With the implementation of China’s “reform and opening up policy” made in 1978. China has successfully transformed itself from an inflexible centrally-planned economy to an open and market-oriented economy. On the other hand, Chinese firms may identify currency risk when dealing with foreign companies. A key difference between investing in domestic and foreign assets is that the latter exposes the investor to a currency risk. The change of foreign exchange rate can cause risk in potential corporate profitability, net cash flows and market value. This study applies an integrated foreign exchange risk management approach with Chinese trading companies and gives possible solution in hedging currency risk.

1. Introduction

China, one of the large emerging markets, with the implementation of its “reform and opening up policy” made in 1978. China has successfully transformed itself from an inflexible centrally-planned economy to an open and market-oriented economy, and accomplished remarkable progress in trade market. China has maintained high and stable growth rates for over two decades. Since China is becoming an increasingly important member in the world’s economic scene, the movements of the foreign exchange rate could be an important issue for Chinese firms. On 19 of June 2010, China’s central bank declared that it will further implement the reform of foreign exchange and enhance the flexibility of RMB exchange rate (Money for life guide, 2010). In the recent financial crisis, it has shown that China’s exchange rate policy is a substantial international issue (Zhang, 2001). However, China’s central bank is in dilemma because of the effects of the foreign exchange reform and the currency risk to the Chinese companies.

In the influences of the foreign exchange reform to Chinese enterprises, Anderson, UBS’s chief Asia economist, stated that the impact of importation should be better than the impact of exportation for Chinese firms. However, in the external business competitions, Chinese firms engage in importing machinery and raw materials from other countries, are definitely affected by the foreign exchange reform. Their selling prices are down right now because of losing the competitive advantage from exchange rate reform. But Woetzel, director of McKinsey & Company’s Greater China Office, argued that the exchange rate reform will bring Chinese enterprises to the international market, and the effect of the whole foreign exchange reform process will allow Chinese companies to meet the international standards (Let the world to aware of a brilliant future of China’s economy 2005).

This essay is organized as follows: Section 1, review the process of China’s foreign exchange rate reform and the new Renminbi (RMB) exchange policy and its impact on China’s balance of trade and the economic development. Section 2, briefly discuss about the impacts of foreign exchange reform in China and the risk to Chinese firms. Section 3, focus on the currency risk affecting the multinational companies in China, examines the relationship between foreign exchange rate arrangements, and states the solution to hedge the currency risk during the foreign exchange reform. Section 4 concludes the paper.

2. The Foreign Exchange Reform in China

Renminbi (RMB) has become a national currency in 1949, but it has been invariable and inconvertible. Consequently, RMB was limited to be an accounting instrument and a capital for allocating company’s resource. With its market isolation from outside world, RMB could not athletically take action to the unpredictable foreign exchange rate, nor make appropriate adjustment that based on the change supply and demand of foreign exchange immediately. Zhang (2001) explained that this situation is essentially related to the monopoly condition of China’s foreign trade policy, only dozen of authorized import and export corporations could cooperate with foreign firms under the import and export contract. Furthermore, these foreign trade corporations (FTCs) had to relinquish the earnings from foreign trading because they had to exchange the currency from the Bank of China at the official exchange rate, and normally the rate is not reasonable. Obviously, there were no incentives for traders under this business circumstances, the changes in the official exchange rate would definitely affect the multinational firms’ financial profits.

In order to improve incentives and promote export performance, China has endeavoured at least four times to reform and loosen its foreign trade management system since 1978 (Zhang, 1997). The main progress of the reform was launched in the last two decades, it proposed to fracture the traditional foreign exchange system between domestic firms and the world markets by dispersing the authorization of the trading right. It also introduced the agency system for increasing the initiative and autonomy to the trading companies in the early 1980, and permitted them to assume independent accountability through the contract responsibility system (CRS) since the late 1980s. However, Iwatsubo & Karikomi (2006) states that the past reform on China’s exchange rate system did not seem to have significant effects.

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Figure 1 Exchange Rates of the RMB – US dollar (1979–1994)

(Source from Zhang, 1997)

To summarize the whole process of the China’s foreign exchange reform, it can be divided into 3 main stages. In 1994-1996, that was the first stage of foreign exchange reform, which is called “stable development stage”. China started to prepare for its regaining of membership in WTO and GATT by reducing substantially tariffs and import licenses. In order to enlarge Chinese markets, China started to implement socialism and market-orient policy and reformed the foreign exchange system in 1994. It launched a new exchange rate policy which based on the market’s supply and demand, and managed floating exchange rate regime. China adjusted the exchange rate from 1 USD= less than 6 RMB to 1 USD= 8.7 RMB (see figure 1). The competitive advantage of China’s product kept increasing in the international markets because of the depreciation of RMB, which can benefit the exportation and attract foreign investments. In general, China’s economy, foreign reserve account, capital, and financial projects have continued to move forward (Zhang, 1999).

In 1997–2001, after several years of high inflation and speedy growth of China’s economy, the second stage, “high-deflation stage” was started to begin. Unfortunately, the impacts of high inflation and Asia financial crisis almost started at the same time. That was a huge economic shock to China because all Asia’s currencies were devaluated, which deducted the China’s competitive power in the international markets. The profit from import and export trading fell down to the lowest point in 2001, which lose more than 12 billion USD by comparing before Asia financial crises. Therefore, China’s central bank reduced the reserve rate from 13% to 8% in March of 1998 and 8% to 6% in 1999, in order to release the pressure of national expenditure. The GDP growth rate reduced about 2–3% by comparing before 1997 (see figure 2) (Xia & Chen, 2005).

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Figure 2 China GDP Growth Rate 1997–2010

Source: TradingEconmics.com; National Bureau of Statistics

In 2002 to present, is the third stage of China’s foreign stage reform, “boost development stage”. In 2003, China’s GDP growth rate reached 9.1%, in 2004 and 2005, China maintained 10.1% and 9.9% growth rate in GDP (see figure 2). However, this circumstance enlarged the appreciation pressure on RMB.

On 21 July 2005, China gave up the fixed exchange rate that it had adopted and grown into over a decade. China’s exchange rate had been effectively fixed at 8.28 yuan per USD within a slight range of 0.3 percent plus or minus with no control on the RMB’s value against other currencies (Ronald, 2005). At the same time, The People Bank of China launched the new exchange rate policy; the new policy depends on market supply and demand to foreign currencies, adjusts by referencing to a basket of currencies and follows the published exchange rate fluctuation in international markets. The Chinese government stated that the China’s monetary management team will keep tuning the RMB exchange rate at a reasonable and balanced level (Huang, 2006). Since then, China’s balance of payments and trade has undergone several different stages, from high-inflation period to high-deflation period.

3. The Currency Risk in China

Chinese companies face additional risks in operating with foreign companies in international circumstance. One of main risks is the currency risk, which appears from changes of exchange rates between different currencies. One simple method is to measure the return in domestic currency conditions and compare it with the returns in local currency conditions, and characterise the “Currency effect”. However, curry surprise is an essential method to calculate currency risk, which defines as the unforeseen adjustment of the foreign currency relative to its forward rate or market expect rate (Srinivasan& Steve 2003).

Exchange rate instability can work against an international firm, for example, if a payment in a foreign currency has to be completed at a future date, it cannot be guaranteed that the price in the foreign exchange market will be stable in the future. It is possible that the exchange rate will move against the company, leading the company to suffer loss. On the other hand, the foreign exchange market can also provide advantages, reducing the payment cost in terms of their home currency. Generally, when the home currency is devalued, the companies can get advantages in exporting goods to other countries because their products become cheaper. In the same way, Firms get benefit in importing from other countries when their currency becomes stronger, it then increases the currency’s purchasing power in other countries.

Therefore, foreign exchange risk can be a significant issue for Chinese enterprises, it can cause risk in potential corporate profitability, net cash flows, and market value. Thus it influences management decisions of multinational corporations.

4. Risk Management for Hedging Currency Risk

Since currency surprise has been an essentially noise in currency risk management, hedging currency risk is the act of reducing or negating the risks that arise out of changes in the prices of one currency against another. In order to acquire the maximum profit and minimum loss in dealing with foreign firms, there are several methods for a business to defend the “risky currency”. The first one is called “Internal Hedging Strategies”, it means leading and lagging the receipts and payments of cash to gain a business advantage. It can ensure that the local companies utilize the exchange rate movements to guarantee maximum profit. For example, if a company has to pay $1 million on a specific date for imported fabric and receives an export order for $1 million, it can attempt either to setback the payment for imports or request an early payment to the buyer. Therefore, the cash inflow from exportation is used as the payment for imports. This method can reduce the depreciation risk in import-payment and evade the risk in export-receipt by managing both cash flows.

The second method is called “Forward Transactions”. It is a relatively easy method to execute currency risk management. In this situation, both companies have to sign a contract which states a specify exchange rate for the payment or receipt in the future, regardless of what the real market exchange rate at that time is. The main idea behind the forward transaction is that while the exchange rate is set on both parties, they do not have to concern about instability of incomes and costs respectively.

The third strategy is “Currency futures”, the same idea as forward contracts except the pre-set date of the transaction in the future is set. It is a transferable futures contract that specifies the exchange rate at which a currency can be bought or sold at a future date. It allows foreign trade companies to hedge against foreign exchange risk. The advantage of currency futures is exchange-traded. counter-party risk is eliminated, and it also facilitates that currency futures are more transparent in their pricing and more accessible to all market participants (Srinivasan & Steve, 2003).

The next method is “Currency Swaps”. It is a swap that involves the exchange of principal and interest in one currency for the principal and interest payments in another currency. This real time transaction can also be utilized for hedging interest rate risks by exchanging their fixed and floating interest rate contract with each other (Nicolaus, 2000).

The last method for hedging currency risk is “Currency options”, these are financial instruments that give the buyer of the contract the right but not the obligation to either buy or sell a designated quantity of a specific currency at a predetermined exchange rate. While a call option gives the owner the obligation to buy the currency at a contracted price. On the same way, a put option gives the holder the right to sell it at an agreed price, regardless of an unfavorable market price for the same. However, foreign exchange risk can be a significant issue for Chinese enterprises, it changes of future cash flow resulting from the unexpected exchange fluctuation and create risk in corporate profitability, net cash flows and market value. Thus it is necessary to evaluate and generate a suitable hedging method to prevent the loss from investing with multinational corporations.

5. Conclusion

To summaries this article, subsequent to the review the whole process of China’s exchange rate reform, it seems that globalization will drive China toward further financial integration. This situation moves determinedly towards increasing exchange rate flexibility. The process and speed of moving towards more flexibility should be deliberate. Particularly, China should concern the developing and emerging markets changing their foreign exchange policy. In the past, some Asia developing countries rushed into opening the capital account in order to formulate their currencies more convertible, but in fact, it results currency and banking crises when hot money left their economies. Since China still has a long way to go for building up a well-built, well-managed and synchronized financial system, it should also continue to give a high priority in enhancing its financial stability. As The People’s Bank of China said, the reform of the RMB exchange rate will help increase the competitiveness of the country’s exports on the international markets and it would continue reforms of the yuan exchange rate regime and increase the flexibility of the exchange rate.

This paper explores the impacts of foreign exchange rate on trade between China and other countries. Since effective currency risk management has became popular in company corporate level. This essay presented an overview of hedging foreign currency risk exposure with Internal Hedging Strategies, Forward Transactions, Currency Futures Currency Swaps and Currency Options. These instruments have been comprehensively described in terms of their common and characteristics. However, hedging currency risk is a very important strategy in financial planning and budgeting when Chinese companies do businesses with foreign companies.