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Chinas Exchange Rate: Issues and Policies

by

Maria DaCosta

Department of Economics

University of Wisconsin-Eau Claire

Eau Claire WI 54702-4004

[email protected]

Eastern Economic Association

Annual MeetingWashington D.C.

February 20-22, 2004
mailto:[email protected]:[email protected]


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Introduction

China has been under increasing pressure to revalue its currency -- the yuan. China'sexchange rate has been pegged to the dollar since 1994 and as China's trade andeconomic position has strengthened, such policy has come under attack. How important

has China's exchange rate policy been to the success of China's economic reform?Should China revalue its currency? What would the effects of such revaluation be onChina's economy? Should China allow the currency to float? These are the questionsaddressed in this study.This paper is structured as follows. In the first part we provide an overview of alternativeexchange rate regimes and Chinas exchange rate policy. Then we examine the impact ofexchange rate fluctuations on three economic areas: inflation, the external sector,and financial stability. The connections between inflation and exchange rate, namely theso-called pass-through effect, are discussed in part two. Part three investigates the impactof the exchange rate on the external sector by examining the issues of competitiveness

and openness. In part four, we address the exchange rates impact on financial stability.Policy recommendations are discussed and concluding remarks offered in part five.1. Overview

Generally speaking there are three exchange rate regimes: fixed, floating (free) andmanaged float. It has been suggested in the literature that countries generally float theircurrencies if their GDP is large, if there is a relatively low level of openness, a highinflation differential with other countries, a high degree of integration in internationalcapital markets, and substantial diversification in traded goods (Heller 1977; Holden,Holden & Suss 1979). On the other hand, Williamson (1991) suggests that a fixedexchange rate is appropriate if the economy in question is small and open; there is onemajor trading partner (to which currency it is tied); the real shocks and macroeconomicpolicies of both economies are considerably synchronized; and there is a seriouscommitment to keeping the selected fixed rate.1

In its 1997 Annual Report, the IMF advised a large number of countries, namely the EastAsian nations, to introduce more flexibility into their exchange rate systems. Althoughnone of the exchange rate systems can be considered superior, a floating system canreduce problems associated with current account balances, namely during periods of higheconomic growth. A fixed exchange rate system, on the other hand, may be moredesirable in periods of high inflation.

What about economies in transition like China that are undergoing major structuralreforms? The following two subsections offer a synopsis of Chinas exchange rate policyand the reasons why a revaluation is called for.

1 Zhang (2001a).

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1.1. Chinas exchange rate policy: an overview

Figure 1 shows Chinas official exchange rate. Before 1994 there were multipleexchange rates and therefore the official rate (as shown in Figure 1) did not really reflectthe average exchange rate used for all the trade transactions. It is also not determined by

the market. China has adopted a fixed exchange rate since 1994 the yuan has beenvirtually tied to an exchange rate of 8.27 yuan to the dollar, with only a hairbreadthtrading band of 0.3 percent (New York Times, April 10, 2004).

Figure 1: Average "Market" Rate (Yuan/USD)

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1.00

2.00

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6.007.00

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10.00

1972

1974

1976

1978

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1990

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1994

1996

1998

2000

Market Rate (Yuan/USD) rf =

Source: IMF, International Financial Statistics, 2002

Chinas foreign trade as well as foreign exchange and exchange rate reforms, reflectChinas overall approach to economic reform a gradual approach (Lardy 1992).

Before 1978

Before 1978, China was a planned economy with very little economic transactions with

the outside world. China had a fixed exchange rate from 1955 to 1972, when it changedto a composite peg. The renminbi yuan was pegged to a basket of 13 currencies and laterpegged to the average rates of the U.S. dollar and the German Mark (Zhang 2001b).Foreign trade was centralized and controlled by the state. The official exchange rateplayed no major role in foreign trade.

Period 1978-1984

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The role of the exchange rate changed with Chinas open door policy. Foreign tradewas decentralized and in 1979 there were about a dozen foreign trade corporationsmanaging foreign transactions, nationwide. By the mid-1980s there were 800 authorizedimport and export corporations.2 The official exchange rate, overvalued and out of linewith world prices, was complemented by an internal rate for trade settlements. This rate

was lower than the overvalued official rate, and led to frequent devaluations of theofficial rate (see Figure 1) until both ended up merging into one, by 1985.

Period 1985-1993

In 1985 regionally based swap markets, known as Foreign Exchanges AdjustmentCenters, were created so joint ventures could swap retained foreign exchange acquiredthrough exports. In 1988, a formal foreign exchange retention system was established.And local governments and State-Owned Enterprises (SOEs) could now participate in theswap markets as well. After 1988, the price of those retention rights was determinedby market conditions leading to a flexible effective exchange rate of the yuan (Zhang

2001). By 1993, 80 percent of foreign exchange transactions were conducted at swapmarket rates (Xu 2000 p.264).3

In short, from 1978 to 1993 the official market rate was clearly lower than the internalsettlement rate and the swap rate, suggesting a constant pressure for the yuan todepreciate. Consequently, the official rate was subject to regular devaluations (see Figure1). It was only after the 1994 reform that the yuan became stable.

The 1994 reform

The year of 1994 brought sweeping macroeconomic reforms that included a sweepingreform in foreign exchange markets as well. Multiple rates were replaced with a singleunified rate. A market-based managed float system tying the yuan to the U.S. dollar wasintroduced. By the end of 1996 the yuan was fully convertible on the current account, fortrade related purposes.4 The transition to the new system went more smoothly thanexpected.

1.2. Why revaluation?

Not too long ago the academic discussion and debate engulfing Chinas currency waswhether or not the yuan should depreciate (Xu 2000), not revalue. The context was avery different one -- in the wake of the Asian financial crisis of 1997-98, and amidst the

2 and by 1990 over 5000 (Lardy 1992, p. 39).3 For more on the interesting dynamics of these swap markets see, for instance, Zhang (2001).4 With effect from the 1st of January 1994, these measures included: unification of multiple exchange rates;adoption of a managed uniform floating exchange rate regime based on market supply and demand;abolition of the foreign exchange retention system and the introduction of a foreign exchange surrenderingsystem; abolishing the compulsory foreign exchange plan, permitting en-users to buy foreign exchangefrom designated banks on presentation of valid import documentation; termination of the issuing of foreignexchange certificates (FECs) and phasing out FECs already issued; establishment of an inter-bank foreignexchange market. Zhang, 2001.

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competitive devaluation wars that followed, China remained committed to its yuan/dollarpeg and won widespread praise, from the same countries no less, that are now attackingChina for taking the same policy stance. That policy decision came at a cost as studies dosuggest that the successful defense of the currency peg in the aftermath of the Asian crisismade the shocks more contractionary than what they would otherwise have been (Yang et

al. 2001).

The current context is a very different one, indeed. Figure 2 shows what the fuss is allabout. At a time, when many currencies are appreciating with respect to the U.S. dollar(the euro-U.S. dollar has reached an all-time high, and thus the euro-yuan rate) theChinese yuan has remained virtually unchanged. Chinas trading partners are accusingChina of keeping its currency undervalued in order to fuel a predatory export boom(The Wall Street Journal, February 13th, 2004).

Figure 2

Source: The Economist, Feb. 5th, 2004.

Are they right? Growing economic imbalances suggest that China should considerrevaluation of its currency: large and growing foreign exchange reserves (Figure 3),large current account surpluses, and exports growing faster than imports (see Figure 5) allpoint towards a correction.

In addition, internal pressures are building up. The expectation of a rising yuan isattracting money from Chinese individuals and firms to invest or speculate. Bankdeposits are growing at a very fast rate, 20% last year, as well as bank lending, fuelinginflationary pressures and speculative bubbles. Inflation, which has been practically zero,was 6 percent last December. There are signs everywhere the economy is overheating.To tackle this problem the PBC could increase the interest rates but doing that willencourage even larger inflows and larger deposits.

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Figure 3

Source: The Wall Street Journal, Feb. 13th, 2004.

Given these imbalances and the internal pressures it is no wonder that there are at thepresent time strong signals that China will be revaluing the yuan soon (The Wall StreetJournal, Financial Times, The Economist, etc.). What will the implications be? Andshould China adopt a floating system, as it has been called for by some? How vulnerablewould China be to exchange rate fluctuations?

The next three sections of the study explore the relationships between exchange ratefluctuations and inflation, external sector, and financial stability, with an emphasis onChina, and possible policy implications.

2. Exchange Rate and Inflation

The influence of exchange rates on inflation is known as the pass-through effect.Exchange rates can influence domestic prices through the prices of traded final goods andimported intermediate goods, as well as through inflation expectations.

The literature on the exchange rate pass-through to prices is extensive. The magnitudeof the pass-through effect is particularly relevant for developing appropriate monetaryand exchange rate policies. It is widely accepted that a low exchange rate pass-throughfacilitates an independent monetary policy and inflation targeting. But, there is noagreement on the conditions that lead to a low pass-through.

Traditional literature has relied on microeconomic factors to explain the exchange ratepass-through to import prices and emphasized the role of market power and pricediscrimination in international markets (see Goldberg and Knetter for a survey). Theseconditions are regarded as exogenous to monetary policy. Taylor (2000)offers analternative explanation by suggesting that a low inflationary environment is conducive toa low exchange rate pass-through. Firms will set prices in response to the persistence ofthe cost increases higher inflation persistence will bring about more persistent costs. In

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this framework, the policy regime will help determine the pass-through effect. Recentstudies, such as Campa and Goldberg (2001) and Gagnon and Ihrig (2001) have exploredthis relationship for developed countries.

There is some evidence that the exchange rate pass-through is larger in emerging

economies, such as China, than in developed economies (for instance Calvo andReinhart, 2000). A study by Choudri and Hakura (2001) found strong evidence of apositive correlation between the exchange rate pass-through and the average inflationrate, in support of the Taylor hypothesis. They tested Taylors hypothesis by examining alarge database comprising 71 countries (including China) for the period 1979-2000 (aperiod of particular significance for China). The theoretical link between inflation andpass-through is examined in an open-economy-macroeconomic-model type frameworkthat incorporates imperfect competition and price inertia (based on staggered priceadjustment). The sample countries exhibit great variation in terms of inflation history.The authors tackle that by dividing the countries into low, moderate and high inflationgroups, according to their average inflation rates less than 10 percent, between 10 and

30 percent and more than 30 percent, respectively over the period in question.Furthermore, the exchange rate pass through effect is estimated for the short (T=1),medium (T=4) and long run (T=20). China, with an average inflation rate of 5.9 percentfalls in the low inflation group. The estimates of the exchange rate pass-through forChina are 0.04, 0.30, and 0.41, for the short, medium and long run respectively (seeappendix 1). In other words, fluctuations in the exchange rate can explain 4 percent of ayears change in CPI in the short run but 30 percent over a four-year period. For theUnited States those estimates are 0 and 2 percent.

Why do emerging economies exhibit a higher exchange rate pass-through? Ho andMcCauley (2003) offer two possible explanations.5 One reason is that developingcountries are expected to show a stronger linkage between the exchange rate anddomestic prices because of patterns of consumption stemming from relatively lowincomes. In a modern version of Engels Law one can expect higher-income economiesto have a relatively larger share of services in their consumption basket than lower-income economies, whose basket tends to have a larger share of tradable agriculturalgoods and manufactures. This greater dependence on commodity trade contributes to ahigher pass-through effect.6 They find, indeed, a negative and significant correlationbetween income and pass-through. A second reason is the countrys inflation history.The authors find a positive relationship between inflation history and pass-through. Arelated factor would be currency crises. Currency crises and periods of high inflation arelikely to lead to the use of foreign currencies in transactions and thus increase thedomestic prices vulnerability to the exchange rate.7

5 They compare and contrast the economies of 12 developing economies (Brazil, Chile, Mexico, Indonesia,Korea, Philippines, Thailand, Czech Republic, Hungary, Poland, Israel and South Africa) with 6 industrialeconomies (Australia, Canada, New Zealand, Sweden, Switzerland, and the United Kingdom).6 Some tudies show that pass-through is stronger in emerging economies in Latin America than in Asia,however. See for instance Kamin and Klau (2001) and Goldfajn and Werlang (2000).7Other factors such as openness and financial dollarization were also tested by Ho and McAuley but found

to be of no significance for their sample countries. Other studies, however, such as Honohan and Shi(2002), have identified dollarization as an important factor in explaining higher pass-through in emerging

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Chinas monetary policy experience8

China's government has had a tendency to alternate between austerity programs to fightinflation and expansionary programs to avoid unemployment. This stop-and-go

monetary policy spawned four severe boom-and-bust cycles because of disjointedfinancial channels and inadequate market financial tools that would allow for a finertuning of macroeconomic imbalances (Figure 4).

Figure 4: China's Real GDP Growth and Inflation Rate (%)

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

rate of growth of real GDP Inflation

Source: IMF International Financial Statistics, 2002.

By 1992 China's financial situation had become critical. The People's Bank of China(PBC) was a central bank in name only. The little control that the head office of the PBChad over its regional branch offices diminished, while the regional branch offices showedgreater independence and less accountability. This allowed the regional localgovernments to exert greater influence and pressure on the local PBC branches. Thefinancial institutions in turn were pressured by the local governments to extendunauthorized loans to support local state enterprises and risky and speculative investmentin real estate construction to spur regional growth. The additional loans that the centralbank injected into the money supply to finance planned investment, together with theunauthorized spending by the local PBC branches and regional governments, exacerbatedChinas inflation further. By 1993, average annual inflation rose to 14.6%, threatening

Chinas spectacular growth. Then came the macro reform package of 1994, including therestructuring effort under the 16-point financial reform program, which attempted toaddress some of these problems. Greater control of credit and loan expansion wasexerted over the banking system, increasing the efficiency of credit allocation decisions.

market economies. Honohan and Shi defined dollarization as foreign currency deposits held as apercentage of the M2 money supply. A higher level of dollarization is associated with higher pass-through effects. (China, unfortunately, is not one of the 80 countries included in the study).8 This section draws heavily from DaCosta and Foo (2002).

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However, the tightening of credit constrained the banks from extending credit to theunprofitable SOEs. The SOEs in turn were unable to meet their debt obligations to theircreditors, resulting in a problem called the triangular debt. By November 1993, theCentral Committee abandoned its austerity program instituted under the new financialreforms and reinstated expansionary policies. The result was rapid inflation with an

average annual rate of 24.2% in 1994.

Chinese experts acknowledge that its monetary policy is out of step with its marketeconomy. Four important factors contributed to the misstep. Firstly, when China begantransforming its planned economy to a market economy, it replaced its planned budgetsystem with an incipient money market. On the supply side, the rapid and extensivemonetization of its economy resulted in aggregate savings in state banks growing at anaverage of 20.7% a year from 1979-88 and an increase in per-capita savings of 33.7%.Households' bank deposits rose from 7% to 38% of the national income between 1978and 1989. However, on the demand side the credit allocation in China is still dependenton administrative planning.

Secondly, the Peoples Bank of China (PBC) lacks the authority to implementindependent monetary policies without political pressure from the State Council. ThePBC is forced to allocate loan quotas based on the state priority investment, particularlyto the unprofitable SOEs. Thirdly, the non-state sectors operating mostly under marketconditions have expanded much faster than the state-owned sectors. The share ofindustrial output of the state-owned enterprises dropped from 78% to 29% between 1978and 1996. That means that Chinas continued use of direct policy becomes less and lesseffective. Fourthly, the decentralization of the government decision-makingresponsibilities to regional and local government has increased pressure on the budgetand the ability of the government to finance public expenditures.9 The current revenuesystem of allowing local governments to collect and retain tax revenue reduced thecentral governments ability to implement effective fiscal polices or to counter monetaryimbalances when local governments independently pursued expansionary investment tosupport regional growth regardless of efficiency. The result is that more than 50% ofChinas financial resources in the economy are beyond direct budgetary control. Thissituation contributed to the push by the government to encourage banks to finance publicinvestments.

Although the Chinese government views monetary policy as a tool of indirect control, theactual control on monetary credit and other financial variables is still primarily direct,under the purview of the State Council. The exacerbation in the macroeconomicimbalances is an after-the-fact reactive monetary policy, rather than proactive aspracticed in most advanced economies. China's gradualist approach to financial reformshas become a hindrance to its development. 10Bank managers do not practice risk

9The share of government revenue in the national income fell from 37.2% to 19% between 1978-1988. In1979, the budget provided 75% of the state sectors capital investment and in 1988 only 25%. In the sameperiod, the amount of non-budgetary funds (portion distributed by local governments, departments, andenterprises) grew from 31% to 94.8% of fiscal revenue (DaCosta & Foo, 2002).10Chen and Thomas (1999) enumerate the downside of China's gradual reform and Dornbusch andGiavazzi (1999) recommend a not-too-gradual approach.

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management because it is less risky if the loans are politically directed and thereforethey are not to blame. Direct control by setting credit upper limits and the interest ratesfor banks and other financial institutions misallocates funds, particularly to unprofitableSOEs, and is contrary to market discipline. Direct control also leads to the growth ofillegitimate inter-enterprise borrowing and lending markets.

China has the characteristics of a government-permeated financial system. Thegovernment owns most of the financial institutions and banks (state, provincial or local)and bank lending is still under government control. In particular, the four specializedbanks, accounting for about 70% of the total bank deposits and loans, are required to lendto the unprofitable SOEs. Dornbusch and Giavazzi (1999) estimated that 50% to 70% ofthe four banks' total loans were non-performing loans. To deal with the bad loans of thefour state-owned banks, four Asset-Management Companies (AMCs) Huarong, Cinda,Orient, and Great Wall were set up in 1999. The AMCs loan recovery rate has beenextremely low and the NPLs are now estimated at $480 billion (The Wall Street Journal,January 13th, 2004).

In conclusion, since China, as well as other emerging economies, is more susceptible tothe effects of exchange rate fluctuations namely pass-through exchange rates arelikely to play a more important role in policymaking in those economies. If inflationtargeting is the main focus of monetary policy, then exchange rates are going to demandgreater attention than in industrial economies like the United States. The fear offloating and Chinas reluctance to embrace such a regime is well warranted.

Xu (2000) makes the case for using exchange rate stability as a nominal anchor because itis a target easier to identify than the CPI. In China, CPI may rise for reasons unrelatedto a monetary inflation. (Xu p. 274)

3. Exchange Rate and the External Sector

Exchange rate trends and associated uncertainty can also have important economicramifications through its impact on the external sector. An overly strong currency can,for instance, reduce a countrys external competitiveness and negatively impact exportsand growth. It can also reduce incentives for investment and change the allocation ofresources and the level of profits. Under exchange rate uncertainty, firms may delayinvestment decisions (Dixit 1989). Finally, exchange rate uncertainties can reduce thevolume of trade.11

In more open economies, aggregate profits are more likely to be positively correlatedwith exchange rate competitiveness (Ho and McCauley 2003). The greater the openness,the more vulnerable an economy is likely to be to fluctuations in exchange rates.Emerging markets, being relatively more open, and more actively courting foreign directinvestment, are more likely to be susceptible to these effects.

11 Though there is no consensus in the literature regarding the impact of exchange rate variability on trade,Calvo and Reinhart (2000b) contend that there is more conclusive evidence on the negative impact ontrade if one differentiates between the studies on emerging markets and those on industrial economies.

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How open is China? One can measure openness by taking the sum of exports andimports and divide it by the respective Gross Domestic Product.12By all accounts Chinahas been growing increasingly more integrated in the world economy in terms of bothtrade flows and capital flows. In 1978 China ranked thirty-second among exporting

nations, whereas in 2003 it ranked number four! Figure 5 shows the volume of trade(exports and imports) in millions of US dollars since 1980. China has been running asignificant trade surplus since 1993.

A very trade dependent economy will have to take into account the export sector whileformulating its monetary policy. Exchange rate reform was one of the most influentialfactors in Chinas long run export expansion (Zhang, 2001). Simulation outcomes revealthat Chinas policy preference has been to place a higher weight on competitiveness thanon inflation. (Zhang 2001).

Figure 5: Trade (Millions of US Dollars)

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Exports (Millions of US Dollars) Imports (Millions of US Dollars)


4. Exchange Rate and Financial Stability

This relationship is highly complex. Exchange rate fluctuations can seriously destabilizean economy's financial system as it was amply exposed by the Asian crisis. Bothpegged and flexible exchange rate regimes can exhibit vulnerabilities in the face of strongcapital flows. Strong capital flows increase the overall vulnerability of the system.Here we look at real exchange rate misalignment, susceptibility to reversal of capitalflows, and currency mismatches.

Most studies in this area concern the cases illustrated by the Asian crisis, where we saw areal appreciation of domestic currencies (pegged to the U.S. dollar) associated with verylarge capital inflows together with rapid credit expansion, speculative investment and

12 Lardy (1992) estimated Chinas openness (trade ratio) to be 9.7% in 1978, 12.8% in 1980, and 26.8% in1989 (p.150).

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the creation of asset price bubbles in the presence of growing external imbalances. Thereversal of capital flows can be disastrous and cripple the economy. Studies haveconcluded that these effects are more severe in emerging economies than in industrialones (see for instance Calvo and Reinhart, 2000b) and their effects more costly.

China is supposedly in the opposite situation the renminbi yuan, pegged to the dollar isdevaluing, at a time when it is appreciating in real terms due to increasing exports andgrowing current account surpluses. Figure 6 shows the movements of Chinas nominaland real effective exchange rates. In a fixed exchange rate system, the nominal exchangerate remains stable but the real exchange rate varies, along with the prices of imports andexports. Until about 1995 the nominal exceeded the real exchange rate.

Figure 6: Nominal vs. Real Effective Exchange Rates

50

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450

1980

1982

1984

1986

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1990

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Index(1995=100

Nominal Effective Exchange Rate (index 1995=100)

Real Effective Exchange Rate


Another issue has to do with the so-called currency mismatches defined here as asituation in which the profile of actual or potential foreign currency commitments isinsufficiently matched by the profile of actual and potential foreign currency cash flowavailable at the corresponding time horizon (Ho and McCauley, pp. 15). Suddenexchange rate adjustments are bound to bring about currency mismatches in banks andfirms balance sheets. At stake, is not only the currency denomination but also issuesconcerning maturity and liquidity.13

China would be particularly sensitive in this area given the fragility of its banking systemand institutions, compounded by a weak financial structure. A rapid appreciation of theyuan can cause adverse balance sheet effects of institutions (including the PCB) that have

13 Explanations put forth to explain why currency mismatches occur include moral hazard (an implicitguarantee by the government), original sin (the market for lending in domestic currency is nonexistent orunderdeveloped), and commitment problem.

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accumulated a lot of foreign reserves or foreign denominated assets, like U.STreasuries.14

Figure 7

Source: The Economist, 2003

The degree to which Chinas banking sector is mismatched is unknown (currencymismatches are notoriously difficult to measure), but it is safe to assume that given theshare of NPLs and problems associated with their management, they would be at risk.

Chinas banking and financial challenges

Given the severity of the problems facing China's financial system to date, it appears thatChina has been able to maintain its high economic growth rate and stave off animpending domestic banking crisis because of four major intrinsic economic factors: thehigh captured domestic savings (an average of 40 percent of income is saved), low publicdebt and negligible domestic debt, the current inconvertibility of the renminbi yuan onthe capital account, and the large foreign exchange reserves. Although the financialreform of 1993 has reduced the risk of an imminent banking crisis (DaCosta & Foo,2002) Chinas financial system is still inadequate and in the risk of failing from theexpanding NPLs and the increased competition from external forces under the WTOregime. The big four remain saddled with Communist-era management systems, hugepayrolls, vast networks of branches and a conviction that no matter how many bad loansthey build up, they are too large to be allowed by Beijing to fail (Financial Times,February 16th, 2004) a classic case of moral hazard! Standard & Poor puts the number

of bad loans in Chinas banking system at about 45 percent (Financial Times, September15, 2003).

Competition will soon be tougher! Foreign banks will be allowed to engage in localcurrency businesses with Chinese companies within two years and with individuals

14 Ho and McCauley note that the Central Bank of China (Taiwan) faced technical insolvency when theNew Taiwan dollar appreciated in 1988, because of its large foreign reserves (2003).

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within five years. The geographical constraints for foreign banks will also be removedafter five years. The competition with the domestic banks will be fierce, with dominoeffects in the industrial sector and SOEs. The unhealthy links between state-owned banksand SOEs described above will be subject to attacks on two fronts. On one hand, SOEswill be forced to increasingly contend with foreign competitors as new firms penetrate

sectors that were previously barred to them. And on the other hand, the state-ownedbanks that have been lending to these non-performing enterprises will be less able to doso, as they, in turn, are forced to trim their operations and become more efficientthemselves in order to compete with the best in the business, from all over the world.

In conclusion, despite calls from the IMF for China to make its currency flexible,Chinas banking and financial institutions are not ready. Johnston et al. (1997) list thefollowing preconditions for capital account liberalization as necessary: competitive andmature domestic financial markets; a healthy banking sector under the effectivesupervision of a competent regulatory authority; the capacity to conduct monetary policyeffectively with indirect instruments such as interest rates and the exchange rate; and a

sustainable payments balance, especially the current-account balance.

At this time China appears to meet at most one of these four preconditions. Until all theconditions are met liberalization of capital movements, and a floating exchange rate,would be premature.

5. Conclusion

It is clear that despite the financial reforms to date, China's financial system is still weakand inadequate. As long as financial and fiscal functions are not distinct and banks lackindependence from fiscal budget deficit financing and policy directives, even if afinancial framework is in place, they will still be ineffectual in supporting a developingmarket economy. Chinas control of the monetary transmission channels may havechanged but the basic administrative control and mechanisms have basically remained.The distribution of economic resources, particularly credit, is contradictory with thestructure and functions of a market economy. An effective financial and monetary policytransmission is crucial to a market economy because China's control over aggregatedemand and price level depend to a large extent on the control it can exert over moneysupply.

A change in the yuans value would be the biggest shift in monetary policy in a decade(The Wall Street Journal, February 13, 2004). And such a shift appears to be on the way.Against expectations of a greater strengthening of the yuan, and a louder and louder callfor flexible exchange rates, China seems poised to loosen the peg by 3 to 6 percent (TheWall Street Journal, Feb. 13th, 2004) or by as much as 5 percent to 10 percent (The NewYork Times, Feb. 10th, 2004) in value against the dollar. It has also been reported thatChina may choose to peg the yuan to a basket of as many as 10 currencies (compatiblewith historical precedent). At any rate, it is safe to conclude that the actual 8.30 peg ishighly unlikely to be maintained and that soon we will see a revaluation of the yuan and asomewhat more flexible system such as a wider band or a currency basket but

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probably nothing remotely close to a floating system at least not yet! Incrementalchanges have Chinas economic reform hallmark, after all.

Developing countries must take exchange rate fluctuations more seriously than industrialcountries. It would be premature for a large, developing country like China, afflicted

with a fragile banking system and underdeveloped capital markets to embrace a floatingsystem this prematurely. Floating exchange rates would be something to ponder onlyafter Chinas financial institutions are stronger and more developed. As the Economisthas recently stated, and this paper attempted to illustrate a developing countryseconomic institutions may matter more than its exchange rate regime (The Economist,September 13th, 2003).

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