Academic journal article The European Journal of Comparative Economics

The Difficulties of the Chinese and Indian Exchange Rate Regimes

Academic journal article The European Journal of Comparative Economics

The Difficulties of the Chinese and Indian Exchange Rate Regimes

Article excerpt

1. Introduction

China and India have both attempted distorting the exchange rate in order to foster exports-led growth. This is described as the 'Bretton Woods II' framework, where developing countries buy bonds in the US and keep undervalued exchange rates, in order to foster export-led growth.

The costs and benefits of this approach need to factor in the extent to which monetary policy is distorted by the pursuit of exchange rate policy. In this paper, we start by identifying dates of structural change, and the characteristics of the de facto exchange rate regime, for both countries. These results utilise recent developments in the econometrics of structural change.

We then examine business cycle conditions and the short-term rate (ex-pressed in real terms) in both India and China. We find that through the great business cycle boom of the early 2000s, both countries followed ex-pansionary monetary policy. This is consistent with the idea that de facto exchange rate pegging induces a loss of monetary policy autonomy. By fol-lowing expansionary monetary policy at a time of buoyant business cycle conditions, in both countries, monetary policy contributed to exacerbating instability of GDP; it helped exacerbate both boom and bust.

Capital flows and conditions on currency markets changed profoundly from late 2007 onwards. Hence, this paper is primarily focused on the period from 1998 till 2007, the period where both countries were trying to use monetary policy to obtain exchange rate undervaluation. These difficulties need to be brought into the assessment of the 'Bretton Woods II' regime.

2. The exchange rate regime

An extensive literature suggests that both China and India have de facto pegged exchange rates, where policy makers desire to influence the bilateral exchange rate against the USD (Shah et al., 2005; Frankel, 2009; Patnaik, 2007).

In India, according to the RBI (the Indian central bank), the rupee is a "market determined exchange rate", in the sense that there is a currency market and the exchange rate is not administratively determined. India has clearly moved away from fixed exchange rates. However, RBI actively trades on the market, with the goal of "containing volatility", and influencing the market price.

Patnaik (2007) shows that the INR is de facto pegged to the USD. As is typical with such an exchange rate regime, the nominal INR/USD exchange rate has had low volatility, while all other measures of the exchange rate have been more volatile. Over the 1993-2006 period, the annualised volatility of the INR/USD was 4.2%. For a comparison, the annualised volatility of the USD/JPY rate was 11.6%.

[FIGURE 1 OMITTED]

China on the other hand is more open in discussing currency pegging. The objective of monetary policy "is to maintain the stability of the value of the currency and thereby promote economic growth."' After being fixed to the US dollar for many years, China announced a shift away from a fixed rate to a basket peg in July 2005. However, the renminbi remained de facto pegged to the US dollar (Shah et al., 2005).

2.1 Comparison of the level of the exchange rate

We embark on our comparison of the two exchange rate regimes by examining fluctuations of the bilateral exchange rate to the US dollar. This is shown in Figure 1. In order to directly compare fluctuations of the INR and the CNY against the USD, the Figure rescales the Chinese exchange rate to be identical to the rupee-dollar exchange rate at the starting point of the graph.

In these units (i.e., rescaled to INR/USD exchange rate levels), both trajectories were similar, other than a substantial rupee depreciation from 2001 to 2002. The graph also visually conveys the greater flexibility of the bilateral rupee-dollar rate when compared with the yuan-dollar rate.

A key concern of Chinese currency policy has been about the impact of the real exchange rate on exports. …

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