Exchange Rate Choices and China"s Managed Float

By Guan Tao

A market-based exchange rate is the general objective and exchange rate policy is always about selecting the appropriate approach at the appropriate time.

In early 1994, the renminbi"s of fi cial exchange rate was merged with the exchange rate of the foreign exchange adjustment market, thereby establishing a single managed fl oat system based on market supply and demand. China’s experience stands in contrast to a completely fi xed exchange rate or a completely free- fl oating exchange rate. After reviewing the exchange rate reforms of the past two decades or so, it is clear that a market-based exchange rate is the general objective and exchange rate policy is always about selecting the appropriate approach at the appropriate time.

There has long been much controversy over what constitutes the best exchange rate system and what policies should be applied. The general consensus is that there are advantages and disadvantages to both fi xed and fl oating rate systems. No system fi ts all countries -- or even certain countries -- all of the time. For the government,a managed fl oating exchange rate system means foregoing the bene fi ts of the fi xed exchange rate or the freefl oating exchange rate. At the same time, the government has been criticized for the cost of maintaining an exchange rate under a managed fl oat system.

Over the past two decades, China has set various policies under the framework of a managed fl oat, and there has been no shortage of controversy. During the Asian fi nancial crisis, when Asian currencies depreciated sharply and the renminbi faced strong downward pressure, the West unfairly accused China of setting the stage for the crisis with its fi rst adjustment of the renminbi exchange rate in early 1994. In order to counter this argument while safeguarding domestic fi nancial stability and shouldering some of the responsibility of a world economic power, China chose to prevent the renminbi from depreciating. It held the currency stable at around 8.28 to one US dollar. This avoided further competitive devaluations, making an important contribution to fi nancial stability in Asia and the rest of the world.However, eventually an appreciation of the renminbi against the US dollar and other currencies increased dif fi culties for Chinese exporters, which aggravated the nation"s domestic de fl ationary trend. Obviously, holding the renminbi steady was the correct policy choice but it came at a price.

After the August 11, 2015 exchange rate reform, which effectively devalued the renminbi, China once again faced pressure from capital out fl ows. At that point, China opted for a managed fl oating exchange rate, allowing the renminbi to trade in accordance with market supply and demand but with a reference to a basket of currencies. To a certain extent, this eased pressure from an overvalued renminbi due to the past appreciation of the US dollar. It promoted a balanced and reasonable exchange rate for the renminbi,although it brought about certain challenges. As the US dollar continued to strengthen in the offshore market, the renminbi’s exchange rate against the dollar continued to fall on the domestic market. This led to market panic and an acceleration of capital out fl ows. By the end of 2016,the renminbi exchange rate had weakened beyond seven to the dollar and the nation’s foreign exchange reserves had slipped to only a shade more than US$3 trillion. That prompted heated policy debates over whether to maintain stability in the exchange rate or stabilize foreign reserves.

The insistence on maintaining a managed fl oating exchange rate revealed a series of problems. But were there no risks in other exchange rate choices? Had the currency been allowed to fl oat in the early stages, a very sharp depreciation would have been highly likely. Before the economy stabilized, it was dif fi cult to predict when the renminbi exchange rate would touch bottom. Moreover,renminbi depreciation would have led to competitive devaluations, incurring more trade protectionism against China. That in turn would have triggered panic buying of foreign exchange on the home market, threatening the security of the banking system and causing other unforeseen risks.

There is no perfect solution to the exchange rate problem.The key is determining the target as soon as possible.In addition, the tools must match the target. We should not hastily conclude that advantages outweigh disadvantages or that risks are always controllable. Instead,it is necessary to focus on the risks that each option may present, by preparing the corresponding plans on the basis of scenario analysis and stress testing.

It is impossible to extract only the advantages when dealing with the impact of capital fl ows. When there is an imbalance of supply and demand on the foreign exchange market, it is necessary to let the currency appreciate or depreciate, and it may be necessary to use foreign exchange reserves to intervene in the market or strengthen capital fl ow management. In reality, it is impossible to maintain the exchange rate as well as reserves, and to continue the free cross-border fl ow of capital at the same time.The author calls this the"impossible triangle of foreign exchange policy."

During the Asian fi nancial crisis, China chose not to depreciate the renminbi,and not to use up foreign exchange reserves to maintain exchange rate stability. Instead, it dealt with potential capital out fl ows by strengthening and improving foreign exchange management, including cracking down on underreporting of exports and import fraud, as well as limiting the use of foreign exchange under the capital account.

After the exchange reform of July 21, 2005 and the return of the renminbi exchange rate system to a managed fl oating rate, China adopted the following measures to deal with the impact of capital in fl ows. First, it worked to maintain the basic stability of the renminbi at a reasonable and balanced level. Eventually,the renminbi exchange rate against the US dollar began to improve gradually. Second,China worked to accumulate foreign exchange reserves in accordance with the pool theory by absorbing excess capital in fl ows. At the end of 2006, after making clear that China did not aim to pursue endless increases in its foreign exchange holdings, reserves still reached nearly US$3 trillion. The idea of controlling capital in fl ows and stepping up out fl ows gained support and this improved capital fl ow management.

Since the second quarter of 2014, and especially after the 2015 exchange reform, China experienced a long period of capital out fl ows. In response, China adopted a threepronged approach. Because it had long been judged that China had suf fi cient foreign exchange reserves, the reserves were used as an intervention tool to bridge the gap between foreign exchange supply and demand. After the 2015 reform, market adjustments took on a bigger role, though there was a reference to a basket of currencies. The currency fl uctuated inversely against the US dollar as the dollar index changed. When both the intervention and the exchange rate adjustment were not suf fi cient to reorder the market,China began to adjust its capital fl ow management policies.Especially in late 2016, the management of capital out fl ows was strengthened step by step, and in the process more time was gained for reform. In 2017, overseas investments of enterprises became more rational and there was a total surplus from the current account and direct investment.Foreign exchange reserves, adjusted for valuation changes,were no longer falling. This resolved the risks from capital fl ows, which safeguarded China’s national fi nancial security.

The three policy instruments of exchange rate adjustment, reserve intervention and capital management are neither intrinsically good nor bad. The key is to make policy objectives clear and thus select the appropriate policy tools. Certainly, it is imperative that we pay attention to the details in managing capital fl ows and meet our international obligations. Meanwhile, exchange rate management buys time for reforms, but it should not be seen as a substitute for reform. Some management measures must be temporary.When the situation improves, these measures should be withdrawn in a timely manner. And that is when China should return to policy neutrality.

Credibility — the Key to Success

After the 2015 exchange reform, the mechanics of the mid-price quotation mechanism were disclosed in a move to boost transparency. This improved communication between the central bank and the market, and there were clear bene fi ts as a result. In the second half of 2016, for example,when the renminbi fell against the US dollar, the negative impact on sentiment was less pronounced than in the past. The market understood that the weakening of the renminbi was due to a strong US dollar instead of a"currency war." Nevertheless,because nearly 90% of China"s cross-border foreign currency payments were in US dollars,the signi fi cant decline in the exchange rate still had an impact on sentiment.

The key to successfully maintaining the stability of the renminbi exchange rate in 2017 was to reshape the credibility of the government role in the market. At the end of May, the counter-cyclical factor was introduced into the mid-price quotation mechanism to offset procyclical behavior of the foreign exchange market.This was done to better re fl ect domestic economic fundamentals and take the initiative in determining exchange rate direction. In the context of the market betting on renminbi weakness and with foreign exchange in short supply, the renminbi actually appreciated by more than 6% against the US currency, aided by a stabilizing domestic economy and the unexpectedly weaker US dollar. During the same period, foreign exchange settlements by enterprises increased substantially, purchases of foreign exchange remained basically stable, and foreign exchange supply and demand were largely in balance. At the same time, the goal of securing foreign reserves was successfully achieved.Utimately, the objective was to maintain con fi dence rather than target speci fi c levels for the exchange rate or the size of foreign exchange reserves. With the problem of con fi dence solved and the exchange rate stabilized, the nation"s foreign reserves were protected.

This shows that credibility is the key to successful exchange rate policies.Stabilizing market con fi dence and expectations relies on communication as well as market operations. Credible price signals are necessary to ensuring the effectiveness of capital fl ow management.

All in the Timing

There is no "best time"for exchange rate reform.In theory, when the market situation is good, the risks of exchange rate reform are relatively small; when the market situation is poor, the risks are greater. However,judging from the experience of the past two decades,the so-called "best time" for such reforms requires more discussion.

For example, the 1994 currency reform was initiated under the unfavorable conditions of an overheated domestic economy and strong expectations of renminbi depreciation. At that time,it was widely believed that the goals of stabilizing the exchange rate and increasing foreign reserves could not be reached at the same time. However, due to the successful macroeconomic controls and the comprehensive reforms,the reform goals were achieved beyond expectations. The renminbi shifted from weakness to strength, and foreign exchange reserves rose steadily.

In another example, at the end of 2011, due to the impact of debt problems in Europe and the US, China experienced a rare situation of net capital out fl ows. In December of that year, the domestic market price of the renminbi against the dollar fell continuously. For the fi rst time, the quota for renminbi purchases and sales in the Hong Kong market was used up. However, with a current account surplus and a capital account de fi cit, there was a basic balance in China"s international payments. Market expectations for the nation’s currency were divided. In April of 2012, authorities took advantage of the situation to expand the permitted daily trading range of the renminbi. They introduced a management tool of assessing a bank’s overall foreign exchange purchases and settlements. The central bank largely withdrew from routine foreign exchange market intervention and the renminbi exchange rate showed a pattern of two-way trading. Foreign exchange supply and demand tended to become basically balanced.

Controversial Timing

The timing of the exchange rate reform in August 2015 was highly controversial. One school of thought contended that at that time China had suffered an unexpected setback on the stock market and the foreign exchange market was in turmoil. Why exacerbate market fears?However, it was unclear at the time how long the domestic economic downturn would last, whether capital in fl ows would revive or whether the US dollar would continue to strengthen. If domestic stock prices continued to slide and expectations of further US interest rate hikes prevailed, the negative sentiment might worsen. The adjustment of the exchange rate mechanism was therefore not an impulsive act by authorities. Without reforming the exchange rate mechanism, authorities would have needed to use a large amount of foreign exchange reserves to stabilize the exchange rate. At the same time, market prices would have continued to deviate sharply from the renminbi mid-price,and that in itself would have affected the benchmark position of the mid-price.The government would have had a series of dif fi cult policy issues to address.

This suggests that the "best time" for reform is merely an ideal concept. Reform means change, change means uncertainty, and uncertainty means risk. Any reform must aim at the best results possible and the avoidance of the worst-case scenario.Moreover, opportunities arise for those who are prepared.Preparations for the exchange reform of July 21, 2005 had actually begun in 2001 but implementation was repeatedly delayed. During the period, however, China implemented its joint-stock reform of the wholly stateowned commercial banks.Helped by the improvement in the macroeconomic environment, the 2005 exchange rate reform was a surprising success.

It is also necessary to have an objective understanding of the role of exchange rate adjustment in international payments. The current account imbalances and the renminbi exchange rate were once the focus of Sino-US trade disputes. However,since the exchange rate reform of 2005, the renminbi has appreciated signi fi cantly against most currencies. This has promoted the rebalancing of China’s economy and helped reduce the size of the current account surplus as a percentage of gross domestic product. Since 2012, the International Monetary Fund has no longer considered the renminbi exchange rate to be signi fi cantly undervalued and in recent years, the US Treasury Department has not threatened to label China as a currency manipulator.

The increasing fl exibility of the renminbi exchange rate has helped smooth the fl ow of cross-border capital.Over the last two decades or so, whenever the renminbi exchange rate showed a clear one-way trend, capital in fl ows or out fl ows would re fl ect this. As a result, capital fl ow management policies would be adjusted. When the renminbi exchange rate showed a two-way trading pattern, such as in 2012,2014, and 2017, this led to a self-balancing pattern for the international balance of payments with current account surpluses and capital account de fi cits. At this point, authorities would gradually relax their capital fl ow management policies.

The role of exchange rate adjustments in the international balance of payments cannot be overestimated.At the beginning of the 2005 exchange rate reform, of fi cials predicted that a one-time revaluation of the renminbi by 2% would help the trade balance. The market concluded that an appreciation of the renminbi of more than 5%would have disastrous consequences for exports. However,after the reform, despite the strong appreciation of the renminbi China became a global export leader and the current account surplus widened sharply in absolute terms and as well as a percentage of GDP. This was related to the lag effect in exchange rate adjustments. The rebalancing of China’s economy requires a basket of measures such as the expansion of domestic demand, structural adjustments and reduced surpluses. In recent years, the current balance of international receipts and payments tends to be synchronized with the transformation and upgrading of the domestic service sector and domestic consumption.The US, for example, has focused on conducting trade wars and currency wars instead of making needed structural economic adjustments. This merely results in increasingly fi erce trade imbalances and a transfer of trade imbalances.

To promote a greater balance of international payments,exchange rate leverage must be brought into play. External imbalances in the economy are a manifestation of internal imbalances. Therefore, to achieve rebalancing of the economy, it is necessary to solve the fundamental problems of domestic economic imbalances.

It is necessary to adapt to the new normal of renminbi exchange rate fl exibility. The 19th Congress of the Communist Party of China clearly stated that it is necessary to improve the socialist market economic system, promote a full opening of the domestic economy and build an open global economy. The exchange rate is the price relationship of two currencies, thereby connecting the domestic and international markets.Promoting a more market-based exchange rate is the aim of deeper reforms and an expanded opening up to the outside world. At the recent Boao Forum for Asia,China announced a series of new measures for opening its economy, including the fi nancial sector. Yi Gang, the governor of China’s central bank, clearly stated that the opening up of the fi nancial sector must keep pace with the reform of the exchange rate mechanism.

The 2015 exchange rate reform optimized the currency’s mid-price formation mechanism. That was an important step in the marketization of the renminbi exchange rate. Although the reforms were hampered by the deterioration of the overall market environment,the central bank eventually returned to policy neutrality as the foreign exchange situation stabilized. It withdrew temporary measures, including the counter-cyclical factor.

Policy neutrality, as far as exchange rate policy is concerned, is designed to prevent excessive volatility in the exchange rate, rather than choosing an exchange rate target on behalf of the market.This has further increased the volatility of the renminbi exchange rate since 2018.Apparently, some people have not yet adapted to this change.They are still concerned with the rise and fall of the renminbi exchange rate, trying to fi gure out the intent of exchange rate policy. They expect to see a government hand exerting in fl uence on the market.However, they have overlooked the need for exchange rate adjustments amid market fragmentation, a basic balance between foreign exchange supply and demand and a rapid growth in exports.

New Normal

The increase in the volatility of the renminbi exchange rate will become a new normal. Instead of guessing the direction of the exchange rate, enterprises should establish a risk-neutral awareness, and try their best to manage exchange rate risks in their main business area. In September 2017, the central bank reduced the foreign exchange risk reserve ratio for forward foreign exchange purchases to zero,and this sent an important signal to the market. From that time onwards bank forward settlements shifted from a surplus to a de fi cit.

Deepening the marketoriented reform of the exchange rate is a challenge that must be dealt with in order to expand the openingup to the outside world. The government and the market should gradually increase their tolerance of exchange rate fl uctuations.

The author is a professor at the Dong Furen Economic and Social Development Institute of Wuhan University and a senior researcher at China Finance 40 Forum.