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Examining the Chinese Exchange Rate Reform and the Possibility of the Chinese Yuan Becoming a Regional Trade Currency: IntroductionThe fix of the Chinese Yuan to the United States (U.S.) dollar had been in place since 1994. The trade imbalance between the U.S. and China has led some scholars to believe that China is manipulating its currency to hold down the dollar prices of its goods in order to create a trade advantage that contributes to the loss of U.S. jobs and businesses (Krugman cited in Fair 2010). In February 2005, the U.S. congress proposed an imposed tariff of 27.5% on Chinese goods unless China raises the value of its currency by the same percentage.
Due to this imposed pressure (Zhang 2009), the Chinese government announced a change in its exchange rate system from the fixed rate to a more manageable system (floating rate) on July 21st 2005 which was regarded as a historical change in China.
During a one year cycle (from July 2005 to July 2006), the Yuan appreciation to the U.S. dollar appeared to be in line with the inflation difference between the two countries which justified the Purchasing Power Parity (PPP) (Zhang 2009) and (Pilbeam 2006). This encouraged scholars such as McKinnon cited in Zhang to suggest that the annual inflation difference between China and U.S. should be followed as a model. This point of view was challenged during mid-2006 after a significant regime change.
Before mid-2006, China had an adequate monetary control on capital inflows and the expected appreciation was more modest. The People’s Bank of China (PBC) could sterilize excess foreign exchange accumulation to prevent excess money growth and keep inflation rate between 2 to 3% which is lower than the U.S. However, with the increasingly fast RMB appreciation after mid-2006, the PBC could not hold back the excess money growth due to the upsurge of capital inflows. Consequently, inflation in China started to rise and exceeded that in the U.S.
During the period from October 2006 to November 2007 inflation rate reached 1.4% and by time implicated the assessment of a sensible RMB/USD exchange rate movement.