Structural Evolution of RMB Exchange Rate Reform: Historical Review, Experience and Prospect
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Ming Zhang
Abstract
The Renminbi (RMB) exchange rate regime reform has gone through three stages roughly once every decade since 1994. It is a structural evolution through the unification of dual exchange rates, increased fluctuations and central parity rate reform in response to the dynamic macro environment in China and abroad. This paper unpacks leading and supporting reforms for each stage and reviews the effects. The reform has developed historical experience in adopting progressive strategies, avoiding sharp exchange rate fluctuations in the near term, maintaining appropriate capital controls, and guaranteeing the reform through domestic structural reforms. Achieving a free-floating exchange rate will be the ultimate goal, but it will not be made easily in the short run. During the transitional period, it is recommended that an annual target zone for RMB’s effective exchange rate be arranged for the CFETS currency basket, along with necessary capital controls.
1 Introduction
The RMB exchange rate reform has been a major issue of concern both in China and abroad. Recent years have witnessed the RMB climbing up in the settlement of global transactions as it played a more prominent role in the international monetary system. Now the world is undergoing change on a scale unseen in a century and walks into a period of turmoil and revolution. We need to summarize experience from the RMB exchange rate regime reform to determine the direction and prepare for a higher level of open economy.
In light of international experience, the circumstances of a country impact on its choice of the optimal exchange rate regime (Frankel, 1999). Following the collapse of the Bretton Woods system, emerging economies more opted for crawling pegs or managed floats and not many for fixed and floating exchange rates (Lu and Zhang, 2021). According to IMF’s Annual Report on Exchange Arrangements and Exchange Restrictions 2020,[1] only China, of the global top 10 economies, did not adopt a free-floating exchange rate.[2] Some scholars pointed out that the People’s Bank of China (PBOC) has made an effort to transition from “crawl-like arrangements” to a floating rate after the “811 Exchange Rate Regime Reform” in 2015 (Yu and Xiao, 2017).
Where will the RMB exchange rate regime reform go in the future? Model and timing choices are key to answering this question. Without copying the experience of developed countries in taking a free-floating exchange rate at one go, the PBOC applied progressive strategies as the model of reform. Yi and Tang (2001) believed that no single exchange rate regime was right for all countries. Also, the optimal exchange rate regime would not be right at all times and varies depending on a country’s individual circumstances (Frankel, 1999). As far as the timing is concerned, the PBOC would choose times with a favorable macro environment which is generally required for a successful exchange rate regime reform. Specifically, changes in the exchange market pressures (EMP) index delineate the macro environmental uncertainty facing the PBOC (Figure 1).[3] China had faced sustained positive EMP (with only brief periods of negative EMP during the subprime and European debt crises) between 2001 and2013. In 2014 after the Federal Reserve (Fed) brought an end to its quantitative easing (QE) policy, the U.S. Dollar Index (USDX) started to go up. Since then, China turned to deal with persistent negative EMP from the second half of 2014 to the end of 2016. Since 2017, China’s EMP have gradually weakened in scale and trend, indicating a growing bi-directional volatility. At the current, as China fights the great uncertainty in domestic and international macro environment, it is even more arduous to choose right times for the next stage of RMB exchange rate reform.
Changes in USD-CNY Exchange Rate and EMP Index
Note: Subject to data availability, the EMP index is calculated over the period from Dec. 1995 to Nov. 2021.
Source: Wind.
Here the structural evolution of RMB exchange rate regime reform is summarized into “three stages, two approaches, and one goal”. “Three stages” means that the RMB exchange rate regime reform has gone through three stages roughly once every decade since 1994, i.e., the structural evolution through the unification of dual exchange rates, increased fluctuations and central parity rate reform. “Two approaches” indicates the combination of leading and supporting reforms by the PBOC for each stage. “One goal” is the ultimate goal of achieving a free-floating exchange rate, which will not be made easily in the short run due to the complicated macro environment in China and abroad. It is recommended that an annual target zone for effective exchange rate be arranged for the CFETS currency basket during the transitional period.
The innovations of this paper are as follows. First, it divides the RMB exchange rate regime reform into three stages, distinguishes leading from supporting reforms for comparative analysis, and reviews the effects of reform on this basis. Second, four experience is drawn therein, among which “maintaining appropriate capital controls” and “guaranteeing reform effects through important structural reforms” are particularly notable. New perspectives and ideas listed here may help readers understand the logic behind the RMB exchange rate regime reform in a comprehensive, complete and systematic manner. In the case that the international monetary system is shocked, readers will better infer the evolution and direction of reform. Third, based on the structural evolution, we propose that achieving a free-floating exchange rate will be the ultimate goal of the RMB exchange rate regime reform, and that the target for the transitional period is to arrange an annual target zone for effective exchange rate for the CFETS currency basket. From the perspective of exchange rate regime design, the findings of this paper lay the foundation for a major open economy like China to push the exchange rate regime reform under the new development pattern that is focused on the domestic economy and features positive interplay between domestic and international economic flows, and contribute paths of opening up wider and building a higher level of open economy.
2 Historical Review of RMB Exchange Rate Regime Reform
The RMB exchange rate regime reform has gone through three stages since 1994. The background and content of previous movements are first analyzed, followed by a comprehensive review of the three major reforms.
2.1 From 1994 until the First Half of 2005: Transition from Dual Exchange Rates Regime to Unification of Dual Exchange Rates Regime
The RMB exchange rate ushered in its first stage of reform from 1994 until the first half of 2005, marked by a unification of dual exchange rates regime in 1994 that aimed to stabilize exchange rates, increase reserves, and build a unified and regulated forex market.
2.1.1 Background
The PBOC unified RMB exchange rates in response to the macro environment in China and abroad and for China’s economic growth. The early 1990s witnessed the demise of the Soviet Union and the drastic changes in Eastern European countries. The tense international political landscape forced China to reconsider the direction of reform. China’s GDP growth rate registered only 3.9% in 1990. Under internal and external pressures, Deng Xiaoping’s South Tour Speeches in 1992 reaffirmed the necessity and significance of deepening reform and accelerating development, hence pushing the country’s reform, opening up and modernization to a new stage.
The RMB exchange rate regime reform was called for under internal and external pressures when the dual exchange rates regime could no longer satisfy China’s economic development. On the one hand, the dual exchange rates regime bred rent seeking and corruption. Prior to 1994, China maintained a dual exchange rates regime, and it was a situation where an official exchange rate and a swap market exchange rate coexisted. While swap rate remained consistently higher than official rate, arbitrage space was created for rent seeking and corruption. On the other hand, the dual exchange rates regime failed to satisfy China’s economic development at that time. The Third Plenary Session of the Eleventh CPC Central Committee in 1978 decided to pursue opening up as a fundamental national policy of China. For the exchange rate is a key variable to global trade and investment, this market landscape with dual exchange rates could not adapt to economic development any more.
Against this background, the central government of China set the goal for RMB exchange rate regime reform at this stage. The Third Plenary Session of the Fourteenth CPC Central Committee held in November 1993 made it clear “to reform the forex management system, establishing a market-based and managed floating exchange rate regime and a unified and regulated forex market”.
2.1.2 Content
2.1.2.1 Leading Reform
The leading reform had three priorities. One was to implement the unification of dual exchange rates. In early 1994, a single, managed floating exchange rate regime based on market supply and demand was adopted by the PBOC. The official and swap market exchange rates were unified, and all currency conversions in China adopted a unified rate of 8.7 yuan per dollar. Another was to adjust the RMB central parity rate. Besides some transitional arrangements for the exchange rate regime functioning normally, the PBOC used the weighted average exchange rates of 18 major swap markets as the central parity rate in 1994. The last one was a temporary policy of pegging RMB to the U.S. dollar during the Asian Financial Crisis from 1997 to 1998.
2.1.2.2 Supporting Reform
The supporting reform focused on building a national unified and regulated forex market with concrete effort as follows. First, a unified and regulated interbank forex market across China was built. The China Foreign Exchange Trading Center System (CFETS) was established by the Chinese government in 1994. Second, the supporting reform was improved. Measures were taken to annul forex retention and surrender to the government as well as mandatory plans for forex receipts and payments (Guan, 2018). Third, the forex management system was upgraded. Restrictions on current international payments and transfers were all removed in 1996, and the current account convertibility of RMB was realized. Fourth, the capital account was liberalized gradually. Significant progress was seen in cross-border investment in securities with the setup of the Qualified Foreign Institutional Investor (QFII) in 2002.[1]
2.1.3 Effects and Review
Generally, the RMB exchange rate regime reform was quite successful at this stage.
First, the goal of reform was achieved. The target of “stabilizing exchange rates, increasing reserves, and building a unified and regulated forex market” was reached in 1994. The primary achievements from 1994 until the first half of 2005 included unifying exchange rates, establishing a national unified and regulated forex market, and gradually completing the supporting reform.
Second, the nominal exchange rate was adjusted more flexibly and the RMB exchange rate-setting mechanism grew more transparent. From 1994 to 2004, the RMB exchange rate was kept stable in a range of 8.2 to 8.7 yuan to one dollar.
Third, the RMB exchange rate regime reform facilitated the optimal allocation of resources and drove economic growth. After the RMB exchange rate regime reform in 1994, economic development gradually gained momentum and forex reserves grew steadily. From 1994 to 2004, the average annual growth rate of China’s GDP was as high as 9.5% and forex reserves rose from USD51.6 billion to USD609.9 billion. Also, institutionally, the unification of dual exchange rates eliminated rent seeking and corruption resulted from the dual exchange rates regime.
Fourth, the RMB exchange rate was once adjusted in place without further depreciation expectations. The 1994 reform induced the exchange rate to depreciate by nearly 50 percent. Nevertheless, it did not cause domestic inflation out of control but contributed significantly to the export-oriented manufacturing. Since the depreciation was so large that the market psychologically established that it was enough, not only did no further depreciation expectations form, but as China’s current accountsurpluses continued to widen, the exchange rate of RMB against the U.S. dollar gained continuous appreciation expectations.
2.2 From the Second Half of 2005 until the First Half of 2015: Trial of Managed Floating Exchange Rate Regime
The RMB exchange rate ushered in its second stage of reform from the second half of 2005 until the first half of 2015, marked by the “721 Exchange Rate Regime Reform” in 2005, with a major goal to “improve the RMB exchange rate-setting mechanism and maintain the RMB exchange rate stable around a reasonable and balanced level”.
2.2.1 Background
The turbulent international environment repeatedly put the exchange rate regime reform on hold. First, a global stock crash resulted from the bursting of the dotcom bubble of 2000 in the U.S. Second, the 9/11 terrorist attacks in 2001 and the Fed’s sharp interest rate cuts led to the dollar reversal in 2002. Third, the issue of undervalued RMB exchange rates was internationalized. In late 2002, Haruhiko Kuroda, the then Vice Minister of Finance for International Affairs, Japanese Ministry of Finance, released an article claiming that China exported deflation to the world by undervaluing the RMB (Guan, 2018). Fourth, the Iraq War broke out in 2003 and aggravated global geopolitical tensions.
A sound domestic economy fostered a good external environment for the RMB exchange rate regime reform. China’s economy was seeing rapid growth during this period. From 2000 to 2004, China’s GDP growth rate surged from 8.5% to 10.1%, its current account surpluses from USD20.4 billion to USD68.9 billion, its actual use of foreign direct investment (FDI) from USD40.7 billion to USD60.6 billion, and its forex reserves from USD 165.6 billion to USD609.9 billion.
In this context, the central government of China set the goal for RMB exchange rate regime reform at this stage. The Third Plenary Session of the Sixteenth CPC Central Committee held in 2003 set the general tone for the next stage of RMB exchange rate regime reform, which was to “improve the RMB exchange rate-setting mechanism and maintain the RMB exchange rate stable around a reasonable and balanced level”.[1]
A great deal of preparatory work was done for launching the RMB exchange rate reform. Prior to the “721 Exchange Rate Regime Reform” in 2005, the preparation made by the Chinese government involved: 1) steadily liberalizing the capital market andremoving some unnecessary controls on capital account transactions; 2) reforming and restructuring commercial banks, disposing non-performing assets and raising the capital adequacy ratio (CAR) for the healthy development of commercial banks; and 3) relaxing the restrictions on transactions under the current account for individuals and businesses.
The time window for the RMB exchange rate regime reform was finally ushered in by the favorable macro environment in China and abroad in 2005. In the first half of 2005, the world economy was running smoothly, China’s domestic economy grew rapidly, and along with relatively low inflation as well as the notable progress in preparation, the time window for the RMB exchange rate regime reform opened (Guan, 2018).
2.2.2 Content
2.2.2.1 Leading Reform
Here are the details of leading reform at this stage.
First, the “721 Exchange Rate Regime Reform” was launched in 2005, and the PBOC made major adjustments as follows. Firstly, the exchange rate level was adjusted at one go. The RMB appreciated against the U.S. dollar by 2% from 8.28 to 8.11 yuan on July 21, 2005. Secondly, the methods of exchange control were reformed by introducing a managed floating exchange regime based on market supply and demand and by reference to the currency basket. Thirdly, the central parity rate-setting mechanism was reformed to be determined “with reference to the previous close” from “with reference to the prior day’s weighted rate of the inter-bank market”. Fourthly, the daily exchange rate of the U.S. dollar against the RMB in the inter-bank market continued to float within a band of 3/1000 of the central parity rate of the U.S. dollar trading announced by the PBOC.[1]
Second, the PBOC carried out marginal reforms on expanding the daily band of RMB exchange rate in the decade after the “721 Exchange Rate Regime Reform”. In May 2007 the daily band was increased from 0.3 percent to 0.5 percent, to 1 percent in April 2012, and then to 2 percent in March 2014.[2]
Third, the RMB exchange rate had been temporarily re-pegged to the U.S. dollar for 18 months, for mitigating the impact of the global financial crisis of 2008 and the world economic recession after that.
2.2.2.2 Supporting Reform
The details of supporting reform are as follows.
The forex market was improving day by day. Specifically, firstly, the inter-bank market diversified transaction subjects and types and introduced new trading means and institutional arrangements. Secondly, the forex settlement and sales market increased its agents and business scope and applied an integrated position management for forex settlement and sales. Thirdly, the exchange rate and position management were further relaxed to empower banks with stronger autonomy. Fourthly, it set to build offshore RMB markets covering Hong Kong SAR, London and other places, among which Hong Kong SAR was in a major position. As of June 2021, Hong Kong SAR’s international payments in RMB registered as high as 77% worldwide (Zhang and Pan, 2022).
In addition, the capital account was liberalized gradually. The PBOC continued to enlarge the scale and investment scope of QFII and QDII regarding institutions’ use of forex. The Qualified Domestic Institutional Investor (QDII) was set up in 2006. China had accelerated the liberalization of its capital account from 2013 until the first half of 2015. As for individual use of forex, the PBOC rolled out preferential policies successively for individual forex settlement and sales to facilitates forex holding and use by market players. The total individual annual purchases rose from USD20000 to USD50000 in 2007.[1]
2.2.3 Effects and Review
Generally, this stage was successful and achieved its goal.
To put it more specifically, firstly, the reform realized its goal of “improving the RMB exchange rate-setting mechanism and maintaining the RMB exchange rate stable around a reasonable and balanced level”. Secondly, the RMB exchange rate-setting mechanism was more transparent. One was the decline in forex intervention. Since the PBOC’s intervention in the forex market declined after the “721 Exchange Rate Regime Reform” in 2005, the RMB exchange rate became more flexible (Zhang, 2015) and the autonomy of domestic monetary policy stronger (Hu, 2010). The other was the increased transparency of the RMB exchange rate-setting mechanism, which was recognized internationally. During this period, the RMB exchange rate steadily appreciated to create a better environment for RMB internationalization. The Chinese RMB added in the Special Drawing Rights Basket (SDR basket) by the IMF in 2015 demonstrated the international community’s wide recognition of the RMB as an international currency (Zhang and Li, 2019). Thirdly, the flexibility of nominal exchange rate adjustments was improved. In fact, China had adopted a Basket, Band and Crawl (BBC) regime since the “721 Exchange Rate Regime Reform” in 2005(Eichengreen and Razo-Garcia, 2006; Zhang, 2011). Such a regime could balance the flexibility and stability of exchange rate adjustments and was therefore favored by many emerging market economies. Fourthly, the current account imbalance was well eliminated when the RMB exchange rate regime reform facilitated the optimal allocation of resources. Since 2009, the current account surpluses to GDP in China had been on a downward trend, and by U.S. standards, China’s current account imbalance no longer existed (Ming, 2018).[1]
A disadvantage was that the PBOC, when dealing with the expectations of RMB appreciation and depreciation, failed to make adequate adjustments once and for all, resulting in the USD-CNY exchange rate not following changes in market supply and demand. We found this stage’s exchange rate regime reform left two problems for the PBOC to address. One was the large amount of forex reserves accumulated over the decade when the PBOC had maintained the exchange rate stability through open market operations in the forex market. Excessive forex reserves, in addition to meaning low investment returns and national welfare losses, grew funds outstanding for forex (FOFFE) and pressure on the PBOC to write off, which would also add market distortions (Zhang, 2012). The other was the accumulated pressure on the RMB depreciating against the U.S. dollar in the market, which severely challenged the “811 Exchange Rate Regime Reform” from 2014 to 2015. As revealed by the accumulation of such depreciation pressure itself, the RMB exchange rate would not fully represent changes in market supply and demand and the RMB exchange rate-setting mechanism required further market-based reforms.
2.3 From the Second Half of 2015 to Date: Adjustment and Trial of RMB Central Parity Rate Reform
The RMB exchange rate started its third major stage of reform from the second half of 2015 to date, marked by the “811 Exchange Rate Regime Reform” in 2015, and set a goal to “improve the market-based mechanism for setting the RMB exchange rate and highlight the market plays the decisive role in resource allocation”.
2.3.1 Background
The macro environment changed drastically in China and abroad. On the one hand, China’s non-reserve financial account began to experience persistent deficits since the second quarter of 2014. On the other hand, the international macro environment changed too much after the global financial crisis of 2008 and the end of the 2010–2012 sovereigndebt crisis in the Europe. The USDX started to go up in September 2014 with the Fed ending its quantitative easing (QE) policy. At that time when the RMB exchange rate was roughly pegged to the U.S. dollar, it resulted in a significant appreciation of RMB against other currencies (Gu, 2019). From the first quarter of 2014, the exchange rate of RMB against the U.S. dollar turned from being undervalued to overvalued (Figure 2).
USD-CNY Exchange Rate Has Faced Depreciation Pressure since 2014
Note: The RMB depreciation pressure is portrayed by the spread between the central parity rate and closing rate of RMB against the U.S. dollar.
Source: Wind.
In terms of policies, the Chinese government has placed more emphasis on playing the leading role of the market in resource allocation. The Third Plenary Session of the Eighteenth CPC Central Committee in 2013 made it clear to improve the market-based mechanism for setting the RMB exchange rate and emphasized that the market should play the decisive role in resource allocation.
To adapt to a new situation, a new round of RMB exchange rate reform was imminent. The PBOC then initiated the “811 Exchange Rate Regime Reform” in 2015, kicking off the third stage of RMB exchange rate regime reform on adjusting the central parity rate-setting mechanism.
2.3.2 Content
2.3.2.1 Leading Reform
This stage targeted at adjusting the RMB central parity rate-setting mechanism. Its landmark event was the “811 Exchange Rate Regime Reform” in 2015, since which the RMB exchange rate-setting mechanism has developed from a one-factor to double-factor and then to three-factor rule.
The one-factor rule was first applied. On August 11, 2015, the PBOC noted that central parity rate quotes should refer to the previous close, following a one-factor rule of “central parity rate = previous close” and organizing quoting banks to improve the RMB central parity rate-setting mechanism.[1]
The next was a double-factor rule. On December 11, 2015, the CFETS released the RMB exchange rate index against a currency basket, namely the CFETS RMB Index.[2] A double-factor rule of “central parity rate = previous close plus CFETS currency basket-based adjustment” was adopted by the PBOC since the beginning of 2016.[3]
Then it was a three-factor rule. The RMB depreciation expectations had eased but not yet been eradicated after the double-factor rule was in use. In May 2017, the PBOC announced a three-factor rule of “central parity rate = previous close plus CFETS currency basket-based adjustment plus counter-cyclical factor” to curb market unilateral depreciation expectations.[4]
2.3.2.2 Supporting Reform
The supporting measures for RMB exchange rate regime reform revolved around how to curb market unilateral depreciation expectations, and they were as follows. One was that the PBOC stabilized the exchange rate of RMB against the U.S. dollar by selling U.S. dollars and buying RMB in the forex market. Another was that it began to tighten the controls on short-term capital outflows denominated in foreign currencies since 2016 to alleviate the shortage of U.S. dollars in the forex market. And gradually, the two-way liberalization of financial markets was bolstered by launching the Shanghai-Hong Kong Stock Connect (2014), the Mutual Recognition of Funds (MRF) between mainland China and Hong Kong (2015), the Shenzhen-Hong Kong Stock Connect (2016), the Bond Connect (2017), and the Cross-boundary Wealth Management Connect (2021).[5]
2.3.3 Effects and Review
This stage was correct in the direction of reform but debatable over the timing. Thereform was not thorough enough to completely dispel RMB depreciation expectations.
First, it was hard to say that this RMB exchange rate regime reform achieved full success. Viewing from the effects, the RMB exchange rate became more market-based and the PBOC gradually exited from normal forex market intervention since the “811 Exchange Rate Regime Reform” (Xiao et al., 2021), but this reform was not thorough.
Second, nominal exchange rate adjustments became more flexible. The “811 Exchange Rate Regime Reform” allowed stronger flexibility of the RMB exchange rate (Xiao et al., 2021). In particular, the past five years have seen a significantly enhanced flexibility of the RMB exchange rate and growing bi-directional volatility, which was closely related to the PBOC’s exit from normal intervention during the same period. It was undoubtedly worthy of high recognition.
Third, the choice of timing impacted on the role of the RMB exchange rate regime reform in optimizing the resource allocation. The timing for the “811 Exchange Rate Regime Reform” was still debatable (Zhang, 2016). It was evidenced by the facts as follows. Firstly, China’s forex reserves had shrunk by USD1 trillion after the “811 Exchange Rate Regime Reform”, causing a major loss of national wealth. Secondly, persistent depreciation expectations of RMB against the U.S. dollar after the “811 Exchange Rate Regime Reform” slowed down RMB internationalization, with many indicators concerning currency internationalization dropping sharply. Thirdly, capital controls, especially the controls on capital outflows, had been greatly reinforced after the “811 Exchange Rate Regime Reform” and gave a distinct asymmetrical feature of “broad entry and strict exit”.
Fourth, the constantly adjusted RMB central parity rate-setting mechanism enlarged the opacity of the RMB exchange rate-setting mechanism. In particular, scholars differed on the three-factor rule. Some said the counter-cyclical factor reduced the volatility of the RMB exchange rate (He et al., 2018). However, another school of scholars argued that the addition of more factors, compared with the one-factor rule, actually diminished the transparency and predictability of setting the RMB exchange rate to a large extent. The counter-cyclical factor, as a policy tool stabilizing exchange rates, might be appropriately employed in the short term (Zhang and Chen, 2020).
Fifth, this reform did not completely dispel RMB depreciation expectations. Intensifying RMB depreciation expectations forced the PBOC to stabilize the RMB exchange rate through intervening in the forex market with forex reserves, tightening controls on capital outflows, and interfering in Hong Kong SAR’s offshore markets. As a result, the “811 Exchange Rate Regime Reform” in 2015 was actually in an awkward situation of “three steps forward and two steps back”.
3 Experience of RMB Exchange Rate Regime Reform
The PBOC seeks market-based financial stability and a path to the RMB exchange rate regime reform with Chinese characteristics. Looking back, we can summarize the experience as follows.
3.1 Adopting Progressive Strategies for RMB Exchange Rate Regime Reform
Scholars have mixed reviews on adopting progressive strategies for the RMB exchange rate regime reform, with most of them agreeing it suitable for the economic development and national conditions in China. At the operational level, the PBOC used a prudent and exploratory trial-and-error approach (Wu, 2018). According to Wang and Lin (2019), the RMB exchange rate-setting mechanism was being slowly adjusted over a period of time, but no detour was taken and no serious negative impact produced on domestic economic growth and institutional reform. Guan (2017b, 2021) held China’s current exchange rate choice to be the third path, the “intermediate solution” rather than the “corner solution”.
The RMB exchange rate regime reform remains consistent in the direction even with progressive strategies. Since 1994, it has been advancing towards “a free-floating exchange rate regime based on market supply and demand”, a guideline repeatedly embodied in important conferences.
Progressive strategies are beneficial to the PBOC exchanging time for space to mitigate the negative impact brought about by the failure of reform. For families and businesses lacking experience against the risk of forex fluctuations as well as financial markets with underdeveloped forward markets, progressive strategies enable them to adapt gradually and transform with less market volatility. Behind the progressive reform, the exchange rate worked as a stabilizing anchor for industrial competitiveness and the smooth transition of economic growth engines (Fan and Xi, 2018). However, progressive strategies have disadvantages. They are likely to create space for arbitrage, such as the exchange rate spread between onshore and offshore markets; and arbitrage activities on a certain scale, such as cross-border arbitrage, could be triggered.
3.2 Avoiding Sharp Exchange Rate Fluctuations in the Near Term
In the course of reform, near-term sharp fluctuations in the exchange rate of RMB against the U.S. dollar are avoided by the PBOC for diminishing the negative impact of exchange rate overshooting on foreign trade and investment. Especially in the face of major shocks, the PBOC may keep the exchange rate of RMB against the U.S. dollar unchanged for a certain period of time to stabilize expectations of domestic and foreign market players. Say, it had temporarily pegged the RMB to the U.S. dollar in the wake of the 1997 Asian and 2008 Financial Crises.
With this experience, the PBOC deals with negative external shocks by adopting tailored strategies according to the national conditions of different times. A case was that the exchange rate of RMB against the U.S. dollar continued to maintain a bidirectional volatility after the outbreak of the coronavirus pandemic, as the PBOC did not choose to peg the RMB to the U.S. dollar again. It is because, with the times changing, both onshore and offshore markets of China have established mature forward forex markets for companies and financial institutions hedging the risk of exchange rate fluctuations. The risk awareness and sensitivity of market players have also been significantly improved. The PBOC’s strategy adjustments to negative external shocks showcased the remarkable progress China has made in the RMB exchange rate regime reform and the forex market development.
3.3 Maintaining Appropriate Capital Controls
In the course of advancing domestic financial reforms and the RMB exchange rate regime reform, the PBOC have always maintained appropriate capital controls to avoid excessive exchange rate fluctuations in the short term. A typical case was that the PBOC obviously tightened the controls on short-term capital outflows to stop a vicious cycle of deteriorating RMB depreciation expectations and short-term capital outflows after the “811 Exchange Rate Regime Reform” in 2015. In fact, China’s economy smoothly overcoming negative shocks such as the Asian Financial Crisis and the global financial crisis was inseparable from its successful capital controls.
Today, China’s capital controls are featured by “broad entry and strict exit”. With decades of progressive liberalization, China has liberalized its capital account rather wider, with the highest level in direct investment and followed by the securities investment, while money markets, derivatives and cross-border loans continue to be subject to many controls.
What kind of capital account liberalization strategy should China adopt for the next stage? A view in favor of accelerating capital account liberalization holds that if China liberalizes its capital account further, foreign capital will pour in in large numbers to offset the outflows of Chinese domestic capital, and the impact on the forex market and domestic financial markets will be limited. However, a cruel fact is that the volatility of foreign capital flows, in many cases, outweighs that of domestic capital. For example, if domestic financial markets confront negative internal and external shocks, the outflows of domestic capital and the exit of foreign capital could concur and reinforce each other. This phenomenon could be explained by China’s massive capital outflows resulted from the outbreak of the Russia-Ukraine conflict and the steep Fed’s interest rate hikes and balance sheet shrinkage in the first half of 2022. It means that for countries like China, where financial markets are not yet well established and systemic risk is accumulating, appropriate capital controls are the last firewall against systemic financial crises and cannot be easily removed.
3.4 Guaranteeing Reform Effects through Domestic Structural Reforms
Domestic structural reforms impact on the effects of RMB exchange rate regime reform. As mentioned earlier, the effects of the 1994 reform, the “721 Exchange Rate Regime Reform” in 2005 and the “811 Exchange Rate Regime Reform” in 2015 were quite varied. The 1994 reform and the “721 Exchange Rate Regime Reform” in 2005 appeared to be more successful than the latter. We believe that compared with the “811 Exchange Rate Regime Reform” in 2015, the other two were more guaranteed by major structural reforms. Deng Xiaoping’s South Tour Speeches before the 1994 reform reaffirmed the necessity and significance of deepening reform and accelerating development. The establishment of a socialist market economy boosted the confidence of micro entities. Before the “721 Exchange Rate Regime Reform” in 2005, with the accession to the WTO at the end of 2001, China’s trade and current account surpluses continued to climb, forex reserves hit new highs, and the RMB dealt with heavy appreciation pressure. Prior to the exchange rate regime reform in 2015, however, the Chinese government postponed large structural reforms because of the global financial crisis (Zhang, 2020b). To sum up, advancing major structural reforms in China boosts the confidence of micro entities and economic growth and keeps the RMB exchange rate strong, thereby offering a strong support for subsequent exchange rate regime reform.
4 Prospect of RMB Exchange Rate Regime Reform
About the prospect of the RMB exchange rate regime reform, we need to think about three questions. What is the ultimate goal of the RMB exchange rate reform? Is the macro environment in China and abroad good for realizing the ultimate goal? What is the choice of exchange rate regime during the transitional period and its safeguard measures?
4.1 Ultimate Goal of RMB Exchange Rate Regime Reform: A Free-Floating Exchange Rate
What is the future direction for the RMB exchange rate-setting mechanism? We hold that the ultimate goal pursued by the RMB exchange rate regime reform is to realize a free-floating exchange rate. First of all, China will further liberalize its capital account in the future, and a major country like China must keep its monetary policy independent, which, according to the “impossible trinity”, means the PBOC must adopt a more flexible exchange rate regime. What’s more, a free-floating RMB exchange rate will eliminate persistent overvaluation or undervaluation, and reduce the resource misallocation caused by it. Furthermore, the three-factor rule adopted by the PBOC for setting the central parity rate is unique. In essence, the reference to previous close is the reference to market supply and demand (Free Floating); stabilizing the exchange rate against the currency basket is pegging to the currency basket (Basket Pegging); and the counter-cyclical factor maintains the PBOC’s ability to intervene in exchange rates. It is a combination of three exchange rate mechanisms, capable of stabilizing the exchange rate in the short run but bringing about increasing opacity and uncertainty, and is therefore destined to be a transitional exchange rate arrangement. Finally, from international practices, nine of the top 10 economies have chosen a free-floating exchange rate regime, and it means China will make the same choice in the future.
4.2 Complex Macro Environment in China and Abroad Impeding the Ultimate Goal Realization in the Near Term
Looking at the current macro environment in China and abroad, it is not optimistic that the RMB exchange rate will be freely floating in the near term.
As far as the international environment is concerned, impacted by the coronavirus pandemic and the outbreak of the Russia-Ukraine conflict, the global economy has gradually shifted from “long stagnation” with low growth, inflation and interest rates and high debt levels to a stagflation pattern of low growth and high inflation. In 2022, in combating the rising inflation, the Fed embarked on the most aggressive rate hikes since the first half of the 1990s. For some time to come, the Fed’s monetary policy adjustments will negatively impact on China’s balance of payments, and the RMB will face large depreciation pressure. To deal with the negative impact of changes in the external environment on the formulation and implementation of China’s macroeconomic policy, the RMB exchange rate must be sufficiently flexible and necessary supervision over cross-border capital flows should keep on (Yu, 2022).
From a domestic environmental perspective, China’s economy is undergoing structural change, its economic growth is bottoming out, and systemic risk has not yet been controlled fundamentally. Theoretically, the RMB exchange rate becoming free-floating will make its fluctuations cushion against various internal and external shocks. Realistically, even the PBOC is wary of the possibility that RMB depreciation expectations and short-term capital outflows will reinforce each other or even detonate domestic systemic risk. Now the systemic risk in China’s real estate, local government debt and small and medium-sized commercial banks remain salient. In the event of sustained large short-term capital outflows, the Chinese government might have to stabilize its exchange rate by raising domestic interest rates after consuming most of its forex reserves, and significant hikes in domestic interest rates could detonate risks associated with real estate and local debt (Zhang, 2020a). To prevent these systemic risk outbreaks, the Chinese government must strengthen its management of cross-border capital flows in the short to medium term (Yu, 2020).
To prevent systemic risk, besides necessary capital flow controls, the PBOC will continue to exert its influence on RMB exchange rate decisions to some extent. Based on a long-term observation over the decision making of the PBOC, we are not optimistic about it turning to a free-floating exchange rate regime in the near term.
4.3 Exchange Rate Regime Choice during Transitional Period
A key consideration for the RMB exchange rate regime reform is how to achieve both volatility and general stability during the transitional period. For the leading reform, arranging a target zone limiting annual fluctuation brands for the CFETS currency basket will be an effective approach to balance the flexibility and stability of the RMB exchange rate. On the supporting reform, it is better to retain appropriate capital controls on the basis of combining the RMB exchange rate reform with domestic structural reforms.
4.3.1 Leading Reform
It is recommended that an annual target zone for effective exchange rate be arranged for the CFETS currency basket during the transitional period towards a free-floating exchange rate regime. For example, if the CFETS currency basket is set an annual target zone of ±10%, as long as its appreciation or depreciation is within a zone of 10% a year, the PBOC will leave the exchange rate to be decided entirely by market supply and demand without any intervention. Only when the exchange rate fluctuates more than ±10% within a year will the PBOC choose to intervene.
Different from the current exchange rate regime, arranging an annual target zone for effective exchange rate for the CFETS currency basket during the transitional period will have the advantage as follows. Firstly, it is more flexible, and will increase the flexibility and transparency of the RMB exchange rate-setting mechanism. Secondly, it can better stabilize market expectations by preventing the exchange rate from fluctuating sharply in the near term. Thirdly, it will put the RMB exchange rate on a market more independent from the U.S. dollar to make the RMB stronger as a regional anchor currency option.
Additionally, by arranging an annual target zone for effective exchange rate for the CFETS currency basket, the PBOC will get to seize new opportunities brought about by the Russia-Ukraine conflict for RMB internationalization. Today as commodity exporters such as Russia and Iran have doubts about the security of U.S. dollar assets, a good opportunity is created for China to advance RMB denomination and settlement of commodity imports; also, the attractiveness of RMB assets to overseas investors is on the rise, and to a certain extent, Chinese government bonds and financial bonds begin to feature international security assets. To seize new opportunities, the RMB exchange rate-setting mechanism which adopts an annual target zone arrangement will embrace more flexibility so that the RMB exchange rate changes based more on market supply and demand; and it will allow exchange rate changes to better reflect market expectations and boost confidence in the holding and use of the RMB.
4.3.2 Supporting Reform
Safeguard measures are indispensable in arranging the annual target zone for effective exchange rate for the CFETS currency basket. We believe the key is to maintain appropriate capital controls, and make some suggestions for it. 1) Controls on ODI and QDII need to be moderately relaxed to improve the pattern of “broad entry and strict exit”. 2) Capital account management is better to be coordinated with the macroprudential regulation that mitigates systemic risk and improves financial capacity of regulating cross-border capital flows safely. 3) The reform of the RMB interest rate-setting mechanism should be sped up. The market-based reform of the RMB interest rate-setting mechanism allows interest rates to be adjusted flexibly by changes in market supply and demand, so that arbitrage opportunities will be avoided and the continuous one-way flow of capital not triggered. 4) The PBOC needs to put appropriate controls on cross-border bank lending, the most volatile type of cross-border capital flow. 5) The Tobin tax may be introduced, as price-based measures will increase the transparency and predictability of capital controls, making resource allocation more efficient. 6) The actual-demand principle of forex management should be adjusted to make it more flexible. A more flexible approach to forex management is suggested to satisfy other forex demand of businesses and individuals, so that fluctuations in the RMB exchange rate truly reflect comprehensive market supply and demand.
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© 2023 Ming Zhang, Yinmo Chen, Published by DeGryuter
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Articles in the same Issue
- Frontmater
- Structural Evolution of RMB Exchange Rate Reform: Historical Review, Experience and Prospect
- A Study of Coordinating China’s Two-Pillar Regulatory Policy under the Shock of the Fed’s Interest Rate Hike—From the Perspective of “Stable Growth” and “Risk Prevention”
- The “Stagflation” Risk and Policy Control: Causes, Governance and Inspirations
- Robot Application and Adjustment of Export Product Scope: Can We Have Both Efficiency and Quality?
- The Effect of “Pressure-Type” Fiscal Incentives on Industrial Restructuring in China
- Convergence Analysis of Village Collective Economy Based on a Long-Term (1978–2018) Observation of 40 Villages in the Suburbs of Beijing
