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China’s Exchange Rate Policy against the Backdrop of Unbalanced International Monetary System*
2006-06-01
By Xia Bin & Chen Daofu
Research Report No 001, 2006
I. Study on the Performance of the RMB Exchange Rate
1. The market expectation of appreciation is going down
The reform of China’s exchange rate system has witnessed a key and delightful step towards floating, stabilizing the market expectation. Besides, the widening spread between RMB and US dollar and an expected firm US dollar in the near term have, to some extent, relieved the pressure on RMB appreciation.
Based on an examination of market data, the market still expects RMB to appreciate but not largely. Overseas, the RMB NDF market recently went down, and the exposure of the net forward foreign exchange sales by banks widened, which shows that the appeals for large RMB appreciation have been calmed down. Furthermore, a study of such long-term capital inflows as FDI found that the absolute amount of foreign investment actually utilized by China has been on the rise since 2002, but its proportion in GDP has been on the decline thereafter. And the proportion even saw negative growth in 6 out of the first 10 months of this year.
2. The real pressure for a large appreciation is not intensive
First, the reform of the exchange rate regime has continuously relieved the pressure on RMB appreciation. Second, the spread between RMB and US dollar will still be maintained in the near future. It is difficult to rapidly check the declining market interest rate in China. On the other hand, the US will continue to increase its interest rate in order to attract overseas capital inflows and prevent the inflation and offset the huge deficit. Third, the price levels between China and US have been moving closer and closer. From 1994 to 2003, monetary wages of the American manufacturing industry grew 3.03% annually on average, while the growth in China far surpassed that of the US and hit 13.04%[1]. Moreover, the ongoing price reforms in China’s coal, electricity and oil sectors will also reduce the pressure on RMB appreciation. Fourth, as the reform of the market mechanism deepens, we cannot eliminate the possibility that RMB will depreciate in the middle or long term. From the middle/long-term perspective, it is possible that RMB will depreciate in some periods, because of the over RMB2 trillion gap in the social insurance fund, the over RMB1 trillion worth of non-performing bank loans, huge immeasurable deficits suffered by some local governments, and the chronic leftover of the chance-waiting problem-solving and domestic-demand-led strategies in the mechanism. Fifth, it is the matter of progressiveness for convertibility of RMB under the capital account. China will take a very cautious and progressive attitude towards the full convertibility of RMB under the capital account, and the central bank of China will also accumulate its experience in intervening in the foreign exchange market during this process, both of which will surely increase the speculative cost of investors and make it harder for international hot money to directly impact the RMB exchange rate.
3.Conclusive judgment
First, the RMB exchange rate will continue to maintain relatively stable, though it is expected to fluctuate in two directions and slightly appreciate. Currently, the pressure of RMB appreciation expectation obviously exceeds the real economy’s internal appreciation need. Under such circumstance, large adjustment to the RMB exchange rate will incur an excessive risk that will be neither beneficial for the stability of China’s economy and finance nor beneficial for the stability of the world economy and the US economy. This is particularly true as China’s financial reform is entering a critical period, in which there are many economic and financial variables, financial institutions and enterprises still need time to adapt to a floating exchange rate, and the exchange rate adjustment will only have limited effect on improving the imbalance of international economy. Therefore, the ground rules of initiative, controllability and progressiveness will not and shall not be changed. In adjusting the exchange rate policy this year and next year, more consideration should be given to the guideline of observation and adaptation.
Second, the floating range of the exchange rate should be appropriately expanded at good opportunities. The appearance of such opportunities is stimulated and advanced by new market supply and demand factors, which will generate after the reforms in the financial system and foreign exchange market have been furthered and the market-oriented reformative measures implemented been generally integrated. Even if the floating range is expanded, it will still be a managed and appropriate one.
II. Basic Reason for HighExpectation of RMB Appreciation: the Monetary FactorsTranscend the Real Economic Factors
The deepening of China’s market-oriented reform and the improvement of labor productivity have provided the basis of RMB appreciation. Besides, the opening China, was offered great opportunities as the Cold War ended and international funds overcame their long-term ideological obstacle; moreover, the broad market with cheap labor forms another important stimulus for the reported twin surpluses for 12 out of 15 years from 1990 to 2004. This has also driven RMB to appreciate. However, it shall be noticed that although the appreciation cannot be fully justified without mentioning the real economic factors, the monetary factors have imposed a bigger effect than the real economic factors.
The US, as the world No.1 economy and the international reserve currency issuer, started with only solving its domestic economic conflict in the past several years by maintaining low interest rates, and issued an excessive amount of US dollars. In the mean time, the central banks of other economies, especially in Asia, continuously supported the huge twin deficits of the US by intervening in their foreign exchange markets, resulting in a drastic increase in the world monetary base. International capital flows had grown much faster than international trade after the 1970s. Since 1997, the growth of global monetary base has far exceeded that of global production. The consequential huge amount of monetary fund, beyond doubt, had to chase after the sources of profit around the world. Global excessive surpluses of fund have never stopped hunting for chances around the world, from the burst bubbles of American new economy, network and stock markets to the current American real estate bubbles, and from speculation in oil to speculation in gold, precious metal and even forest resources worldwide. As a matter of fact, the cross-border flow of excessive fund surpluses since the 1990s has incessantly led to the instability of some countries and regions and even the global economy. Now, simply balancing Sino-US trade is not enough for settling the economic issue of the US, as said by Alan Greenspan, Chairman of the Federal Reserve Board. But the twin surpluses and high foreign exchange reserve that China registered over many years, according to the habitual thinking the US used in tackling its past economic problems, has become an excuse for the American economic problem, and has been utilized by international hot money groups to create a climate for RMB appreciation. In addition, the appreciation pressure was reinforced, as domestic economic entities accelerated their asset restructuring in face of great pressure from the public voices at home and abroad for RMB appreciation. The backflow of overseas funds that flowed abroad in past years, the monetary asset adjustment done by domestic traders through such means as trade credit, and the individual monetary asset conversion will inevitably amplify the need for RMB appreciation that is reflected by the real economic side in the end.
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*A summary of the Year-2005 Report on China’s Exchange Rate Regime.
[1]Ronald I McKinnon, Exchange Rates under the US Dollar Standard, P.205, published by China Financial Publishing House, May 2005
