RENMINBI EXCHANGE RATES AND RELEVANT INSTITUTIONAL FACTORS Yi gang In recent years, China has experienced rapid social and economic development. Against this backdrop, growing pressure for renminbi appreciation emerged and Chinas trade surplus and foreign reserves increased rapidly. This article explains the development of the RMB exchange rate by examining productivity growth and institutional fac tors, such as the transformation of the foreign exchange rate system and legal reforms to strengthen the rule of law Development of the Renminbi Exchange Rate On January 1, 1994, China unified the"dual" exchange rate s gime into a single one. The official rate before January 1, 1994 was RMB per USD and 8.7 RMB per USD after exchange rate uni- fication. Some observers argued that China depreciated the RMB by 40 percent in 1994. However, that argument is a misconception Before 1994, China was still under the"dual"exchange rate egime, under which 80 percent of the foreign exchange trading vol- ume was at the market rate, and only 20 percent at the official rate The 8.7 RMB per USD rate was basically the market rate at the end of 1993. During 1993, the supply of foreign exchange mainly consis ed of two sources: (1) joint-venture firms that were allowed to retain their foreign exchange, and (2) domestic export companies that had excess foreign exchange retained under the foreign exchange Cato Joumal, VoL 2S, No. 2(Spring/Summer 200S). Copyright Cato Institute. All rights reserved. Yi Gang is Assistant Governor of the People's Bank of China
Renminbi Exchange Rates and Relevant Institutional Factors Yi Gang In recent years, China has experienced rapid social and economic development. Against this backdrop, growing pressure for renminbi appreciation emerged and China’s trade surplus and foreign reserves increased rapidly. This article explains the development of the RMB exchange rate by examining productivity growth and institutional factors, such as the transformation of the foreign exchange rate system and legal reforms to strengthen the rule of law. Development of the Renminbi Exchange Rate On January 1, 1994, China unified the “dual” exchange rate regime into a single one. The official rate before January 1, 1994 was 5.8 RMB per USD and 8.7 RMB per USD after exchange rate unification. Some observers argued that China depreciated the RMB by 40 percent in 1994. However, that argument is a misconception. Before 1994, China was still under the “dual” exchange rate regime, under which 80 percent of the foreign exchange trading volume was at the market rate, and only 20 percent at the official rate. The 8.7 RMB per USD rate was basically the market rate at the end of 1993. During 1993, the supply of foreign exchange mainly consisted of two sources: (1) joint-venture firms that were allowed to retain their foreign exchange, and (2) domestic export companies that had excess foreign exchange retained under the foreign exchange Cato Journal, Vol. 28, No. 2 (Spring/Summer 2008). Copyright © Cato Institute. All rights reserved. Yi Gang is Assistant Governor of the People’s Bank of China. 187
CATO JOURNAL retention system. Under the"dual" exchange rate regime, if a firm needed foreign exchange to import, it could obtain foreign exchange through three channels: (1)buy foreign exchange at the market rate, (2)buy a quota from the market and use the quota to purchase for- eign exchange at the official rate, and (3)apply for a quota from the State Administration of Foreign Exchange(SAFE)and use the quota to buy foreign exchange at the official rate. The price of a quota was roughly the difference between the official and the market rates. My estimation is that the weighted average of the rmb exchange rate depreciated by 4 percent vis-a-vis the dollar in 1993, compared with the 8.7 RMB per USD as the starting rate of the new regime at the beginning of 1994(Table 1). The trade surplus in 1994 was very nodest, only $5. 4 billion. And the trade surplus for 1995-2004 was fairly stable, indicating that the rmb/USd exchange rate was close to its equilibrium level. The appreciation pressure afterward was partly driven by the productivity gains and the institutional reasons explained in this article, and partly by the weakening of U.S. dollar, especially since 2002. Since 1994, China has been promoting market-oriented reform of the rmb exchange rate mechanism. Three stages can be delineated 1. 1994-96: a single and managed floating exchange rate regime based on market supply and demand. During this period, the nominal rmb/usd exchange rate rose by nearly 5 percent 2. 1997-2005 after the 1997-98 Asian financial crisis Chin maintained a stable exchange rate at 8.28 RMB per USD 3 July 2005-present: China reformed the RMB exchange rate regime by moving to a managed float based on market suppl and demand with reference to a basket of currencies. The new system features and expanded floating band, an improved spot rate formation mechanism the establishment of a forward mar- ket, reformed open market operations, and a more market-ori- ented foreign exchange management mechanism From July 21, 2005, to the end of November 2007, the RMB appreciated by a total of 12 percent against the USD. According to the Bank for International Settlements. the nominal effective exchange rate index for the RMB increased by 40.9 percent from January 1994 to February 2002, decreased by 13. 1 percent fron February 2002 to July 2005, and rose again by 2. 1 percent from July
188 Cato Journal retention system. Under the “dual” exchange rate regime, if a firm needed foreign exchange to import, it could obtain foreign exchange through three channels: (1) buy foreign exchange at the market rate, (2) buy a quota from the market and use the quota to purchase foreign exchange at the official rate, and (3) apply for a quota from the State Administration of Foreign Exchange (SAFE) and use the quota to buy foreign exchange at the official rate. The price of a quota was roughly the difference between the official and the market rates. My estimation is that the weighted average of the RMB exchange rate depreciated by 4 percent vis-à-vis the dollar in 1993, compared with the 8.7 RMB per USD as the starting rate of the new regime at the beginning of 1994 (Table 1). The trade surplus in 1994 was very modest, only $5.4 billion. And the trade surplus for 1995–2004 was fairly stable, indicating that the RMB/USD exchange rate was close to its equilibrium level. The appreciation pressure afterward was partly driven by the productivity gains and the institutional reasons explained in this article, and partly by the weakening of U.S. dollar, especially since 2002. Since 1994, China has been promoting market-oriented reform of the RMB exchange rate mechanism. Three stages can be delineated: 1. 1994–96: a single and managed floating exchange rate regime based on market supply and demand. During this period, the nominal RMB/USD exchange rate rose by nearly 5 percent. 2. 1997–2005: after the 1997–98 Asian financial crisis China maintained a stable exchange rate at 8.28 RMB per USD. 3. July 2005–present: China reformed the RMB exchange rate regime by moving to a managed float based on market supply and demand with reference to a basket of currencies. The new system features and expanded floating band, an improved spot rate formation mechanism, the establishment of a forward market, reformed open market operations, and a more market-oriented foreign exchange management mechanism. From July 21, 2005, to the end of November 2007, the RMB appreciated by a total of 12 percent against the USD. According to the Bank for International Settlements, the nominal effective exchange rate index for the RMB increased by 40.9 percent from January 1994 to February 2002, decreased by 13.1 percent from February 2002 to July 2005, and rose again by 2.1 percent from July
RENMINBI EXCHANGE RATES TABLE I RMB DEPRECIATION VIS-A-VIS THE US DOLLAR. 1993-94 Official Market Weighted Average Rate Rate RMB/USD RMB/USD RMB/USD 199301 5.22 199302 5.22 7.72 1993.03 1993.04 5.70 8.20 7.70 1993.05 5.70 7.70 1993.06 10.07 19930 5.70 10.10 1993.08 570 10.70 9.70 1993.09 5.70 10.00 9.14 1993.10 5.70 1993.11 1993.12 5.80 8.70 1993 Average 9.04 1994 Regime Change 8.70 Change in Exchange Rate(%) The official rate is weighted at 20 percent and the market rate at 80 percent SOURCE: State Administration of Foreign Exchange 2005 to November 2007. The real effective exchange rate index for the RMB rose by 58 percent from January 1994 to February 2002, decreased by 16. 5 percent from February 2002 to July 2005, and then rose by 6.6 percent from July 2005 to November 2007 Exchange Rate Theory and Application in China he exchange rate is the relative price of two currencies, reflecting the relative prices of factors, assets, and all products in two countries
2005 to November 2007. The real effective exchange rate index for the RMB rose by 58 percent from January 1994 to February 2002, decreased by 16.5 percent from February 2002 to July 2005, and then rose by 6.6 percent from July 2005 to November 2007. Exchange Rate: Theory and Application in China The exchange rate is the relative price of two currencies, reflecting the relative prices of factors, assets, and all products in two countries. 189 Renminbi Exchange Rates table 1 RMB Depreciation vis-à-vis the U.S. Dollar, 1993–94 Official Market Weighted Average Rate Rate Rate* RMB/USD RMB/USD RMB/USD 1993.01 5.22 7.00 6.64 1993.02 5.22 8.34 7.72 1993.03 5.22 8.20 7.60 1993.04 5.70 8.20 7.70 1993.05 5.70 8.20 7.70 1993.06 5.70 10.07 9.20 1993.07 5.70 11.20 10.10 1993.08 5.70 10.70 9.70 1993.09 5.70 10.00 9.14 1993.10 5.70 9.00 8.34 1993.11 5.80 8.90 8.28 1993.12 5.80 8.70 8.12 1993 Average 5.60 9.04 8.35 1994 Regime Change 8.70 Change in Exchange Rate (%) –35.67 3.94 –3.98 *The official rate is weighted at 20 percent and the market rate at 80 percent. Source: State Administration of Foreign Exchange
CATO JOURNAL A country can choose between a fixed or flexible foreign exchange rate regime; and the selection, in turn, affects the effectiveness of monetary and other macroeconomic policies Key theories related to the exchange rate regime include the"dual istic conflict"and the"impossible triangle. " The former, as explained in the Mundell-Fleming model under the assumption of free capital flows, demonstrated that monetary policy is ineffective in a fixed exchange rate arrangement, but effective under a floating arrange- ment. That is, the independence of monetary policy conflicts with the ixed exchange rate regime, and you can have only one of them. The theory of the"impossible triangle"(Obstfeld and Taylor 1998)expand ed the Mundell-Fleming model, and showed that a govemment can only select two out of the following three goals: an independent mon- etary policy, a fixed exchange rate, and capital mobility However, neither theory can explain any other combination except for the extreme ("comer solution")cases of these three elements, which can be applied to the current situation in China. Yi Gang and Tang Xuan 2001)developed a more general theory of the"expanded triangle, and argued"an economy shall opt for different exchange rate systems in dif ferent stages. "In cases of insignificant capital flows and less-developed derivative markets, an"intermediate "solution can help economic enti- ties manage exchange rate risks. However, in case of large-scale capital flows and developed derivative products, a country has to take specula- tive attacks in addition to exchange rate risks into consideration when an intermediary arrangement is adopted, the subsequent moral hazard and confidence crisis may turn out to be the root causes of monetary cri- sis.Therefore, after the free flow of capital is achieved, the exchange rate ystem will acquire added flexibility or turn into a currency coalition. Eventually, the"comer solution" will prevail A large economy like China cannot give up the independence of monetary policy. Therefore, China has to choose between a fixed exchange rate and the free flow of capital; in a sense, it has to choose between stability and efficiency (Yi 2000). Over the long run, China bound to have a free flow of capital and a floating exchange rate regime Labor Productivity and Total Factor Productivity Changes A number of factors have contributed to the fluctuation of rmB exchange rates. These factors include, among others, labor produc tivity and total factor productivity
A country can choose between a fixed or flexible foreign exchange rate regime; and the selection, in turn, affects the effectiveness of monetary and other macroeconomic policies. Key theories related to the exchange rate regime include the “dualistic conflict” and the “impossible triangle.” The former, as explained in the Mundell-Fleming model under the assumption of free capital flows, demonstrated that monetary policy is ineffective in a fixed exchange rate arrangement, but effective under a floating arrangement. That is, the independence of monetary policy conflicts with the fixed exchange rate regime, and you can have only one of them. The theory of the “impossible triangle” (Obstfeld and Taylor 1998) expanded the Mundell-Fleming model, and showed that a government can only select two out of the following three goals: an independent monetary policy, a fixed exchange rate, and capital mobility. However, neither theory can explain any other combination except for the extreme (“corner solution”) cases of these three elements, which can be applied to the current situation in China. Yi Gang and Tang Xuan (2001) developed a more general theory of the “expanded triangle,” and argued “an economy shall opt for different exchange rate systems in different stages.” In cases of insignificant capital flows and less-developed derivative markets, an “intermediate” solution can help economic entities manage exchange rate risks. However, in case of large-scale capital flows and developed derivative products, a country has to take speculative attacks in addition to exchange rate risks into consideration. When an intermediary arrangement is adopted, the subsequent moral hazard and confidence crisis may turn out to be the root causes of monetary crisis. Therefore, after the free flow of capital is achieved, the exchange rate system will acquire added flexibility or turn into a currency coalition. Eventually, the “corner solution” will prevail. A large economy like China cannot give up the independence of monetary policy. Therefore, China has to choose between a fixed exchange rate and the free flow of capital; in a sense, it has to choose between stability and efficiency (Yi 2000). Over the long run, China is bound to have a free flow of capital and a floating exchange rate regime. Labor Productivity and Total Factor Productivity Changes A number of factors have contributed to the fluctuation of RMB exchange rates. These factors include, among others, labor productivity and total factor productivity. 190 Cato Journal
RENMINBI EXCHANGE RATES China has maintained an average annual GDP growth rate of 9.7 ercent from 1978 to 2006, and the rate has exceeded 10 percent since 2003. The key contributing factors are enhanced labor produc- ivity and total factor productivity. Such enhancements are at the core for Chinas increased competitiveness and are the most impor- tant contributing factors for the evolvement of Chinas macroeco- nomic policies, trade surplus, and foreign exchange reserves Labor Productivity Chinas labor productivity( total output per worker) has skyrocket- d from 1, 586 RMB per worker in 1990 to 5, 747 in 2005, resulting in an annual average growth rate of 8.96 percent(Table 2). This increase is largely due to rapid urbanization during which rural work ers have enhanced their human capital with better education and TABLE 2 LABOR PRODUCTIVITY. 1990-2005 Labor GDP Productivity Productivity rMb billion (RMB billion, (Annual based on fixed Employment based on fixed growth price in 1978) (Millions) price in 1978) rate, % 1990 1,02685 647.49 1585.9 654.91 1,712.09 1,830.9s 2373.75 3.36050 2,554 3578.62 2,76999 720.85 384267 738 3.000.00 730.25 4,108.18 3,272 2003 3.600.73 74432 4837.61 3.963.79 52.00 5271.00 2005 758.25 5.747.23 Average growth rate of labor productivity from 1990 to 2005 8.96 SOURCE: CEIO
191 Renminbi Exchange Rates China has maintained an average annual GDP growth rate of 9.7 percent from 1978 to 2006, and the rate has exceeded 10 percent since 2003. The key contributing factors are enhanced labor productivity and total factor productivity. Such enhancements are at the core for China’s increased competitiveness and are the most important contributing factors for the evolvement of China’s macroeconomic policies, trade surplus, and foreign exchange reserves. Labor Productivity China’s labor productivity (total output per worker) has skyrocketed from 1,586 RMB per worker in 1990 to 5,747 in 2005, resulting in an annual average growth rate of 8.96 percent (Table 2). This increase is largely due to rapid urbanization during which rural workers have enhanced their human capital with better education and table 2 Labor Productivity, 1990–2005 Labor Labor GDP Productivity Productivity (RMB billion, (RMB billion, (Annual based on fixed Employment based on fixed growth price in 1978) (Millions) price in 1978) rate, %) 1990 1,026.85 647.49 1,585.90 — 1991 1,121.26 654.91 1,712.09 7.96 1995 1,830.98 680.65 2,690.05 9.94 1998 2,373.75 706.37 3,360.50 6.59 1999 2,554.92 713.94 3,578.62 6.49 2000 2,769.99 720.85 3,842.67 7.38 2001 3,000.00 730.25 4,108.18 6.91 2002 3,272.66 737.40 4,438.11 8.03 2003 3,600.73 744.32 4,837.61 9.00 2004 3,963.79 752.00 5,271.00 8.96 2005 4,357.84 758.25 5,747.23 9.03 Average growth rate of labor productivity from 1990 to 2005 8.96 Source: CEIC