China’s exchange rate system has evolved
since its economic reforms started in 1970. Initially China adopted a centrally
planned administrative system, later between 1988 and 1993 they adopted a dual
exchange rate system where in an official fixed exchange rate coexisted with a
market determined rate in swap centers which were special foreign exchange
markets. As there was a gradual depreciation in market determined exchange rate
so by 1994 fixed exchange rate became highly overvalued. At this point the official
exchange rate was devalued and merged with market exchange rate. Also the
exchange rate policy was changed to managed float with a limited degree of
flexibility and since 1995 renminbi has been de facto pegged to US dollar.
Unlike other major economies China’s growth
is highly imbalanced with most striking imbalance being the imbalance in
balance of payment. China is having a unique situation called “Twin Surplus”
wherein it has current account surplus along with capital account surplus.
China’s foreign reserve is highest in the word and is about USD 3.44 tn.
Running twin surplus implies that China fails to buy foreign capital goods and
technology with the borrowed money; instead it lends the money back to
creditors at a very low return. Under the current de facto pegged exchange
system domestic policies are oriented to achieve an external target wherein
liquidity expands and contracts to preserve the foreign exchange rate vis-a-vis
US dollar. The particular circumstances which china faces require huge costs
for maintaining a fixed exchange rate in the form of medium and long term US
government bonds at a very low return. Also to stop capital outflow authorities
have implemented controls on bank landing which has generated a liquidity
overhang in the banking system.
Due to hard pegged exchange rate and
Capital controls China has been able to keep Renmbi moderately undervalued.
There is no doubt that a weaker exchange rate has helped China for making its
exports competitive which has played a key role in unexceptional growth made by
china in recent years. However chines authorities are also acknowledging the
challenges arising from the exchange rate regime.
In more recent times, evidence suggests
that china is facing challenges to maintain its currency’s hard peg to US
dollar. A twin surplus of China’s BOP creates appreciation pressure on the
renminbi exchange rate which requires repeated official intervention in foreign
exchange markets. People’s bank of China has conducted large scale open market
operations to sterilize the domestic monitory expansion caused by foreign
exchange intervention through sterilization bills issues by central bank and
exchanged for cash by banking system. However the cost of intervention through
US government security instruments is increasing and which in turn is
increasing the imbalance of BOP further and clearly highlight the desirability
of reforms in China to allow greater exchange flexibility. It is believed that
greater exchange rate flexibility will be beneficial from a domestic point of
view as it will improve investment decisions; however movement towards greater
exchange rate if done should be done cautiously and should be sequenced with
rectifying the weakness of the banking system and liberalizing the capital
account.