Let’s put aside for now the debate on whether Chinese Yuan is undervalued or not,  what are the motives for China to fix its currency to the US dollar around 1995?

First comes to my mind is the need to remove currency risk in trade.  As we know, almost all trade contracts are denominated in dollar, not in Yuan.  Currencies tend to move a lot, and nobody likes volatility.  By pegging Yuan to the dollar, Chinese firms essentially save the cost from buying expensive currency risk hedging contracts.

Second, by fixing Yuan to the dollar, more or less, China submitted its monetary policy to the Fed, i.e.,  the Fed’s monetary policy tends to have a great impact on China’s own monetary policy. In other words, China’s central bank largely lost its autonomy.  Good thing or bad?

Below is a chart I just made looking at China’s domestic inflation, an important gauge for macro-stability, before and after the pegging to the US dollar.

(click on the graph to enlarge)

The chart is very dramatic.  Before 1995,  China’s inflation (in red) was very high and volatile.  The Great Inflation in 1988 partly contributed to the 1989 students’ demonstration, which eventually led to the unfortunate Tian’anmen incident.  After 1995, China’s inflation plummeted, and since then has remained quite stable – inflation never went up to over 10% again.

Was this because Chinese government suddenly improved their macro economy management skills?  I don’t think so.

Here is what really happened –  In essence, China achieved its macro-stability by outsourcing its monetary policy to the Fed, which has much more experiences in fighting inflation and also enjoys better credibility.

(update on Oct. 7, 2011)

A re-look at the interest rate changes during 1995-2005 between China and the US, I changed my view that China’s inflation decline was due to its pegging to the US dollar.  The more plausible explanation is China’s central bank successfully prevented inflation from rising by continuously raising interest rate, eventually pushing down inflation.