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Increasing Role of Market in China's Foreign Exchange Rate
For the past two years, Dai Xianglong, China's central bank governor, has been asked, "Will the renminbi be devalued" nearly everywhere he went. Recently, a new question has replaced it - "Will China freely float the renminbi exchange rate?"
Dai Xianglong's answer to the second question has been, using a stable exchange rate as foundation, it is worth studying the suggestions to expand the range of the RMB, but the People's Bank of China currently has no plans to change the current system. In other words, perhaps China will increase the flexibility of its policies, but in the it will not use a "managed floating exchange rate system" in the short term to freely float the RMB.
Actually, the main reason why the markets are so concerned about this question is that the Chinese central bank has stood on the sidelines and watched as the RMB exchange rate repeatedly broke through the old ranges. It goes back to the old question, "Once the RMB is freely floated, will it devalue?"
The consensus in Beijing is that the time is not ripe to freely float the RMB.
But, the recent changes in the RMB market show that the central government is gradually interfering less and less in the foreign exchanges market.
Some astute observers have noticed that lately, when Dai Xianglong talks about the exchange rate, no longer promises that the government will not devalue the RMB and uses the more objective "the stability of the RMB exchange rate has a strong foundation."
People's Bank of China Research Department vice-director Lin Tao stressed that the central bank is gradually improving the RMB exchange rate mechanisms. The changes in the exchange rate will reflect the supply and demand of the market and gradually weaken the foreign currency market's expectations of the government to guarantee the RMB exchange rate.
Thus, some people have summed up the central bank's management of the exchange rate as "strengthen market mechanisms, weaken policy guarantees."
Whether China will expand the range of the exchange rate or adopt a more flexible exchange rate system depend on a number of factors.
1) Environmental Factors. Since East Asia has recovered from the Asian financial crisis, every country's currency has started to rebound. Japan's economy is starting to show signs of recovery, lifting the pressure of the RMB to devalue. Thus, the environment for China to adjust its foreign exchange policy has relaxed.
2) Economic Factors. Once the market plays a big role in setting the foreign exchange prices, will the RMB appreciate or devalue? What about the range the RMB is traded at? These questions will undoubtedly be crucial influences in the monetary authority's policy. Thus, the foreign exchange rate's flexibility must be based on its stability.
Currently, China's economy has turned around the past couple of years' slowing growth rate. Earnings from foreign trade are good and the supply in the foreign exchange market is greater than demand. China's foreign exchange reserves have increased steadily. Thus, the market feels that the RMB is very strong right now. People predict that foreign trade will maintain its trade surplus in the second half so more foreign capital will flow in. The supply in the foreign exchange market being greater than demand won't change and the RMB will continue to be stable. The monetary authorities are full of confidence that the foreign exchange rate will remain stable. These provide a stable foundation for the monetary managers to broaden the range of the foreign exchange rate.
3) Momentum. The expectations of formally joining the WTO should give authorities the momentum to increase the flexibility in the exchange ate system. On the other hand, the foreign exchange rate system isn't a target of reforms. Currently there is little pressure to completely open the exchange rate so China is still adopting the secure method of adapting the foreign exchange rate to the market.
4) Market Reaction. China's monetary authority will carefully loosen the range of the foreign exchange rate because of the sensitivity of the foreign exchange index. This kind of caution not only includes carefully studying its effects, it also includes listening to the market's reaction.
Many people in the industry consider now to be a good time for the central bank to broaden the range of the foreign exchange rate. China should be more vocal about increasing the role of the market on the foreign exchange price at this critical time and slowly increase reform. That way the government can increase the efficiency of its management over foreign currency as well as change the expectations that the RMB will devalue.
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