Retrospect of the Chinese Exchange Rate Regime after Reform: Stylized Facts during the Period from 2005 to 2010

19China & World Economy / 19 – 35, Vol. 18, No. 6, 2010

©2010 The AuthorChina & World Economy ©2010 Institute of World Economics and Politics, Chinese Academy of Social Sciences

Retrospect of the Chinese Exchange RateRegime after Reform: Stylized Factsduring the Period from 2005 to 2010

Jie Sun*

Abstract

In the present paper, we estimate the de facto RMB exchange rate regime, the currencybasket, the floating band and the foreign exchange market pressure before and after thereform of the Chinese exchange rate regime in 2005. We find the following stylized facts: thevalue of the RMB became stable after the reform; the weight of the US dollar remained highin the basket, while other currencies remained statistically significant; and the floating bandgradually increased to 10 percent during 2005–2008, and then greatly narrowed from thelate summer of 2008 under the assumption of a yearly resetting interval. We find that theforeign exchange market pressure increased from 2005 to 2008. A possible reason is thatthe weight of the US dollar in the basket was slightly lower than the share of the US dollarin total transactions on the Chinese foreign exchange market. Therefore, it is reasonable forChina to adopt a dollar peg exchange rate regime.

Key words: currency basket, exchange market pressure, floating band, RMB exchange rateJEL codes: C22, E61, F31, F32

I. Introduction

In 1994, China instituted its interbank foreign exchange market and established markettransactions as a mechanism to determine the exchange rate under a managed floatingregime. In 1996, China further liberalized current account transactions. Since the Asianfinancial crisis in 1997, the Chinese Government’s stable exchange rate policy had graduallyevolved into a de facto dollar-peg system. In 2005, the Chinese authorities announced areform of the exchange rate regime involving switching to a basket peg regime. They later

* Jie Sun, Senior Fellow, Institute of World Economics and Politics, Chinese Academy of Social Sciences,Beijing, China. Email; [email protected] author thanks John Ross, Kentaro Kawasaki, XinhuaHe, Hongjin Li and Wei Huang for helpful comments and suggestions.

mailto:[email protected]

20 Jie Sun / 19 – 35, Vol. 18, No. 6, 2010


disclosed a list of 11 currencies that were important to the basket based on their shares inChinese foreign trade. However, the numerical weights of these currencies were not released.Faced with the impact of global financial turmoil in the late summer of 2008, the RMBexchange rate regime moved back to a de facto dollar-peg system. On 19 June 2010, thePeople’s Bank of China announced the reform of the RMB exchange rate determinationtowards more flexibility, and a return to the basket peg regime.

Empirical studies of the Chinese exchange rate regime began shortly after the reform in2005. Shah et al. (2005) use daily data consisting of 68 observations after 26 July 2005 toexamine the new Chinese exchange rate regime. They determine that the RMB remainedpegged to the dollar rather than a basket and that it has extremely limited flexibility. Usingsample data from 3 January 2005 to 25 January 2006, Ogawa and Sakane (2006) concludethat the Chinese Government made a statistically significant but small change in its exchangerate policy. Based on daily data from 21 July 2005 to 24 May 2007, Moosa (2008) verifiesthat the old regime of a simple and strict dollar peg had indeed been abandoned. However,he concludes that the current exchange rate regime is not a basket peg, but is a discretionarycrawling peg against the US dollar. Using daily exchange rate data from August 2005 toNovember 2008, Frankel (2009) estimates the RMB basket and finds that, in the basket, asubstantial part of the dollar’s weight had shifted to the euro.

In the present paper, we evaluate the RMB exchange rate regime reform of 2005.Specifically, the present paper focuses on the following issues: What is the de facto RMBexchange rate regime since the reform of 2005? What is the basket composed of? Are therechanges in terms of foreign exchange market pressure? Finally, based on those findings,how should the RMB exchange rate regime be evaluated?

II. The de facto RMB Exchange Rate Regime

Three key steps are needed to verify the de facto RMB basket peg regime and to determinewhether the RMB exchange rate is a variant of the band–basket–crawl (BBC) framework.1

The first step is the classification of the de facto RMB exchange rate regime, the second isthe estimation of its currency basket and the third is the inference of the flexibility band.

1. Estimation for the de facto RMB Exchange Rate RegimeApplying the methodology of Levy-Yeyati and Sturzenegger (2003), we attempt to investigatecharacteristics of the RMB exchange rate against the US dollar in three ways: measuring

1 According to Williamson (1996), there are five keys elements in the BBC regime: the choice of pegbasket, intervention currency, parity, band width and rate of crawl.

21Chinese Exchange Rate Regime after Reform


the volatility of the RMB against the US dollar exchange rate (the average of the absolutemonthly percentage changes in the nominal exchange rate during a calendar year, δe ),measuring the volatility of the change in the exchange rate (the standard deviation of themonthly percentage changes in the exchange rate, δΔe) and measuring the volatility of

reserves (δr ).2 Using monthly data in calendar year intervals, we establish four groups in

the sample period from July 2005 to June 2010. For comparative analysis, we also collecteddata before the reform from July 2001 to June 2005 in four groups. We investigate two kindsof exchange rates: the RMB against the US dollar and the RMB against the Swiss franc,3 toverify whether the shift had really been made from a dollar peg to a basket peg.4 Theexchange rate between the RMB and the US dollar and the exchange rate between the RMBand the Swiss franc were obtained from the Pacific Exchange Rate Service of the SanderSchool of Business, University of British Columbia (UBC database). Data needed in thecalculation of δr was obtained from the International Financial Statistics of the IMF. Table 1

presents the results of the exchange rate data for the RMB against the US dollar and, inparentheses, the results of the exchange rate data for the RMB against the Swiss franc.

Table 1 shows that some changes occurred in the RMB exchange rate regime after July2005. First, δe increased from 0.00498 to 0.35211, indicating that RMB moved significantlyagainst the US dollar.5 In the meantime, the exchange rate of the RMB against the Swissfranc became fairly stable (indicated by δe in parentheses). The higher percentage changeof the RMB exchange rate against the US dollar suggests a deviation from the dollar peg,and the low percentage change of the exchange rate of the RMB against the Swiss francindicates the stabilizing effect of a basket peg on the RMB value. Second, the volatility of

2 To estimate as closely as possible the change in reserves that reflects intervention, Levy-Yeyati andSturzenegger (2003) subtract government deposits in the central bank from the central bank’s netforeign assets as: Rt = (Foreign Asset – Foreign Liabilities-Central Government Deposits)/et. Hence, themonthly intervention on the foreign market (rt) is defined as rt = (Rt – Rt–1)/(Monetary Baset–1/et).3 We investigate the exchange rate of the RMB against the US dollar to show whether the RMB is stilldollar pegged, and we investigate the exchange rate of the RMB against the Swiss franc to show theoverall feature of RMB volatility as the conventional measurement of Frankel and Wei (1994).4 For countries that report a fixed exchange rate regime, Levy-Yeyati and Sturzenegger (2003) use thelegal peg currency as a reference or the currency against which their exchange rate exhibits the lowestvolatility. They eliminate countries that peg their currency to a basket from the sample unless thecentral peg parity or the basket weight is known. Here, we report volatility characteristics of theexchange rate of the RMB against the Swiss franc to verify whether the shift from the dollar peg to thebasket peg is really made, even though the US dollar is still significant in the basket.5 Considering the fact that from the late summer of 2008 the RMB’s peg to the US dollar was tightened,the δe increased more in the period from July 2005 to June 2008. The δΔe also increased more in the sameperiod for the same reason.

22 Jie Sun / 19 – 35, Vol. 18, No. 6, 2010


the exchange rate of the RMB against the US dollar increased, indicated by the rise in δΔefrom 0.00618 to 0.43052, and the volatility of the exchange rate of the RMB against theSwiss franc fell, indicated by the decrease of δΔe in parentheses from 2.39653 to 2.33261.This also suggests the stabilizing effect of a basket peg on the RMB value. Third, thehigher volatility of reserves reflects that the central bank intervened in the foreign exchangemarket more intensively than before the reform.

Comparing the changes of δe , δΔe and δr before and after 21 July 2005, the exchange

rate of the RMB against the US dollar became high–high–high, and the exchange rate of theRMB against the Swiss franc became low–low–high, respectively. Following theclassification of Levy-Yeyati and Sturzenegger (2003), we can make the following judgment:the exchange rate of the RMB against the US dollar presents features of a dirty float or adiscretionary crawling peg, which is in accordance with conclusion of Moosa (2008); andthe exchange rate of the RMB against the Swiss franc presents features of a fixed regime.However, if the exchange rate of the RMB is indeed basket pegged, the stable value ofRMB measured by the Swiss franc as numeraire will be one of the goals and the expectedresult of a basket peg regime. Hence, the changes of δe , δΔe and δr can also be regarded as

features of a basket peg regime.

Table 1. De facto Exchange Rate Regimeof the RMB before and after July 2005 Reform

δe δΔe δr

July 2001–June 2002 0.00352 (1.88953) 0.00521 (2.07546) 1.683677

July 2002–June 2003 0.00493 (1.92854) 0.00651 (2.35614) 1.263490

July 2003–June 2004 0.00664 (2.08954) 0.00761 (2.57693) 1.274151

July 2004–June 2005 0.00483 (2.00783) 0.00594 (2.56363) 2.855897

July 2001–June 2005 average 0.00498 (1.97886) 0.00618 (2.39653) 1.769304

July 2005–June 2006 0.28371 (1.73282) 0.40824 (2.23928) 2.568633

July 2006–June 2007 0.39950 (1.26565) 0.16633 (1.50867) 3.152985

July 2007–June 2008 0.83654 (1.79160) 0.48314 (2.48332) 3.883790


July 2008–June 2009 0.20833 (2.59143) 0.32010 (3.14246) 2.201698

July 2009–May 2010 0.03246 (1.53401) 0.04558 (2.24189) 5.897458



Source: Calculated by the author based on data from the University of British Columbia database and theInternational Financial Statistics of the IMF.

Note: δr estimation ends in May 2010 due to data availability.



2. Estimation for the RMB Currency BasketIf the exchange rate of the RMB is really pegged to a currency basket, we can estimate thecurrency basket composition. In other words, if the inferred currency basket is statisticallysignificant, we can regard the result as a verification of the de facto RMB basket peg regime.

The initial method of uncovering the weights of constituent currencies in a de factobasket using OLS regression was established by Frankel and Wei (1994), and furtherdeveloped by McKinnon and Schnabl (2003) and Schnabl (2006). However, these methodsdiffer in terms of technical detail.

The first issue is the choice of the numeraire or the measurement of a currency’s value.Frankel and Wei (1994) were the first to express a currency’s value in terms of its exchangerate against a remote currency; namely, the Swiss franc.6 The choice of this numeraire wassoon widely accepted by other researchers. Later, Frankel and Wei (2008) began to use thespecial drawing rights (SDR) as the numeraire, because they believe a weighted index suchas the SDR or a trade-weighted measure is more appropriate. Their reasoning is that anauthority’s intervention depends on the magnitude of the deviation from their referencebasket, which is usually a weighted average of major currencies rather than a remote currencylike the Swiss franc. If a trade-weighted measure is used in the equation, the possibility ofcorrelation between the error term and the numeraire should be minimized. This argument issound on one hand. On the other hand, because the SDR’s main currencies are oftenincluded in the equation as candidate currencies of the basket, the results from applyingthe exchange rates of those currencies against the Swiss franc will more clearly demonstratethe volatility of and the correlation among the value of those currencies than the applicationof the exchange rates of those currencies against the SDR. In fact, a merit of using a remotecurrency like the Swiss franc is its lower correlation with the US dollar, the euro and theJapanese yen than that of the SDR. Therefore, in the present paper, we will use the Swissfranc as a numeraire to measure the values of candidate currencies.

The second issue is the choice of the regression period. Frankel and Wei (1994) maketheir first regression estimation by treating all available data as one period. Later researchersdivide their available data into several periods, such as yearly, quarterly or monthly. Rollingregression has also been applied in order to estimate the basket changes in different periods.Obviously, if there are no structural changes, extending the regression period for as long aspossible could decrease the effect of white noise on the regression results, making the

6 Frankel (1995) chooses the inverse of the domestic consumer price index (CPI) as the numeraire, so asto interpret changes in the value of a currency as the changes in its purchasing power. However, CPI dataare only available on a monthly basis, whereas in exchange rate analysis, daily or weekly data are oftenused.

24 Jie Sun / 19 – 35, Vol. 18, No. 6, 2010


overall currency basket estimate more accurate. Considering the fact that the compositionand weights of the currency basket might change over time, the choice of regression periodcould be important. However, the regression period should be approximately close to thepossible basket resetting interval. Frankel (2009) uses monthly periods in his estimation ofthe RMB basket. However, he finds that monthly periods might be too short. Here, webelieve that yearly periods might be appropriate.

In the present paper, we use the Swiss franc as the numeraire, and the US dollar, theeuro, the Japanese yen, the Korean won, the Singapore dollar, the British pound, theMalaysian ringgit, the Russian ruble, the Australian dollar, the Thai baht and the Canadiandollar as candidate currencies. Our estimation of the RMB currency basket is based ondaily data in the two sample periods: from 21 July 2005 when China began to adopt a basketpeg to 18 July 2008 when China tightened the RMB’s peg to the dollar because of the globalfinancial turmoil, and from 21 July 2008 to 18 June 2010 when China announced a return toa basket peg. The estimation equation is as follows:

d(log(CNY)) = a1d(log(USD)) + a2d(log(EURO)) + a3d(log(JPY)) + a4d(log(KRW)) + a5d(log(SGD)) + a6d(log(GBP)) + a7d(log(MYR)) + a8d(log(RUB)) + a9d(log(AUD)) + a10d(log(THB)) + a11 d(log(CAD)). (1)

We apply a two-step cointegration test to the equation. After conducting a unit root teston all variables, we find that no unit roots exist in the first difference. We then apply a unit roottest to the residual of the regression and find no unit root as well. We delete currencies thatare statistically insignificant and, finally, obtain the estimations shown in Table 2.

From Table 2, we find that the weight of the US dollar in the RMB currency basket in theperiod from 21 July 2005 to 18 July 2008 is still dominant, at 84 percent, but the exchange rateof the RMB deviates from a hard dollar peg. Compared to the estimated results attained byother researchers, derived from data of a much shorter period than ours, the weight of theUS dollar in the basket decreased to an average level of 84 percent from over 95 percent.7

The estimates under the assumption of 12 month basket resetting intervals show thatthe composition of other statistically significant currencies changed in the RMB basket indifferent intervals. Furthermore, although the weight of the US dollar remained large andsignificant in all of the five intervals after reform in 2005, it changed from 79 to 96 percent indifferent periods. The weight of the US dollar in the RMB basket presents a significant

7 We use the same regression equation to estimate the basket during the period from January 2001 to June2005 and find that the weight of US dollar is as high as 99 percent. The estimations of Ogawa and Sakane(2006), Moosa (2008) and Frankel (2009) after the reform varied from 95 to 98 percent.



decrease to 79 percent in the first year after the reform, rebounds to approximately90 percent in the second and third year, but peaks at 96 percent in the fourth year becauseof the impact of the global financial turmoil.8

In a press briefing on 6 March 2010, Zhou Xiaochuan, the Chinese central bank governorsaid that the current RMB dollar peg was only a temporary special policy, and that Chinawould be very cautious in timing the normalization of the RMB exchange rate policies toend pegging the currency to the US dollar. This speech hinted that the central bank wouldexecute basket adjustment. Three months later, the People’s Bank of China announced areturn from the dollar peg to a basket peg regime.

3. Estimation for the Band of RMB Basket PegUnder the basket peg system, it is impossible to have the market exchange rate pegged toa benchmark level that is determined by a currency basket at all times. Hence, the BBCregime is a practical form of the basket peg system. One of the important features of theBBC or the basket peg regime is the floating band around its benchmark.

There are several possible ways to estimate the floating band of a basket peg system

8 The composition and weight of each candidate currency estimated in the basket varied during the periodsfrom July 2005 to July 2008 and from July 2008 to June 2010. Among those candidate currencies, thetwo most statistically significant currencies, the US dollar and the Singapore dollar, were kept in thebasket in the two periods. However, the weight of the US dollar in the basket increased from 84.2 to90.1 percent, whereas the weight of the Singapore dollar in the basket decreased from 16.6 percent to7.4 percent.

Table 2. Estimations of the RMB Basket

Source: Calculated by the author based on data from the University of British Columbia database.

July 2005–July 2008 Coefficient Standard error t-value p-value

USD 0.842277 0.015756 53.455950 0.000000

Euro –0.054912 0.023298 –2.356962 0.018700

JPY 0.021141 0.009995 2.115126 0.034700

SGD 0.165562 0.019378 8.543852 0.000000

R2 0.959850 — Durbin–Watson 1.772751

July 2008–June 2010 Coefficient Standard error t-value p-value

USD 0.900908 0.013278 67.850860 0.000000

KRW –0.011447 0.002602 –4.399838 0.000000

SGD 0.074060 0.011664 6.349341 0.000000

THB 0.054063 0.015344 3.523419 0.000500

R2 0.992804 — Durbin–Watson 2.395049

26 Jie Sun / 19 – 35, Vol. 18, No. 6, 2010


(e.g. Frankel, 2009). Here, we propose a simple way to directly illustrate the differencebetween the RMB market exchange rate and the basket benchmark level at every observation.

Based on the estimates of the composition currencies and their respective weights inthe basket during the two periods following the reform, as shown in Table 2, and supposingthe market exchange rate and the basket benchmark level equal to 100 on 21 July 2005, wecan calculate the floating band as the difference between the market exchange rate and thebasket benchmark level at every daily observation. It should be mentioned here that theresults shown in Figure 1 are obtained under the assumption that the composition currenciesand their weights in the RMB basket are kept unchanged during the two periods. We alsoassume that there are yearly crawling adjustments by taking into consideration the Balassa–Samuelson effect under the background of the rapid growth of the Chinese economy. Thedifference between the RMB market exchange rate and the basket benchmark level is resetto zero at yearly intervals (Figure 1).

We find three interesting phenomena in Figure 1. First, under the assumption of ayearly crawling peg, the floating band becomes wider in the first three resetting intervals,increasing from 3 to 5 percent and, finally, to 10 percent, indicating that the RMB exchangerate became more flexible with the basket. Second, the estimated floating band, or theinferred flexibility, points towards appreciation against the benchmark level. Third, sincethe late summer of 2008, the RMB exchange rate has been highly correlated with the

Figure 1. Estimation for the Floating Bandof the RMB Basket Peg

Source: Calculated by the author.

-20

-15

-10

-5

0

5

10

15

20

25

July-20-2005 July-20-2006 July-20-2007 July-20-2008 July-20-2009

Market exchange rate change of RMBagainst the Swiss francBasket change

Band

Date

20 July 2005 20 July 2006 20 July 2007 20 July 200920 July 2008



benchmark level that is determined by the currency basket within a floating band of lessthan 1 percent. The weight of the US dollar in the basket remains very high, indicating areturn to an approximate hard peg to the dollar.

III. Exchange Market Pressure of RMBand Central Bank Intervention

The exchange market pressure, a notion to capture the idea that in practice an excessdemand or supply of money could result in a change in the exchange rate or a change inforeign exchange reserves, can serve as a key indicator of the durability of an exchange rateregime. Girton and Roper (1977) undertake the initial research on exchange market pressure(EMP) within the framework of the monetary approach to exchange rate determination. Anexcess money supply must be compensated by a change in the exchange rate under a freefloat regime, and by a change in foreign reserves under a fixed regime. Under an intermediateregime or soft peg system, which is commonly used globally, an excess money supply mustbe compensated both by a change in the exchange rate and a change in foreign reserves.With this framework in mind, Girton and Roper (1977) believe that both the differencesbetween relative changes in foreign reserves to money supply and the differences betweenrelative changes in exchange rate to money supply indicate the level of exchange marketpressure. Therefore, most economists refer to central bank intervention on the foreignexchange market as an indicator of exchange market pressure.

Roper and Turnovsky (1980) use a stochastic small open-economy IS–LM model tomodify the original exchange market pressure analysis. They assume that the excess demandis absorbed through changes in the exchange rate, in foreign reserves, or in domesticcredit. They then introduce a policy reaction function that describes foreign reserves orintervention as a function of the observed deviation of the exchange rate from its long-runequilibrium level. The excess demand for domestic currency is equal to an unequallyweighted liner combination of changes in the exchange rate and changes in the moneybase/foreign reserves. Weymark (1997) constructs an exchange market pressure index byintroducing expectation generated by the exchange rate policy that is currently implemented,capturing the actual magnitude of external imbalance in the changes of observed variables.Known as the model-dependent exchange market pressure indexes, these indexes are derivedfrom highly restrictive structural monetary models containing estimate parameters thatinclude changes in the exchange rate and changes in foreign reserves.

Study of the exchange market pressure index became prevalent after the British poundcrisis in 1992, and interest especially increased following the Asian financial crisis in 1997,

28 Jie Sun / 19 – 35, Vol. 18, No. 6, 2010


when the exchange market pressure index served as a key leading indicator of the currencycrises. Eichengreen et al. (1995) argue that being model dependent is not a desirablecharacteristic of an operational index, because empirical models linking macroeconomicvariables to the exchange rate have little explanatory power in the short and intermediatehorizons. Instead, Eichengreen et al. (1995) develop a simpler and model-independentexchange market pressure measure in which the exchange market pressure is a linearcombination of the relevant interest rate differential, the percentage change in foreignreserves and the percentage change in the bilateral exchange rate. In contrast to the model-dependent index, weights of the three components are calculated from the standard deviationof the difference between components in the analyzed country and the reference countryrather than being estimated by any model. Inspired by Sachs et al. (1996), in order to avoidthe exchange market pressure index being driven by the most volatile component, Stavarek(2007) changes the weighting scheme. Here, we calculate the exchange market pressure inshort and intermediate horizons by applying a model-independent exchange market pressureindex with the following equation, as in Stavarek (2007):

))()())1()1()1((

/1()))1()1()1((

/1()))1()1()1((

/1( *

11tt

irme

r

t

t

irme

rm

t

t

irme

et ii

rmrm

eeEMP −∆

+++

∆

++−

∆

++=

−−

σσσ

σ

σσσ

σ

σσσ

σ

, (2)

where eσ is the standard deviation of the rate of change in the real exchange rate )(1−

∆

t

t

ee

, rmσ

is the standard deviation of the difference between the relative changes in the ratio offoreign reserves and money (money base) in the analyzed country and the reference country

)(1

∗

∗

−

∆−

∆

t

t

t

t

rmrm

rmrm

, iσ is the standard deviation of the nominal interest rate differential in the

analyzed country and the reference country )( *tt ii −∆ , rm is the ratio of reserves to money

base and * indicates the data of the reference country.We focus on measuring the exchange market pressure between the RMB and the US

dollar because the transaction on the foreign exchange market in China is dominated by theUS dollar. To illustrate the change in exchange market pressure before and after the reformof 2005, we calculate the exchange market pressure during the period from January 2002 toJune 2005, from July 2005 to June 2008, and from July 2008 to June 2010 for comparison. Weestimate this index by using two kinds of data sources to cross check the results.

One data source is the International Financial Statistics of the IMF. For US data,foreign reserves are obtained from net foreign assets in the central bank column, money isfrom the money base and the interest rate is obtained from the federal fund rate. For China’s



data,9 foreign reserves are calculated using the formula in Levy-Yeyati and Sturzenegger(2003), shown in footnote 2, in which government deposits in the central bank are subtractedfrom the central bank’s net foreign assets to approximate as closely as possible the changein reserves, which reflects intervention in the foreign exchange market. Money is obtainedfrom reserve money in the central bank column and the interest rate is obtained from thebank rate (discount rate). The exchange rate is the real exchange rate, consumer price index(CPI) data (change over previous period) for the USA is obtained from the InternationalFinancial Statistics of the IMF, and CPI data (change over previous period) for China isobtained from the China Economic Information Network. For both the US and Chinese CPIdata, the benchmark periods are set as January 2002.

The other data source is government department websites that originally release thedata. The exchange rate of the RMB against the US dollar is obtained from the People’sBank of China, China’s CPI data (change over previous period) is obtained from the ChinaEconomic Information Network, and US CPI data (change over previous period) is obtainedfrom the US Department of Labor. Foreign reserves are obtained from the State Administrationof Foreign Exchange of China and the US Department of the Treasury,10 China’s interestrate is obtained from the overnight weighted average interest rate on the national interbankmarket from the People’s Bank of China and the US interest rate is obtained from the FederalReserve’s overnight federal fund rate. Money base is obtained from the People’s Bank ofChina and the Federal Reserve of the USA.

Using the framework of the monetary approach to exchange rate determination andcombining with Equation 2, we obtain Equation 3 to estimate the foreign exchange marketpressure within the framework put forward by Frankel and Xie (2009):

ΔEMPt = ΔHt – ΔRest/MBt , (3)11

where Res = foreign exchange reserves, MB = monetary base and H is defined as the valueof the analyzed currency using the Swiss franc as a numeraire.

We use Equation 3 to estimate the overall exchange market pressure while we applyEquation 2 to estimate the foreign exchange market pressure of a currency to one of thereference currencies, such as the US dollar.

9 In the International Financial Statistics database, data for China is not based on standardized reportforms. There is no net foreign asset in the central bank column.10 Foreign reserves released by the Department of the Treasury of the US are weekly data. Because weconduct a monthly analysis ( we collect weekly data at the end of the month), a small error might exist.11 The original equation showed in Frankel and Xie (2009) is ΔEMPt = ΔlogHt + ΔRest/MBt . However,

according to the monetary approach to exchange rate determination, we set the equation as

ΔEMPt = ΔlogHt – ΔRest/MBt .

30 Jie Sun / 19 – 35, Vol. 18, No. 6, 2010


From Table 3, we find that in terms of the foreign exchange market pressure of the RMBagainst the US dollar estimated by Equation 2, the RMB appreciation pressure calculatedusing International Financial Statistics data, denoted as EMP (IFS), is slightly lower than theresult calculated using the data originally released on government department websites,denoted as EMP (original). However, both results show that the foreign market pressure ofthe RMB against the US dollar increased after the reform began on 21 July 2005. Surprisingly,in light of the global financial turmoil, when the Chinese authorities tightened the currency’speg to the US dollar, the foreign exchange market pressure towards appreciation between theRMB and the US dollar apparently decreased. Compared with the results estimated by Equation2 in every period, the overall foreign exchange market pressure estimated by Equation 3 fromFrankel and Xie (2009) using original source data, denoted as EMP (FX), reveals same changesbefore and after the reform as well as before and after the global financial turmoil.

Clearly, the foreign exchange market pressure increased after the reform in 2005. However,the decrease of the foreign exchange market pressure after the RMB tightened its peg to thedollar in 2009 is unexpected. There are plausible explanations for the decrease, and in the nextsection, we will focus on the foreign exchange market to determine some possible reasons.

Table 3. Exchange Market Pressure of the RMBagainst the US Dollar

EMP (IFS) EMP (original) EMP (FX)

Mean –0.001214 –0.003690 –0.191462

Median –0.000474 –0.004891 –0.183231

Maximum 0.023665 0.014853 0.319596

Minimum –0.032228 –0.027138 –0.487704

January 2002–June 2005

Standard deviation 0.011291 0.009344 0.130265

Mean –0.003541 –0.003735 –0.292581

Median –0.003675 –0.004084 –0.276702

Maximum 0.034177 0.018948 –0.075098

Minimum –0.030022 –0.026042 –0.505606

July 2005–June 2008


Mean –0.000471 –0.000695 –0.147431

Median –0.001171 0.000218 –0.196620

Maximum 0.027049 0.012609 0.183978

Minimum –0.047091 –0.021036 –0.411978

July 2008–June 2010a


Source: calculated by the author.Note: a EMP (IFS) estimation ends in May 2010 due to data availability. EMP (IFS), estimation by

Equation 2 calculated using International Financial Statistics data; EMP (original), calculated usingthe data originally released on government department websites; and EMP (FX), estimation byEquation 3 from Frankel and Xie (2009) using original source data.



IV. Peg to a Basket or Peg to the Dollar?

If a peg to the dollar can be regarded as a corner solution of a basket peg regime in whichthe dollar is the only constituent currency in the basket, choosing between pegging to abasket or pegging to the dollar is an issue relating to the choice of basket or the choice ofthe constituent currency in the basket.

The choice of basket for developing economies will be determined mainly by their tradepattern, especially when the volume of goods traded is the main part of the total volume oftheir international payments. Furthermore, the volume of their financial account is oftenassociated with trade. Therefore, the final goal of a basket peg regime is to stabilize foreigntrade by stabilizing the effective exchange rate of their currencies (Ogawa and Ito, 2000).12

The exchange rate level is directly determined by the transaction on the market. Whichcurrency (such as the US dollar) or basket that a currency will finally float with or peg to isalso determined by currency components in total market transactions. Obviously, thecurrency components of the market transaction are determined by the currency componentsof a nation’s international payments. In China, the currency components of the markettransaction are closely related to its international trade payments, because it is difficult forforeign exchange speculators to make transactions on China’s foreign exchange marketunder Chinese membership qualification requirements.13

Two features of China’s international payments should be highlighted. First, the volumeof current account transactions is two times larger than the volume of financial accounttransactions. More importantly, in terms of balance, which is crucial in determining theRMB exchange rate level, the balance of current account transactions is 25 times higherthan the balance of capital account transactions. Second, trade of goods accounts for80 percent of the total volume and balance of current account transactions. These twofeatures suggest that the RMB exchange rate is determined mainly by China’s foreign tradepatterns. Table 4 shows China’s top six trade partners with their trade share in parentheses.

With regard to the data in Table 4, we need to take two more issues into consideration.First, because the Hong Kong (HK) dollar is hard pegged to the US dollar under the linkedexchange rate system, the effect of the transaction between the RMB and the HK dollar will

12 The choice is a little complicated for China because the huge volume of foreign reserves can be aninfluential factor in the choice of optimal currency basket to keep the market value of foreign reservesstable.13 According to the membership regulations of the interbank foreign exchange market participants, mosttransactions are made by banks for their clients whose demand or supply are from foreign trade needsunder the current account liberalization.

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be similar to the effect of the transaction between the RMB and the US dollar in determiningthe exchange rate level. Second, the US dollar is widely used as an invoicing currency inforeign trade, especially in the trade between China and countries whose currencies are notmajor currencies on the international market. Even for the trade of a developed country likeJapan, Ito et al. (2009) found that the ratio of the yen as an invoicing currency accountedfor only 40 percent of total Japanese exports and 20 percent of total Japanese importsduring the period from 1980 to 2008. This research suggests that the US dollar should bewidely used as the invoicing currency in trade between China and rest of the world. TheChina Foreign Exchange Trade Center does not release data on currency components oftotal transactions on the market, but we have obtained some information from insidermarket surveys. Zhao (2009) points out that transactions between the RMB and the USdollar account for 91 percent of the total volume of foreign exchange transactions onChina’s interbank foreign exchange market, equating to approximately US$200m per day.

Given membership regulations, foreign trade patterns, as well as the global dollarstandard, the domination of transactions between the RMB and the US dollar on China’sforeign exchange market is a natural result. Hence, the RMB exchange rate having a tightpeg to the US dollar is also a natural result of foreign exchange market transactions.

From this perspective, we can understand why the exchange market pressure betweenthe RMB and the US dollar increased after the reform, despite the fact that during2005–2008, the weight of the US dollar in the RMB currency basket decreased from99 percent to an average level of 84 percent. On one hand, the RMB should shift from ahard dollar peg to a basket regime in order to accommodate its currency component in totaltransactions on the foreign exchange market. On the other hand, the weight of the US dollarin the RMB currency basket should also approximately correspond to the component ofthe US dollar in total market transactions. As the data shows, the 84 percent average level

Table 4. China’s Main Trade Partners in 2004–2008(% of Total Trade)

2004 2005 2006 2007 2008 2004–2008

USA (14.7) USA (14.9) USA (14.9) USA (13.9) USA (13.1) USA (14.1)

Japan (14.5) Japan (12.9) Eurozone (12.2) Eurozone (12.7) Eurozone (12.8) Eurozone (12.5)

Eurozone (12.2) Eurozone (12.2) Japan (11.8) Japan (11.8) Japan (10.4) Japan (11.7)

Hong Kong (9.8) Hong Kong (9.6) Hong Kong (9.4) Hong Kong (9.4) Hong Kong (8.0) Hong Kong (9.0)

Korea (7.8) Korea (7.9) Korea (7.6) Korea (7.6) Korea (7.3) Korea (7.5)

Singapore (2.3) Singapore (2.3) Singapore (2.3) Russia (2.3) Australia (2.3) Australia (2.2)

Source: Calculated by the author based on data from Direction of Trade, International Financial Statistics ofthe IMF.



of the weight of the US dollar in the RMB currency basket is slightly lower than the actual91 percent average level of the US dollar in total market transactions. This can explain whythe foreign exchange market pressure between the RMB and the US dollar increased afterthe reform. This also accounts for why the foreign exchange market pressure between theRMB and the US dollar decreased when the RMB tightened its peg to the US dollar in thelate summer of 2008.14

V. Conclusions

We estimated the de facto RMB exchange rate regime, currency basket, floating band andforeign exchange market pressure before and after the reform of 2005. We have establishedthe following stylized facts:

First, according to the de facto exchange rate regime classification standards of Levy-Yeyati and Sturzenegger (2003), the exchange rate of the RMB against the US dollar exhibitscharacteristics of a dirty float or a discretionary crawling peg, whereas the value of theRMB, measured by the exchange rate of the RMB against the Swiss franc, exhibitscharacteristics of a fixed regime.

Second, since the reform, the weight of the US dollar in the RMB basket remained high,the weight of the Singapore dollar increased, and the euro, the Japanese yen, the Koreanwon and the British pound are statistically significant in the basket. The weight of the USdollar in the basket decreased sharply at the beginning of the reform and graduallyrebounded during the following period.

Third, the floating band gradually increased to 10 percent towards appreciation in thefirst 3 years, but greatly narrowed from the late summer of 2008 under the assumption ofyearly resetting intervals.

Finally, the foreign exchange market pressure index, based on Stavarek (2007), increasedafter the reform until the late summer of 2008. Since the RMB tightened its peg to the USdollar in the period from July 2008 to June 2010, the foreign exchange market pressure hasdecreased.

From the stylized facts, we can reach the following conclusions. First, the Chineseexchange rate regime clearly shifted from a hard dollar peg to a basket peg from July 2005,

14 The foreign exchange market pressure index we apply here is based on the monetary approach toexchange rate determination. However, we explain the foreign exchange market pressure index changeby the currency component on the foreign exchange market, which is based on foreign trade. The latterperspective can be turned into the former one because the increase in foreign reserves gained from tradesurplus will be sterilized by the central bank and, finally, will become excessive domestic money supply.

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even though the weight of the US dollar remained high in the basket. As a result, the valueof the RMB, as measured by the Swiss franc, became more stable.

Second, the RMB became more flexible in the period from July 2005 to June 2008 interms of the floating band. However, due to the impact of the global financial turmoil fromthe late summer of 2008, the RMB tightened its peg to the US dollar again.

Finally, the RMB exchange rate keeps pegging to the US dollar as a natural reaction toChinese foreign exchange market transactions, in which the share of the US dollar dominates.This explains why the foreign exchange market pressure increased after the reform whenthe RMB shifted away from the hard dollar peg and why the foreign exchange marketpressure decreased after the RMB tightened its peg to the US dollar in the late summer of2008. It would be valuable to estimate using new data the possible change in the basketcomposition and the RMB’s foreign exchange market pressure since the return of thebasket peg in the early summer of 2010.

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(Edited by Xiaoming Feng)

http://www.chinaforex.com.cn/blog/user1/zhao0h/archives/2009/

Documents

Retrospect of the Chinese Exchange Rate Regime after Reform: Stylized Facts during the Period from 2005 to 2010