Implications of China's foreign exchange system for the wool market / Will Martin.

Abstract

China’s foreign exchange regime includes controls on the use of foreign exchange and an overvalued exchange rate. While a system of foreign exchange retention and secondary markets for foreign exchange has been introduced to mitigate the effect of the overvaluation and to increase the efficiency with which foreign exchange is used, overvaluation still reduces returns to exporters. Given the more price-responsive nature of the post-reform Chinese economy, this policy reduces exports and hence foreign exchange availability. The resulting shortage of foreign exchange raises its price on secondary markets and increases the price of importables at the margin. A general equilibrium model of the post-reform Chinese economy is developed to analyse the short-run effects of exchange rate devaluation. The model points to a number of major beneficial effects on the Chinese economy, including a major appreciation of the secondary market exchange rate, with a consequent fall in prices of imports. Exports grow dramatically, providing additional foreign exchange to finance imports. Real incomes rise, the balance of trade improves, and the expansion of labour-intensive export industries raises the demand for labour and hence real wage rates. Within the textile sector, wool and cotton imports are projected to grow rapidly in response to the lower secondary market prices for foreign exchange and the greater incentive for export production of textiles and apparel.