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Home >> Opinion
UPDATED: 17:16, July 29, 2005
RMB exchange rate reform--decided out of China's own need
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When the national economic statistics of the first half of this year were just released on July 20, people were immersed in analysis and judgment of the economic situation.

At 7:00 on the evening of July 21, after only one day, the People's Bank of China (PBOC), the central bank, announced a world-shaking news: With approval from the State Council, from July 21, China began to institute a regulated, managed floating exchange rate regime based on market supply and demand and in reference to a basket of currencies.

A reform independently decided out of own need
The reform is an important policy decision made out of the actual needs of China's reform and development, rather than under certain international pressure.

As is emphasized by Zhou Xiaochuan, governor of the central bank: "This represents a kind of self-decision and is the need of China's march to a socialist market economy and optimization of resources allocation and the need for reform and long-term stable development, rather than a result gained after communication and consultation with other countries."

In 1994, China reformed its double-track exchange rate system and introduced the unification of exchange rates. After the unification, China instituted a managed floating exchange rate regime based on market supply and demand.

In plain words, this exchange rate system means: Selling or buying foreign exchange by enterprises and individuals has to be carried out through designated foreign exchange banks; these designated banks, in turn, enter the inter-bank foreign exchange market, or sell their surplus foreign exchange to other banks to gain the people's currency, or use the RMB to buy foreign currencies from other banks to make up the shortage of foreign exchange; this buying and selling, supply and demand give rise to price parity between the RMB and foreign currencies, or called the RMB exchange rate; meanwhile, the central bank sets up a certain floating limit to the exchange rate, foreign exchange is bought up when supply exceeds demand, sold out when it is in short supply. Doing so aims to maintain a basic stability of the RMB exchange rate through such a regulating method.

Before 1997, RMB exchange rate was stable with a bit rise, and for this reason, people at home and abroad had growing confidence in the RMB. But thereafter the Asian financial crisis broke out, in order to prevent an alternate depreciation of currencies in Asian neighbors and a resultant deepening of the crisis, China, as a large responsible country, promised not to devalue the RMB and took the initiative to narrow the floating band of exchange rate, but the goal for instituting a managed floating exchange rate regime remained unchanged.

We should say that the managed floating exchange rate system based on market supply and demand conforms to China's national conditions for it adapts to the stage of China's economic development, the level of financial supervision and administration and enterprises' sustainability. However, along with the evolvement of the situation, the necessity of perfecting the RMB exchange rate determination mechanism has revealed itself with each passing day. In other words, what is to be changed in the RMB exchange rate reform is not the RMB exchange rate system, still less permission of a revaluation, but rather it is designed to perfect the RMB exchange rate formation mechanism.

  • Improving the RMB exchange rate formation mechanism is the inherent requirement for the establishment of a sound socialist market economy system, as well as an important content of deepening reform to the economic-financial system and strengthening the macro-control system.

    In recent years, along with the rapid growth of China's exports and foreign investments, correspondingly, in the balance of payments statement, it is shown a "double surpluses" of the current account and the capital account; in the inter-bank foreign exchange market, it is manifested as a continuous stream of foreign exchange and that the supply exceeds the demand.

    In order to stabilize the RMB exchange rate, the central bank cannot but passively purchase a huge amount of foreign exchange, correspondingly, it will provide a huge supply of RMB, consequently increasing the monetary base.

    Statistics show that the basic currency supplied in such a way has accounted for 90 percent of the total of basic currency. The independence of the monetary policy is subject to serious challenge. The too rapid growth of money supply would give rise to such problems as investment expansion, inflationary pressure and assets bubble.

    Perfecting the RMB exchange rate formation mechanism and allowing it to be more elastic make it possible to give better play to the basic role of the market in the allocation of resources; this helps improve the initiative and efficiency of financial regulation and control and thus helps strengthen and improve macro regulation and control.

  • Perfecting the RMB exchange rate formation mechanism is conducive to implementation of the strategy for the sustainable development of the economy based mainly on domestic demand and to optimization of resources allocation.

    Experts put it frankly that if the original exchange rate formation mechanism is stuck to for a long time, it will likely affect improvement of the economic structure.

    Firstly, it will encourage the uneven development between foreign-related departments and domestic departments.

    Secondly, it will affect the coordinated proportion among the three major industries (primary, secondary and tertiary).

    Thirdly, it will hamper the normal transfer of industry from coastal areas to the inland. Inordinate stability of the exchange rate makes it possible for rough machining labor-intensive production to exist in coastal areas and to lack driving force and pressure to shift toward central and western regions.

  • Perfecting the RMB exchange rate formation mechanism and properly increasing the elasticity of exchange rate will increase the uncertainty of risk capital flows gains, which helps curb massive unilateral flows of capital, guard against and obviate financial risks and maintain financial stability.

    Excessive rigidity of exchange rate reduces the exchange rate risks of venture capital flows, is likely to cause massive in and out of venture capital and to bring impacts on economic development and financial stability. The Mexican financial crisis in 1994 and the Asian financial crisis in 1997 were both directly associated with this.

    Regarding this, Zhou Xiaochuan has a very vivid metaphor. He said: "A fixed exchange rate is like a shield in the hand when fighting, however you attack me, I will remain unmoved; if I fail to hold on, the impact will cause influence. A floating exchange rate is like a foam-rubber cushion, if you want to fight your way in, I'll react softly, ok, you've come in, but I won't let you hit me; when you want to quit, I'll give you a pinch and let you go only after you have taken a layer of your skin off."

  • Perfecting the RMB exchange rate formation mechanism facilitates the development of the foreign economy. This move helps spur the enterprise to strengthen technical innovation, management innovation and the creation of a brand name and to strengthen marketing, after-sale service, thereby fundamentally enhance the enterprise's competitiveness; it also helps maintain a basic balance between import and export and improve trading conditions.

    Reform is a must and is imminent.

    Experts put it frankly that if RMB exchange rate reform is delayed indefinitely, it will bring about three major risks.

    First is the risk of domestic economic bubble. If the monetary base grows too big, it will cause inflation when flowing to the commodity market; when the money flows to the capital market, it will lead to a bubble of assets. The emergence of economic bubble will aggravate the frailty of the financial system and will reduce the capability to resist monetary impacts.

    Second is the risk of weakening the independence of monetary policy. The principle of the "Mundell ternary paradox" tells us that of the three things: full capital opening, independent monetary policy and stable exchange rate, a country can only choose two, and cannot have all three.

    Third is the risk of a reversion of the situation. If the exchange rate must be reformed, then an active reform is better than a passive one; reform carried out under revaluation pressure is better than reform carried out under devaluation pressure.

    Internationally, since the 1990s, Poland has experienced the evolution from a managed floating exchange rate system under which its currency was pegged to one, or a basket of currencies to a free floating exchange rate system. Because its exchange rate system was actively adjusted in light of changes in domestic and foreign situations, therefore it could avoid to the maximum possible economic-social upheavals.

    While Thailand had, before 1997, all along pegged its currency to the US dollar without changing its exchange rate system, as a result, the country was compelled to drastically devalue its currency during the Asian financial crisis, thus resulting in the outbreak of the monetary and financial crisis.

    The opportunity for exchange rate reform often appears only in a twinkle. When opportunity comes, it is imperative to seize it!

    To put it in a nutshell, RMB exchange rate reform is by no means "you want me to reform it", but rather it is "I want to change it"!

    Part 1.  Part 2.  Part 3.  Part 4.  Part 5.  Part 6.  Part 7.  Part 8.

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