Chapter 15 Reform of China’s Foreign Exchange System in 1994

Manuel Guitián, and Robert Mundell
Published Date:
June 1996
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Nanping Lu

Since China opened its doors to the outside world in 1979, serious reform has taken place in the foreign exchange system. However, during the transition period that ensued, an irrational price structure emerged, and a dual exchange rate system of both the official (swap) rate and the market rate formed. In 1994, a year of tremendous change, a number of major reform measures were implemented. First, the fixed exchange rate was replaced with a managed floating rate system and, on January 1, 1994, the official exchange rate began to be determined by the supply of and demand for foreign exchange in the market, thus putting an end to the dual exchange rate system. Up to then, enterprises had been required to surrender part of their foreign exchange earnings at the official exchange rate but could keep the rest, called foreign exchange quotas, for their own use. The use of the retained quotas had to be approved by different agencies.

The second major reform of the foreign exchange system was the decision that, as of January 1, 1994, enterprises would sell all their foreign exchange earnings to designated foreign exchange banks, thereby abolishing the retention of foreign exchange quotas and the approval mechanism for the use of foreign exchange under the current account. As a result, conditional convertibility under the current account has been achieved. When enterprises need foreign exchange, they can buy directly from the banks with renminbi and a valid certificate.

Third, when China experimented with its first foreign exchange swap market in 1985, the foreign exchange market was established in the form of foreign exchange swap centers in each administrative region. The enterprises participated directly in the market and the banks served only as brokers. The unified foreign exchange market established in 1994 is a two-tier market comprising the interbank market and the retail market. The designated foreign exchange banks are the major participants in the interbank market, in which transactions are conducted through price bidding on a nationally integrated electronic network known as the China Foreign Exchange Trading System (CFETS). The CFETS provides a clearing and settlement service as well as funds to balance the positions of the banks when necessary. The designated foreign exchange banks, while enjoying the limited flexibility of determining their individual trading rate, buy foreign exchange from, and sell it to, the enterprises in line with the market exchange rate publicized by the central bank. Meanwhile, the foreign exchange swap centers have been maintained, as part of a preferential policy granted to foreign-funded enterprises, to provide these enterprises with a transaction service in conformity with the basic exchange rate publicized by the central bank. These centers also constitute a part of the unified foreign exchange market.

In addition, the Chinese authorities have improved the foreign exchange system by strengthening the management of foreign debt and investment, abolishing foreign currency settlements of domestic transactions, terminating the issuance and circulation of foreign exchange certificates, and correcting the mechanism for collecting and reporting international balance of payments data.

The smooth operation of the new foreign exchange system shows that the objectives of China’s foreign exchange reform have been realized. Market supplies are sufficient and state reserves have increased. From April to December 1994, the total cumulative amount of foreign exchange bought by banks was $85.77 billion, and the amount sold was $51.95 billion, with a surplus of $33.83 billion. Since 1994, 22 Chinese cities have been connected to the interbank market network, and 303 financial institutions have become members. The market ran well in 1994, and transactions were brisk: settled transactions amounted to $40.77 billion. The exchange rate was basically stable at Y 8.70 per US$1 and then appreciated slightly, by 3 percent, to Y 8.45 per US$1. State reserves rose by $30.4 billion, to $51.6 billion, and then rose to 1.4 times that amount at the beginning of 1995.

The reform of the foreign exchange system has helped the economy develop in a fast, healthy, and sustained way. The stability of the exchange rate restores the population’s confidence in the renminbi, which helps counter inflation and encourages enterprises’ export business. In 1994, total external trade amounted to $236.7 billion, up 21 percent over the previous year, while exports increased by 32 percent and imports by 11 percent. The foreign investment environment improved further, and foreign direct investment amounted to $33.8 billion, up 33.4 percent over the 1993 level. The increase in state foreign exchange reserves has consolidated China’s external payments capability and strengthened its financial position, thereby laying the foundation for healthy economic development and the smooth operation of the reform package.

The reforms of the foreign exchange system have also brought China closer to its goal of establishing a socialist market economic system. Because of the success of the reforms to date, the market function of allocating foreign exchange resources under the state economic plan has improved. Also as a result of the reforms, the central bank’s foreign exchange assets have increased, introducing new challenges for its credit control mechanism. Some new operations have been delegated to the designated foreign exchange banks, creating a competitive environment for these banks in the foreign exchange business, which has furthered the commercialization of the specialized banks. Foreign exchange reform has benefited enterprises by simplifying the approval procedures for using foreign exchange, thus increasing enterprises’ liquidity. Overall, the reforms have improved economic efficiency and permitted the establishment of a modern enterprise system.

The reforms have promoted the integration of the Chinese economy with the world economy. Currently, China imposes few restrictions on foreign exchange payments under the current account and is close to meeting the obligations of Article VIII of the IMF’s Articles of Agreement. China will complete the transition from Article XIV status to Article VIII status of the IMF Agreement before 2000 by achieving convertibility of the Chinese yuan under the current account. To succeed, China must build on the current reforms, including relaxing restrictions on the use of foreign exchange for services. In addition, China must further develop the foreign exchange market and consolidate the exchange rate mechanism for its currency.

Meanwhile, the reforms pose new challenges for China’s mechanism for managing its resources. In the past, China experienced shortages of foreign exchange resources that created great pressure for depreciating the renminbi exchange rate. In 1994, the newly unified foreign exchange market reflected a different situation, that is, foreign pressure to appreciate the Chinese currency. In this case, the central bank intervened in the market and bought the excess foreign exchange to halt the depreciation of the renminbi. However, the increased state reserves caused the monetary base to expand; to offset the impact of the expansion, the central bank then took some accommodating measures and tried to maintain the money level at the 1993 level. These measures included withdrawing the central bank’s re-lending, decreasing special loans, opening special renminbi deposits, and terminating fiscal overdrafts from the central bank. In addition, management of the capital account was strengthened by restricting the inflow of short-term capital and reducing external borrowing to relax supply pressures in the market. Furthermore, enterprises were prohibited from freely swapping their foreign exchange loans and international commercial loans for renminbi because, when facing a shortage of renminbi, these enterprises are likely to borrow externally and then swap the foreign exchange for renminbi in order to discharge their domestic obligations.

In summary, the reform of the foreign exchange system has accelerated the pace of China’s efforts to marketize and internationalize its economy. Macroeconomic control in this more complicated environment must be well balanced and must draw on a combination of the experiences of the advanced industrial countries as well as Chinese characteristics in order to be feasible in the Chinese context.

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