On January 1, 1994, China took a major step toward currency convertibility by unifying its official and swap market exchange rates. A national foreign exchange market centered around banks replaced the system of trading foreign exchange through the foreign exchange adjustment centers. The major motivation behind the reform is to overhaul the fragmented swap market and to improve the efficiency of foreign exchange allocation. However, no one has published a study on the degree of market segmentation and the efficiency of the FEACs. Such a study would put the significance of the unification in perspective. In an attempt to provide this perspective, this paper evaluates the swap market's performance before the unification, examines the implications of the unification for the Chinese economy, and raises concerns about the ability of the People's Bank of China (PBoC) to control the Renminbi (RMB) and about the macroeconomic consequences of the reform.
II. THE DUAL AND THE UNIFIED EXCHANGE RATE SYSTEMS
A. The Dual Exchange Rate System
China's currency, the RMB, has been inconvertible since it became a national currency in 1949. Until the start of the economic reform in 1978, the central government directly planned China's foreign trade and foreign exchange allocation. A dozen of foreign trade corporations (FTCs) carried out foreign trade plans. The FTCs had to surrender all their foreign exchange earnings to and purchase foreign exchange from the central government at the official exchange rate. Besides receiving FTC profits, the central government subsidized FTC losses. During this period, the RMB exchange rate served little economic function. It was only a price for budget allocation under the trade plans.
The country's foreign trade reform has driven the development of the exchange rate system since 1978. In order to increase the role of market forces and to reduce the burden of trade subsidies on the central government's budget, China started in 1979 to decentralize foreign trade and the administration of foreign exchange earnings. It also gradually reduced the fiscal subsidies for the FTCs and introduced a foreign exchange retention system. Under this system, FTCs gained the right to buy back at the official exchange rate specified quotas of foreign exchange earnings previously surrendered to the central government. The retention system led to establishing the FEACs across the country in 1986. Table 1 summarizes the FEACs' main features. Through the FEACs, enterprises short of foreign exchange could "adjust" their needs by purchasing at a negotiated rate foreign exchange quotas from the enterprises who had surplus foreign exchange quotas. China thus had a dual exchange rate system. It used the administered official exchange rate for transactions under the foreign trade plan and for most capital account transactions. On the other hand, the more depreciated, flexible swap market exchange rates determined in the FEACs were applicable to foreign exchange transactions outside the foreign trade plan.
B. The Unified Foreign Exchange System
On January 1, 1994, China unified its official and swap market exchange rates (see Lo and Bang, 1994; PBoC, 1994a, 1994b; Zhou, 1994). Table 2 summarizes the details of the reform process. At end of 1993, the official exchange rate was depreciated from RMB 5.8 to RMB 8.7 per U.S. dollar, the Shanghai swap rate at the time. (All exchange rates below are quoted as RMB/USD.) In April 1994, the China Foreign Exchange Trading System (CFETS) was established in Shanghai. A national interbank foreign exchange market centered around the designated foreign exchange banks (DFEBs) replaced the system of local and unlinked FEACs. By the end of 1994, the CEFTS had 303 members from 26 cities and produced a cumulated transaction volume of USD 40.7 billion from April to December 1994. The new regime abolished the foreign exchange retention system and required domestic enterprises to sell all their foreign exchange earnings to and purchase foreign exchange from the DFEBs at the exchange rates quoted by the banks. …