Chinese Currency Reform and East Asia: Steps Toward Regional Exchange Rate Stability

ITO Takatoshi Faculty Fellow, RIETI

With the question of revaluation resolved, the currency basket is next on the agenda

The recent revaluation of the yuan has left many unresolved questions and whether the U.S. government will be satisfied with China's steps or not will depend on future developments. With the elimination of the dollar-yuan peg, the adoption of a common currency basket by East Asian countries is the next medium- to long-term issue to consider in the effort to ensure stable exchange rates within the region.

One certainty - and a host of questions

China's central bank, the People's Bank of China, announced on July 21 a 2% revaluation of the yuan against the U.S. dollar and said the Chinese currency would now be allowed to fluctuate against a basket of currencies, a move it called a first step in the reform of China's system of foreign exchange. According to the announcement, "the People's Bank of China, with authorization of the State Council, is hereby making the following announcements regarding reforming the RMB exchange rate regime." This suggests the revaluation was carried out not at the sole discretion of the central bank but was also approved by high-ranking government officials.

The exchange rate reform has four main points. First, the yuan's dollar peg was abandoned in favor of a "managed float" against a basket of currencies. This float is to be based on supply and demand in the market. Second, the closing rate at the end each business day is to become the central rate for a trading band on the following day. Third, the closing rate for July 21 was set at 8.11 yuan to the dollar, a 2% revaluation compared to the previous day. Fourth, the yuan will be allowed to fluctuate up to 0.3% plus/minus the central rate against the dollar each day. In addition, the reform calls for that the exchange rate will in the medium- and long-term be "more flexible based on market condition with reference to a basket of currencies."

Taking the announcement at face value, the daily trading band against the dollar will be set at 0.3% above or below the central value. It is not clear, however, if this means the yuan will be allowed to move freely as long as it does not hit the upper or lower limit, or if officials will intervene to ensure that the yuan does not hit the limit. In addition, since the composition of the currency basket and the weights of its constituent currencies were not announced, it is not possible to determine in advance how the float will be managed.

The daily closing rates announced by the central bank include the yuan's value against the dollar, the yen, the euro, and the Hong Kong dollar. However, if the yuan-dollar rate is used as the central rate for the following day, reference to a currency basket would be basically meaningless. If the basket were used seriously, officials would probably steer the yuan-dollar rate so that the closing rate would be close to the reference currency basket. This was the most opaque part of the central bank announcement.

Theoretically, under the new exchange rate regime, it would be possible for the central rate to gradually rise, though only by a bit each day. With strong buying pressure, the yuan would reach the upper limit each day (a daily appreciation of 0.3%), which would then become the central rate for the following day. If this were continuously repeated, the yuan would appreciate 3% over 10 days, 6% over one month (around 20 business days), and 20% over three months. This system is called a crawling peg. Right after the July 21 announcement, it was believed that changes in the central rate of China's crawling peg were to be based on the above-mentioned currency basket under the new exchange rate regime.

However, on July 26, the People's Bank of China said it was incorrect to consider this 2% revaluation as the "first step in reform," or to assume that the revaluation range would gradually be expanded. In this case, the above example of a gradual rise in the value of the yuan will not happen.

A faster but smaller reform

Until the July 21 reform, many market participants had believed the yuan would be revalued by 5% to 10% sometime in August. Chinese President Hu Jintao will visit the U.S. in September and if the revaluation had taken place around that time, it would have looked like China had caved in to U.S. pressure. Furthermore, in October the U.S. Department of the Treasury will submit its semiannual report on foreign exchange policy to Congress. The last report fell short in calling China as a country of manipulating its exchange rate, and gave it six months to make the reform. If nothing had been done, it would have been very likely the upcoming report would have been very critical of China. August was considered the last moment that China could reform its exchange rate system without looking like its hand had been forced by the U.S.

The U.S. Department of the Treasury has frequency dispatched envoys to convince officials and experts in China of the need for exchange rate reform. It also appears that China decided it was not a good policy to cause problems for the Bush administration, and particularly for the Department of the Treasury, with the U.S. Congress. By implementing the reforms before August, China fooled the markets. The reform was thus both earlier and more modest than expected.

Whether the present exchange rate system will satisfy the U.S. or not will likely depend on movements in the yuan, the growth rate of China's foreign exchange reserves, and trends in the trade balance between the two countries.

Deeper debate on monetary cooperation

Under a currency basket system that incorporates the yen, the euro, and the dollar, changes in the value of the yuan are a weighted average of the changes against these three currencies. In other words, if both the yen and euro weaken against the dollar, the yuan will also weaken against the dollar, but not by as much as the yen or euro themselves. If the yen and euro are equally weighted in the currency basket and the yen depreciates against the dollar while the euro appreciates, whether the yuan rises or falls against the dollar will depend on which is larger, the yen depreciation or the euro appreciation.

For example, movements in the yuan-dollar rate between July 22 and July 28 can be explained to a certain extent by changes in the yen-dollar and the euro-dollar rate. Even when both the yen and euro moved in the same direction against the dollar during this period, the yuan did not fluctuate as much against the dollar as the other two currencies. Thus it can be inferred that the weights of the yen and the euro in the currency basket are quite modest. Of course this assumption is based on a very small data set, and movements will have to be watched for a while to make a more precise determination.

Moving to a basket system, however, does not necessarily mean that all currencies included in the basket must be used for intervention and foreign exchange reserves. Intervention to maintain the yuan's value against the basket can be done with yen, euro, or dollars. If one assumes that the exchange rates between the yen, dollar, and euro are not affected much by Chinese intervention, whichever currency China uses for intervention, the results will be the same due to arbitrage between the three currencies.

Furthermore, the composition of foreign exchange reserves is determined to ensure liquidity and from an asset management perspective. This means the currencies in which foreign exchange reserves are held are not necessarily the same as the basket currencies. Thus, adoption of a currency basket system need not imply a shift in China's foreign reserve holdings or a sell-off of the U.S. government bonds it holds.

In a "basket band crawl" (BBC), the central rate is based on a basket composed of the currencies of major trading partners and rather large fluctuations in the exchange rate are permitted. A BBC exchange rate system maintains a stable effective exchange rate but allows a certain degree of short term fluctuation. Singapore and Thailand are often cited as examples of countries in Asia that have exchange rates systems similar to a BBC. This system maintains a country's export competitiveness while automatically tracking currency the trends of its major trading partners.

Almost 50% of East Asia's trade takes place within the region. If exchange rates between countries within the region were stable and regional currencies floated in the same manner against the dollar and the euro, trade, investment, and capital flows within the region would become more stable, benefiting the region as a whole. But if each country employs a different currency basket, this will lead to confusion.

In the medium to long term, if all East Asian countries were to employ a BBC based on a common basket of currencies, the regional exchange rate system would become extremely solid. China's dollar peg was a major obstacle to such enhanced regional monetary cooperation. With the obstacle removed, East Asian government officials responsible for exchange rate policy should deepen their discussions on monetary cooperation.

>> Original text in Japanese

* Translated by RIETI.

July 29, 2005 Nihon Keizai Shimbun

August 11, 2005