China's foreign exchange regime is on the verge of significant change as the country's financial system undergoes historic reforms aimed at liberalizing the capital market and enabling cross-border movement of funds.

Political and economic factors will play a fundamental role in the process.

Chinese Premier Wen Jiabao indicated the establishment of a more flexible renminbi (RMB) exchange rate mechanism by deepening reforms, more adaptable to the market supply and demand changes, when he met the Citibank chief executive Charles O. Prince and the US former Secretary of the Treasury Robert E. Rubin on September 28th.

The indication sparked speculation on whether RMB reform by the Chinese Government was in the offing.

In 1994, China realized the unification system of RMB exchange rate and RMB's conditional convertibility under current account. And China has, since then, adopted an exchange rate policy basically pegged to the US dollar.

From the middle of 2003, however, the US business world began criticizing the Chinese Government for manipulating the exchange rate to gain an unfair advantage, and the US Government began applying pressure on China in an attempt to cause fluctuations of the RMB exchange rate.

For a while, consequently, speculative activities targeting RMB appreciation focused on China, which, coupled with waves of foreign investment, led to a soaring increase in the levels of China's foreign reserves.

Since 2000, China's foreign reserves have witnessed a threefold growth, and a continuous 15 per cent during the first half of this year, to top US$ 470 billion by the middle of the year.

In spite of the enormous pressure from the Western world, the Chinese Government has maintained its policy and waited for the speculative wave to subside.

Under the current exchange rate mechanism, the exchange rate is largely determined by the supply and demand of the foreign exchange wholesale market between banks authorized to transact foreign exchange. But limited by specific regulations and due to the small number of market transactions, 95 per cent of the forex transactions are monopolized by China's four State-owned banks.

Therefore, the money regulators can control the exchange rate not only by the staple of forex transactions, but also by adjusting the balance of strength between supply and demand, by implementing policies to restrict transaction conditions.

In this way China is able to track the US dollar to continue its forex policy.

But two possible factors may belie this assurance of maintaining the status quo.

One is the unsuccessful macroeconomic management that could lead to an overheated economy, and in turn result in abandoning the policy of pegging to the US dollar and begin appreciation of the RMB.

The possibility of this is slim, since the government's macroeconomic management efforts have begun to bite, as signaled by the Bank of Asia's optimistic forecast in its September 22 report, that the Chinese economy will successfully achieve a 'soft landing' in 2005. And even though the country's economy continues on its overheated trend, China still has effective measures, like the interest rate lever, to take.

The other possible factor is the continued weakening of the US dollar, which means that China may suffer from an overheated economy caused by an inward flood of money if the RMB continues to peg to the US dollar in such circumstances. Moreover, this situation may also force other countries, including China's neighbours in Asia to urge RMB appreciation.

This possibility, however, also seems unlikely over the next few months, because the good prospects of the United States' economy and the higher interest rate rise by the Federal Reserve, after a 10-15 per cent decline against the euro and Japanese yen in the second half of 2003, will probably push the dollar upward.

Maintaining a fixed exchange rate may, of course, not be the best choice to make.

In the near future, expectations of RMB appreciation by the market will lead to a continued large influx of speculative money into China. In order to maintain the exchange rate, the government will have to buy in a great amount of US dollars, and that, ultimately, may result in money supply inflation. The government, therefore, would have no choice but to issue a larger number of bonds, so as to keep control of the money supply.

For example, China's foreign reserves growth accounted for less than two per cent of its domestic M1 money supply between 1998 and 2000. That percentage increased dramatically to 6.35 per cent, 8.6 per cent and 11.2 per cent respectively in 2001, 2002 and 2003, putting tangible pressure on the money regulators.

For the sake of long-term interests RMB appreciation is inevitable given the remarkable improvement of China's exports, inward foreign investment and productivity over the last 20 years.

Experience of the new industrialized countries, including Japan and other countries in Asia, shows that the opening of the financial market and currency appreciation is a necessary step after 25 to 30 years of rapid economic growth, because currency appreciation can help improve trade conditions and alleviate the burden of foreign debt.

Another potential beneficiary of RMB appreciation will be the Chinese government leaders. The move will greatly hasten the pace of achieving the government's objective of increasing fourfold the Gross National Product (GNP) of 2000 before 2020 , overtaking the United States in terms of overall economic scale by the middle of the 21st century.

Therefore, the RMB exchange rate system reform accords with China's short and long-term interests. In addition, China's WTO (World Trade Organization) pledges to fully open RMB business to foreign banks by 2006 reinforces the urgent need to reform the RMB exchange rate mechanism.

One possible choice of reform is to widen the fluctuation range of the RMB exchange rate, which is also the US government's call. But big risks lurk in the resultant influx of speculative currency if this choice is followed.

By far the safer way is to increase the RMB quote price and on the basis of the new quote price, to continue the policy of pegging to the US dollar.

The quote price increase needs to be large enough to preclude speculators expectations for further possible RMB appreciation, and as a result, to efficiently block a rush of money into the Chinese market. Under this scenario, the government will have a favourable environment to adjust the exchange rate flexibility.

The current situation appears more conducive to the adjustment of RMB exchange rate, compared with that of 10 months ago.

The initial success of China's macroeconomic management reduces risks in continuing the sticking-to-the-US-dollar policy and renders the Chinese government active in controlling the exchange rate.

Politically, the new generation of Chinese leaders is less concerned about being seen to be yielding to pressure from the outside by adjusting the RMB exchange rate, compared to its predecessors, who had a more political bent when it came to smoothing the way for exchange rate system reform.

Even so, the current environment is not the best for making an adjustment to the exchange rate system.

Unveiling the major reform orientation of China's RMB exchange rate ahead of this week's US presidential election, while keeping the time and measures unspecified, has given the Chinese Government an advantage when it comes to communicating with the Western nations at events like the G7 meeting.

Source: China Daily