China’s Exchange Rate System

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.