China and Its Currency Regimes

University Degree Business and Administrative studies

Factors affecting choice of currency regime: The Chinese Case Group 5

FACTORS AFFECTING THE CHOICE OF THE CURRENCY REGIME IN PLACE: THE CASE OF CHINA

Group 5: Composition

Ritesh Etwaroo – 0511358

Rachel Sheik Bajeet – 0510894

Joshen Ragaven – 0511013

Deeptee Keesoonah - 0510853

Programme of study: Bsc (Hons) Management with Finance Level III

Module: International Finance

Lecturer: Mrs. Margaret Wong Pin Lun

Submission: 11th April 2008

ACKNOWLEDGEMENTS

First and foremost, we would like to thank Mrs. Margaret Wong who assisted us whenever we needed clarification on some issues. Her assistance was on indelible help to us indeed.

Next, we would like to thank some friends and colleagues who supported us all way long.

ABSTRACT

“No single currency regime is right for all countries and at all times.”

Frankel, 1999

In an era where exchange rate flexibility is a buzzword, many countries are now shifting to more flexible currency regimes. Such is the case of China. Since the 1980s China had different exchange rate regimes. For example, in 1981, a dual-exchange rate system was introduced. This system was discontinued in 1985, but after the establishment of special economic zones to boost the country’s export performance, the dual-exchange rate system was reintroduced in 1986.

In 1994 the country informed the IMF that it will be switching to a managed floating exchange rate system and this was the official policy for almost ten years. However, de facto, the country chose to peg its currency to the USD during all these years. However, in 2005, China ended its decade-old peg to the dollar and said it will let the Yuan fluctuate versus a basket of currencies.

The report will give a brief outlook on the country and its economy, especially on its monetary policy. Then, a cursory description will be made on the types of currency regimes in place in China from the 1970s till now.

Getting into the heat of the subject, the reasons for the choice of the currency regime in place will be analysed. Firstly, some general factors would be considered, advocating the choice of the currency regime. Then, we would move to the Chinese case. As the basket-peg system is new, so the analysis will spread both on the new currency regime and its predecessor. Factors in favour of the dollar peg would be discussed, and then factors leading to the transition to basket-pegging would be considered. Finally, critics against the actual currency regime would be raised.

COUNTRY OUTLOOK

China has a population, of 1.3 billion, that is it represents one fifth of the world’s population. Because of its vast , rapidly growing , and large investments, China is often considered as an . It has the world's and . In international trade terms, China is the third largest and the second largest in the world. Its official currency is the Yuan or Renminbi (RMB) in chinese.

The economy of the People's Republic of China is the second largest in the world after the with a GDP of 10.21 trillion (2006) when measured on (PPP) basis. It is the fourth largest in the world after the US, and , with a nominal of 3.42 trillion (2007) when measured in terms. China has been the major nation for the past quarter of a century with an average annual GDP growth rate above 10%.

During the winter of 2007-2008, inflation ran about 7% on an annual basis, rising to 8.7% in statistics for February, 2008, released by the National Bureau of Statistics of China in March, 2008. Foreign exchange reserves were $819 billion at the end of 2005, $1.066 trillion at the end of 2006, and have now surpassed those of Japan, making China's foreign exchange reserves the .

Since the late 1970s, economic reforms have been shaping up, from an economy largely closed to international trade to a more market-oriented economy, which has a rapidly growing and is a major player in the . There are less state controlled enterprises now. As of 2005, 70% of China's GDP was in the . These reforms have helped reduce poverty rate from 53% in 1981 and 8% in 2001, just in two decades.

CHINA AND ITS MONETARY POLICY

In its first quarterly meeting in 2008, the People’s Bank of China argued that at present China's economy maintained a steady and rapid development momentum, but problems such as a potential rebound of fixed asset investment, excess money and credit supply and excessive liquidity were not adequately addressed, accompanied by a palpable pressure of price hike. Weighing the monetary policy stance and measures for the coming periods, the Monetary Policy Committee held the view that a tight monetary policy should be implemented.

Improvement of the managed floating exchange rate regime should be effected, continuously following the principle of "making it a self-initiated, controllable and gradual process". Market supply and demand of foreign exchange should be allowed to play a greater role in the process of increasing RMB exchange rate flexibility, with a view to keeping the RMB exchange rate basically stable at an adaptive and equilibrium level.

Exchange rate flexibility may have many beneficial effects. Among them, it can bring monetary policy independence. An independent interest rate policy is a key tool for improving domestic macroeconomic management and promoting stable growth and low inflation. As the Chinese economy becomes more exposed to global influences through its rising trade and financial linkages in the world economy, it will become more exposed to external shocks. Monetary policy is typically the first line of defense against macroeconomic shocks.

Three experiences of the other Asian countries, that is, Thailand, Korea and Malaysia proved that a liberalised capital account before having a flexible exchange rate was dangerous. As a member of the WTO, it was imperative that China should choose a more flexible exchange rate regime in future. But before this can happen, the domestic financial sector especially the banking sector needs to be liberalized. The country recently announced the intention to switch to a free floating system and indicated that financial liberation now is a policy priority.

TYPES AND EVOLUTION IN CHINA’S CURRENCY REGIMES: from the 1950s till now

Along with china gradual economic reform since 1970, its exchange rate regime has also evolved. The regime has changed from a centrally planned administrative mechanism to a dual rate system , then to a managed float with narrow band, afterwards to a managed float with a very narrow band- peg to US dollar and finally to a peg against a basket of currencies.

1949-1979 : Centrally Controlled Exchange Rate System

Before 1979 the exchange rate system of China was centrally planned. The central government had the monopoly power to determine the value of the currency. The exchange rate regime only served as a central accounting device. Under this exchange rate system, only some state owned enterprises could sign export and import contracts (Zhang, 1999). The exchange rate system could not affect the current account balance, because the amounts of imports and of exports were decided on by the central government.

Should the domestic importers want to import goods, firstly the import goods must be approved by the central government and then they could buy foreign exchange (using the official exchange rate) from government. If the traders would make a loss in international trade transactions, the government would subsidise them. Under this exchange rate regime, the domestic importers and exporters did not have any incentives to maximize profits because they could not keep any profits which they earned, while on the other hand, they never suffered any real losses.

1979-1985 : Dual Exchange Rate System

Following policy reforms, the Yuan started to reform from a centralized control system to a system according to which the exchange rate was decided by the market forces of demand and supply. This was done to bring down the overvalued Yuan in order to promote exports.

The Chinese government established the State Administration of Foreign Exchange (SAFE) to control the foreign exchange market in 1979. At the same time, a retention system was introduced to promote export performance. Under this system, the domestic exporters do not need to hand in all of the profits to the central government. Instead they could retain a certain amount of foreign exchange which they earned on the trade transaction. In turn, importers buy the foreign exchange from those exporters at the official exchange rate, to pay their suppliers.

Besides the retention system, the Chinese government introduced the dual exchange rate system in 1981 to promote the country’s export performance: an official rate for non trade related transactions and an internal settlement rate (ISR) for authorized current account transaction, both rates being fixed by government. Through this, the Yuan devalued much. Importers did not face much problem from this devaluation, as the overvalued Yuan gave them high profits. The exporter, in turn, made much more profit than in the previous system, as they benefited from the ISR rate which was lower than the official rate. But Banks were confused which rate to apply: the ISR or the official rate? In 1985, the Chinese government abolished the ISR, which ended the era of the dual exchange rate system.

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1986-1993: Swap Exchange Rate Market

From 1980 onwards the Chinese government built Special Economic Zones (SEZ’s) in the costal area. The SEZ’s attracted a lot of FDI (Zhang; 1999). Experiencing rapid growth, these companies needed a lot of foreign exchange. In 1986 The Chinese government established Foreign Exchange Adjustment Centres (FEAC), also called swap centres.

The dual exchange rate system emerged again in China, one was the swap exchange and the other was the official exchange rate. Lin and Schram (2003) explain that companies can bid and ask in the swap centre. This was the first time in China ...

This is a preview of the whole essay

1986-1993: Swap Exchange Rate Market

This swap centre was different from that in developed countries. This swap market was a place where foreign fund enterprises and domestic companies sold their retained foreign exchange for domestic currency. Zhang (1999) indicates that because the official exchange rate was fixed at that period, the fluctuating swap market exchange rate became the effective exchange rate.

In 1988 the Chinese government also adopted some policies to deepen the reform of the exchange rate system. The trader could then hold a higher portion of retention and the price were liberalised.

Zhang (2001) claims that although the swap market was a milestone in China’s foreign exchange reform it had its own problems. He mentions that the swap market exchange rate was very volatile, because some large FTC gathered a lot of retention “quotas”. This large amount of “quotas” in and out of the swap market resulted in large fluctuations which could result in serious problems and this problem clearly indicated the need for unification of the different exchange rates.

1994-2005: Unification of the Exchange Rate – dollar peg

The dual-exchange rate regime was unified into a single market-based official exchange rate. After China uniformed the exchange rate in 1994, the government started to adopt a managed floating exchange rate with a narrow band (Huang and Wang; 2004). In 1994, the RMB equalled to 8.7 Yuan per 1 USD and the value could be adjusted within in ± 0.25 percent of its previous market exchange. From 1995, the RMB started to have a little appreciation, in 1995, it reached 8.3 per USD and in 1995, it was 8.3 per USD.

Although the government announced to the IMF to have a managed floating exchange rate system from the 1994, actually the exchange rate was de facto pegged to the USD since 1994.

From 1994 until July 2005, the policy on currency has been to peg informally the value of the Yuan against the value of the United States dollar. This policy was praised during the Asian financial crisis of 1998 as it prevented a round of competitive devaluations.

Although China's previous currency regime was commonly referred to as a peg to the US dollar, China actually maintained a version of a managed float against the dollar: Since 1994, the Yuan was allowed to fluctuate within a narrow band.

2005-now: The Basket peg

In July 2005 China announced a switch in its exchange rate regime whereby its currency, until then effectively pegged to the US dollar, would instead be pegged to a 'basket' of foreign currencies. The following month, the 11 currencies comprising this basket were revealed, namely U.S. dollar, euro, Japanese yen, Singapore dollar, Malaysian ringitt and South Korean won, with a smaller proportion made up of the British pound, Thai baht and Russian ruble. Their weighting, however, and the frequency with which these weights might be altered were not disclosed. It was also announced that the Yuan would trade within a narrow 0.3 percent band against the basket. As such, the Yuan may fluctuate 0.3 percent above or below the previous day's closing exchange rate—but the value will be determined by referring to a basket of currencies, not just the dollar.

In August 2005, PBOC Governor Zhou Xiaochuan named four factors that China takes into consideration to determine the currencies and their weights in the basket for the RMB’s exchange rate: the currency’s share of trade in goods and services; the currency structure of China’s foreign debt; sources of foreign direct investment for China; and current transfer items under the current account. Zhou noted that the bulk of currencies in the basket are those of China’s biggest trade partners: the United States, the Eurozone, Japan, and South Korea. The currencies of other significant trade partners, including Singapore, the United Kingdom, Malaysia, Russia, Australia, Canada, and Thailand, are also taken into account.

Unlike a true floating exchange rate, the yuan would (according to the Chinese government) be allowed to fluctuate by 0.3% on a daily basis against the basket. Since July 2005, China has allowed the yuan to appreciate steadily but very slowly. It has continued to accumulate foreign reserves at a rapid pace, which suggests that if the yuan were allowed to freely float it would appreciate much more rapidly. The current situation might be best described as a “managed float” — market forces are determining the general direction of the yuan’s movement, but the government is retarding its rate of appreciation through market intervention.

FACTORS AFFECTING CHOICE OF CURRENCY REGIME

GENERAL FACTORS

The following factors are the main factors affecting the choice of a currency regime adopted by a particular country:

Export led growth strategy

Countries will usually peg their currency to the currency of their major trading partners in order to boost up exports. For example Calvo and Mishkin (2003) claim that if a country major partner is USA and the country fixes its exchange rate to USD, then not only trade between the US and this country would increase but trade between the country and other countries using dollar peg currency would also rise. According to Nilsson and Nilsson( 2000) pegged exchange rate regime can be used as an export growth strategy in the following ways:

Pegged exchange rate regime would reduce transaction cost and exchange rate volatility and thereby make export more competitive.
Most exports of developing countries are invoiced in terms of USD and adopting a USD pegged exchange rate regime guarantees exchange rate stability and boost up exports.

Capital mobility

In recent years, the increasing trend of capital mobility has shifted attention to the implication of capital movement in the choice of exchange rate regime. Capital inflows can be classified under three main headings: foreign direct investment, bank financed capital flows (external debt), and portfolio investment. Each of them is a major determinant of the choice of the exchange rate regime.

In case of export oriented FDI strategy, countries can adopt an intermediate exchange rate to stimulate exports. Countries experiencing large short term volatile capital inflows such as external debt prefer pegged exchange rate system but this arouse speculator doubt about credibility of the central bank. Countries in this instance then need to choose one of either firmly fixed or free floating regime, but if a country has capital control a pegged exchange rate can stay. Short term portfolio investment can cause financial crisis. Countries need to choose either to firmly fixed or float unless they have capital control.

Financial sector development

Financial sector development can affect a country’s choice of exchange rate regime. Countries with sophisticated financial markets, large range of financial instruments and well regulated financial framework will usually choose flexible exchange rate regimes. Zhang (2001) claims that availability of financial instrument influence a country’s choice. In the case of developing countries, financial instrument are usually limited. Some do not even have stock exchange markets. Consequently these countries are reluctant to float their currencies and will prefer to adopt a fixed exchange rate regime to shield their fledging industries against large exchange rate movements.

Dollarization

Berg and Borenstein (2000) in their paper, the choice of exchange rate regime and monetary target in highly dollarised economies, talk about dollarization as a determinant of exchange rate. They defined dollarization as “the holding by residents of foreign currency and foreign currency denominated deposits at domestic bank.”

They distinguish two motives for the demand of foreign currency:

Currency substitution- which relates to the use of foreign currency for money payment transaction.
Asset substitution where assets dominated in foreign currency are demanded to cover for risks.

They concluded that Countries having high level of currency substitution will usually adopt a fixed exchange rate regime. “Floating exchange rate would be sensitive to changes in expectations (shifts in demand for domestic money would be huge) and would result in higher volatility.” However a flexible rate may still be used as it will permit easier adjustment in case of real shocks. Under asset substitution, high capital mobility with limited effectiveness (or high cost) of sterilization a more flexible exchange rate is recommended.

Rate of inflation

Rate of inflation influences a country choice of exchange rate regime. Countries with strong currency are usually known to have relatively low inflation rate and sound financial institutions. Generally countries with history of high inflation rate will choose to peg their exchange rate regime to a strong currency. The government of Russian economies pegged their exchange rate against USD to take care of inflation which arouse when the country moved from socialist to market system. “Pegging the exchange rate can lower inflation by inducing greater policy discipline and instilling greater confidence in the currency”.( IMF). However Mohr, Siebrits and Calitz (2005) argued that countries can successfully target inflation with a flexible exchange rate system.

Political factors

The level of political stability can also influence the choice of currency regime. Edwards (1996) found a relationship between exchange rate regime and frequency of government changes. The more often a country changes government, the more likely it is to adopt a fixed exchange rate system. Barro and Gordon (1983) emphasise the credibility gains of adopting an exchange rate peg. Government having low institutional credibility but attempting to convince the public of their commitment to price stability may adopt a peg regime to reduce inflationary expectations. (choice of exchange rate regime in transition economies: an empirical analysis). This view was particularly true in early years of transition from a socialist to a market economy. For initial economic stabilization, a fixed exchange rate regime could provide an anchor for domestic prices where no credible domestic monetary institution existed (the choice of exchange rate regime: an empirical analysis for transition economies.)

Regional exchange rate arrangements

The degree of economic integration between countries has important implication for exchange rate regime they adopt. Countries that are highly integrated with one another with respect to trade and other economic and political reasons are likely to form an optimum currency area. Where regional trade level is high, countries are likely to establish regional cooperation on exchange rate policy. A common currency would reduce transaction costs and interest rate and encourage further integration and growth. Smaller countries are usually better off by pegging their currencies to a large neighbour or adopting a large neighbour currency as their own. However where regional common currency is not feasible, it is preferable to peg the currency.

There are three main approaches to regional exchange rate cooperation.

Firstly there is mutual exchange rate pegging arrangement where members of a group agree to limit fluctuations of their exchange rate to agreed bands around prescribed central parities. They also agree to coordinate economic policies to react collectively when exchange rate near the edges of the bands. On good example is the exchange rate mechanism of the European monetary system. Today the system has evolved into the Europe economic and monetary union with its single currency the Euro.
Regional currency union. All members of a union use a same common and give up their own monetary policy. The largest currency union is the EMU. Another good example is the CFA franc zone. The CFA franc zone consists of two separate monetary unions of sub Saharan African countries and the Comoros.
The third approach is to peg to an outside currency or a basket of currencies as the monetary standard for the regional group. For example Asian countries peg their currencies to the US dollar. They formed the ‘dollar standard’ in Asia. For these group of countries a currency union would not be appropriate at this time because intra regional trading links are less significant than in Europe and the countries are not subject to greater asymmetry of shocks

THE DOLLAR-PEG SYSTEM

The following section deals with the factors in favour of the dollar peg.

Export led growth strategy

According to Canalog (1998), it was found that after 1979 that China shifted its trade policy to promote international trade. In fact from 1981 to 1985, China adopted a dual exchange rate system. One rate was the official exchange rate and the other one was the internal settlement rate (ISR). The ISR was used for trade purposes. The ISR was abolished in 1985.

From 1986 to 1993, China still fostered the dual exchange rate system, one of them still being the official exchange rate and the other was swap market exchange rate. The Swap market exchange rate was used for trade purposes and was determined by market forces.

In 1994 the dual exchange rate system was abolished and the exchange rate was unified as one official exchange rate at 8.27 Yuan/Dollar.

Counties opted to have pegged exchange rate regime in case where they had export-led growth strategies to boost exports. Zhang (2000) claims that China’s export-led growth policy affected China’s choice of exchange rate system. Since the country started to reform its exchange rate system, the Chinese government used a real target approach.

Corden (2001: 26) explains that the country used this approach to reach internal and external balance. Zhang (2000) states that the ISR exchange rate, swap market exchange rate and interbank exchange rate all expressed the government’s real objective: to boost the export performance. The exchange rate was targeted at “the cost of earning a unit of foreign exchange through exporting”.

Morrison and Laboute (2005) is of the opinion that keeping the Chinese currency pegged to the USD reduces the uncertainty and risk in the international trade and financial markets and to some extent, it increased the trade performance between China and the United States. This can be illustrated below:

Figure 1: China’s real exchange rate against U.S and its bilateral export: 1991-2003

Source: World Development Indicator and Direction of trade Statistics 2004

The figure above shows the real exchange rate of RMB (Chinese Currency) against the USD and the bilateral export from China to the United States. As we can find the devaluation in 1997 led to dramatic increased exports to the US.

Pegging to the USD triggered increased exports between China and Japan and this can be illustrated below:

Figure 2: China’s trade with Japan and U.S.: 1991-2003

Source: International Financial Statistics 2004

However, the reason why China pegged its currency to the USD instead of the Yen, was because most of the international trade were invoiced in USD (McKinnon; 2000).

Sato (1998) claimed that the main reason why Yen were not be used as the invoiced currency for international trade was because of the relatively underdeveloped financial markets.

Capital Mobility

The Chinese currency therefore remained pegged to the USD from 1994.

In the early 90s, China had only operated its stock market. Some of the emerging market economies which had external debt and portfolio investment inflows, and changed their original exchange rate regimes were affected by the financial crises.

Prasad, et al (2005) explain that “…the experiences of numerous emerging market countries have shown the risks associated with maintaining a fixed exchange rate in tandem with a capital account that is open in either de jure or de facto terms”.

One of the reasons why China had kept the de facto pegged exchange rate during the 90s was that it had a strong capital control regulations to prevent large capital outflows that could cause financial crises (Huang and Wang, 2004).

Since China had joined the WTO, their capital account had to be liberalized. At the same time this could lead to financial crisis since short term financial inflows are very volatile. According to (Prasad et al 2005), a flexible exchange rate regime is a necessary prerequisite before complete capital account liberisation.

Financial sector development

In China, there are four kinds of banks namely; wholly state-owned banks, commercial banks, credit co-operative banks and foreign banks. (Hansakul 2004). Various are the challenges for China’s banking sector. For instance there a many NPLs (Non performing loans) derived from activities by state- owned enterprises. Those enterprises could not repay the loans. These banks were far from being sound financial intermediaries. Furthermore the loan officers lacked the necessary skills. Given the current state of China’s banking sector, the Chinese Government had to choose a fixed exchange rate system. The financial sector was far from being developed to foster a flexible exchange rate regime.

Dollarisation

Prasad et al. (2005) indicate the increase in foreign assets since 2000 and state that net foreign assets are equal to 6 percent of GDP and 3 percent of board.

The table below indicates the foreign currency bank deposits of non-banks in China: 1992-2001.

Figure 3: Foreign Currency Bank Deposits of non-banks in Mainland China: 1992-2001 (Billions of USD)

Source: Ma and McCauley (2002), People’s Bank of China, BIS

Higher degrees of foreign asset holdings cause countries to choose one of the possibilities, either firmly fixed or flexible exchange rates.

Inflation Rate

Agbola and Kunanopparat (2003) explain that if the inflation differential between a country and its major trading partner is small, the country would prefer to peg its exchange rate. Schnabl and Mckinnon (2003) explain that the rationale is that the price of the tradable goods will be stable. Mckinnon (1999) found that the inflation differential between most of the Asian economies and the U.S. was very small and most of these countries chose to peg their exchange rate at some stage.

Figure 4: China’s CPI base inflation rate: 1986-2003.

Source: Compiled by researcher from World Development Indicator (University of the Western Cape)

Since China started to reform its exchange rate regime from the 80s, the official exchange rate devaluated, which resulted in a high inflation rate in late 80s and the reform of the exchange rate system in 1994 resulted in another climax for the inflation rate. Because of the high inflation, the Chinese government started to anchor its currency to that of its trading partner United States and in this way tried to lower the inflation rate (McKinnon; 2005).

Political Factors

When China decided to reform the state-owned enterprises (SOE’s) in the 90s, this led to massive unemployment. Kaplan (2006) explains that one of the reasons why the Chinese government does not want to change to a flexible exchange rate and keeps the exchange rate undervalued is because they want to protect the export-oriented manufacturing sector and the employment in this export sector.

Floating the exchange rate would hurt the export performance of the manufacturing sector, which offers many job opportunities for laid-off workers from SOE’s. Floating the exchange rate would definitely worsen the unemployment position in SOE’s sector.

THE BASKET-PEG SYSTEM

As China entered into the WTO in 2001, it was committable for China to open its capital account. China could not control the capital account forever. Pegging the exchange rate to the U.S. dollar boosted the export performance. Asian country’s experience told us that it was import to have a more flexible exchange rate before fully liberalized the capital account. Otherwise, it caused financial crises. China needed to float its exchange rate in the future. The main factors influencing the shift were:

Political factors

Since 2003, while China was using the dollar peg, the USD fell in value. The fall in the value of the dollar caused the value of the Yuan to fall also, making mainland Chinese exports more competitive. This led to some pressure on China from the United States to increase the value of the Yuan in order to encourage imports and decrease exports. This is a policy that some feel would preserve manufacturing jobs in the United States. The G7 and European Union are also in favour of a re-evaluation of the exchange rate. Washington threatened to blacklist China as a currency manipulator, in the Treasury Currency Report if it did not revalue the Yuan vis-à-vis the dollar. It was deemed to be a revaluation of around 25-30%. Like any nation, China foremost has its own interests in mind. China is interested in social stability as 10-15 million new jobs have to be created each year accommodating workers joining the labor force. Formidable challenges lie ahead as thousands of new cities are built; China is undergoing its fastest and largest transformation ever.

At the same time, U.S. law-makers blamed their country's $162 billion 2004 trade deficit with China on an unfairly cheap Yuan. Senators were preparing a bill that would have slapped a 27.5 percent tax on Chinese imports if Beijing did not revalue its currency. The 2.1% revaluation of the 21st July 2005 can be analyzed as a political choice, showing the commitment of China. On the other hand, the smallness of the revaluation can be analysed as a proof that China doesn’t want a significant, large revaluation. Studies show that the USD still has a large proportion in the basket, and a narrow peg with the USD still exists. So, the shift in the currency regime is mainly political, rather than rational.

Achieving monetary policy independence

An independent interest rate policy is a key tool for improving domestic macroeconomic management and promoting stable growth and low inflation. As the Chinese economy becomes more complex and market-oriented, it will become harder to manage through command and control methods as in the past. And, as it becomes more exposed to global influences through its rising trade and financial linkages to the world economy, it will also become more exposed to external shocks. Monetary policy is typically the first line of defense against macroeconomic shocks, both internal and external. Hence, having an independent monetary policy is important for overall macroeconomic stability.

Developing the domestic financial sector

For developing the domestic financial sector, opening up of the capital account—to inflows as well as to outflows - also serves as an important catalyst. Inflows can bring in technical expertise on developing new financial instruments, creating and managing risk assessment systems, and improving corporate governance. Indeed, the approach of using foreign strategic investors to improve the efficiency of domestic banks is a strategy the Chinese authorities see as playing a useful role in their overall reform effort. Allowing outflows would help increase efficiency by creating competition for the domestic banking system and limiting the captive source of funds (bank deposits) that now keep domestic banks flush with liquidity.

Besides, under the new regime, over-the-counter dealings for the Yuan are possible. Banks have better autonomy to manage their credit portfolios. The financial intermediation sector is developing and achieving more autonomy than previously. These are good signs for the financial sector.

Preserving trade competitiveness

Of the 11 currencies supposedly in the basket, the only currencies with statistically significant weights over the period are the US dollar and the Malaysian ringgit. The two major non-dollar currencies, the euro and the yen, receive zero weight in the basket, perhaps an indication that the Chinese authorities are more concerned with preserving trade competitiveness against major Asian rivals than with minimising variability against the world's major currencies or China's most important export markets.

Looking in more detail, experts find that in the first six months following the shift to the basket peg, the currency was still in effect pegged to the dollar. Since February 2006, however, some weight in the basket has shifted away from the dollar to other currencies, particularly those of Malaysia, Korean, Russia and Thailand. This has occurred to the extent that if the Korean won and the Malaysian ringgit were to stop appreciating against the dollar, or even to reverse, it is likely that the Chinese currency will also do so.

Growing current account surpluses and an reserve accumulation posits an undervalued currency

China’s increasing export growth and trade surpluses have been phenomenal recently. For 2006, exports of goods may be as high as $950 billion, nearly triple the level of four years ago. The current account surplus is expected to be $220 billion in 2006, up from $35 billion in 2002 and $160 billion in 2005. In 2005, China intervened in the foreign exchange market to accumulate reserves of $250 billion, preventing the currency from appreciating in the face of a massive current and capital account surplus. This reserve accumulation was driven by a current account surplus of close to $160 billion, an inflow of about $50 billion in FDI, and hot money inflows that were about $50 billion. Without aggressive intervention, the Yuan would have sharply appreciated.

Hot money is flowing into China in expectation of a Yuan appreciation driven by massive trade surpluses and FDI inflows. This anticipated appreciation is not the result of the United States browbeating China into letting its currency appreciate; rather the huge and growing Chinese current and capital account surpluses are driving market pressure for an appreciation.

Several studies by Frankel (2004) and Chinn et al. (2006), based on the Balassa-Samuelson effect, show that the Yuan is effectively sharply undervalued.

Bringing back the Yuan to its equilibrium would be beneficial for Chinese imports but export prices will climb up. So, this revaluation will occur not in the short term, but in the long term, as the central bank monitors the change in the USD in a band.

A move towards greater exchange rate flexibility

A shift to a flexible exchange rate regime, especially the adoption of a currency band that refers to a basket of currencies, provides monetary authorities with a certain degree of freedom in independently implementing policies that would have been restricted if a dollar peg system had been maintained amid the free movement of capital. China needs greater exchange rate policy flexibility considering that domestic monetary policy management will become increasingly important in the near future as capital flows are liberalized and China begins to deal with the overheating of the economy in advance of the Beijing Olympics, and the economic downturn expected to follow.

Degree of international financial integration and trade pattern

China is one of the major trading partners in the world. As such, its degree of financial embeddedness in the world economy in high. With a currency basket system, it can peg its currency with its major trading partners. Besides, this is one of the criteria for the selection of currencies in the basket. Given also its level of global integration, this move to a more flexible regime would provide a stable exchange rate.

Role of IMF

The International Monetary Fund (IMF) is an international organisation of 185 member countries currently and was conceived in July 1944 after the depression of the 1930’s. In order to restore international monetary relations, the founders of IMF charged the institution with controlling of the international monetary system to ensure exchange rate stability and encouraging member countries to eliminate exchange restrictions that hindered trade.

The current role of the IMF’s exchange rate surveillance is to assess impact of countries’ exchange rate and other policies on their external stability and hence on the stability of the international system of exchange rates. Under the Article IV of the IMF’s Articles of Agreement, which set the foundation of surveillance, the member countries are largely free to choose their own exchange rate regime which will promote a stable system of exchange rates and avoid manipulation of exchange rates in order to prevent effective balance of payment adjustment or gain an unfair competitive advantage the members should intervene in the exchange market if it becomes necessary to counter uncontrollable conditions and that they should take into account interests of other member countries in their exchange intervention policies.

As such the IMF’s role in China’s choice of currency regime has been minimal in that it just provided it with guidelines and framework on which exchange rate regime will be suitable for the economy. However, in recent years the IMF had been suggesting China to change its currency regime to a more flexible one in order to alleviate its increasing reserve accumulation also due to allegations from certain countries that China is manipulating its exchange rate. Following which the Chinese People’s Bank has changed its currency regime from a fixed to a basket of currencies. However, the IMF has been very hesitant and purposely evasive on both the appropriate level of China’s exchange rate, as well as on the intervention measures that it has taken to support the current level of exchange rate. It has just said that the preferred currency regime of China should be more flexible and also the IMF has not “defined either by how much or when the RMB would need to change to meet the standard of greater flexibility”

CRITICS AGAINST THE ACTUAL CURRENCY REGIME

China mull move from dollar peg has been at the heart of much discussion. Opinions about the new currency regime have been well divergent. The new currency regime did not obtained absolute consensus.

Robert Mundell’s perspective

Robert Mundell, winner of 1999 Nobel Prize in economics, is one among the persons who leveled greatest criticism against the drop of the dollar peg.

Mundell also argued that “any change by China - whether a one-off revaluation of the exchange rate or a shift to a floating rate - would not be in China's own interests, and would in fact have little effect on the root causes of America's dissatisfaction. He further stated that the shift in the currency regime would bring "damaging" volatility to China, thereby harming growth and employment in the domestic economy.

China as a currency manipulator

Critics of China’s currency regime point to three factors as evidence that the Chinese government is manipulating its currency: (i) its high, and rising bilateral trade surplus with the United States; (ii) its high, and rising global current account surplus; and (iii) its high, and rising international reserves accumulation.

These critics contend that the RMB is undervalued, relative to the U.S. Dollar by between 15 and 40 percent, or an average of 27.5 percent. Undervaluation operates as a subsidy by the Chinese government to Chinese companies by making Chinese products less expensive in U.S. and foreign markets. As a result, the United States trade deficit with China has widened and tens of thousands of U.S. jobs, primarily in the manufacturing sector, have disappeared. Groups have called on the U.S. government to force China to adopt a more flexible exchange rate policy - even a freely-floating exchange rate policy and to penalize China for past and current currency manipulation.

Complexity and non-transparency

Williamson (2000) criticized the basket peg system by advancing that the basket peg regime is not transparent. Transparency is important as it helps the public understand the rationale behind policies and sets trust in the system. Such is China’s case where the weights assigned to currencies in the basket and the frequency of adjustments is not made available.

Another disadvantage of the currency basket peg is its complexity. It is very complex to derive optimal weights by deriving estimated parameters. In addition, it is argued that the monetary authorities should intervene in the foreign exchange markets of all currencies within the basket.

China and the savings glut

Pettis (2007) argue that china’s currency regime has been so successful in boosting its trade surplus that the trade surplus has run out of control and every attempt to rein it in has failed. Unfortunately the currency regime has put into place a self-reinforcing system in which rising trade surpluses cause too-rapid expansion of the money supply, which is funneled by the banking system into greater industrial production, which causes further upward pressure on the trade surplus. It is difficult for China to escape from this trap without a sharp adjustment in the currency, but aside from the continuing need to boost employment, one of the consequences of the currency regime and its subsequent impact on monetary conditions may have been the creation of a very shaky banking system and overinvestment into both production and speculative assets. Since all of these are funded by the banking system, any sharp adjustment, aside from the adverse short term impact on employment, could have significant unintended consequences for the country’s very rigid and opaque financial system.

As long as China is locked into this system, the trade surpluses will not go away.

CONCLUSION

On the optimistic side, China has a brilliant future ahead, especially in terms of economic prosperity. The choice of its currency regime has indeed boosted China’s competitiveness in the world. Apart from being a low-cost leader in the global market, the currency regime consisting of a managed float, be it a dollar or a basket peg, has helped China to invoice cheaper than the USA, the world’s premier exporter. However, under the actual currency regime, although there are multiple reasons advanced for this shift, it has been political pressure that has catalysed the matter. The dollar still has a major percentage in the currency basket. Besides, an undervalued Yuan is bringing so much prosperity to China, with one of the rare countries with a Balance of Payment surplus in such a global context. So, rationally any country would like to keep the system while a free float system would bring the Yuan to an equilibrium, that is around 30% higher (Frankel, 2005) and could reduce exports.

Source: Wikipedia

Referring to the concept of the ideal currency, based on the trinity consisting of monetary independence, exchange rate stability, and full financial integration, it is said that a country must give up one of the three goals because it is impossible to achieve all those three at a time. Economic forces do not allow the simultaneous movement of these three policies. China, with its Yuan, is lagging behind by much. Monetary independence is a buzzword but little is being done about it. Managed float still exists. Exchange rate stability is a question mark with an undervalued Yuan. Will the Yuan reach its equilibrium and if so, when? So many mysteries are yet to be resolved. Financial integration in there but can we have full financial integration? This surely is rhetoric.

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