account is best for resource allocation and social welfare. the bop balance, and current account balance in particular, is the basis for equilibrium exchange rate analysis. an internationally accepted indicator is the current account balance to gdp ratio. for example, the current account norm is the core concept in the macroeconomic balance ( mb ) approach, which is used by the imf to assess member country ’ s exchange rate. if a country ’ s current account balance exceeds the norm in the medium term, its exchange rate is believed to be undervalued, and otherwise the exchange rate is overvalued. the size of the gap between current account balance and the current account norm indicates the degree of undervaluation or overvaluation. in the medium and long term, the correlation between exchange rate and current account balance may not be this simple because resource endowment, industrial division of labor and consumption behaviors are more significant factors in international trade and economic activities. nevertheless, good policy - making on exchange rate needs to be supported by forward - looking judgment on the supply and demand on the foreign exchange market and such judgment is based on analysis of current account balance. the supply and demand on the foreign exchange market is of course related to the overall bop situation, not only the current account. generally speaking, however, the current account reflects activities of the real economy, and the current account balance accounts for the major part of bop. since 2007, the share of current account surplus in china ’ s bop surplus has been over 75 percent. moreover, with a full convertibility, china ’ s current account is responsive to market supply and demand. therefore, the analysis of the foreign exchange market based on the current account will not lead to systematic errors. since return on investment as a current account item is related to the capital account, as a practical consideration, it is not included in current account balance analysis. instead, the analysis looks at trade balance, which is represented by trade statistics from the customs because it is regularly updated and readily available. ii. the exchange rate floating is based on the current account, mainly the trade account balances managed floating exchange rate serves three purposes. it is needed to deal with any unexpected movements in domestic and international markets to avoid dramatic currency fluctuations and curb financial speculation ; to bring the exchange rate to an appropriate level that helps improve resources allocation and promote a balanced bop account ; and to make sure that any improvement in resources allocation could be absorbed by most companies and would not lead to massive closures and job

cuts. the equilibrium exchange rate determination theory treats exchange rate as a function of current account balance or trade balance. if the function has a linear relationship with current account balance, it could be adjusted accordingly. however, the relationship is much likely to be non - linear, which means exchange rate floating needs to be progressed in a gradual and proper manner and should be managed in line with the state of the economy and bop position. exchange rate adjustment poses pressures on the corporate sector ’ s structural adjustment. a large or rapidly growing trade surplus means companies are generally adaptive to such pressures, while a shrinking surplus suggests companies need to enhance their ability to deal with exchange rate adjustment. the adjustment process needs to be properly paced to take full advantage of favorable factors and contain the impact of disadvantages. it should also take into account global economic development and international cooperation to help secure the current period of strategic opportunities. exchange rate adjustment helps improve the relative position of domestic and external prices, and optimize resources allocation between domestic - oriented sectors and the external sector. it supports domestic consumption growth, industrial restructuring and innovations. this progress will in turn facilitate market - based adjustment of current account position and ultimately contribute to balanced and sustainable growth. exchange rate adjustment also affects capital account. therefore, it is necessary to closely monitor capital flows, stand ready to conduct sterilization operations, and impose limits on external debts. it is important to put restrictions on converting the external debts of foreign currencies into rmb, and step up efforts to address irregularities in foreign exchange flows, as experiences from thailand and other countries show, borrowing external debt and converting it into domestic currencies by the private sector, corporate sector or other sectors is a major channel for capital inflows. temporary control on capital inflow and outflow may also be introduced if circumstances warrant, as what has been done recently by a number of emerging market economies. iii. measure the exchange rate with reference to a basket of currencies a floating exchange rate has impact on total imports and exports of an economy. therefore, the floating cannot be aimed to adjust bilateral trade balance and it is not advisable to just look at the rmb / usd exchange rate. theoretically, the best indicator to measure the international relative price of tradables is real effective exchange rate, i. e. the exchange rate measured by a basket of currencies of major trading partners. real effective exchange rate reflects the movement of dollar exchange rate to other major currencies and has