Chinese Currency Reforms

Koen Huisman (40005710)

November 2005

City University of Hong Kong

EF3461 Economies of Mainland China

& Hong Kong, Term Paper

Contents

1 Introduction 3

2 History and Current State of the Chinese Currency Market 4

2.1 The Stability Argument . . . . . . . . . . . . . . . . . . . . . 4

2.2 The US Current Account Deficit . . . . . . . . . . . . . . . . . 6

2.3 Consequences of the Undervaluation . . . . . . . . . . . . . . . 7

2.4 The Risks of a Gradual Reform . . . . . . . . . . . . . . . . . 9

3 Why Countries Maintain Under/Over-valued Currencies 11

4 Advantages of a Revaluation 13

5 Possible Solutions to the Undervaluation 15

6 Conditions for a Fixed Exchange Rate and the Case of China 16

7 The Hong Kong Dollar 18

8 Conclusion 22

2

1 Introduction

On July 21st 2005 the Chinese government announced it would revalue its

currency (the Renminbi (RMB)) by 2.1% against the US dollar, after a long

period of pressure from the US senate to adjust its foreign exchange policy.

Although the move was unexpected, it will probably not be enough to end

the criticism from the rest of the world about the current undervaluation of

the currency. This paper will discuss this criticism, as well as the possible

advantages of a revaluation; not only for the US, but also for China.

The main part of this paper will address the current situation of the

undervaluation of the RMB, by giving a broad theoretical overview of the

pro’s and con’s of prolonged periods of deviation from the fundamental value

of a currency. Furthermore the historic and current situation of the RMB

will be discussed, as well as some possible solutions to solve the current

disequilibrium and some suggestions for alternative currency regimes.

The last part of the paper will give some insight in the history and actual

position of the Hong Kong dollar, which is also linked to the US Dollar. The

possible influence of changes in the Renminbi policy on the Hong Kong dollar

will be discussed.

3

2 History and Current State of the Chinese

Currency Market

For the last 10 years the Chinese currency RMB has been pegged to the US

Dollar at the rate of 8.28 RMB for 1 US$. Such a link creates a so-called

fixed exchange rate, in with the Chinese Central Bank is the party which has

to maintain that certain rate. This implies that when the market rate of the

currency moves above a certain threshold, the Central Bank will sell the home

currency for foreign currency to create more supply of the home currency and

more demand for the foreign currency. This will lead to downward pressure

on the currency through basic laws of supply and demand. If on the other

hand the currency starts to decline in value, the Central Bank will exchange

foreign currency for the home currency to support the exchange rate. It is

obvious that such a policy requires much more attention and effort from the

government and the Central Bank (in this paper the terms government and

Central Bank will be used interchangeably) than floating rates: in which the

exchange rate is not influenced by the government or Central bank, and the

market rate is thus established trough supply and demand for the currency

from market participants.

2.1 The Stability Argument

Probably the most important reason for a country to implement a fixed

exchange rate is stability in the rate. As it is the case with most economic

variables, economies almost never benefit from large swings in those variables,

such as inflation, exchange rate, interest rates etc. A stable exchange rate

will lead to more certain revenues and costs for exporters and importers,

and will help a country to build stable trade relationships. On the other

4

hand one can argue that fixed exchange rates are an unnecessary government

intervention in the free flow of capital, which will only lead to disequilibria in

the long run, and the subsequent strong adjustments in the exchange rates

which cause uncertainty and can ultimately result in an economic crisis. It

doesn’t require much effort to find a long list of crises caused by governments

defending their fixed exchange rate, such as the devaluation of the British

Pound after the collapse of the Bretton Woods system, or the Mexican Peso

crisis in 1994.

As with most economic issues, there is no closed-form solution for the

question whether or not a country should have a fixed exchange rate, a

floating one or something in between. Williamson (2004) however describes

the most important economic conditions for a successful implementation of

a fixed exchange rate. Further on in this paper some of these criteria will be

discussed, as well as the extent to which the Chinese currency fits into this.

As stated before, stability is often the prime reason for the introduction

of a fixed rate regime. This is also the main explanation of the Chinese

government for their exchange rate policy. Lardy (2005) however explains

that there are some comments to be made on this. First of all the Chinese

currency peg is constructed as a constant value of the Chinese Renminbi

(RMB) against the US Dollar. Large moves of the US Dollar against other

major currencies (and there have been quite a few in the last decade) there-

fore immediately influence the value of the RMB against those currencies.

Furthermore the link to the US Dollar is a nominal link, which doesn’t take

into account the possible differences in the development of the price level in

both countries. The real exchange rate (which is the nominal rate divided

by the difference in the development in price levels) is therefore not equal to

the (fixed) nominal exchange rate.

5

The history of the RMB exchange rate is also far from stable. Since the

start of the economic reforms in 1978 there have been a large number of

strong devaluations, such as the 21.2% devaluation in 1989. Furthermore

from 1978 until 1994 the currency declined by a couple of devaluations from

1.5 RMB/US$ to 8.28 RMB/US$.

Although the exchange rate has been stable at 8.28 RMB/US$ since mid-

1994, the Chinese government has a long history of statements indicating

future reform of the exchange rate mechanism, which should lead to a more

free-floating rate. Especially after pressure from the US started to grow (due

to the exploding US current account deficit) Chinese officials have indicated

that further reforms are on the way, but without giving much insight into

the size of the reforms let alone the timing.

2.2 The US Current Account Deficit

Before touching the issue of a possible RMB revaluation, it is worth to address

briefly the reason for the US pressure to revaluate. Due to rising oil prices and

ever-growing imports the US is currently running a strong current account

deficit, which is mostly financed by capital inflows from Asian countries.

The dangerous aspect in this is that if these countries would stop creating

massive amounts of US$ reserves, the need to attract more money into the

US to finance the current account deficit will result in an upward pressure on

US interest rates. This in turn could lead to a hard-landing of the economy.

The only solution to reduce the current account deficit is a devaluation of the

US$. Although there has already been a gradual decline in the US$ exchange

rate against most major currencies, a large part of the deficit is still caused

by the large trade gap with China. But since the RMB is pegged to the

US$, the US$ can’t decline against the RMB, and therefore the gap is still

6

increasing. The US senate is as a result urging the Chinese government to

revaluate the RMB, which in turn would relief some of the pressure from the

US deficit.

2.3 Consequences of the Undervaluation

The last couple of years China has been running a large surplus on its current

account, due to strong exports supported by competitive prices of the Chinese

export products (figure 1). These low prices are mainly the result of two

aspects: the large supply of cheap labor in China, and the undervaluation of

the RMB against other currencies. This combination leads to a large demand

for China’s products, and imposes a serious threat to foreign competitors

in certain products (see for example the current dispute on China’s textile

exports). A country which runs large surpluses on its trade balance normally

sees an upward movement of its currency rate, as the demand for the currency

increases due to the strong exports. The subsequent rise in the exchange rate

creates a rise in the price level of Chinese products for foreigners, which in

turn will reduce exports and create an equilibrium. However, as the Chinese

RMB is pegged to the US$, the currency can not appreciate against it, and

the artificial undervaluation will remain in place. Furthermore due to the

steady decline of the US$ against most other major currencies (as a result

of the exploding US current account deficit), the RMB has in fact even

devaluated against most of the currencies. This situation has caused its

trade surplus to increase even more, with current account surpluses of 3%

of GDP in 2003, 4% in 2004 and forecasts of 6% in 2005. The underlying

surplus is in fact even larger, when one keeps in mind that China’s economy

is currently booming. A strong economy will increase the amount of imports,

thereby reducing the surplus on the trade balance. A slowdown of the Chinese

7

Figure 1: China’s current account balance. Source: Deutsche Bank Research,”China & India: A visual essay”, 12/10/2005.

economy in the next couple of years would therefore even lead to an even

further increase of the trade surplus, as the stabilizing effect of high imports

diminishes.

Another result of the undervaluation of the RMB is that a situation has

arisen in which speculation of a RMB revaluation is growing. As it is likely

that the RMB will strengthen in the (near) future against the US$, a large

number of speculators are putting their money in RMB denominated assets,

to profit from such a revaluation. This has led to large inflows in RMB

portfolios, creating an additional flow of money into China. This is the part

which is called the capital account section of the Balance of Payments (figure

2). Together with the current account surplus, this has created a huge build-

up of US$ reserves in China. The possible consequences of such a prolonged

undervaluation of a currency will be discussed further on in this paper.

To calculate the possible size of the undervaluation of the RMB against

the US$, Lardy (2005) describes a framework in which an exchange rate is

8

Figure 2: The Balance of Payments, source: Wikipedia.com

calculated which would lead to an equilibrium on the Balance of Payments.

By gradually increasing the value of the RMB in the model one can simulate

the influence on the current account (by taking into account the elasticity

between exports/imports and the exchange rate). When done for the RMB,

such an analysis results in a current undervaluation of somewhere between

20 and 25%.

2.4 The Risks of a Gradual Reform

After a long period of strong political pressure from the US in particular to

reform the exchange rate policy of China (which in fact means a revaluation

of the RMB) the Chinese government decided to revaluate the currency by

2.1% against the US$ on July 21st 2005. Although this seems to be a first

step towards a more appropriate exchange rate, there are some necessary

9

remarks to make. First of all, it is obvious that such a small adjustment will

not make a large difference with regards to China’s trade surpluses and the

US’s deficits. As stated before, the fundamental value of the RMB might

be around 20% higher than the old value of the peg, implicating that a

2.1% adjustment is only a very small first step. The danger of such a small

change however is that it is likely to attract even more speculation into the

RMB, as the Chinese government has shown that it will probably revalue the

RMB more in the future, serving as an excellent investment opportunity for

speculators. The inflow of speculative funds will therefore only increase after

this small revaluation, creating even more upward pressure on the RMB.

Furthermore the small change in the peg-value will convince the US senate

that putting pressure on China to force them to revaluate the RMB has in fact

paid off; creating an additional incentive to urge for more reforms. Criticism

of China’s current RMB policy is therefore not likely to be silenced. Finally

a policy of gradually adjusting the exchange rate regime is probably not the

best way to change to a more floating rate regime. The last 25 years China

has always used gradual changes to reform its economy, but the currency

market might ask for a different approach. Due to the huge amounts of money

involved, as well as the role of speculators and the influence of expectations,

changing the rate of the RMB slowly could lead to an unsustainable situation

in which the outside world is convinced that in the end a revaluation will

occur, causing massive imbalances in money flows. Goldstein (2004) therefore

argues that a sharp revaluation of approximately 20% would be the first step

of an optimal solution to the undervaluation, instead of gradually adjusting

the rate while risking huge imbalances.

10

3 Why Countries Maintain Under/Over-valued

Currencies

Countries following a fixed exchange rate regime can have different arguments

for maintaining an undervalued or an overvalued rate for their currency. The

most common reason for keeping a currency below its fundamental (market)

value is the competitive advantage caused by the artificially low rate. If a

country pegs its currency at say 10% below the market value, its exports will

profit from it driven by foreign demand for the low-priced products. Such

a strategy will therefore benefit competitiveness, exports and in the end

GDP growth and employment. Goldstein (2004) mentions the main risks

of maintaining an undervalued currency, namely the danger of increasingly

protectionist measures by other countries (such as trade barriers and tariffs)

and other international trade conflicts. It can furthermore lead to exchange

rate instability as speculators will flow money into assets denominated in

the local currency to profit from the undervaluation. If the country in the

end has to revaluate its currency, the government will pay the speculators’

gains (for example if speculators invest 100 mln US$ in the local currency,

which appreciates by 10% afterwards, the government will lose 10 mln US$

if the speculators convert all their investments back into US$ at the higher

rate). Due to these risks countries should focus on improving efficiency and

productivity to stimulate domestic growth, instead of creating demand for

exports through an artificially undervalued exchange rate.

More common is the case of a country trying to defend an overvalued

exchange rate. In this kind of situations it is probably not the government

choosing an artificially high rate, but the difference between the fixed rate

and the market value arises from downwards pressure on the currency (for

11

example because of a lack of confidence in the countries economy). The

country will probably be reluctant to devaluate the local currency, as this

will incur the risk of contraction of the economy. Although the export will

profit from such a devaluation (local goods will be cheaper for foreigner, it

will however take some time before it effects exports), the value of foreign

debt expressed in the local currency will rise, and due to decreasing confi-

dence in the country and its currency it is likely they will have to pay higher

interest on newly attracted foreign debt. Furthermore most countries having

an overvalued currency will probably run a deficit on the current account.

They therefore have to attract foreign funds to cover the current account

and to roll over maturing loans. It will not be surprising that shortly after

a devaluation investors will demand a higher return (interest) on loans than

before. The decline in confidence after a devaluation (and possible specu-

lation of a further decline) will turn out to be costly, therefore giving the

government incentives to defend an overvalued exchange rate.

However as it is the case with maintaining an undervalued currency, there

are of course also risks related to the defence of an overvalued currency. As

the government (or Central Bank) has to keep on buying local currency in

exchange of foreign reserves, it is obvious that such a situation can not last

forever, because finally they will run out of foreign currency (or other assets,

such as gold) to maintain the peg and will be forced to devalue the currency

thereby giving speculators their gain. The expectation that the government

will not have enough foreign currency to defend the peg in the end will already

attract speculators trying to defeat the currency peg, thereby increasing the

pressure on the buying action of the government. A devaluation in the end

will have serious negative impacts on the credibility of the government, as

well on the economy and exchange rate as a whole.

12

4 Advantages of a Revaluation

Goldstein (2004) and Williamson (2004) argue that contrary to the Chinese

government’s view a revaluation of the RMB would in fact turn out to be

in the interest of China itself as well. First of all it is pointed out that the

common argument for a undervaluation, namely to support weak domestic

demand, is not appropriate in China’s situation. In fact the Chinese economy

is expanding at a very high rate, with a government trying to maintain

control on the growth rate. The positive effect on the export position that a

undervalued currency has can therefore be dangerous in the case of China, as

domestic demand is everything but weak. On of the more appropriate reasons

for the maintenance of the low value of the RMB is therefore probably that

the government was afraid for a slowdown in growth due to the spreading of

SARS a couple of years ago. As is has turned out that the negative impacts

on the economy have been limited, this argument seems to be no longer valid,

and a change in policy is therefore required. The real danger namely lies in

the credit growth created by the massive inflow of funds into China, due to

a current account surplus caused by strong exports, and huge capital inflows

as a result of speculation on a revaluation. This in fact has lead to a boost

in credit, which will create excess lending and a sharp increase in bad loans

because banks will use the excess funds to lend money to the public and to

companies. Especially with the opening of the capital markets scheduled for

early 2007 under the WTO-entry guidelines, is will be essential for China

to keep on reforming the banking system in order to compete with foreign

13

bank; a jump in bad credit is therefore probably the worst that can happen to

the current reforms. The current exchange rate regime is therefore a serious

enemy of the bank reform as a whole.

Inflation risk is one of the other negative impacts of the continuing under-

valuation of the RMB. With the booming Chinese economy already signaling

the first signs of inflationary pressures, a continued undervaluation of the

currency will keep on stimulating exports and therefore creating inflation.

Furthermore the ongoing capital inflow will make it even harder to control

inflation. Currently China is one of the biggest importers and exporters of

the world. Although its economy still needs a significant number of reforms,

it has good access to the world markets. It is therefore in China’s inter-

est to maintain these relationships with the rest of the world, and to avoid

trade disputes which could harm China’s access to the export market. In the

light of the growing pressure from the US and other countries to revaluate

the RMB, it becomes clear that also when they don’t revalue, the current

Chinese export position can not be sustained.

Finally the reluctance of China to adjust its currency regime has created

a situation in which all the Asian countries (even those with a floating rate

regime) try to avoid their currency from appreciating against the US$, as

this would hurt their export position compared to China. The Asian region

is therefore characterized by undervalued currencies; a situation that could

have severe impacts on the world economy as it deepens the trade deficit of

the US with the rest of the world. A Chinese revaluation could therefore

lead to a revaluation of multiple currencies in the region against the US$,

thereby decreasing the US trade deficit and preventing the US economy from

a hard landing. Such a hard landing would have severe negative impacts on

the Chinese economy as well.

14

The last argument mentioned is on the other hand also one of the most

important reasons for the rest of the world to continue their efforts to per-

suade the Chinese government to adjust the RMB policy, namely preventing

the US economy from a hard landing. On the other hand, a similar hard

landing of the Chinese economy caused by the prolonged undervaluation of

the RMB (as described above) would also have severe negative consequences

for the rest of the world. It is therefore in both China’s as the rest of the

world’s interest that the Chinese government changes its current exchange

rate regime, and revaluates the RMB significantly.

5 Possible Solutions to the Undervaluation

If China decides to adjust its currency regime, the question that immedi-

ately arises is of course how to implement such a revaluation, without giving

speculators a change to profit from it, and to create as less uncertainty as

possible. Goldstein (2004) outlines some of the most common strategies in

revaluating a currency. The first one is the so-called Slow Go approach, in

which the currency is revalued by only a small percentage, combined with

other reforms in the trade and capital account, or tax measures that would

be substitutes for a revaluation. The risk in such a strategy (which is the one

the market expects China’s government to adopt) is that due to the gradual

changes, it might attract additional speculative inflows by creating a sure-bet

for speculators. Furthermore it won’t be sufficient to solve excessive lending

and the risk of a hard landing for the Chinese economy.

The second strategy is to immediately open the capital markets and

15

change at once to a floating exchange rate. This is the reform proposed by

US Treasury Secretary Snow, who urges China to open its markets as soon

as possible, thereby changing to a freely floating RMB. Goldstein (2004) ar-

gues that although it would be the preferred situation in the long run, it is

definitely not the optimal strategy for current China due to the state of its

banking system. A too sudden change to liberalized capital markets would

pose a severe threat to the fragile Chinese banks as they are not ready yet

for free capital flows.

An optimal reform therefore should consist of two stages, namely a sharp,

one-shot revaluation of the RMB combined with a peg to a currency basket

and a wider trading band, followed by a reform of the banking system which

should in the end result in liberalized capital flows and a floating exchange

regime. The first step would relief both the political as economic pressure

from the RMB, and is the only way to avoid further massive capital inflows

initiated by speculative reasons. The second step is necessary to make the

banks well-capitalized and solvent enough to cope with the opportunities and

threats of liberalized capital flows. An opening of the capital account before

the banks are fully reformed could ruin the current reforms.

6 Conditions for a Fixed Exchange Rate and

the Case of China

The last issue to be addressed regarding a possible reform of China’s currency

and capital flows regime is the question which regime the government should

adopt after the proposed two-step reform as described above. Whereas some

16

advocate for a completely free-floating currency, the Chinese government is

likely to keep some kind of control on its currency, which might turn out to

be a new peg to the US$, but at a different rate than the current one. It

is however questionable if such a renewed peg would be sustainable in the

long run. Williamson (2004) namely describes the necessary conditions for

a fixed exchange rate, and possible discrepancies between these criteria and

China’s position. First of all the economy has to be small and open, so that

it makes sense to peg the currency to a larger currency area (such as the

US). This is for example the case for Hong Kong, which is very small and

it therefore relies heavily on trade with other countries. China however has

a strong import and export market and is a relatively open economy, but

it is definitely not small. The second criterion that is violated by China is

that the bulk of trade should be undertaken with the country the currency

is pegged to (or countries that have also pegged to that currency). This is

also not the case for China, which has a sizable trade relation with the US,

but it’s definitely not the major part of its imports and exports.

Due to these problems a new fixed exchange rate regime after eventual

reforms is probably not the optimal strategy. More appropriate solutions to

the Chinese situation could therefore be something in between fixed rates

and fully floating, such as an adjustable peg with a large band, or a broad

currency basket in close cooperation with other Asian countries. 1

1See for example Policy Brief 05-1: A Currency Basket for East Asia, Not Just China[pdf] by John Williamson, Institute for International Economics August 2005.

17

7 The Hong Kong Dollar

An interesting case related to the Chinese currency issue is the situation of

Hong Kong, which currency (HK$) is also linked to the US$. Although its

government is not under such pressure as China’s to adjust the current ex-

change rate regime, the question whether it should abandon the linked rate

to the US$ is an ongoing debate. The last part of this paper will there-

fore focus on the HK$ by discussing the current peg with the US$, and by

comparing the Hong Kong currency with the Chinese RMB to discuss the

potential influence of changes in China’s currency regime on Hong Kong.

The Hong Kong economy is of course completely different than China’s in a

large number of aspects, this paper will therefore only focus on the exchange

rate aspects.

One of the main differences between Hong Kong’s currency regime and

that of China is the fact that Hong Kong has a currency board instead of

a Central Bank. A currency board does not operate as a separate entity

(such as a central bank), but it is a rule-based exchange mechanism with a

explicit commitment to convert domestic currency into the linked currency

and vice versa. This means that the Hong Kong currency board provides

the market with a rate at which market participants can buy the HK$ from

the currency board, and a rate at which they can sell. An important aspect

of this system is that the whole monetary base must be backed by foreign

reserves (US$). This ensures that the currency board will never run out of

reserves to guarantee the fixed exchange rate, as all the Hong Kong Dollars

are fully backed by foreign reserves. The peg therefore works as a rule-based

mechanism, whereas in countries with a Central Bank the currency peg is

only supported, and not fully guaranteed.

The start of the current peg to the US$ of Hong Kong’s currency goes

18

back to 1983, when the official rate of 7.8 HK$ for 1 US$ was set, a rate that

is still the actual peg. This decision followed a period of economic turmoil,

with sharp changes in inflation, exchange rates and GDP growth caused by

the uncertainty about the political future of Hong Kong. Nowadays the total

value of external trade is more than 250% of GDP, which makes the Hong

Kong economy vulnerable to shocks in exchange rates. As the US$ is the

main currency in which transactions are settled, it was a logical step to peg

to the US$, which leads to a stable exchange rate and less uncertainty. Other

advantages of the peg includes the fact that it prevents the government from

using the currency to finance fiscal deficits (printing money), and that is

leads to an automatic adjustment of the balance of payments (as changes in

changes in money supply lead to changes in the interest rate due to the fixed

exchange rate, which influences the demand for the currency).

The most important disadvantage of the link is the fact that Hong Kong

has to follow the US monetary policy, even at times when the economies

are in a completely different part of the economic cycle. This could lead

to periods of for example contractionary monetary policy during a period of

recession in Hong Kong when there is in fact need for expansionary measures.

Furthermore, due to the currency board, there is no Central Bank which can

operate as a lender of last resort for the banking system (such as the Federal

Reserve for the US banks).

During the 22 years in which the peg has existed, there have been two

significant attacks on the HK$. The first one was in 1987 when prolonged

weakness of the US$ led to an undervaluation of the HK$. This induced

speculators to deposit money in HK$, as there was strong pressure to reval-

uate the currency. The Hong Kong government solved the crisis by using the

threat of a negative interest rate; the threat itself was enough to scare spec-

19

Figure 3: The HK$/US$ Exchange Rate, data source: Federal Reserve

ulators. The second attack was during the Asian financial crisis. Combined

with continuing strength in the US$, the HK$ was under severe pressure to

devaluate (as the other Asian currencies did). The government intervened

by buying up to 80 billion HK$ of equity, through which both the equity

market as well as the currency market were strongly supported. China on

the other hand has seen four major devaluations in the period in which Hong

Kong had a fixed exchange rate. None of these moves have had impact on

the exchange rate of the Hong Kong Dollar.

Although China is a very important trade partner of Hong Kong (44%

of Hong Kong’s trade is with China, see Williamson (2004)) and some ar-

gue that Hong Kong should adopt the RMB as well in the future (due to

political reasons), history thus shows that the two currencies are relatively

unrelated to each other. This is mainly caused by two aspects: the difference

in exchange rate regimes and the different economic situation. The Hong

20

Figure 4: The RMB/US$ Exchange Rate, data source: Federal Reserve

Kong currency board is a very strong rule-based mechanism to support the

exchange rate, whereas the RMB is much more influenced by political is-

sues, as well as discrepancies between China’s economy and the US economy,

which lead to unsustainable imbalances. The Hong Kong economy on the

other hand is much more developed, and behaves more in line with the US

economy. The influence of a potential revaluation of the Chinese RMB will

therefore have very limited consequences on the HK$. Based on the strong

position of the Hong Kong currency board as well as their history of main-

taining the peg (for more than 22 years already) it is not assumable that

Hong Kong will choose to abandon this link after a Chinese revaluation. The

economic situation is too different and it is not in accordance with Hong

Kong’s monetary past.

21

8 Conclusion

The Chinese currency (RMB) has a long history of a fixed currency regime,

characterized by a number of significant devaluations. Recently however, the

US is urging China to revaluate its currency, as its artificial undervaluation

is one of the major causes of the ever-growing current account deficit of the

US. After a long period of political and economic pressure the Chinese gov-

ernment finally decided to revalue the RMB by 2.1% in July 2005. Although

this looks like a good first step, it is questionable whether such a slow-go

reform will be able to solve the current imbalances. A gradual revaluation of

the RMB will namely lead to strong capital inflows, caused by speculators

who expect China to increase the value of the RMB even further in the fu-

ture. The main risk of the current undervaluation is probably the excessive

lending caused by the flood of funds going into China, on both the current

account as well as the capital account. Strong exports (due to cheap la-

bor and an undervalued home-currency) have led to a strong surplus on the

current account, whereas the expectation of revaluation has initiated strong

speculative capital inflows. This excessive supply of credit could pose a se-

rious threat to the current bank reforms. Furthermore a revaluation would

prevent both the US and the Chinese economy of a hard landing, by reducing

global payment imbalances, as well as inflationary pressure in China. Prob-

ably the best way to achieve such a reform is a two-step strategy: China’s

government should first revaluate the RMB with a sharp one-shot increase,

followed by further reforms in the banking sector before opening the capital

markets. An approach as suggested by the US Treasury Secretary Snow of

an immediate opening of the capital flows is therefore not the right way, as

China’s banks are not ready yet for a full liberalization of capital flows. A

revaluation should preferably be followed by a system somewhere in between

22

floating rates and fixed rates (such as a broad currency basket or an ad-

justable peg), as a new fixed rate regime is unlikely to be sustainable in the

long run due to the size of China’s economy and the differences with the US.

Finally a change in China’s currency regime will probably not influence the

HK$, as Hong Kong has a long history of its own US$ peg and a much more

developed economy.

References

[1] Goldstein, M. 2004. Ajusting China’s Exchange Rate Policies. Working

Paper, Institute for International Economics.

[2] Hong Kong Monetary Autority. 2000. HKMA Background Brief No.1:

Hong Kong’s Linked Exchange Rate System.

[3] Lardy, N.R. 2005. Exchange Rate and Monetary Policy in China, Cato

Journal, Vol. 25, No. 1 (Winter 2005).

[4] Williamson, J. 2004. The choice of Exchange Rate Regime: The Rele-

vance of International Experience to China’s Decision, outline of a lec-

ture at a conference on exchange rates organized by the Central Univer-

sity of Finance and Economics Beijing, China September 7, 2004.

23