RETHINKINGMACROPOLICY I: FIRST STEPSAND EARLYLESSONS APuL6-17,203 Exchange Rate Arrangement: Flexible and fixed Exchange Rate Debate Revisited Gang y The People,s bank of china Paper presented at the rethinking Macro Policy ll: First Steps and Early Lessons Conference Hosted by the International Monetary Fund Washington dc-April 16-17, 2013 The views expressed in this paper are those of the author(s)only, and the presence of them, or of links to them, on the IMF website does not imply that the IMF, its Executive Board, or its management endorses or shares the views expressed in the
Exchange Rate Arrangements: The Flexible and Fixed Exchange rate debate revisited Gang yi China as an Optimal currency area China is a large country with tremendous differences across its land. The diversities between eastern and western regions, to some extent, exceed those of the euro zone. For instance, in the eastern part of China(such as the Pearl River Delta), the per capita income is about five times that of the western part(such as the Guizhou Province and Qinghai Province), whereas inside the euro zone, Germanys per capita income is only about 1. 5 times that of greece However even with these diversities china is still better positioned as an optimal currency area than the euro zone and can issue common currency, for China satisfies several key elements that are required by an optimal currency area The first one concerns fiscal setting. China, as a sovereign country possesses a centralized fiscal transfer payment system that enables the transfer of funds from the relatively rich regions in the coastal area to the poor regions in its less-developed middle and western regions every year Second, China also has a highly mobile labor market. Many people from the low-income regions seek better job opportunities in high-income regions consequently, at least 160 million rural workers are now working in Chinas cities. Third, China has a very unified domestic market sharing an integrated system of trading and transportation domestic markets such as the commodity market and the product market, are all homogeneous. Fourth
1 Exchange Rate Arrangements: The Flexible and Fixed Exchange Rate Debate Revisited Gang Yi China as an Optimal Currency Area China is a large country with tremendous differences across its land. The diversities between eastern and western regions, to some extent, exceed those of the euro zone. For instance, in the eastern part of China (such as the Pearl River Delta), the per capita income is about five times that of the western part (such as the Guizhou Province and Qinghai Province), whereas inside the euro zone, Germany’s per capita income is only about 1.5 times that of Greece. However, even with these diversities, China is still better positioned as an optimal currency area than the euro zone and can issue a common currency, for China satisfies several key elements that are required by an optimal currency area. The first one concerns fiscal setting. China, as a sovereign country, possesses a centralized fiscal transfer payment system that enables the transfer of funds from the relatively rich regions in the coastal area to the poor regions in its less-developed middle and western regions every year. Second, China also has a highly mobile labor market. Many people from the low-income regions seek better job opportunities in high-income regions; consequently, at least 160 million rural workers are now working in China’s cities. Third, China has a very unified domestic market sharing an integrated system of trading and transportation. Domestic markets, such as the commodity market and the product market, are all homogeneous. Fourth
China' s macroeconomic policies are very effective and coordinated those are part of the reasons why china can be viewed as an optimal currency area even though the regional differences between the rich ones and the poor ones, in terms of per capita income, are still very large. As long as fiscal transfer and macroeconomic policies work well, and the labor market remains highly mobile, China as an optimal currency area will operate smoothly and stay sustainable albeit the diversities remain The other reason Id like to refer to is the ability of the chinese government to address financial systemic risks. One example was when I was involved in the tackling of financial crises as a key representative from the Peoples Bank of China. Local financial crises were breaking out in provinces or regions, including the ones in Guangdong Province and then in Hunan Province in the late 1990s, as well as the problems in Xinjiang Uygur Autonomous Region and Ningxia Hui Autonomous Region Guangdong is a developed area with many people who are very rich But in the late 1990s, Guangdong experienced major fiscal insolvency and financial institution problems. Other regions, such as Ningxia and Xinjiang, although less developed also underwent financial difficulties. When addressing these kinds of problems, we usually have to decide first whether the central bank should intervene by providing liquidity as the lender of last resort. We also need to figure out how to handle local government debt and deal with the relationship between local governments and the central government. We have to design a framework that not only can prevent moral hazard but also can calm down the crisis situation. In this way the capabilities of the Peoples Bank of China and other financial supervisors to identify problems and address potential systemic risks have been tested and
2 China’s macroeconomic policies are very effective and coordinated. Those are part of the reasons why China can be viewed as an optimal currency area, even though the regional differences between the rich ones and the poor ones, in terms of per capita income, are still very large. As long as fiscal transfer and macroeconomic policies work well, and the labor market remains highly mobile, China as an optimal currency area will operate smoothly and stay sustainable, albeit the diversities remain. The other reason I’d like to refer to is the ability of the Chinese government to address financial systemic risks. One example was when I was involved in the tackling of financial crises as a key representative from the People’s Bank of China. Local financial crises were breaking out in provinces or regions, including the ones in Guangdong Province and then in Hunan Province in the late 1990s, as well as the problems in Xinjiang Uygur Autonomous Region and Ningxia Hui Autonomous Region. Guangdong is a developed area with many people who are very rich. But in the late 1990s, Guangdong experienced major fiscal insolvency and financial institution problems. Other regions, such as Ningxia and Xinjiang, although less developed, also underwent financial difficulties. When addressing these kinds of problems, we usually have to decide first whether the central bank should intervene by providing liquidity as the lender of last resort. We also need to figure out how to handle local government debt and deal with the relationship between local governments and the central government. We have to design a framework that not only can prevent moral hazard but also can calm down the crisis situation. In this way, the capabilities of the People’s Bank of China and other financial supervisors to identify problems and address potential systemic risks have been tested and
proven, and they solidified the ground on which the common currency established Chinas Policy Choices over Exchange Rate Regimes There is continuous theoretical debate in the history of exchange rate regimes since the beginning of the 1970s, when the Bretton Woods system collapsed and exchange rate regimes of many countries kept evolving. In reality exchange rate arrangements are not the simple dichotomy of fixed or floating exchange rates According to the IMF, there are eight categories of exchange rate arrangements, and the IMF's view regarding exchange rate arrangements also evolved over time during the bretton Woods era. the imf was of the opinion that fixed exchange rate arrangements were better. Before the Argentine crisis, it argued for the bipolar view(either fixed or floating) while after the crisis it called for floating exchange rates. After 2009, the IMF took the view that exchange rate arrangements all had merits and shortcomings The floating exchange rate arrangement has several merits. First, using a floating exchange rate makes it easy to adjust to economic shocks, and the arrangement itself is less vulnerable to speculative attacks. It also helps to avoid the resource misallocation caused by exchange rate distortions. But floating exchange rate also has its problems. For example, it may cause uncertainty or excess fluctuation or overshooting and it leads to a larger exchange rate risk. Fixed exchange rate arrangements are favorable because they give rise to lower inflation(for developing countries)and facilitate more investment and trade however they also result in exchange rate distortions and are vulnerable to currency crisis and speculative capital flows
3 proven, and they solidified the ground on which the common currency is established. China’s Policy Choices over Exchange Rate Regimes There is continuous theoretical debate in the history of exchange rate regimes since the beginning of the 1970s, when the Bretton Woods system collapsed and exchange rate regimes of many countries kept evolving. In reality, exchange rate arrangements are not the simple dichotomy of fixed or floating exchange rates. According to the IMF, there are eight categories of exchange rate arrangements, and the IMF’s view regarding exchange rate arrangements also evolved over time. During the Bretton Woods era, the IMF was of the opinion that fixed exchange rate arrangements were better. Before the Argentine crisis, it argued for the bipolar view (either fixed or floating), while after the crisis it called for floating exchange rates. After 2009, the IMF took the view that exchange rate arrangements all had merits and shortcomings. The floating exchange rate arrangement has several merits. First, using a floating exchange rate makes it easy to adjust to economic shocks, and the arrangement itself is less vulnerable to speculative attacks. It also helps to avoid the resource misallocation caused by exchange rate distortions. But a floating exchange rate also has its problems. For example, it may cause uncertainty or excess fluctuation or overshooting, and it leads to a larger exchange rate risk. Fixed exchange rate arrangements are favorable because they give rise to lower inflation (for developing countries) and facilitate more investment and trade. However, they also result in exchange rate distortions and are vulnerable to currency crisis and speculative capital flows
Here I will briefly discuss China's progress in exchange rate regime reforms. In 1994, China unified the dual-track exchange rate regime, which used to offer two different foreign exchange prices of the renminbi. Since then, China has been implementing a managed floating exchange rate regime and reforms were pursued in a" mini bang approach rather than a"big bang, which perfectly suited Chinas specific circumstances. From 1994 through 2002, the real effective exchange rate (reer) of the renminbi which is regularly compiled by the Bank of International Settlements increased very rapidly together with the U.S. dollar, to which the renminbi was pegged. Between 2002 and 2005, when the U. S dollar weakened in value, the renminbi started to depreciate along with the dollar, which caused some problems and disputes In 2005. the preconditions for foreign exchange mechanism reform were broadly in place. For example, the financial reforms were well under way, and major state-owned banks were overhauled and listed (or were to be listed). The foreign exchange market was developed to a better level, and Chinas capital account was gradually opened. Most important, China was experiencing stable growth and low inflation, which provided a relatively favorable background for reform. Therefore, as the opportune time arrived China decided to de-peg the renminbi against the U.S. dollar, and hence came the more flexible renminbi exchange rates afterward. Since the 2005 reform to the end of February 2013, the renminbi nominal exchange rate to the U.S. dollar has appreciated about 32 percent, and the reer of the renminbi appreciated by more than 36 percent. The trend of the renminbi exchange rate has changed from unilateral appreciation to two-way floating and the price now falls into a broad equilibrium range
4 Here I will briefly discuss China’s progress in exchange rate regime reforms. In 1994, China unified the dual-track exchange rate regime, which used to offer two different foreign exchange prices of the renminbi. Since then, China has been implementing a managed floating exchange rate regime, and reforms were pursued in a “mini bang” approach rather than a “big bang,” which perfectly suited China’s specific circumstances. From 1994 through 2002, the real effective exchange rate (REER) of the renminbi, which is regularly compiled by the Bank of International Settlements, increased very rapidly together with the U.S. dollar, to which the renminbi was pegged. Between 2002 and 2005, when the U.S. dollar weakened in value, the renminbi started to depreciate along with the dollar, which caused some problems and disputes. In 2005, the preconditions for foreign exchange mechanism reform were broadly in place. For example, the financial reforms were well under way, and major state-owned banks were overhauled and listed (or were to be listed). The foreign exchange market was developed to a better level, and China’s capital account was gradually opened. Most important, China was experiencing stable growth and low inflation, which provided a relatively favorable background for reform. Therefore, as the opportune time arrived, China decided to de-peg the renminbi against the U.S. dollar, and hence came the more flexible renminbi exchange rates afterward. Since the 2005 reform to the end of February 2013, the renminbi nominal exchange rate to the U.S. dollar has appreciated about 32 percent, and the REER of the renminbi appreciated by more than 36 percent. The trend of the renminbi exchange rate has changed from unilateral appreciation to two-way floating and the price now falls into a broad equilibrium range