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In choosing an appropriate exchange rate regime, developing countries should take some specific circumstances into consideration: the degree of sophistication of their financial sector development, the balance of payments constraint, the need to protect external competitiveness and the changes in the international monetary and financial environment.
China is currently using a tightly managed floating rate system, with the Renminbi (Yuan) only allowed to fluctuate in a tightly controlled narrow band. By actively intervening in the foreign exchange markets, China currently accumulated over $500 billion in foreign currency reserves. The main reasons why China pegged its currency to the dollar are as follows:
- US is the largest trading partner with whom China is running a trade surplus.
- Preventing volatility in Current and Capital accounts.
- Restricting capital mobility, thus preventing "hot money" from wreaking havoc on the fragile emerging private sector and financial markets.
- Safeguarding its internal economy from major shocks brought upon by revaluations in the currency.
- Promoting growth and stabilization of the banking sector and financial markets.
- Moving towards a global market integration and free market economy.
Given the previous relative stability of the US economy, sophisticated financial markets and its status as the world's largest economy has given China ample reasons to choose to peg its currency to the US dollar. By allowing the US$ to take the brunt of the foreign exchange rate fluctuations, China is using this tool to its advantage and is safeguarding its
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economy from the financial crisis that was previously seen in Asia, Russia and Latin America. These crises arose when the fixed exchange rate regime allowed unrestricted flow of speculative capital to flood the financial markets and the economy, driving economic growth to unsustainable levels and resulting in the "bursting" of economic bubble, hyperinflation and extreme devaluations of the currency exchange rates. By pegging and putting restrictive monetary controls in place China is using a preventative strategy against the catastrophic results of excessive speculation and the creation of unsustainable economic bubbles.
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