REFORMS OF THE EXCHANGE RATE REGIME:

THE CHINESE EXPERIENCE

TAO ZHANG

PEOPLE’S BANK OF CHINA

INTRODUCTION

• Exchange rate, capital control, and monetary policy

• Globalization poses challenges to choosing policies that are shaping exchange rates ， capital control ， and monetary policy: impossible trilogy?

• The rising cost of capital control and its ineffectiveness

OUTLINE

• Policy concerns• The international experience of the

choice of exchange rate regimes• Reform in China• Future of RMB

Policy Concerns

• Key concerns of developing countries– Fixed exchange rate system is not consistent with

the independence and flexibility of monetary policy– Challenges to capital control: transition from a

highly restrictive system to one that is more appropriate to a changing economy

International experiences

• IMF: current statistics

• Historical changes

Statistics at IMF（ 187 member countries)

No separate l egal tender 41Currency board 7Other conventi onal fi xed peg 41Pegged wi thi n hori zontal bands 4Crawl i ng pegs 5Crawl i ng bands 5Managed fl oat i ng 50I ndependentl y fl oat i ng 34

Source:Annual report on exchange arrangement and exchange restrictions 2004

Historical changes

Source:A.M. Husain et al., 2004

Exchange rate regime not permanently set

• 1970s: from Peg to float (Canada, Australia) ）• 1990s:from float to peg (EU, Poland)• Denmark: Peg (post-WWII) ； 1970s: float ；

after 1985 ： back to peg

Regime Durability(Average # of years until regime transition takes place)

（ 1975-2001 ）All regimes

Pegs Intermediate Floats

All countries

11.4 23.2 18.4 14.3

Advanced economies

19.4 46 26.8 88.0

Emerging markets

8.6 8.4 16.5 11.0

Developing countries

10.7 27.3 16.2 5.5

Source:A.M. Husain et al.,2004 from Reinhart and Rogoff,2003)

RMB: the Chinese experience

• Evolution of the RMB regime

• The new regime

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Int.transaction rate Official rate Swap market rate Unified inter-bank rate

1979,FX retention systen

1994unified with the exchange rate

Dual rate

China: evolution of foreign exchange rate system

Evolution of the RMB Exchange Rate System

• 1980s, a fixed exchange rate system plus frequent RMB devaluation

• 1988-1993, a dual exchange rate system: official fixed exchange rate coexisted with the market-determined rate in the swap centers

• The swap market rate depreciated sharply in the early 1990s• 1994, the official rate was devalued and unified with the ex

change rate at the swap centers; • 1995, a de jure managed floating exchange rate system alth

ough the currency has been de facto fixed to $• 2004(21 July): Managed floating

Policy challenges

• More difficult maintaining external balances, especially trade balances

• Constraints for developing abilities of competition by domestic firms

• Increased uncertainty with $

• Limited freedom for independent monetary policy

Preparing reforms

Bank sector reforms

Deepening of the foreign exchange market

Relaxed foreign exchange control

Banking sector reforms• 1998/99， 270 billion Yuan (about 33 b$) capit

alization for SOBs; 4 AMCs established, managing 1.4 trillion Yuan NPLs

2003-2005, CCB, BOC, and ICBC financial restructuring

2003, rural credit institutions reforms started

70-80% of banking institutions now restructured

Deepening foreign exchange market

Transition of foreign exchange settlement system from forced to voluntary

Raised retention ratio for domestic firms

Raised ceilings for domestic residents to purchase foreign exchange when travel abroad

May 2005, inter-bank foreign exchange pair trading launched

Relaxed foreign Exchange control

Less constraints on current account transactions for both individuals and firms

Easy market entry and business operations

Favorable macro-economic developments

Strong growth

Moderate inflation

Rising dollar interest rates

Strong external demand

Strong dollar and moderation of Euro and Yen

But there are disturbances…

An issue being politicalized

Loss of focus: bilateral balance

Rising trade protectionism

…encouraged market speculations

The new exchange rate regime: 21 July

Initial level “adjusted to” Y8:11 per US$: Taking into account trade balance and structure, and impact on domestic firmsA 0.3% range of fluctuation for $ rate; For non-$ rates, 1.5%; subsequently (23/09) widened to 3.0%.

But it is more a change of regime (managed floating)rather than level

Stop of a de facto US $ peg; A basket-currency-based, but not peggedMore market-based; Pre-set adjustment: 2%

Explaining 2%

Average trade surplus at about 2% of GDP in 2000-2004The 2% adjustment hoped to help restore trade balance, but in part onlyMinimize shocks to domestic firms

Basket currencies

Basket-currency-based (referenced), but not peg Changes in the basket currencies serve as

reference for bench-mark rate and range of fluctuation

International balance: weaker link Not directly related to bilateral

Composition of the basket currencies

Emphasis on merchandise trade and services: $10b above: has to be included $5b above: important to consider

US$, Euro, Japanese Yen, Korean Won, Other currencies:Sin, UK, MAL; and Rus,

Australia, Thai, Canada, etc Also factors of concern:

origins of external debts consideration of origins of FDI (balance $560

b) consideration of balance of income transfers

Understanding “gradualism”Following the pattern of the overall market-based reform process witnessed in the past 20 yearsContinuation of earlier efforts

1980’s: dual rate system; FX retention system; unified inter-bank FX market

1994: unified FX rates 1996: current account convertibility

Why not immediate float?Not prepared well:

global economic imbalances and uncertainties;

large amount of cross-border capital flows

Necessary regulatory role of state for a large transition economyCentral bank: filtering abnormal fluctuations

Preliminary assessment of the new regime

More fluctuations?Responses of firmsRevaluation pressure

Fluctuations

Fluctuations less than expectedTwo way movements: beating market expectation

22/07 to 21/09: up to 8.1128 and down to 8.0871 (a range of 257bp) compared with 10+ bp for the whole year pre-reform

Firms’ responses

Spot transaction (RMB vs foreign currencies): smaller surplus (15% down) in August (m-t-m)Forward transactions: more active (both purchase and sale doubled in Aug y-o-y)

But more firm purchase (up 52%) and less sale m-t-m (down 23%)

Overall, limited impact on exporting firms in the short runLittle impact on FDI

Pressure on revaluation?

•Immediate impact

• NDF discount: from 4111 22 July narrowed to 2750 end Aug, in line with the interest rate difference between LIBOR and CHIBOR

•But still 60% of the surveyed exporting firms hold expectations of further revaluation

Follow-up measures

•More relaxed foreign exchange management: higher ratio of retention rate (30-50% to 50-80%)

•Further easiness of market entry: more non-bank and non-financial firms allowed for the inter-bank marke transaction

•Inter-bank forward transaction system introduced

Sept 23 measures

•Not a change of the new regime adopted 21 July: a technical step

•Expansion of floating band vs. non-$ only, help banks to better control risk by reducing arbitrage opportunities

•Widening of buying-selling range follows international practice and discourages speculation

The future of RMBShort-term objectives: Improving the managed floating regimeLess administrative measures determining the exchange rateAs economic fundamentals and market infrastructure improve, range of fluctuation will be allowed to expandInstitutional support for new product development like derivative productsForward transactions recently introduced; more on swaps, optionsMore on interest rate liberalization

RMB: Long term Objectives

Consistency in the overall economic reform framework: building a market-based economyImproving foreign exchange regime: A market-based managed floating regimeEventual convertibility Maintaining the RMB stability which reflects the appropriate and equilibrium levelSupported by relaxed c/b capital movements in a selective and phased manner

RMB: only A policy instrument

RMB: only partly affect the Chinese external balanceChange of development strategy is more crucialDomestic consumption is keyStructural policies face challenges

Key structural issues

• Too much reliance on exports and investment• Rapidly expanded trade surplus• Direct financing remains weak• Consumer credit policy; min. wages; social

securities, personal income tax;• Urbanization and rural development• Financial sector reforms

SUMMARY• International experiences point to a trend of

reform in exchange rate regimes, particularly for emerging economies

• But the way of reforms is not universal

• The short-to-medium-term objective of the Chinese RMB reforms emphasize is a more market-responsive managing floating

• Plus a gradual realization of full currency convertibility

• The RMB policy serves the overall macroeconomic policy objectives; not just external surplus

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