13 Exchange Rate Policy

Wanda Tseng, and Markus Rodlauer
Published Date:
February 2003
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Nicolas Blancher

Although China’s exchange rate regime is officially described as a managed float, the renminbi has in practice been tightly linked to the U.S. dollar, especially since the Asian financial crisis.1 This policy was credited with serving as an important anchor of stability, both for China and the region, during this period. However, as the region has stabilized, the question has arisen whether China should allow greater flexibility of the renminbi, particularly in light of continued rapid structural change in the economy, including as a result of World Trade Organization (WTO) accession.

China’s External Position

China’s external position, resilient during the Asian crisis, has remained strong since then. During the crisis the renminbi appreciated by about 10 percent in real effective terms, and it came under pressure in the thinly traded parallel and offshore nondeliverable forward markets. These developments gave rise to concerns that the renminbi might have become overvalued. Exports did slow sharply in 1998 (Figure 13.1), but China’s export shares held up well in major markets, suggesting that weak external demand, rather than an overvalued currency, was the main reason for the slowdown. The real appreciation reversed itself with the recovery of Asian currencies and the sustained deflation in China in recent years (Figure 13.2), and pressures in the offshore markets have since subsided.

Figure 13.1.Export Growth

(In percent)1

Source: IMF, Direction of Trade Statistics.

1Change from the preceding quarter.

Figure 13.2.Bilateral and Effective Exchange Rates

(Index, 1990=100)1

Source: IMF Information Notice System.

1A decline indicates a depreciation.

China maintained small current account surpluses (relative to GDP) during 1997–2001. Its export market share has increased steadily, particularly in the United States and the European Union (Figure 13.3). At the same time, China’s manufactured exports (which now account for 90 percent of total exports) continued to diversify across sectors, with rapid expansion in machinery and equipment, including electronic goods (Figure 13.4). China’s imports have kept pace with the expansion in exports, boosted by the rapid growth of domestic demand, foreign direct investment, and exports.

Figure 13.3.China’s Share of Foreign Import Markets

(In percent of total exports)

Source: IMF, Direction of Trade Statistics.

Figure 13.4.Product Composition of Manufactured Exports

(In billions of dollars)

Source: China Economic Information Center.

China’s accession to the WTO should support the continued expansion of the tradable goods sector (World Bank, 1997). Initially, WTO accession may have only a limited impact on China’s exports; the impact on imports is expected to be more significant as market opening and larger investment inflows are likely to boost imports before export gains materialize. In the longer run, however, WTO accession should contribute to sustained export growth, broadly offsetting the initial import expansion (see Chapter 12).

China’s overall external position is strong, as shown by the evolution of key indicators of external vulnerability in recent years:

  • China’s international reserves are equivalent to nine months of imports and more than three times its short-term external debt.2

  • China’s external debt relative to its GDP (as well as to exports) is small and has been declining in recent years.

  • China’s capital account is relatively closed to debt-creating flows, with most capital inflows coming in the form of foreign direct investment.

The Case for Greater Exchange Rate Flexibility

Although the stability of the renminbi has served China and the region well in recent years, a number of considerations suggest that greater exchange rate flexibility will be beneficial to the Chinese economy going forward, especially after China’s accession to the WTO. This assessment is based on the following:

  • The impact of the multitude of ongoing structural changes on the equilibrium exchange rate is difficult to ascertain. For example, further trade liberalization could result in its decline, but rapid productivity gains in China’s traded goods sector would put upward pressure on it. Such productivity gains should materialize from continued reform of state-owned enterprises, growth of the nonstate sector, and technology transfers from inward foreign direct investment.

  • China’s economy does not form an optimum currency area with the U.S. economy, because the two economies are subject to different shocks. However, under the current regime, the volatility of the renminbi’s effective exchange rate closely reflects that of the dollar. To better achieve effective exchange rate stability and cope with a greater variety of external shocks, making the renminbi exchange rate more flexible is a prerequisite.

  • China has used its control over capital movements to combine a fixed exchange rate with an independent monetary policy. However, capital controls are not watertight, will likely become more porous over time, and are eventually to be removed: convertibility of the renminbi is a stated, and appropriate, long-term policy goal. Preserving monetary independence will thus increasingly require a more flexible exchange rate.

  • China is facing a proliferation of floating exchange rate regimes in the rest of the world, especially in Asia. In this context, if the region is hit by a shock and neighboring countries’ currencies adjust, keeping the renminbi stable vis-à-vis the dollar implies that a relatively heavier share of the adjustment burden will fall on China’s domestic economy.

  • Factor markets in China are not very flexible, and the scope for fiscal policy to help the adjustment to shocks is narrowing. Capital mobility between regions is limited, and wages and prices are not fully market determined, despite progress in increasing their flexibility. The insufficient availability of skilled labor creates bottlenecks in some fast-growing sectors.

  • China has a large and relatively diversified economy, which seems well positioned to absorb exchange rate fluctuations. Indeed, China resembles other large economies, which nearly without exception have more flexible exchange rate arrangements in place (Gao, 2000).

  • As recent international experience has illustrated, defending rigid exchange rate regimes becomes increasingly difficult with growing capital mobility, and greater flexibility helps reduce the risk of sharp capital flow reversals (Mussa and others, 2000).

These considerations suggest that, from a medium-term perspective, greater exchange rate flexibility would be more appropriate for China. Furthermore, China’s external position allows it to make a gradual move toward greater flexibility from a position of strength.

Modalities and Supporting Measures

Greater flexibility of the exchange rate is desirable, but the move should be gradual and carefully prepared. Current conditions do not support a free float. Instead a gradual move not only would give time for the corporate and banking sectors to adjust, but also would allow the development of China’s foreign exchange market infrastructure and regulatory framework (IMF, 1998).

Successful transition to a situation where market forces play a progressively larger role in exchange rate determination requires a comprehensive and well-sequenced set of supporting measures (Ping, 2000). A key priority is to strengthen the foreign exchange market, especially to give market participants greater freedom in handling foreign exchange and hedging against foreign exchange risk.3 A number of measures are needed to allow for trading to develop and for market participants to use exchange rate flexibility effectively. Key among these are:

  • Allowing enterprises greater flexibility to choose the bank with which they conduct their foreign exchange business and further reducing surrender requirements

  • Easing restrictions on foreign exchange market entry and increasing the number of instruments available for foreign exchange risk management

  • Strengthening the functioning and capacity of the foreign exchange market, for example by introducing two-way quotes, extending trading sessions, and improving settlement procedures.

In parallel, prudential regulation and supervision of banks’ foreign exchange transactions will need to be upgraded, in line with international best practice and prudential rules on foreign exchange risks established by the Basel Committee on Banking Supervision. Specifically, foreign currency lending of banks should be monitored closely to ensure that loans are extended only to borrowers with foreign currency earnings, and effective limits should be placed on banks’ open foreign currency positions (including off-balance sheet activities). These positions should cover branches of domestic banks operating outside of China. Close prudential supervision of the quality and liquidity of banks’ foreign currency assets is also essential.

More broadly, greater exchange rate flexibility is part and parcel of China’s comprehensive and intertwined market-oriented reforms. In particular, it needs to be supported by further progress in reforming the financial sector, the state-owned enterprises (SOEs), and monetary policy (Mehran and others, 1996):

  • Financial sector reform. With banks playing a pivotal role in the foreign exchange market, strengthening the banking sector will be key (see Chapter 10).

  • SOE reforms. To become effective market participants, SOEs will need to strengthen their financial performance and capacity to manage risks, including foreign exchange risk (Chapter 9).

  • Monetary policy and money markets. With greater exchange rate flexibility, a greater burden will fall on monetary policy to ensure price stability. This points to the need for the People’s Bank of China to further strengthen its monetary management, including by fostering the development of the money market and indirect monetary instruments.


Although the policy of keeping the exchange rate stable served China well during the Asian crisis, the Chinese economy would benefit from greater exchange rate flexibility. In particular, in the wake of WTO accession and as China integrates further into the global economy, greater exchange rate flexibility would help China adjust to structural changes and potential shocks, preserve its monetary independence, and limit the risk of sudden capital flow reversals.

Successful transition to greater flexibility requires a range of supporting measures to strengthen the foreign exchange market. It also needs to be accompanied by continued progress in other market-oriented reforms, especially in the banking and SOE sectors.


    GaoHaihong2000“Exchange Rate Policy: Possible Choices for China and Other Asian Economies,”World Economy & ChinaVol. 8No. 4 (July–August).

    International Monetary Fund1998“Exit Strategies—Policy Options for Countries Seeking Exchange Rate Flexibility” Occasional Paper No. 168 (Washington: International Monetary Fund).

    MehranHassanaliMarcQuintynTomNordman and BernardLaurens1996“Monetary and Exchange System Reforms in China” Occasional Paper No. 141 (Washington: International Monetary Fund).

    MussaMichaelPaulMassonAlexanderSwobodaEstebanJadresicPauloMauro and AndyBerg2000“Exchange Rate Regimes in an Increasingly Integrated World Economy” Occasional Paper No. 193 (Washington: International Monetary Fund).

    PingXie2000“The Convertibility of the RMB and China’s Exchange Rate Policies,”World Economy & ChinaVol. 8No. 4 (July–August).

    World Bank1997China 2020—Development Challenges in the New Century (Washington: World Bank).

    ZeeWinston1999China Forex Handbook (Hong Kong: Asian Information Associates).

Following the unification of the renminbi exchange rate in 1994, the People’s Bank of China (PBC) has limited movements of the renminbi against the dollar to plus or minus 0.3 percent around a reference rate. Since the Asian crisis the renminbi has been kept within an even smaller range of plus or minus 0.02 percent. More recently it has been allowed to move slightly outside this narrower range (mainly on the appreciated side).

In this calculation short-term external debt is measured by remaining maturity and based on the revised debt data categories released by the authorities in November 2001.

The current foreign exchange trading system (the Shanghai-based China Foreign Exchange Trading System) was established in 1994 as a nationally integrated electronic system for spot interbank foreign exchange trading (Zee, 1999). There is also a small onshore forward market.

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