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July 11, 2005

Reform of China's Foreign Exchange Rate System - A Stronger RMB Benefits China

Chi Hung KWAN (Senior Fellow, Nomura Institute of Capital Markets Research)

In order to maintain independence of its own monetary policy in an environment of ever intensifying capital flow across national borders, China should change its foreign exchange system from that of pegging to the U.S. dollar to a managed floating rate system. But it is important to realize that foreign exchange rate policy can at best help stabilize the macroeconomy. Devaluation of the Renminbi (RMB) cannot reduce structural unemployment in China, and revaluation of the RMB cannot suppress the structural trade deficit of the U.S.

China Becoming the Largest Holder of Foreign Exchange Reserves

In recent years, the U.S. and other major industrialized countries have demanded a revaluation of the RMB, but the Chinese government, while recognizing the need for reforming its foreign exchange system, has been wary of giving the impression to their citizens of conceding to foreign pressures. In the mean time, however, because of the enhanced competitiveness of its products in the global market, China's trade surplus has kept rising, and a revaluation of the RMB is imminent considering the fundamentals of the economy.

Reflecting the huge external surplus, the level of China's foreign reserves is soaring. According to the balance of payments statistics of 2004, China's current account surplus was 68.7 billion dollars (of which 59.0 billion was from trade), the capital account surplus was 117.0 billion dollars (including direct investment inflow of 60.6 billion), and a surplus of 27.0 billion dollars was recorded as errors and omissions in 2004. It is more common for a developing country to show a deficit in the errors and omissions category, reflecting capital flight. But in the case of China, speculative money anticipating a revaluation of the RMB has been flowing in through informal channels, which resulted in the continued surplus trend since 2002.

The sum of current account, capital account, and errors and omissions corresponds to, by definition, the change in reserve assets, most of which consists of foreign exchange reserves. China's foreign exchange reserves increased 206.7 billion dollars during 2004, to reach 609.9 billion by the end of the year. The level of reserves has continued to rise in 2005, reaching 691.0 billion dollars by the end of May. If the trend continues, China could overtake Japan - with 842.5 billion dollars at the end of May - to become the world's largest holder of foreign exchange reserves in the near future.

The increase in the external imbalance vividly shows that the current exchange rate of the RMB is lower than its market equilibrium rate. If China had adopted the floating rate system and no market interventions were made, the RMB would have risen while there would be no increase in the country's foreign exchange reserves. The adverse effects of maintaining an undervalued exchange rate, however, are already evident.

Adverse Effects of Suppressing the RMB

In an effort to suppress the value of the RMB in the market, the government sells the RMB in exchange for U.S. dollars in the foreign exchange market. The dollars so obtained are largely invested in U.S. Treasuries. This means the money earned by the Chinese people has not been utilized to develop their own economy but has flowed out of the country. The RMB sold through the intervention, on the other hand, by increasing the domestic money supply, has added fuel to the already overheated economy. The central bank has been issuing short term notes to absorb base money as a sterilization measure, but the outstanding volume of such notes has become huge, making it more and more difficult for the market to absorb. Moreover, if China were to neglect the trade imbalances with its trading partners, trade frictions could further intensify.

A very straightforward means to resolve these problems is to let the market determine the exchange rate by adopting a floating rate system. But China, worried of the possibility of increasing unemployment, - besides the antipathy toward foreign pressures - has been reluctant to switch to a new system. It must be noted, however, that foreign exchange policy is an instrument of macroeconomic policy, and utilizing it beyond its capacities to resolve structural problems could in fact aggravate such problems as an overheated economy and trade friction.

The theories of Jan Tinbergen and Robert Mundell provide general guidelines for the formulation of economic policy in the context of multiple objectives. Tinbergen's theory stipulates that the number of independent policy instruments must be no less than the number of independent policy targets. Mundell's theory stipulates that a policy instrument should be assigned to a target that is most effective. Tinbergen in 1969, and Mundell in 1999, received the Nobel Prize in Economic Science.

If China is aiming for the two targets of stabilizing the macroeconomy and sustaining employment, Tinbergen's theory says foreign exchange policy alone would not suffice to achieve both objectives, and it is necessary to employ (at least) another policy measure.

According to Mundell's theory, foreign exchange policy should be applied to achieve macroeconomic stability, and some other measures, such as the formulation of a social safety net and vocational retraining programs should be sought to cope with structural unemployment caused by the changes of industrial structure and the transition to a market economy. If indeed foreign exchange policy were effective in increasing employment, China should aggressively devalue the RMB rather than just attempting to maintain its current rate in the first place.

When assigning foreign exchange policy as an instrument to stabilize the macroeconomy, China will be facing the so-called "impossible trinity" discussed in international monetary economics. That is, three policy goals of free capital movements, an independent monetary policy, and a fixed exchange rate cannot be achieved simultaneously (see table). Thus far, China has - by way of controlling capital flow - maintained the independence of monetary policy and the pegged-to-the-dollar exchange rate which effectively is a fixed exchange rate system.

But with globalization of the Chinese economy accelerating after its accession to the WTO, capital mobility has increased despite government control. China has to decide whether to abandon the independence of monetary policy like the members of EU, or, like Japan, give up the stability of the exchange rate.

Table: "Impossible Trinity" in International
Monetary Economics

 Free Capital MobilityIndependent Monetary Policy Fixed Exchange RateExamples
Capital ControlsNoYesYesChina
Monetary UnionYesNoYesEU
Free FloatingYesYesNoJapan

Managed Floating System a Realistic Choice

Ruling out the possibility that China leaves its monetary policy to be determined by the Federal Reserve Board in Washington, the only option left is for it to adopt the floating rate mechanism. But being only halfway through the country's financial reform, shifting to a totally free floating regime is unlikely for the time being. Thus, the realistic path would be to gradually widen the margin of fluctuation and shift to a managed floating system.

The fate of the RMB has come to affect not only China's domestic economy but also the external imbalance of the U.S. As the inflow of private money into the U.S. has decreased since 2003, the financing of the huge U.S. current account deficit has come to rely more and more heavily on the public money of foreign governments. And the recent trends of foreign reserve balances of various countries indicate that the fund provider is shifting from Japan to the developing countries in Asia.

China, while being the largest source of U.S. trade deficit, has recycled most the dollars so earned into the U.S. by way of purchasing U.S. Treasuries. The U.S. is asking China to revalue the RMB to reduce the bilateral trade imbalance. The "Report to Congress on International Economic and Exchange Rate Policies" submitted on May 17 states, "If current trends continue without substantial alteration, China's policies will likely meet the statute's technical requirements for [designating the country as a currency manipulator]," and "Treasury will monitor progress on China's foreign exchange market developments very closely over the next six months in advance of preparation of the fall report."

But the U.S. trade deficit is a structural phenomenon that reflects the domestic imbalance between investment and savings. As FRB Chairman Greenspan admits, "A revaluation of the RMB would have limited consequences for overall U.S. imports as well as for U.S. exports that compete with Chinese products in third markets [because] such a revaluation would affect Chinese value added but not the dollar cost of intermediate goods imported into China from the rest of Asia..." (Testimony of Alan Greenspan before the U.S. Senate Committee on Finance, June 23, 2005).

In fact, if Chinese authorities were to halt market intervention and allow the RMB to appreciate, foreign exchange buildup would slow, demand for U.S. Treasuries would decrease, and the pressure for a lower U.S. dollar and higher U.S. interest rate would emerge.

Thus, a revaluation of the RMB is necessary not for the U.S. but rather for China's own sake. China should put aside the emotion of " We should support whatever the enemy opposes and oppose whatever the enemy supports" ('Quotations from Chairman Mao Tse-tung'), and should opt for a rational choice based upon its own interests.

(The original Japanese article appeared in the June 30, 2005 issue of Nihon Keizai Shimbun.)

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