The Reform of the Renminbi Exchange Rate Regime

inSight

04 Aug 2005

The Reform of the Renminbi Exchange Rate Regime

The reform of the renminbi exchange rate regime has been smoothly conducted. There has been no sign of destabilising impacts on the global financial markets including the one in Hong Kong.

It is never easy to make transitions in exchange rate regimes. There are in fact few recent examples that were purposely initiated to bring about reforms (rather than undertaken in response to events) and even fewer that have been implemented smoothly. Often financial imbalances create market forces that precipitate a change and, when that happens, the change is often associated with a costly financial crisis. The successful re-introduction of flexibility in the exchange rate of the renminbi on 21 July 2005 is one of the rare examples of a smooth change.

The reform of the exchange rate regime of the renminbi was well planned and executed, and the People's Bank of China (PBoC), under the guidance of the State Council, is to be congratulated. It is, of course, early days yet. The new exchange rate regime has been described as "a managed floating exchange rate system", where the exchange rate is adjusted on the foundation of "market supply and demand with reference to a basket of currencies". In the present circumstances where, with capital account controls, the PBoC is the main market maker in the foreign exchange market, the task is a relatively simple one. As capital account controls are further relaxed, the task will become more difficult. Managing an exchange rate in a free market environment, where no forms are filled, no questions are asked and large deals are done electronically and globally in a matter of seconds, is very different. But I am confident that the Mainland authorities will be equal to the challenge.

In the days and months to come, financial markets worldwide will be watching the movements of the renminbi exchange rate closely. Those with a political agenda will make all kinds of comments on whether the appreciation in the exchange rate is enough. Analysts will be trying hard to work out the composition of the basket of currencies, the weighting of each currency, and what exactly is involved in determining the exchange rate with reference to the basket, rather than the exchange rate being pegged or fixed to the basket. There will also be considerable interest among central banks in the role of the PBoC in exchange rate management, for example how much independence it has and the underlying framework for making day-to-day decisions on the exchange rate. The mechanism of "making reference" to the basket implies a certain degree of flexibility. It will be of interest to all observers how this flexibility is exercised in practice and how the exchange rate policy will evolve with changes in the macroeconomic environment, such as growth, inflation, and balance of payments.

For those who have a financial interest, in whatever form, in the renminbi, I have two views to offer. First, as the economy of the Mainland integrates with that of the rest of the world, under the influence of continuing reform and liberalisation on the Mainland and of globalisation, there is little doubt that what economists call the "real effective exchange rate" of the renminbi will appreciate over time. Do not let this economic jargon put you off. It simply means that since, with the same amount of money, you can now buy a lot more on the Mainland than in (most of) the rest of the world, freer trade and movement of capital will work over time to bring the value of what you can buy in the two places closer together. This can happen in two ways. Prices on the Mainland may go up faster than those in the rest of the world or the (nominal) exchange rate of the renminbi may appreciate. These two processes may also happen in combination. Given that inflation can be quite destabilising, appreciation of the exchange rate, if managed smoothly, can be a less risky adjustment vehicle - hence the need for flexibility in the (nominal) exchange rate. However, and this is my second point, short-term movements can often deviate sharply from the long-term trend, as sentiment in the foreign exchange market sways in accordance with short-term economic developments or, as is quite common nowadays, short-term market plays by investment houses of all sorts. Even if the renminbi appreciates against other main currencies on a weighted average basis, it may depreciate against a particular currency, depending upon developments in the cross exchange rates.

Leaving aside the financial crisis of 1997-98, the reform of the renminbi exchange rate regime is comfortably the monetary event of the decade in this region, if not the world. I am glad that there has been no sign of destabilising implications so far. For Hong Kong in particular, given that our financial markets are more sensitive than those of other jurisdictions to the change because of our proximity to and economic dependence on the Mainland, it is very encouraging that it has turned out to be a non-event. Our exchange rate remains stable and our interest rates close to those of the US dollar.

 

Joseph Yam

4 August 2005

 

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