Foreign Monetary System - Essay Example

There were also huge direct foreign investments in China during the 1990s (Zi et al, 2009). With the increased trade amongst the East Asian countries and huge direct foreign investments from countries like USA, it presented a great future ahead for China. However this was not the case, as it created “cyclic overheating”. After the revised Bretton Woods System, China’s exchange rate was pegged to the US dollar and creating an artificially low rate. These countries benefitted from this as China attracted foreign investment in their country with huge profit initiatives due to cheap labor and the finished products were exported to US.

In retrospect, China used its export earnings and invested it in T-bonds in US, bringing down their interest rates, thus increasing investments in their own country. However, this made China totally dependent on the foreign investments and had no control over its money supply. This lead to the revaluation of the Chinese Renminbi (RMB) in 2005 which meant the currency was no longer pegged with US dollar but was market determined by a basket of currencies. This managed floating exchange rate system was the important change in the Monetary System of China.

This move was important as the old Yuan-Dollar peg, resulted in over investments within the country and over evaluation of the Yuan. Hence, this move was made to cool down the cyclic overheating in the country (Wu, 2006). This cool down of the cyclic overheating in China had started before the revaluation of RMB. According to the study, this cool down was not achieving the full anticipated affects. With the anticipation of the revaluation in 2005, the money supply in the country grew from 2004 to 2005 by 14%, which resulted in an increase in the loans by 11%.

The strong relationship between the loans and the real estate sector, led to an inflation of asset prices and land rents. As China relies on investments and exports to run its economy, it will take considerably more time to cool down the over investments and rectify the imbalances created by it. All the affects in the China’s Economy, whether they are large foreign exchange reserves, increased money supply, overheating of investments or asset price inflation are all focusing on its exchange rate.

Thus the exchange rate system of China plays an integral part in its macroeconomic policies and management (Wu, 2006). In the recent years, China has had to face another challenge. Due to the efforts of the People’s Bank of China (PBC), the capital inflow started to decrease. However, due to the slowed global growth rate PBC has managed and adjusted the policies so that the growth rate of China does not fall at an alarming rate. The challenge here is that over the recent years, PBC and the policymakers have become adept at trying to slow down capital inflow, but are rather inexperienced when it comes to slowing down capital outflow.

One way to create a more balanced inflow and outflow is to decrease the cash reserves required for the Commercial Banks to keep. This was done in the first place to reduce the surplus liquidity formed by capital inflows. In this case, for the PBC to reverse the reduced growth it has to inject liquidity into the economy. As mentioned above, a way out currently adopted by China is the cut in the Required Reserve Ratio. This is a loose