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China has always been named and shamed as a “currency manipulator”. Its bitterest critics claim that China intentionally suppresses the Renminbi (RMB) value below a fair level through massive market intervention, to raise the competitiveness of its exports.
The market, however, has quite a different perception. The Chinese RMB has appreciated by 30 per cent since the 2005 exchange rate reform, and the market for non-deliverable forwards (NDFs) started to move in both directions, indicating that the value of the currency has started to level off. At the same time, China’s surplus has come way down.
China’s current account surplus, after reaching record levels of around 10 per cent of GDP in 2007, has dropped to 2.6 per cent of GDP in 2012.
The People’s Bank of China (PBOC), the central bank in China, has in the meanwhile, silently but significantly changed its course.
Before the global financial crisis, the PBOC used to purchase huge amounts of US dollars to stabilise the RMB exchange rate.
Now it cleans its hand and sits aside. From early 2005 to Q3 2011, about $100 billion assets were added to the balance sheet of the PBOC every quarter on average, but from Q4 2011 to Q4 2012, only $2.4 billion assets shows up every quarter on average. It is the clearest signal that the PBOC has abandoned the clumsy direct intervention of the market.The PBOC is now managing the market by setting the mid-price daily, which the market takes as the starting point for that day’s trading. This is good news for China as it increases the autonomy of the country’s monetary policy.
The PBOC is freed of earlier worries when it bought more USD from the market, there would be more pressure on domestic money supply.
But, the crucial question being – is the current policy sustainable?
The PBOC as firefighter
Firstly, under the current under-limit and lower limit control, the rise or fall of the RMB against the dollar cannot exceed one per cent of the middle rate. When supply exceeds demand on the foreign exchange market, as it happened in Q4 2012, and the PBOC did not soak up all the dollar supply, the RMB to dollar exchange rate hit an upper-limit and the trading on the market froze consequently.
If this becomes the new normal, it will dampen the development of China’s foreign exchange market.
Secondly, since there is still room for the RMB to appreciate in the future, it makes sense for the private sector to prefer holding RMB assets rather than USD assets. How could the PBOC encourage the private sector to hold more dollar assets? Well, one way to do this is through more strict administrative measures, for example, the regulatory agency can urge companies to pay back their foreign debts, so that companies have to procure more dollars from the market. But this means the private sector has to bear more burdens. It looks more like a sort of penalty.
My colleague Zhang Bin and I recently made a new proposal for RMB exchange rate reform.
It’s simple: keep the one per cent daily band if you like, but make a clear announcement that unless the RMB exchange rate (with the dollar, and/or with a currency basket) moves up or down more than 7.5 per cent annually, the PBOC will not intervene in the market.
It means that the PBOC will play the role of a firefighter and only respond to emergencies.
The purpose of this new proposal is to send a clear signal to the market, and create a larger room for the reform of RMB exchange rate regime.
Under this new regime, the RMB may appreciate further, and there is going to be more fluctuation of the RMB exchange rate.
Will this hurt China’s export, employment and macroeconomic stability?
China has a diversified group of trade partners. What really matters is not the bilateral exchange rate, or the nominal exchange rate. If you want to see the impacts of exchange rage on trade performance, it is better to focus on the Real Effective Exchange Rate (REER), which is the weighted average of a country’s currency relative to a basket of the currencies of its major trade partners, and adjusted for the effects of inflation.
We checked the data on the REER movement of RMB, USD, EURO, Singapore dollar, Korea Won, India Rupee, and Mexican Peso in the period of 1994 to 2012.This is the period when China moved from the fixed exchange rate regime to the new managed floating regime. We found that the Singapore dollar, which is under a kind of BBC (Basket, Band and Crawling) regime, was the most stable currency.
The implication is that, constant market intervention does not guarantee exchange rate stability. A larger band for fluctuation, with more clear rules, probably suits China better.
There is already a large body of literature, most famously from Paul Krugman, discussing the exchange rate target zone. The basic message is, given the assumption that the central bank can make a credible announcement, the movement of exchange rates will be rather smooth and stable within the band.
China has grand foreign exchange reserves and its economic growth is quite robust, no matter what the cynics say. China still has large room for manoeuvre for its fiscal and monetary policies. It’s the right time to speed up the reform of RMB exchange rate policy.
The need of the hour is sequential reforms
We do not buy the argument that RMB appreciation perversely aids the US on reducing its current account deficit.
A study by our colleagues at the Institute of World Economics and Politics (IWEP) shows that the income elasticity of China’s exports are much larger than the price elasticity, meaning that China’s exports depend more on how deep are American pockets, not on how cheap the price is on the tag of “Made-in-China” goods.
But we do believe that RMB exchange rate reform should be one of the major components of any policy packages to balance Chinese economy.
We also believe a faster RMB exchange rate reform can pave the way for other reforms like RMB internationalisation and capital account liberalisation.
But these are long-term goals. It’s a long march for China’s financial reform.
First things first. What we need to do is push forward the reform of exchange and interest rates.
The Sequence — cleaning the house, then opening the door and welcoming the guests.
Even if we want to utilise the opening up policy to create new momentum for domestic reforms, as China did successfully in early 2000s with its entry into the WTO, why not open up the financial sector directly?
You just cannot put the cart before the horse.
We are living in an age of uncertainty. International financial markets are in turmoil, and the domestic financial sector is fragile.
Advanced countries are pumping money into their economies through quantitative easing, and releasing a huge flood of liquidity to the international market.
One day they will decide to exit and increase the interest rates, a sudden stop of capital inflow, or even a panic of capital flight will trail, and cause serious risks for emerging markets.
So, why make a frantic dash now?