Ready for RMB Reform

Ready for RMB Reform

Now that the global recovery has taken hold and with the Chinese economy gaining ground, China’s central bank—the People’s Bank of China—has decided to proceed with reform of the renminbi (yuan) exchange rate regime and improve the fexibility. The central bank’s spokesman on June 20 addressed a number of concerns over the issue in a statement posted on its website. Edited excerpts follow:

General guidelines

Starting from July 21, 2005,China has moved into a managed floating exchange rate regime based on market supply and demand with reference to a basket of currencies. The managed foating exchange rate regime is a well established policy in China. We will be following these guidelines in the reform process this time.

Progress since 2005

The reform has been a success. Starting from 2005, the renminbi 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, the reform 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 enterprises to adopt new technologies, promote innovations and enhance core competitiveness, and helped the export sector maintain overall competitiveness. Second, a floating exchange rate regime has helped improve the export structure and trade pattern, and driven China’s economic growth to become more comprehensive, balanced and sustainable. Third, exporters now are more aware of the need 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. Fourth, the reform has demonstrated to the international community China’s efforts to promote a balanced global economy.

Considerations behind China’s exchange policy

As a result of the global fnancial crisis in 2008, the global economy, including the Chinese economy, faced multiple diffculties and uncertainties. China narrowed the floating range of renminbi exchange rate as a response to the crisis. The renminbi exchange rate remained basically stable in the worst of the crisis, while a number of other major sovereign currencies depreciated against the U.S. dollar. The 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 the right choice.

Key aspects in continuing the reform

Based on the 2005 reform, the reform this time will not involve a one-off exchange rate revaluation. Market supply and demand will continue to play a fundamental role for exchange rate determination with reference to a basket of currencies. The renminbi exchange rate floating bands will remain the same as previously announced in the interbank foreign exchange market. The objective is to stabilize the renminbi exchange rate basically around an adaptive and equilibrium level, and in the meantime, to improve China’s balance of payments (BOP) situation, and achieve economic and financial stability.

Benefit from further reform

The reform serves China’s long-term and fundamental interests. First, a foating exchange rate is more responsive to changes of relative prices of domestic and external sectors, and thus helps draw resources to sectors such as the service industry driven by domestic demand. It promotes industry upgrading, improves the growth pattern, reduces trade imbalances and makes the growth less export-reliant. Second, it helps contain inflation and asset bubbles, and enables macroeconomic management to be more proactive, effective, and controllable. Third, it helps nurture strategic opportunities for China’s development. Further reforming the exchange rate regime will provide a favorable environment for international trade and investment and more strategic opportunities for longterm cooperation between China and other countries for mutual benefts.

Avoiding negative impacts

First, it is important to avoid any sharp fluctuations in the 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 largescale renminbi appreciation does not exist as the exchange rate is moving closer to its equilibrium level. Second, the orderly foating of renminbi exchange rate should refect China’s economic fundamentals and meet the needs of macroeconomic management. While a floating exchange rate will promote a more balanced BOP account in general, it does not address bilateral trade imbalances with any particular country. Third, the reform will be gradual, in line with how the corporate sector responds to changes in the exchange rate. The purpose is to maintain an orderly 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 fnancial system from major external shocks.

Right timing

China’s economic recovery has taken hold and the reform will facilitate the country’s economic restructuring by improving the growth quality and effciency. In addition, a two-way floating renminbi with greater flexibility will make macroeconomic management more proactive and effective, in response to various external shocks.

A basket of currencies used as a reference

While China now has a long and diversified list of trade partners, capital andfinancial account transactions have also diversified across the world. A basket of currencies can meet such demand and reflect the effectiveness of the renminbi more accurately. 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 a yuan-to-dollar exchange rate to the yuan's value in terms of a basket of currencies.

No large fluctuation

A large fluctuation of the renminbi exchange rate would bring considerable shocks to domestic economic and financial stability. Keeping the renminbi exchange rate basically stable at an adaptive and equilibrium level is an important element of furthering the reform. The basis for large fluctuations does not exist. China's external trade is now more balanced. The ratio of current account surplus to GDP, after a notable reduction in 2009, has been declining since the beginning of this year, together with the more balanced BOP. Efforts would be needed to improve macroeconomic management and foreign exchange administration to maintain macroeconomic and financial stability.

Impact on enterprises and employment

The corporate sector has to deal with movements in the exchange rates between home and foreign currencies in today's international monetary system where the exchange rate of major sovereign currencies is floating. In a market economy, market conditions facing firms would be constantly changing, with raw material prices, wages, demand and tax rates sometimes fluctuating more dramatically than the exchange rate. Since China began to reform and open up, many firms have developed the ability to be more flexible and adjustable to such changes. In fact, China's exports increased by an annual average of 23.4 percent, while the exchange ratesensitive industries such as the textile and light industries kept growing, without any significant losses or massive closures, between the start of the renminbi exchange rate reform in July 2005 and the breakout of the financial crisis in 2008. Exchange rate floating has become a driving force in industrial upgrading and opening up, facilitating the growth to be more balanced and sustainable. In the future, efforts will be delivered to create favorable conditions and encourage firms to make structural and product adjustments. The banking sector will continue to help enterprises manage exchange rate risks, and provide greater support for growth of these firms.

The reform will also help create jobs, particularly in the service sector. Exchange rate floating will encourage Chinese exporters to produce more high value-added products, and more jobs will be created when the production chain is extended and division of labor is improved. In particular, it will help improve resource allocation between the trade and non-trade sectors, and enable the service sector to absorb surplus labor from other sectors, particularly, the trade sectors.

Coordination with other policies

The exchange rate policy has to work together with other policies to address all the structural problems facing China's economic development. Other measures include improving the income distribution structure by increasing the share of household income, boosting consumer demand, and strengthening the social security system. It is also necessary to promote private sector particularly in the service industry through providing greater market access for private capital. Further reform of the energy pricing mechanism is also necessary to raise economic efficiency and strengthen the growth sustainability. While expanding imports, 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.

Impact on the use of foreign currencies

One primary task for the foreign exchange administration system reform is to facilitate the use of foreign currencies and holding of foreign exchange assets by domestic enterprises and households at lower costs. The reform will not increase the cost of currency exchange services at banks. In fact, the cost of currency exchange for enterprises and households in China is relatively low. Current regulations on currency exchange services at banks will continue to be effective.