China’s Exchange Rate System after WTO Accession: Some Considerations

1. China’s Exchange Rate System after WTO Accession: Some Considerations Jian-Guang Shen, Bank of Finland Institute for Economies in Transition

2. Chinese RMB’s exchange rate, per US$

3. Chinese RMB’s real effective exchange rate

4. China’s exchange rate system • Dual exchange rate regime prior to 1994 • Single exchange rate since 1994 • Nominally a system of managed floating exchange rate • Practically a peg to the US dollar supported by comprehensive, direct capital account controls.

5. China’s exchange rate market • The nation-wide inter-bank foreign exchange market, the China Foreign Exchange Trading Centre (CFETC) • All foreign exchange trading has been conducted in this market. The CFETC also provides settlement services • Over 300 foreign exchange banks and non-banking financial institutions

6. Problems with China’s exchange rate market • Only financial institution headquarters hold CFETC memberships • Dominated by the PBOC and BOC • Capital control regulations suppress supply and demand • Centralised trading system has high costs and restrictions • Only three foreign currencies (USD, HKD, JPY), no futures and options

7. China’s capital control measures I • Capital brought in from abroad must be deposited in special accounts in designated banks. Any repayments and remittances from these accounts are also subject to SAFE approval. • Foreign investment in the Chinese stock market is limited to B shares. Inbound foreign capital must get SAFE approval to convert to RMB. • All long-term foreign borrowing (over one year), including project loans, must be mentioned in the comprehensive state commercial loan plan. These loan contracts need to be approved by SAFE, which assesses the core contents of all mid- to long-term commercial loans. Based on the financial institution’s assets and liability condition, SAFE can suggest a distribution plan among various financial institutions, and set individual foreign exchange loan ceilings for each financial institution. • For short-term foreign debts (less than or equal to one year), SAFE assigns foreign debt balance quotas to designated financial institutions. Each financial institution can borrow from abroad, under supervision, without loan-by-loan approval of local SAFE branches. • For commercial loans of less than three months under current accounts, SAFE approval is not required. Commercial loans of longer than three months but less than or equal to one year have to be registered with SAFE, and the conditions for repayment of principal and interest rates must be approved by SAFE. • Only PBOC-approved state organisations can issue bonds abroad. The size of these issues is determined in accordance with the state foreign capital utilisation plan. • Leasing and trust loans from abroad are subject to local- and national-level plans for technological upgrades and foreign capital utilisation. Such loans may not exceed the foreign exchange quotas set for the enterprises involved and must be registered with SAFE. • All foreign loan guarantees require SAFE approval. Only authorised financial institutions and enterprises are allowed to provide foreign exchange loan guarantees. The amounts to be guaranteed are subject to strict conditions. • Outbound foreign investments by domestic enterprises must receive SAFE approval. • Industrial production up 10.8% • Private consumption up 10.3% • Total investment up 15.1% • Exports up 8.8% • FDI reached USD 20.7 billion

8. China’s capital control measures II • All long-term foreign borrowing (over one year) must be mentioned in the state commercial loan plan. • Commercial loans of longer than three months but less than or equal to one year have to be registered with SAFE, and the conditions for repayment of principal and interest rates must be approved by SAFE. • Only PBOC-approved state organisations can issue bonds abroad. The size of these issues is determined in accordance with the state foreign capital utilisation plan. • Leasing and trust loans from abroad are subject to local- and national-level plans for technological upgrades and foreign capital utilisation. Such loans may not exceed the foreign exchange quotas set for the enterprises involved and must be registered with SAFE. • All foreign loan guarantees require SAFE approval. Only authorised financial institutions and enterprises are allowed to provide foreign exchange loan guarantees. The amounts to be guaranteed are subject to strict conditions. • Outbound foreign investments by domestic enterprises must receive SAFE approval.

9. China’s capital control measures III • Only PBOC-approved state organisations can issue bonds abroad. • Leasing and trust loans from abroad are subject to state plans for foreign capital utilisation. • All foreign loan guarantees require SAFE approval. • Outbound foreign investments must receive SAFE approval.

10. Results of China’s capital control measures • China’s foreign debt structure is dominated by medium- and long-term foreign debt • Short-term foreign capital inflows usually are part of commercial deals • State sovereignty debts are significant

11. Four alternatives: benefits and disadvantages • Fixed exchange rate regime • Crawling peg • Float within bands (target zone) • Managed float with no pre-announced exchange rate path

12. Long term goal • A flexible exchange rate mechanism with free cross-border capital mobility • The role of RMB in the international financial market

13. Manage the transition • The exit strategy: • No depreciation pressure • join a net capital flow situation • China satisfies both, but worries about: • Appreciation pressure • the pace of liberalization in accordance with other financial market development

14. Benefits Stable currency As nominal anchor for monetary policy Prevent currency risks Disadvantages Inflexible in the face of shocks No monetary autonomy under capital liberalisation prone to currency crisis The fixed exchange rate system

15. Benefits Flexible in the face of shocks Monetary autonomy under capital liberalisation Not prone to currency crises Disadvantages Strong fundamentals needed Excessive currency risks Interest rates still fixed by PBOC More developed financial markets needed Floating regime

16. Benefits Some flexibility in the face of shocks Less strong fundamentals needed Avoid excessive currency risks Disadvantages Vulnerable to speculative currency attacks Difficult to decide the band Now RMB has revaluation pressure Floating within bands

17. Benefits Relatively stable currency Some flexibility in the face of shocks Disadvantages Vulnerable to speculative attacks Crawling rule difficult to design Low monetary autonomy and credibility Crawling Peg

18. Capital account liberalisation in China • The effect of WTO accession • Liberalisation of financial markets • Money market • Capital market • Foreign exchange market • Operational difficulties • Commercial banks • Domestic enterprises • The central bank

19. Capital account control still useful • The second-best argument: compensation for imperfect markets in China • Increased risks in the financial system: the lesson of the Latin American and Asian Crises • Assistance for monetary and fiscal policies

20. Conclusions • WTO membership needs more flexible exchange rate system • China as a large continental-type economy • Capital account liberalisation inevitable • More shocks require it