The Reform Initiatives of RMB Exchange Rate Determining Mechanism

1. The Reform Initiatives of RMB Exchange Rate Determining Mechanism April 1st, 2004 Cao Honghui Institute of Finance & Banking Chinese Academy of Social Sciences Email:davidcao2002@163.com

2. Contents I. Why reform RMB exchange rate ? II. Advantages & disadvantages of current RMB exchange rate determination mechanism III. Main targets of the reform IV. Main contents of the reform V. Advantages and disadvantages of the basket mechanism VI. Further measures to be taken

3. I.Why reform RMB exchange rate determination mechanism? 1.Strong expectation for the increase of RMB exchange rate A.Rapid growth of international income/expenditure balance Sheet,capital flow reaches US dollar 100 trillions,obtaining 80% of GDP of China. B.No systematic risks of debt,foreign debt reaches US dollar 43.2 billions in 1998,30.4 billions in 2002,and decreases 16.1% in 2003. C.FDI slows down though the scale enlarges;85% FDI in East coast area,3.22% in Western area;non-state-owned entities obtains the most;the gap of service trading enlarges. D.Why net capital flow increases? ----QFII leads to the capital flow(US dollar 1.7 billions) into domestic market;

4. I.Why reform RMB exchange rate determination mechanism? ---More enterprises IPO overseas in 2003; ---Private sector draws back the foreign currency in advance and the overseas foreign currency; ---The foreign currency savings of inhabitants decreases US dollar 1.9 billions in 2001,increases 7.7 billions in 2002 and 10.7 billions in 2003; ---Foreign reserve increases 150 billions in inter-bank foreign currency market in 2003; ----Gross foreign reserve reaches 330.3 billions in 2003.

5. I.Why reform RMB exchange rate determination mechanism?

6. I.Why reform RMB exchange rate determination mechanism? 2. Some explanations A.From international side ---Globalization accelerates the adjustment of industries which results in the increase of manufacturing trading. ---Limitations of techniques from developed countries. ---Unfairness in international system. B.From domestic side ---high ratio of savings/investment ---large surplus of capital owing to financial restriction

7. I.Why reform RMB exchange rate determination mechanism? 3. New development A. Net export was US dollar 7.9 billions at the first two months of 2003. B. -Impact of interest rate from US would increase; interest rates in US(1%) lower than China. C.- Various policies to adjust RMB exchange rate would affect. ---To adopt some measures to solve trading conflicts; ---To accelerate the liberalization of capital control (QFII,QDII); ---To reduce the tax refund to export firms; ---To rebalance the portfolio of foreign reserve.

8. II.Advantages/disadvantages ofcurrent RMB exchange rate determination mechanism 1.Advantages of current RMB exchange rate systems A.Good for the stable expectation of RMB exchange rate in foreign trading & investment. B.Good for the stability of the value of foreign currency Assets. C.Good for the internationalization of RMB. D.Good for the stability of East Asian currency. E.Good for the stability of CPI in the mainland of P.R.China.

9. II.Advantages & disadvantages of current RMB exchange rate determination mechanism 2. Disadvantages of current RMB exchange rate systems A.Unable to reflect the inner need of domestic economic development to adjust exchange rate. B.Unable to maintain both domestic and overseas equilibrium,which is necessary to maintain the continuous economic growth. C.Fixed against US dollar is not conducive to the stability of the nominal exchange rate of RMB against other currencies

10. II.Advantages & disadvantages of current RMB exchange rate determination mechanism 3.Three methods to eliminate RMB revaluation expectation A.Public announcement to maintain exchange rate. The measures to decrease the pressure can just eliminate some contortion in economy,but cannot entirely eliminate the long term expectation for the increase of RMB exchange rate. B.To increase RMB exchange rate in a wider band. The immense impact of it to the stability of domestic as well as world economic growth cannot be expected and controlled. C.To reform the mechanism of RMB exchange rate determination.

11. III. Main targets of the reform A.To maintain the stability of nominal RMB exchange rate against all other currencies for the stable circumstances for the continuous and steady economic growth. B.To introduce floating system of RMB exchange rate determination gradually. C.To switch to a managed floating system against the basket of foreign currencies instead of US dollar only. D.To establish coherent relationships between domestic monetary policy and exchange rate policy.

12. IV. Main contents of the reform 1.Realistic option for RMB exchange rate reform A.Under the stability of RMB exchange rate,to enhance the elasticity of it by two ways: ---To enlarge the floating band of RMB exchange rate; ---To switch to the managed floating system against a basket of foreign currencies instead of US dollar only. B.Why not the first but the second choice? ---The central exchange rate needs to be adjusted always under the first option ---The revaluation expectation would push it to the ceiling if the band is too narrow, which is similar to one time adjustment of exchange rate. ---While if it is so wide, the fluctuation of exchange rate would strongly impact the economic growth and stability.

13. IV. Main contents of the reform 2.Measures to be taken to establish the basket A.To choose ten currencies of the main economies which have the closest trading and investment relationship with P.R. China. B.To establish different weight for each chosen currency. C.To adjust the weight according to the changes of trade and investment between these countries and China.

14. V. Advantages and disadvantages of the basket mechanism 1. Advantages of the basket A.To enhance the elasticity of RMB exchange rate; B.To reduce the unfavorable impact to economy; C.To eliminate the revaluation expectation of RMB 2. Disadvantages of the basket A.To allow the central bank to adjust exchange rate frequently; B.Unable to avoid the impact of other factor besides the exchange rate; C.Not a long term solution as a system; need to frequently adjust the basket

15. VI.Further measures to be taken 1. Conditions for Further Liberalization of Capital Account A.Improvement of Macroeconomics:High average GDP per person,steady economic growth, efficiency of the economy, stability of prices, healthy public finance, etc. B.Improvement of corporate governance and healthy micro- economic condition; C.More efficient financial institutions and financial markets; D.Stable and efficient RMB exchange rate and interest rate determination mechanism

16. VI.Further measures to be taken 2.More market force for exchange rate determination mechanism A.Continue to make the actual supply of the market meet the actual demand. ---To eliminate the restrictions to the purchase/sales of foreign currency ---To promote the liberalization of capital account to realize the actual demand of residents and non-residents for foreign currency. B.To reduce the need for the central bank to intervene FX too frequently C.To an eventual flexible exchange rate system without threatening the stability of the economy

17. Conclusions - RMB exchange rate determining mechanism should be reformed according to its economic growing status,liberalization of financial system and market reform. - Otherwise,it may be harmful to domestic economic growth and stability as well as regional and even world economic stability.

18. Institute of Finance & Banking,Chinese Academy of Social Sciences Thank You !