China: a fit case for flexible exchange rate?

Abstract

The economies around the world have passed through various Exchange Rate Regimes. China, a key player in world economy , has pegged its exchange rate against US Dollar(USD) . Chinese Yuan has been trading within +/- 0.3% of 8.28 per USD since 1993. The value of the RMB against major currencies has become a contentious issue in political and Economic circles in recent months. China’s effective peg to the US dollar has led to a decline of the RMB exchange rate against other major currencies, particularly the euro and the yen. The pressure has been coming on China from various quarters, including US and Japan, to swiftly move to market-determined flexible exchange rate. This paper analyses whether or not China should move towards flexible exchange rate system and also makes an attempt to examine the prerequisites for the smooth transition of Chinese Economy to Flexible Exchange System, if and when the same happens. For this purpose the paper first discusses the theoretical framework underling the exchange rate. It identifies the principles to be considered while choosing the appropriate exchange the principles to be considered while choosing the appropriate exchange rate regime , and also looks at different theories, which have been put forward to explain the determination of exchange rates: 1. Purchasing power parity (PPP) theory A. Absolute version B. Relative version 2. Traditional flow approach/ Balance –of-payment view/ Exchange market approach 3. Modern approach (based on interest rate parity of exchange rates) The paper also discusses the various exchange rate regimes: 1. Flexible exchange rates 2. Fixed exchange tares 3. Intermediate systems (A.) Crawling Peg (B.) Wider Band (C.) Managed or dirty float (D.) Oscillating Exchange Rates 4. Current No- systems. The paper also enumerates the effect of fiscal and monetary policy under varying exchange rate regimes i.e. fixed and flexible exchange rates under the conditions of low and high capital mobility. The conditions of low and high capital mobility. After having discussed the theoretical framework, the second section of the paper looks at the empirical trend in world economy: 1. Specie (1880-1914) 2. Gold Standard (1919-1945) 3. Bretton Woods System (1946-1971) 4. New system- No system (1973 onwards) The paper also looks at the phases through which exchange rate regime in China has gone through. 1. Phase One (1949-1972) Officially determined exchange rate and a single peg. 2. Phase Two (1973-1985) A basket page and dual exchange rate system 3. Phase Three (1986-1993): managed floating and sap center -----first step toward market determined rates. 4. Phase four (1994-present): Unitary managed floating and current account convertibility. In the third section of the paper, it critically evaluates the current fixed exchange rate system in China. It looks at the China`s ability to control its domestic money supply. The paper also at the sterilization process and its effect on China`s domestic economy and the external balances. The paper has also made an attempt to see whether Renminbi is undervalued, using various criteria such as: 1. Manufacturing wages parity 2. Purchasing power parity 3. Balance of payments and Reserve Accumulation Test. The last section of the paper discusses the role and drivers of capital inflows and also the effect of liberalization of capital outflows on Balance of Payment. The paper finally makers an attempt to look into various objectives from Chinese perspective and try to analyze whether one time Upward Renminbi revaluation by 10-20% hurts these objectives. It also looks at the effect of such revaluation on the rest of the world. Having identified that the RMB revaluation is good for the rest of the world and also china in terms of promoting sustainable non- inflationary growth, the paper goes on to evaluate the various approaches that can be taken towards the revaluation: 1. Slow in steady approach. 2. Flexible exchange rate and full capital account convertibility 3. Flexible exchange rate but restricted capital account convertibility 4. Two stage reforms. Finally paper also makes a mention of reforms in foreign exchange market and existence of strong financial system as a prerequisite for revaluation.