Academic journal article China: An International Journal

Changes in China's Exchange Rate Policy and Future Policy Options

Academic journal article China: An International Journal

Changes in China's Exchange Rate Policy and Future Policy Options

Article excerpt

China Changes Its Exchange Rate Regime

On 21 July 2005, the Chinese Government announced that the country's exchange rate regime would move immediately to a managed floating exchange rate regime based on market supply and demand with reference to a basket of currencies. With this reform measure, the Chinese renminbi (RMB) switched from a peg to the US dollar to a managed float based on a basket of currencies after a 2.1 per cent appreciation. This was widely seen as an improvement to the RMB exchange rate regime, giving it greater flexibility.

It was a calculated political move in response to mounting external pressures to revalue the Chinese RMB. In recent years, China's continuing large trade surpluses and rapid accumulation of foreign exchange reserves have caused global attention to focus on the exchange rate of the RMB and China's exchange rate regime. Given China's growing integration into the global economy and the fact that changes in its currency exchange rate will have a major external impact, the issue of RMB appreciation and the options for China's exchange rate regime have become of major concern to many countries.

Prior to July 2005, external pressure from the US, Japan and other G-7 nations mounted on the Chinese Government to revalue the RMB and end its peg to the US dollar. It was believed that such actions were necessary to correct global trade imbalances and prevent low-valued Chinese exports from flooding US and European markets. (1)

Will further reform measures be introduced? To improve its so-called "socialist market economic system", China will have to undertake further reforms in the financial system. Any move towards an inflation-targeted monetary policy and liberalisation of the capital account will inevitably challenge the current managed floating regime and have significant policy implications for the RMB.

Nevertheless, it is unrealistic to expect that the Chinese Government will take radical measures to further reform its exchange rate regime. Despite continued external pressure, it is likely to continue its incremental reform pattern. While external pressure can play a role in facilitating reform, the Chinese leadership must also take domestic pressures into account.

Debate on China's Exchange Rate Regime

Global debate about the RMB's exchange rate has focused on two key issues: the revaluation of the RMB and the optimal exchange rate regime for China.

The RMB is believed to be undervalued, and estimates of its undervaluation vary from 10 to 40 per cent. Goldstein estimated a revaluation of 15 to 30 per cent based on China's balance of payments data and on the viewpoint of global payments imbalances (no specified period). (2) Funke and Rahn estimated a 12 per cent undervaluation over the period of January 1985 to April 2002. (3) Frankel used the purchasing price parity model and estimated a 36 per cent undervaluation in 2000 based on a cross-country regression of 118 countries. (4) The magnitude of the misalignment depends on the assumptions that researchers make and the approach to estimation they use. Although there is no consensus, the debate has continued to create a strong push for the RMB's further appreciation.

There have also been exhaustive discussions about the options for the exchange rate regime before and after the launch of the new exchange rate regime in July 2005. Martin Wolf proposed a three-step reform. In the short term, China would not change its policy, but capital outflows and imports should be liberalised further, along with special programmes to buy goods abroad. This would lower the pressure on the appreciation of the RMB, he argued. In the medium term, there should be a move to a heavily managed float compatible with exchange controls, rather than an upward adjustment of the peg. Such a float could be achieved by widening the bands or moving to an unspecified currency basket, according to Wolff. …

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