 2005.
6 These are listed in the “Notice of the People’s Bank of China on Issues Regarding Expanding Designated Banks’ Forward Sale
and Purchase of Foreign Exchange Businesses to Customers and Launching RMB Swaps against Foreign Currencies,” PBC
Document No. 201, August 2, 2005, as “repayment of foreign exchange loans issued by the banks; repayment of external
borrowings registered with SAFE; receipt and payment arising from overseas direct investment registered with SAFE; receipt
of equity funds of foreign-funded enterprises registered with SAFE; receipt of foreign exchange arising from a domestic
entity’s overseas listing registered with SAFE; other receipt and payment of foreign exchange approved by SAFE.”
7 “Timeline: the past and present of China’s yuan,” Reuters, [Link]
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8 “DJ BOJ Fukui: Chinese Forex System Not Flexible Enough,” Dow Jones Commodities Service, December 7, 2005.

9 Public Announcement of the People’s Bank of China No. 1 [2006], Public Announcement of the People’s Bank of China on
Further Improving the Inter-Bank Spot Foreign Exchange Market, January 3, 2006. See also “Finance: Under-appreciated
currency,” Economist Intelligence Unit—Business Asia, January 23, 2006, for further explanation of the measures.
10 Public Announcement of the People’s Bank of China No. 1 [2006], Public Announcement of the People’s Bank of China on
Further Improving the Inter-Bank Spot Foreign Exchange Market, January 3, 2006. See also “Finance: Under-appreciated
currency,” Economist Intelligence Unit—Business Asia, January 23, 2006, for further explanation of the measures.
11 Data from Andrew Browne, “China foreign-currency reserves soar,” The Wall Street Journal Asia, January 16, 2006.

12 Data from Andrew Browne, “China foreign-currency reserves soar,” The Wall Street Journal Asia, January 16, 2006.

13 Ethan Ilzetzki, Carmen M. Reinhart and Kenneth S. Rogoff, “Exchange Arrangements Entering the 21st Century: Which
Anchor will hold?”, National Bureau of Economic Research, Working paper 23134, February 2017.
14 Eswar Prasad and Isaac Sorkin, "Sky’s the Limit? National and Global Implications of China’s Reserve Accumulation,"
Brookings Institute, July 21, 2009.
15 Eswar Prasad and Isaac Sorkin, "Sky’s the Limit? National and Global Implications of China’s Reserve Accumulation,"
Brookings Institute, July 21, 2009.
16 Ethan Ilzetzki, Carmen M. Reinhart and Kenneth S. Rogoff, “Exchange Arrangements Entering the 21st Century: Which
Anchor will hold?”, National Bureau of Economic Research, Working paper 23134, February 2017.
17 “G7 Meeting: Snow says global stability needs help from China, others,” Xinhua Financial Network (XFN) News, April 24,
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20 “SAFE approves trial of forex reforms,” Chinese Government, September 22, 2006.

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Floating the Exchange Rate: In Pursuit of the Chinese Dream 320-039

21 “China’s Foreign Currency Reserves Surpass $1 Trillion,” Associated Press Newswires, January 15, 2007.

22 Ren Jie, “China may raise quota on foreign exchange purchases,” China Daily, March 15, 2011.

23 Zhou Xin, “China gives up two of its best-kept forex reserve secrets,” South China Morning Post,
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24 Eswar Prasad and Isaac Sorkin, "Sky’s the Limit? National and Global Implications of China’s Reserve Accumulation,"
Brookings Institute, July 21, 2009.
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26 Diego Comin and Richard H.K. Vietor, "China 'Unbalanced'," HBS No. 711-010, revised March 6, 2012.

27 Eswar S. Prasad, "China's Efforts to Expand the International Use of the Renminbi," U.S.-China Economic and Security
Review Commission, February 4, 2016, p. 14.
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29 “China's trade surplus soars,” CNN, [Link] January 11, 2008.

30 “The China Tariffs,” The Wall Street Journal, April 2, 2007.

31 “Report to Congress on International Economic and Exchange Rate Policies,” U.S. Treasury, June 2007.

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36 Andrew Batson and Jason Leow, “Central banker dismisses prospects of yuan surge,” The Wall Street Journal, March 7, 2008.

37 Glenn Somerville, “Update 1: US’s Paulson Praises China on Currency Progress,” Reuters News, April 2, 2008.

38 "China's Exchange Rate Policies and U.S. Financial Markets," Federal Reserve Bank of San Francisco,
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39 "China's Exchange Rate Policies and U.S. Financial Markets," Federal Reserve Bank of San Francisco,
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41 Chris Isidore, "Fed: Emergency cut," CNN Money, October 8. 2008.

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47 Michael M. Phillips and Stacy Meichtry, “G-7 Mutes Criticism of China—Officials Praise Beijing’s Stabilizing Role in Crisis,
No Longer Fault Yuan Policy,” The Wall Street Journal Asia, February 16, 2009.

15

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320-039 Floating the Exchange Rate: In Pursuit of the Chinese Dream

48“Crisis ‘has hit China’s Economy’”, BBC News, January 28, 2009,
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50 Liu Li, “China hikes banks' reserve requirements,” The Wall Street Journal, February 19, 2011.

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53 Kevin Yao, “China [Link] tightens controls on offshore yuan deals,” Reuters, [Link]
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56 Simon Rabinovitch, “Chinese cities curb housing loans,” Financial Times, [Link]
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57 Jamil Anderlini, “China cuts rates amid growth fears,” Financial Times, July 5, 2012.

58 Keith Bradsher, “In Step to Enhance Currency, China Allows Its Use in Some Foreign Payments,” New York Times,
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60 “China,” Economist Intelligence Unit Report, The Economist, August, 2012.

61 Li Fion and Kyoungwha Kim, “Yuan Traders Diverge With Senate on Exchange Rate: China Credit,” Bloomberg News,
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63 “China lets all firms settle trade in yuan,” Reuters, March 2, 2012.

64 “China Doubling Yuan Band Signals Drive for Convertibility,” Bloomberg News, April 14, 2012.

65 Greg Robb, “Treasury says China is not currency manipulator,” The Wall Street Journal, November 27, 2012.

66 Alice Ross, “CCB issues ‘dim-sum’ bonds in London,” Financial Times, [Link]
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67 Ye Xie and Fion Li, “Yuan Overtakes Ruble as World Payments Currency,” Bloomberg, February 27, 2013.

68 “China and Brazil sign $30bn currency swap agreement,” BBC News, March 26, 2013,
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Floating the Exchange Rate: In Pursuit of the Chinese Dream 320-039

74 Nicole Hong, Clare Connaghan, and Tom Orlik, “Milestone for Yuan Marks Rise of China,” The Wall Street Journal,
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79 Eswar S. Prasad, "China's Efforts to Expand the International Use of the Renminbi," U.S.-China Economic and Security
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91 "Annual Report on Exchange Arrangements and Exchange Restrictions 2017," International Monetary Fund, October 2017.

92 "Annual Report on Exchange Arrangements and Exchange Restrictions 2017," International Monetary Fund, October 2017.

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95 “IMF Adds Chinese Renminbi to Special Drawing Rights Basket,” IMF News, September 30, 2016,
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320-039 Floating the Exchange Rate: In Pursuit of the Chinese Dream

96 “IMF Adds Chinese Renminbi to Special Drawing Rights Basket,” IMF News, September 30, 2016,
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