Further reforming the RMB exchange rate regime 2010, June

Questions and answers

In view of the economic and financial development in China and abroad, particularly China’s Balance of Payments (BOP) situation, the People’s Bank of China (PBC) has decided to further reform the RMB exchange rate regime and increase the RMB exchange rate flexibility. Questions and answers below were prepared by PBC.

Q1: What are the general principles of the exchange rate regime reform?

A: In July 2005, China launched the reform of the RMB exchange rate regime and moved into a managed floating exchange rate regime based on market supply and demand with reference to a basket of currencies. The managed floating regime was established in line with the spirit of the Third Plenary Meeting of the Fourteenth CPC Congress and the Third Plenary Meeting of the Sixteenth CPC Congress. It has proved to be a right decision made in accordance with China’s domestic situation and development strategy. Deepening reform and further opening-up, especially the new development and open-up pattern after the China’s WTO accession, make this regime a logical choice, which has become an important part of China’s socialist market economy system following the scientific approach to development. The managed floating exchange rate regime is a well established policy in China. We are following these guidelines in further reforming the exchange rate regime this time.

Q2: What is your view on the developments since the RMB exchange rate regime reform in 2005?

A: The reform launched in 2005 has been a success. Starting from 2005, the RMB exchange rate regime reform, in a proactive, gradual and controllable process and as part of China’s independent policy initiatives, has been progressing in an orderly manner. Overall, it has played a positive and supportive role in China’s economic development through facilitating macroeconomic management in a changing domestic and international environment. It has produced a number of anticipated results. First, it has encouraged the corporate sector to adopt new technology, promote innovation, and enhance core competitiveness, helping China’s exports maintain an overall competitiveness. Second, a floating exchange rate regime has become a driving force in industrial upgrading and further opening-up. This helps to improve the export structure and transform the trade pattern, and drives economic growth to become more comprehensive, balanced and sustainable. Third, the export sector now has a growing awareness to adapt to exchange rate floating, which has helped them to develop a stronger ability to adapt to exchange rate movements and manage risks, and in turn contributed to the foreign exchange market development itself. Fourth, the exchange rate regime reform has demonstrated to the international community China’s efforts to promote a balanced global economy.

Q3: What are China’s exchange rate policy considerations during the global financial crisis in 2008?

A: As a result of the global financial crisis in 2008, the global economy, including the Chinese economy, has faced multiple difficulties and uncertainties. To respond to the crisis and in line with China’s economic interests, the floating range of RMB exchange rate was narrowed. The RMB exchange rate remained basically stable in the worst of the crisis, while a number of other major sovereign currencies depreciated against the US dollar. The RMB exchange rate policy helped China to uphold external demand and mitigate the shocks of the financial crisis. The renewed economic strength in China also contributed greatly to the Asian and global recovery. The experiences in the past two years have shown that it is a right choice.

Q4: In furthering the RMB exchange rate regime reform this time, what are the key aspects?

A: Following upon the reform in 2005, the reform this time does not involve a one-off exchange rate revaluation. The key remains the same in that market supply and demand will continue to play the fundamental role for exchange rate determination with reference to a basket of currencies. The RMB exchange rate floating bands will also remain the same as previously announced in the inter-bank foreign exchange market. The objective is to stabilize the RMB exchange rate basically around an adaptive and equilibrium level, and in the meantime, improve China’s BOP situation, and achieve economic and financial stability.

Q5: Will China benefit from further reforming the RMB exchange rate regime?

A: The basic objective of further reforming the RMB exchange rate is to improve the managed floating regime for the RMB exchange rate. The decision was made in view of China’s domestic conditions and its own development strategy, following the mandates of the socialist market economic reform and development in the scientific approach. All suits in China’s long-term and fundamental interests. First, it facilitates a comprehensive, balanced and sustainable development that requires structural and sector reforms. A floating exchange rate is more responsive to changes of relative prices of domestic and external sectors, and thus helps draw resources to sectors such as service industry driven by domestic demand. It promotes industry upgrading, improve growth pattern, reduce trade imbalances and make the growth less export- relied. Second, it helps contain inflation and asset bubbles, and enable macroeconomic management to be more proactive, effective, and controllable. Third, it helps nurture strategic opportunities for China’s development. China has benefited from globalization of the world economy. Further reforming the exchange rate regime will provide a favorable environment for international trade and investment and more strategic opportunities for long-term cooperation between China and other countries for mutual interest and benefits.

Q6: How to minimize the potential negative impacts of the RMB exchange rate regime reform?

A: While furthering the exchange rate regime reform provides a great deal of potential for future benefits, efforts would also be needed to minimize possible negative impacts. First, it is important to avoid any sharp and massive fluctuations of the RMB exchange rate. As China’s BOP is now moving closer to a more balanced position, prices of labor, raw materials, land and other capital goods have become higher, which raises the cost of China's export. The basis for a large-scale RMB appreciation does not exist as the RMB exchange rate is moving closer to its equilibrium level. Second, in the self-initiated process, the orderly floating of RMB exchange rate should reflect China’s economic fundamentals and meet the needs of macroeconomic management. While a floating RMB exchange rate will promote a more balanced BOP account in general, it dose not address bilateral trade imbalance with any particular country. Third, the RMB currency reform would be gradual, in view of varied degrees to which the corporate sector would respond to changes of the exchange rate. The purpose is to maintain an orderly process of industrial upgrading, maintain the international competitiveness of Chinese enterprises and provide more jobs in the service sector. Fourth, supervision and regulation on short-term capital speculation would need to be strengthened to protect China’s financial system from major external shocks.

Q7: Is it a good timing to further reform the RMB exchange rate now?

A: Several arguments support that there is a good opportunity to further reform the RMB exchange rate regime now. First, China’s economic recovery has become more solidly based, supported by enhanced economic stability. Second, it has become urgent for China to accelerate economic restructuring and improve its growth pattern, in view of the global financial crisis. The reform of the RMB exchange rate regime will facilitate economic restructuring by improving the growth quality and development efficiency. Third, a two-way floating RMB with greater flexibility will also help make the macroeconomic management more proactive and effective, in response to various external shocks.

Q8: Why is a basket of currencies, rather than just the U.S. dollar, taken as the reference for the RMB exchange rate movement?

A: As its economy becomes more opened, China’s major trading partners now include a long and diversified list. During the period of January-May this year, trading volume with top 5 trading partners (EU, the U.S., ASEAN, Japan and China’s Hong Kong SAR) accounted for 16.3 percent, 12.9 percent, 10.1 percent, 9.4 percent and 7.5 percent respectively in China’s total trade. Meanwhile, capital and financial account transactions have also diversified across various regions in the world. RMB’s floating with reference to any single currency can neither meet the diversified demand currencies in trade and investment with different partners, nor reflect its effective level. A basket of currencies can meet such demand and reflect the effective RMB level more accurately. Therefore, it is necessary for the managed floating exchange rate regime to be based on market supply and demand with reference to a basket of currencies, and thus make the RMB exchange rate more adaptive to market behaviors. As China’s trading and investment partners become more and more diversified, it would be more appropriate for enterprises and households in China to switch their attention from just RMB-to-dollar exchange rate to the RMB’s value in terms of a basket of currencies.

Q9: Will the RMB exchange rate fluctuate by a large margin?

A: A large fluctuation of the RMB exchange rate would bring considerable shocks to the domestic economic and financial stability, which is not in China’s fundamental interest. Maintaining the RMB exchange rate basically stable at an adaptive and equilibrium level is an important element of furthering the RMB exchange rate reform. The basis for large fluctuation of the RMB exchange rate does not exist. China’s external trade is now gradually becoming more balanced. The ratio of current account surplus to GDP, after a notable reduction in 2009, has been declining since the beginning of 2010, together with the more balanced BOP. The PBC will continue to work for the RMB exchange rate floating within the previously announced band in the inter-bank foreign exchange market. Efforts would be needed to improve macroeconomic management and foreign exchange administration to maintain macroeconomic and financial stability. This will facilitates China’s economic restructuring and transforming of its development model in a more proactive and effective manner. These in turn would also help create a sound policy environment for the RMB exchange rate stability.

Q10: What impact would further the exchange rate regime reform have on the corporate sector?

A: In today’s international monetary system where the exchange rate of major sovereign currencies is floating, the corporate sector has to deal with movements in the exchange rates between home and foreign currencies. Market economy implies that market conditions faced by firms would be constantly changing. Many parameters, including price of raw materials, wage, market demand, product mix, tax rate, and etc, may also change, sometimes even more significantly than the exchange rate itself. Since China began to reform and open up, its economy has become more and more market oriented, and many firms have developed the ability to be more flexible and adjustable in face of changes in market parameters. Let us look at what happened during the period between the start of RMB exchange rate regime reform in July 2005 and the financial crisis in 2008. China’s export increased by an annual average of 23.4 percent, while the exchange rate-sensitive industries such as the textile and light industries kept growing, without any significant losses or massive closures. In general, exchange rate floating has become a driving force in industrial upgrading and opening up, facilitating the growth to be more balanced and sustainable. In recent months, the global recovery is taking hold and the Chinese recovery has gained more solid ground. All these have provided favorable conditions for further reforming the exchange rate regime and reducing its potential negative impact to a minimum. Going forward, efforts will be placed to create favorable environments to encourage firms to make structural and product adjustments. The banking sector will also continue to improve financial services, help enterprises to manage the exchange rate risks, and provide greater support for growth of these firms.

Further reforming the exchange rate regime will also be supportive to job creation, particularly in the service sector. Exchange rate floating will turn Chinese exports to be high value-added product based. More jobs will be created by extending the production chains through improved division of labor. In particular, the exchange rate will help improve resource allocation between the tradable and non-tradable sectors, and thus enable the service sector to absorb surplus labor from other sectors, particularly, tradable sectors. At present, the service industry’s share in the national economy is still relatively low, which implies a greater potential for faster expansion and more job opportunities in the service industry. Overall, the positive impacts of further reforming the RMB exchange rate regime on export and job creation will outweigh the negative ones. Continued efforts will be made to create favorable conditions for firms to make sectoral and product adjustment and ensure that the exchange rate regime reform would play a positive role in promoting job creation and greater opening-up.

Q11: How to coordinate exchange rate policy with other policies to promote economic restructuring?

A: Exchange rate policy does have a positive role to play in promoting trade balance and expanding domestic demand, whereas it alone would not be enough to address all the structural problems facing China’s economic development. The exchange rate policy has to work together with other measures for structural adjustment and improvement. This, among others, includes the improvement of income distribution structure by increasing the share of household income, the boost of consumer demand, and the strengthening of the social security system. It is also necessary to promote private sector development particularly in the service sector through a greater market access for private capital. Further reform of energy pricing mechanism is also necessary to raise economic efficiency and strengthen the growth sustainability. In parallel to import expansion, the implementation of the Going Global initiative has to accelerate, and efforts will continue to make it easier for enterprises to make outward investment and for households to purchase and use foreign exchange. The supervision and regulation over capital flows have to be strengthened, and in this regard efforts to identify and penalize foreign exchange-related irregularities have to be stepped up.

Q12: Do you think further reforming the exchange rate regime will have an impact on the use of foreign exchange by enterprises and households?

A: One primary task in the foreign exchange administration system reform in China is to facilitate the use of foreign exchange and holding of foreign exchange assets by domestic enterprises and households at lower cost of currency exchanges. Further reform of the RMB exchange rate regime is not expected to increase the cost of currency exchange services offered by banks. In fact, compared with most other countries and regions, the cost of currency exchange for enterprises and households in China is relatively low. At present, the price at which enterprises and individuals purchase and sell foreign exchange at bank counters is determined by adding or deducting a certain spread from the real time price in the inter-bank foreign exchange market. Under the current regulation, the daily trading price of the RMB against the US dollar on the inter-bank foreign exchange market is allowed to float from the central parity of RMB against the U.S. dollar within a band of 0.5 percent. The spread between quoted non-cash US dollar selling and buying prices offered by banks shall not exceed 1 percent of the central parity. The spread between the quoted US dollar cash selling and buying prices offered by banks shall not exceed 4 percent of the central parity. These regulations would continue to be effective.

June, 21 th, 2010, Beijing,China

WWW.TREASURYANDFINANCE.INFO

Source: The Peoples Bank of China, WWW.PBC.GOV.CN/ENGLISH/


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