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More Flexible Exchange Rate Needed
Editor's note: The following article is based on a writer's speech(r)MDNM at an international symposium sponsored by the United States Federal Reserve, Brookings Institute and the International Monetary Fund. The views expressed are those of the author and do not necessarily reflect the opinion of the government or China Daily.
An orderly exit from the current de facto peg and a smooth transition to a managed float are expected in China from the mid-2000 onwards. The impact of such a policy shift will be positive on the Chinese economy and muted on the rest of Asia.
The motivations behind China's likely move towards a more flexible exchange rate is to allow China to better cope with external shocks to its balance of payments.
A managed float has long been China's policy. Prior to 1994, China practised a system of dual exchange rates: one officially pegged exchange rate, though adjustable, and one "swap-market rate,'' which was basically market determined.
The official exchange rate tended to be substantially overvalued, and was used by the government to allocate scarce foreign exchange to State-owned companies at preferential terms.
On the other hand, the floating "swap-market rate'' reflected pervasive demand and supply conditions, and played an increasing role in China's international transactions.
Due to the sizable differences between the two rates, the official rate was forced to undergo a series of readjustments (devaluations) to mimic the prevalent "market rate.'' Steep devaluations, sometimes of a fairly large magnitude, often took place between 1980 and 1993.
China undertook major reforms to its foreign exchange system in late 1993, putting an end to the practice of multiple exchange rates. On January 1, 1994, the official exchange rate was devalued and unified with the prevalent market rate at 8.7 renminbi (RMB) per US dollar. Since then, the Chinese currency has been under a system of managed float.
However, the currency has been more rigidly managed since the Asian crisis, with little scope for flexibility. Even so, few people believe that China intends to hold a fixed exchange rate in the future --either at the current spot rate level, or at a possibly new devalued rate.
Chinese policy makers have repeatedly stated their exchange rate is determined by the overall balance of payments, signalling the exchange rate will be made flexible enough to respond to shifts in the balance of payments.
The experience of trade liberalization around the world in the past decades suggests trade reforms generally expose a country's domestic economy and balance of payments position to major, unforeseen shocks. Under a fixed exchange rate, large real adjustments in output and employment would be involved in response to the shocks, which could be difficult and destabilizing. In a large number of cases, trade liberalization has been aborted, or even reversed because of inappropriate exchange rate policies that led to a balance of payments crisis.
While the World Trade Organization (WTO) membership should help China's emerging private firms to tap export opportunities overseas, the structural rigidities in China's financial sector, State industry and labour market could compound the difficulties in adjustments during the transitional period.
A pegged exchange rate may lead to mis-pricing of resources, and send the wrong signals to producers and consumers. For instance, an artificially overvalued exchange rate might discourage exports, fuel demand for imported goods, and induce rapid growth in imports in addition to the normal effects of tariff reductions.
From both the resource allocation efficiency angle and the balance of payments perspective, this would be undesirable during the initial years following WTO entry, when steep tariff reductions and removal of non-tariff trade barriers could introduce large shocks to the domestic economy and to the external balance.
Another challenging issue for China's monetary authorities is how to respond to increasing capital mobility, especially following China's entry into the WTO. Over the medium term, China will need a more flexible exchange rate as the country gradually eases the remaining capital and exchange controls.
As China proceeds with domestic financial liberalization, and further opens up many previously closed sectors such as telecommunications, distribution and financial services to foreign competition, capital flow problems will likely pick up significantly.
If China maintains a rigid exchange rate policy, capital flow problems should create a conflict between the need to avoid nominal appreciation, and domestic monetary objectives.
Since intervention cannot be easily sterilized in the Chinese context, reserve accumulation will likely induce an expansion in broad money giving rise to inflationary pressures.
Meanwhile, flexible exchange rate taken by China's major trading partners' currencies calls for China to map out a similar flexible exchange rate policy.
International trends in the use of exchange rate regimes have been towards more flexible systems and away from the pegged, or other forms of fixed-rate arrangements. In 1975, in the immediate aftermath of the Bretton Woods system, nearly 90 per cent of the world's developing countries had some type of pegged exchange rate. This proportion has dropped sharply over the course of the last two decades. The trend is even more pronounced if we measure the relative importance of countries adopting flexible and pegged exchange rates today -- they account for roughly 90 per cent of the world's GDP growth and merchandise trade -- and if we treat the European Union as a single economic entity adopting an independently floating rate vis-a-vis the rest of the world.
All of the top 20 trading partners of the Chinese mainland maintain flexible exchange rates to varying degrees, with Hong Kong and Malaysia the only notable exceptions.
Hong Kong has had a currency board since 1983, whereas Malaysia pegged the ringgit in August 1998, when capital controls were imposed during the height of the Asian crisis.
For two years, we have been dismissing the fear if Renminbi devaluation is adopted. As China sets out to reintroduce greater exchange rate flexibility, some are predicting substantial devaluation.
It is likely we will witness an initial weakening of the renminbi as the government adopts a more hands-off approach towards the foreign exchange market. As a rough indication, the 12-month non-deliverable forwards imply at peak about 12 per cent devaluation in the future spot rate.
However, we consider it unlikely the currency will weaken significantly over an extended period.
Initially, the currency may overshoot on the downside -- possibly by a maximum depreciation of 10 per cent from the equilibrium. However, this should be followed by a sizable "correction'' to push the currency back towards its fair value on the back of strong external fundamentals, including an improving outlook for export growth. While some initial depreciation is likely, we rule out a depreciation of large magnitude and very high volatility over an extended period following China's move to a managed float.
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