Question

(Related to the Apply the Concept on page 1071 ) An article on usatoday.com included the following two observations: First, "Chinese companies and individuals have begun to invest more heavily outside the country." Second, "The yuan has dropped nearly 7 percent against the dollar so far this year. The Chinese government has responded by draining its foreign exchange reserves to buy yuan, hoping to slow the currency's fall." a. Is there a connection between Chinese companies and individuals investing more heavily outside the country and the drop in the yuan? Briefly explain. b. Why might the Chinese government want to slow the fall in the yuan? c. Why would the Chinese government have to drain its foreign exchange reserves to slow the fall in the yuan?

Short answer

Chinese companies and individuals investing more heavily outside China can lead to a drop in the value of the yuan as they sell yuan to buy foreign currencies. The Chinese government may want to intervene to slow the fall of the yuan for economic stability and maintaining domestic and international trust. It uses its foreign exchange reserves to buy the yuan, thus bolstering its value.

Step-by-step solution

Connection between Investments and Currency Value

Yes, there is a connection. When Chinese companies and individuals invest more heavily outside the country, they may sell their yuan to buy foreign currencies to make these investments. This increase in the supply of yuan versus demand can result in a depreciation of the yuan against these currencies, thus causing a drop in its value.

Reason for Government Intervention

The Chinese government might want to slow the fall in the yuan to maintain economic stability and confidence domestically and internationally. A falling currency can lead to higher inflation as import goods become more expensive, which can erode consumer's purchasing power. It also can cause capital to flow out of the country, as investors move to stronger currencies, which could destabilize the financial system.

Why Draining Foreign Exchange Reserves?

The Chinese government would have to drain its foreign exchange reserves to buy up yuan and decrease its supply in the market. This action increases the demand for yuan, which in turn could help in slowing its fall. This is often seen as a last resort due to the goal of maintaining large foreign exchange reserves for financial stability.

Key concepts

Yuan Exchange Rate

The Yuan exchange rate is a critical factor in the global market. It determines how many Yuan are needed to buy a unit of another currency like the U.S. dollar. When the value of the Yuan decreases, this is known as depreciation. A depreciating Yuan means it takes more Yuan to purchase the same amount of foreign currency as before.

Various factors can lead to fluctuations in the Yuan's exchange rate. One significant factor is when Chinese companies and individuals increase their investments outside the country. They need to exchange Yuan for foreign currency to make these investments. This increased supply of Yuan in the international currency markets lowers its value compared to other currencies. This is a direct connection between investment behavior and the Yuan's depreciation.

Currency depreciation can have multiple effects. It might boost exports by making them cheaper on the international market, but it also increases the cost of imports, impacting businesses and consumers domestically. Understanding the Yuan exchange rate changes is vital for anyone involved in international trade or finance.

Foreign Investment

Foreign investment refers to businesses and individuals from one country putting money into ventures, industries, or assets in another country. For example, when Chinese companies invest in the United States, they often need to exchange their Yuan for U.S. dollars.

This financial move plays a considerable role in the behavior of currency values, such as the Yuan. As Chinese investors acquire foreign assets, they increase the demand for other currencies while the demand for the Yuan decreases. This change in demand can lead to the Yuan losing its value against the target foreign currency.

• Affects exchange rates
• Influences currency supply and demand
• Impacts economic growth positively or negatively

Foreign investments are essential for economic diversification and development but can also make domestic economies vulnerable to foreign market fluctuations. A balanced approach is crucial to protect against unforeseen economic disturbances.

Foreign Exchange Reserves Management

Management of foreign exchange reserves is a crucial task for governments, especially in huge economies like China. These reserves are assets held on reserve in foreign currencies used to back liabilities and influence monetary policy.

Foreign exchange reserves are like a safety net. They help ensure a country can pay for its imports and service its foreign debts if the local currency takes a hit. When the Yuan devalues, China might resort to using these reserves to buy back its currency. This is referred to as 'draining reserves'. By purchasing Yuan with the reserves, the government decreases the Yuan's supply, increasing its value.

• Stabilizes the currency
• Controls inflation
• Maintains investor confidence

While draining reserves can stabilize the currency temporarily, it is not a long-term solution. A continual decrease in reserves could lead to vulnerabilities, impacting global financial stability.