Hu Xiaolian: A managed floating exchange rate regime is an established
policy
Article by Ms Hu Xiaolian, Deputy Governor of the People's Bank of China, 15 July 2010.
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China's has moved into a managed floating exchange rate regime based on market demand
and supply with reference to a basket of currencies. As an important component of the
socialist market system, this is a right choice based on China's specific circumstances and
development strategy and is also an established policy.
I. A managed floating exchange rate regime has been in place since 1994
1. The unification of dual exchange rates in 1994 marked the official beginning of
Establishing a managed floating exchange
the managed floating exchange rate regime.
rate regime based on market supply and demand and a unified and well-functioning foreign
exchange market is stipulated in The Decision of the CPC Central Committee on Several
Matters Concerning the Establishment of a Socialist Market Economic System adopted at the
3rd Plenary Session of 14th CPC Central Committee in November 1993. On the first day of
1994, with the unification of RMB's official exchange rate and swap market exchange rate,
the single, managed floating exchange rate based on market supply and demand was
officially adopted. The unification of dual exchange rates into a single exchange rate regime
is worth mentioning because it put an end to the coexistence of official exchange rate and
the swap market exchange rate which traded foreign exchange in the retention system.
In 1994, the exchange rate reform marked the launch of the foreign exchange surrender
system where enterprises are required to sell to the banks their foreign exchange receipts
and buy foreign exchange from the banks when necessary, ended the practice of foreign
exchange retention and submission, and simplified the procedures for banks and enterprises
to use foreign exchange, thus giving exporting enterprises a lot of incentives to export and
earn foreign exchange. Meanwhile, with a unified inter-bank foreign exchange market being
established, China began a new stage where the RMB exchange rate was based on market
supply and demand. The RMB, as an important price tool, started to play a fundamental role
in the allocation of foreign exchange resources. In 1994, when the dual exchange rates were
unified, the RMB to dollar exchange rate adopted the swap market exchange rate of 8.7 yuan
to one dollar. This reflected market fundamentals and the need of supporting exports to
mitigate the shortage of foreign exchange reserve. The nominal RMB to dollar exchange rate
appreciated to 8.3 yuan per dollar, or by about 5 percent between the beginning of 1994 and
1997 when the financial crisis was at its worst in Asia. This proves that RMB exchange rate
was fluctuating and floating, reflecting the characteristics of a managed floating exchange
rate regime.
2. The Asian financial crisis in 1997 caused a slow down in the improvement of
managed floating exchange rate regime. After June 1997, as the crisis deepened, some
Asian currencies depreciated by a large margins. With Chinese export seriously affected,
there were strong domestic opinions calling for RMB's depreciation. If it took place, it would
be understood by various parties. Yet, almost all countries and international organizations
worried that a weaker RMB would be followed by a new round of competitive depreciation. In
order to prevent the further contagion of the crisis, and preserve economic and financial
stability in Asia, China made the announcement that the RMB would be not be depreciated,
its floating range would be narrowed, and its exchange rate would be kept stable around
8.28 yuan to one dollar.
3. As the Asian Financial Crisis tided over, China has been more active on
resuming and improving the managed floating exchange rate regime at an opportune
time. Facing new situations after China's accession into the WTO and sluggish global
economic growth after the 911 attack, the range for RMB exchange rate narrowed for a fairly
long time to reduce uncertainties and maintain the continuity of RMB exchange rate policy.
This measure, however, is ad hoc rather than a long-term institutional arrangement.
4. The exchange rate regime reform in 2005 was the continuation of the reform in
1994. The essential role of a stable and healthy financial system in preventing and
addressing crisis was fully recognized in the wake of the Asian financial crisis. Around 2003,
when financial reform in China was at a critical juncture, the country was faced with the
urgent task of launching joint-stock reform in large state-owned banks, including the
Industrial and Commercial Bank of China (ICBC), Agricultural Bank of China (ABC), Bank of
China and China Construction Bank (CCB). The reform would improve their ability to adapt to
the floating exchange rate regime and to provide companies with better risk management
services, but it was an onerous work. In this context, the reform was first started in large
state-owned banks in the summer of 2003. The Bank of Communications, Bank of China and
Construction Bank of China completing the joint-stock reform and went public. Following that,
in April 2005, the reform in the ICBC was started, and reform in the ABC and the China
Development Bank was put on agenda. Reform in this front went ahead in parallel with the
pilot reform program of non-tradable shares in listed companies, the introduction of
shortterm corporate financing bills and asset securitization products in the money market, and the
progress in the reform of rural credit cooperatives. As a result, the deployment of reform in
large financial institutions, which is the foundation for exchange rate regime reform, was
completed by July 2005.
Meanwhile, the domestic pricing mechanism of resources was gradually reformed; reform in
enterprises, particularly in state-owned enterprises (SOEs) proceeded smoothly; a group of
large enterprises were listed in domestic and overseas markets; restructuring efforts aiming
at better resources allocation was strengthened; and corporate governance and finance
management were enhanced. Progresses in these areas reinforced the foundation for
exchange rate regime reform on the micro level. Because of all these developments, it was
believed that it was the right time to further reform the exchange rate regime. On July 21,
2005, China improved the managed floating exchange rate regime by moving into a
managed floating exchange rate regime based on market supply and demand with reference
to a basket of currencies.
II. The framework of the managed floating regime was enhanced and its content
enriched
1. The mechanism that moves the exchange rate towards the adaptive and
equilibrium level has been gradually established. The RMB exchange rate first dropped
and then climbed up in general over the past three decades. Since 1978, the yuan
depreciated from the initial 2.8 yuan per dollar, then moved downward to 8.7 yuan per dollar
in early 1994, after which it edged up to 8.11 yuan per dollar in July 2005, and further rose to
6.85 yuan per dollar in late 2009. The exchange rate has been allowed to move within a
wider band, i.e., from a daily band of 0.3 percent against the US dollar at the start of the
reform in 2005 to 0.5 percent in 2007. As a result, market participants began to search for
the adaptive and equilibrium exchange rate level by looking at balance of payments positions
and foreign currency supply and demand.
2. Market supply and demand has an increasingly important role in determining
the exchange rate. Following the liberalization of the RMB current account in late 1996, and
with increasing channels for capital flows such as direct investment, portfolio investment and
cross-border financing since 2001, foreign exchange supply and demand has improved,
facilitating trade and investment, and making the holding and use of foreign currency more
convenient. The role of supply and demand is becoming increasingly important in the foreign
exchange market.
3. The foreign exchange market mechanism has improved. Before 1994, the RMB
exchange rate was determined both by the authority and the swap market. Now it is
determined in the interbank foreign exchange market through OTC transactions and
supported by market makers. As the foreign exchange market grows rapidly, the role of
market participants in determining the exchange rate central parity has been increasing. In
response to the diversified trade and investment structure, the exchange rate regime is with
reference to a basket of currencies, rather than pegging to the US dollar.
III. A managed floating exchange rate regime is in China's long-term and
fundamental interests and we will continue to implement the regime
Adopting a managed floating exchange rate regime is an inevitable choice for China to
deepen reform and opening-up, and adapt to the new pattern of development and
openingup after China's accession into the WTO. In line with the scientific approach to development,
this is a choice consistent with China's economic development level, improvement in
marketbased institutional arrangements and financial regulation and enhanced resilience of the
corporate sector. Continued efforts will be made to implement the regime.
1. The regime is essential for economic restructuring and the optimization of
resource allocation. Exchange rate represents the price relations between tradable and
non-tradable goods and services. A fixed exchange rate may make accounting and risk
management easier for market participants for some time, but if misaligned with the
fundamentals of supply and demand for too long a time, such a regime will distort relative
prices on domestic and foreign markets, undermine the efficiency of resource allocation and
accumulate domestic and foreign economic imbalances. A managed floating exchange rate
regime will enhance the efficiency of resource allocation, adjust the relation between
domestic and foreign prices in a flexible manner, channel resources to the sectors that are
driven by domestic demand such as the services sector, promote industrial upgrading,
transform the pattern of economic development, reduce trade imbalances and over-reliance
on export, enable domestic demand to play a more important role in economic development
and thus promote sustainable and balanced economic growth.
2. We need such a regime to strengthen and improve macroeconomic
Since the beginning of the reform and opening-up and especially since the entry
policymaking.
into the WTO, China has seized the historical opportunity of international industrial relocation
and improved productivity and economic strengths. Nevertheless, the economy has
problems such as large BOP surplus, rapid growth of foreign reserves, oversupply of
liquidity, inflation and heightened pressures from asset bubbles. Meanwhile, growing
magnitude of capital flows has posed challenges to the independence and flexibility of
monetary policies. Given the impossible trinity of achieving monetary policy independence,
fixed exchange rate and free capital flow in an open economy, a managed floating exchange
rate regime will help enhance the proactiveness and capability of macroeconomic
management and the effectiveness of monetary policy, curb inflation and asset bubbles and
contain the macroeconomic risks.
3. A rigid exchange rate regime is not responsive to crisis and may even trigger
monetary and financial crises. According to international experiences, prolonged BOP
imbalances and peg to a single currency by a medium- or large-sized economy can hardly
sustain, and may increase its vulnerabilities to crises. A rigid exchange rate has been an
important contributing factor to the Mexican financial crisis in 1994, Asian financial crisis in
1997, Brazilian financial crisis in 1999 and Argentine financial crisis in 2001. Not much harm
will be done to a small country if it links its currency with that of a large one, but this is hardly
the case for large countries as they have larger interaction with global economy. In addition,
a fixed exchange rate is an easy excuse for trade friction and protectionism. Thus, it is
necessary for large countries to have flexible exchange rate policy. China has adopted and
will continue to improve the managed floating exchange rate regime. 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. These measures help maintain
a facilitating environment for free trade, achieve long-term cooperation and common
development, facilitate China's economic development at the juncture of strategic importance
and foster a favorable international economic and trade environment.
On June 19, 2010, the PBC announced to further reform the RMB exchange rate regime
based on measures taken in 2005. According to the announcement, continued emphasis will
be placed to reflecting market supply and demand with reference to a basket of currencies
and the exchange rate floating bands will remain the same as previously announced in the
inter-bank foreign exchange market. This is an important move in reforming the managed
floating exchange rate regime and will help maintain RMB exchange rate basically stable at
an adaptive and equilibrium level, promote a balanced BOP account and financial market
stability and realize quality and rapid growth of the economy.