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Chinese Currency Reforms
Koen Huisman (40005710)
November 2005
City University of Hong Kong
EF3461 Economies of Mainland China
& Hong Kong, Term Paper
Contents
1 Introduction 3
2 History and Current State of the Chinese Currency Market 4
2.1 The Stability Argument . . . . . . . . . . . . . . . . . . . . . 4
2.2 The US Current Account Deficit . . . . . . . . . . . . . . . . . 6
2.3 Consequences of the Undervaluation . . . . . . . . . . . . . . . 7
2.4 The Risks of a Gradual Reform . . . . . . . . . . . . . . . . . 9
3 Why Countries Maintain Under/Over-valued Currencies 11
4 Advantages of a Revaluation 13
5 Possible Solutions to the Undervaluation 15
6 Conditions for a Fixed Exchange Rate and the Case of China 16
7 The Hong Kong Dollar 18
8 Conclusion 22
2
1 Introduction
On July 21st 2005 the Chinese government announced it would revalue its
currency (the Renminbi (RMB)) by 2.1% against the US dollar, after a long
period of pressure from the US senate to adjust its foreign exchange policy.
Although the move was unexpected, it will probably not be enough to end
the criticism from the rest of the world about the current undervaluation of
the currency. This paper will discuss this criticism, as well as the possible
advantages of a revaluation; not only for the US, but also for China.
The main part of this paper will address the current situation of the
undervaluation of the RMB, by giving a broad theoretical overview of the
pro’s and con’s of prolonged periods of deviation from the fundamental value
of a currency. Furthermore the historic and current situation of the RMB
will be discussed, as well as some possible solutions to solve the current
disequilibrium and some suggestions for alternative currency regimes.
The last part of the paper will give some insight in the history and actual
position of the Hong Kong dollar, which is also linked to the US Dollar. The
possible influence of changes in the Renminbi policy on the Hong Kong dollar
will be discussed.
3
2 History and Current State of the Chinese
Currency Market
For the last 10 years the Chinese currency RMB has been pegged to the US
Dollar at the rate of 8.28 RMB for 1 US$. Such a link creates a so-called
fixed exchange rate, in with the Chinese Central Bank is the party which has
to maintain that certain rate. This implies that when the market rate of the
currency moves above a certain threshold, the Central Bank will sell the home
currency for foreign currency to create more supply of the home currency and
more demand for the foreign currency. This will lead to downward pressure
on the currency through basic laws of supply and demand. If on the other
hand the currency starts to decline in value, the Central Bank will exchange
foreign currency for the home currency to support the exchange rate. It is
obvious that such a policy requires much more attention and effort from the
government and the Central Bank (in this paper the terms government and
Central Bank will be used interchangeably) than floating rates: in which the
exchange rate is not influenced by the government or Central bank, and the
market rate is thus established trough supply and demand for the currency
from market participants.
2.1 The Stability Argument
Probably the most important reason for a country to implement a fixed
exchange rate is stability in the rate. As it is the case with most economic
variables, economies almost never benefit from large swings in those variables,
such as inflation, exchange rate, interest rates etc. A stable exchange rate
will lead to more certain revenues and costs for exporters and importers,
and will help a country to build stable trade relationships. On the other
4
hand one can argue that fixed exchange rates are an unnecessary government
intervention in the free flow of capital, which will only lead to disequilibria in
the long run, and the subsequent strong adjustments in the exchange rates
which cause uncertainty and can ultimately result in an economic crisis. It
doesn’t require much effort to find a long list of crises caused by governments
defending their fixed exchange rate, such as the devaluation of the British
Pound after the collapse of the Bretton Woods system, or the Mexican Peso
crisis in 1994.
As with most economic issues, there is no closed-form solution for the
question whether or not a country should have a fixed exchange rate, a
floating one or something in between. Williamson (2004) however describes
the most important economic conditions for a successful implementation of
a fixed exchange rate. Further on in this paper some of these criteria will be
discussed, as well as the extent to which the Chinese currency fits into this.
As stated before, stability is often the prime reason for the introduction
of a fixed rate regime. This is also the main explanation of the Chinese
government for their exchange rate policy. Lardy (2005) however explains
that there are some comments to be made on this. First of all the Chinese
currency peg is constructed as a constant value of the Chinese Renminbi
(RMB) against the US Dollar. Large moves of the US Dollar against other
major currencies (and there have been quite a few in the last decade) there-
fore immediately influence the value of the RMB against those currencies.
Furthermore the link to the US Dollar is a nominal link, which doesn’t take
into account the possible differences in the development of the price level in
both countries. The real exchange rate (which is the nominal rate divided
by the difference in the development in price levels) is therefore not equal to
the (fixed) nominal exchange rate.
5
The history of the RMB exchange rate is also far from stable. Since the
start of the economic reforms in 1978 there have been a large number of
strong devaluations, such as the 21.2% devaluation in 1989. Furthermore
from 1978 until 1994 the currency declined by a couple of devaluations from
1.5 RMB/US$ to 8.28 RMB/US$.
Although the exchange rate has been stable at 8.28 RMB/US$ since mid-
1994, the Chinese government has a long history of statements indicating
future reform of the exchange rate mechanism, which should lead to a more
free-floating rate. Especially after pressure from the US started to grow (due
to the exploding US current account deficit) Chinese officials have indicated
that further reforms are on the way, but without giving much insight into
the size of the reforms let alone the timing.
2.2 The US Current Account Deficit
Before touching the issue of a possible RMB revaluation, it is worth to address
briefly the reason for the US pressure to revaluate. Due to rising oil prices and
ever-growing imports the US is currently running a strong current account
deficit, which is mostly financed by capital inflows from Asian countries.
The dangerous aspect in this is that if these countries would stop creating
massive amounts of US$ reserves, the need to attract more money into the
US to finance the current account deficit will result in an upward pressure on
US interest rates. This in turn could lead to a hard-landing of the economy.
The only solution to reduce the current account deficit is a devaluation of the
US$. Although there has already been a gradual decline in the US$ exchange
rate against most major currencies, a large part of the deficit is still caused
by the large trade gap with China. But since the RMB is pegged to the
US$, the US$ can’t decline against the RMB, and therefore the gap is still
6
increasing. The US senate is as a result urging the Chinese government to
revaluate the RMB, which in turn would relief some of the pressure from the
US deficit.
2.3 Consequences of the Undervaluation
The last couple of years China has been running a large surplus on its current
account, due to strong exports supported by competitive prices of the Chinese
export products (figure 1). These low prices are mainly the result of two
aspects: the large supply of cheap labor in China, and the undervaluation of
the RMB against other currencies. This combination leads to a large demand
for China’s products, and imposes a serious threat to foreign competitors
in certain products (see for example the current dispute on China’s textile
exports). A country which runs large surpluses on its trade balance normally
sees an upward movement of its currency rate, as the demand for the currency
increases due to the strong exports. The subsequent rise in the exchange rate
creates a rise in the price level of Chinese products for foreigners, which in
turn will reduce exports and create an equilibrium. However, as the Chinese
RMB is pegged to the US$, the currency can not appreciate against it, and
the artificial undervaluation will remain in place. Furthermore due to the
steady decline of the US$ against most other major currencies (as a result
of the exploding US current account deficit), the RMB has in fact even
devaluated against most of the currencies. This situation has caused its
trade surplus to increase even more, with current account surpluses of 3%
of GDP in 2003, 4% in 2004 and forecasts of 6% in 2005. The underlying
surplus is in fact even larger, when one keeps in mind that China’s economy
is currently booming. A strong economy will increase the amount of imports,
thereby reducing the surplus on the trade balance. A slowdown of the Chinese
7
Figure 1: China’s current account balance. Source: Deutsche Bank Research,”China & India: A visual essay”, 12/10/2005.
economy in the next couple of years would therefore even lead to an even
further increase of the trade surplus, as the stabilizing effect of high imports
diminishes.
Another result of the undervaluation of the RMB is that a situation has
arisen in which speculation of a RMB revaluation is growing. As it is likely
that the RMB will strengthen in the (near) future against the US$, a large
number of speculators are putting their money in RMB denominated assets,
to profit from such a revaluation. This has led to large inflows in RMB
portfolios, creating an additional flow of money into China. This is the part
which is called the capital account section of the Balance of Payments (figure
2). Together with the current account surplus, this has created a huge build-
up of US$ reserves in China. The possible consequences of such a prolonged
undervaluation of a currency will be discussed further on in this paper.
To calculate the possible size of the undervaluation of the RMB against
the US$, Lardy (2005) describes a framework in which an exchange rate is
8
Figure 2: The Balance of Payments, source: Wikipedia.com
calculated which would lead to an equilibrium on the Balance of Payments.
By gradually increasing the value of the RMB in the model one can simulate
the influence on the current account (by taking into account the elasticity
between exports/imports and the exchange rate). When done for the RMB,
such an analysis results in a current undervaluation of somewhere between
20 and 25%.
2.4 The Risks of a Gradual Reform
After a long period of strong political pressure from the US in particular to
reform the exchange rate policy of China (which in fact means a revaluation
of the RMB) the Chinese government decided to revaluate the currency by
2.1% against the US$ on July 21st 2005. Although this seems to be a first
step towards a more appropriate exchange rate, there are some necessary
9
remarks to make. First of all, it is obvious that such a small adjustment will
not make a large difference with regards to China’s trade surpluses and the
US’s deficits. As stated before, the fundamental value of the RMB might
be around 20% higher than the old value of the peg, implicating that a
2.1% adjustment is only a very small first step. The danger of such a small
change however is that it is likely to attract even more speculation into the
RMB, as the Chinese government has shown that it will probably revalue the
RMB more in the future, serving as an excellent investment opportunity for
speculators. The inflow of speculative funds will therefore only increase after
this small revaluation, creating even more upward pressure on the RMB.
Furthermore the small change in the peg-value will convince the US senate
that putting pressure on China to force them to revaluate the RMB has in fact
paid off; creating an additional incentive to urge for more reforms. Criticism
of China’s current RMB policy is therefore not likely to be silenced. Finally
a policy of gradually adjusting the exchange rate regime is probably not the
best way to change to a more floating rate regime. The last 25 years China
has always used gradual changes to reform its economy, but the currency
market might ask for a different approach. Due to the huge amounts of money
involved, as well as the role of speculators and the influence of expectations,
changing the rate of the RMB slowly could lead to an unsustainable situation
in which the outside world is convinced that in the end a revaluation will
occur, causing massive imbalances in money flows. Goldstein (2004) therefore
argues that a sharp revaluation of approximately 20% would be the first step
of an optimal solution to the undervaluation, instead of gradually adjusting
the rate while risking huge imbalances.
10
3 Why Countries Maintain Under/Over-valued
Currencies
Countries following a fixed exchange rate regime can have different arguments
for maintaining an undervalued or an overvalued rate for their currency. The
most common reason for keeping a currency below its fundamental (market)
value is the competitive advantage caused by the artificially low rate. If a
country pegs its currency at say 10% below the market value, its exports will
profit from it driven by foreign demand for the low-priced products. Such
a strategy will therefore benefit competitiveness, exports and in the end
GDP growth and employment. Goldstein (2004) mentions the main risks
of maintaining an undervalued currency, namely the danger of increasingly
protectionist measures by other countries (such as trade barriers and tariffs)
and other international trade conflicts. It can furthermore lead to exchange
rate instability as speculators will flow money into assets denominated in
the local currency to profit from the undervaluation. If the country in the
end has to revaluate its currency, the government will pay the speculators’
gains (for example if speculators invest 100 mln US$ in the local currency,
which appreciates by 10% afterwards, the government will lose 10 mln US$
if the speculators convert all their investments back into US$ at the higher
rate). Due to these risks countries should focus on improving efficiency and
productivity to stimulate domestic growth, instead of creating demand for
exports through an artificially undervalued exchange rate.
More common is the case of a country trying to defend an overvalued
exchange rate. In this kind of situations it is probably not the government
choosing an artificially high rate, but the difference between the fixed rate
and the market value arises from downwards pressure on the currency (for
11
example because of a lack of confidence in the countries economy). The
country will probably be reluctant to devaluate the local currency, as this
will incur the risk of contraction of the economy. Although the export will
profit from such a devaluation (local goods will be cheaper for foreigner, it
will however take some time before it effects exports), the value of foreign
debt expressed in the local currency will rise, and due to decreasing confi-
dence in the country and its currency it is likely they will have to pay higher
interest on newly attracted foreign debt. Furthermore most countries having
an overvalued currency will probably run a deficit on the current account.
They therefore have to attract foreign funds to cover the current account
and to roll over maturing loans. It will not be surprising that shortly after
a devaluation investors will demand a higher return (interest) on loans than
before. The decline in confidence after a devaluation (and possible specu-
lation of a further decline) will turn out to be costly, therefore giving the
government incentives to defend an overvalued exchange rate.
However as it is the case with maintaining an undervalued currency, there
are of course also risks related to the defence of an overvalued currency. As
the government (or Central Bank) has to keep on buying local currency in
exchange of foreign reserves, it is obvious that such a situation can not last
forever, because finally they will run out of foreign currency (or other assets,
such as gold) to maintain the peg and will be forced to devalue the currency
thereby giving speculators their gain. The expectation that the government
will not have enough foreign currency to defend the peg in the end will already
attract speculators trying to defeat the currency peg, thereby increasing the
pressure on the buying action of the government. A devaluation in the end
will have serious negative impacts on the credibility of the government, as
well on the economy and exchange rate as a whole.
12
4 Advantages of a Revaluation
Goldstein (2004) and Williamson (2004) argue that contrary to the Chinese
government’s view a revaluation of the RMB would in fact turn out to be
in the interest of China itself as well. First of all it is pointed out that the
common argument for a undervaluation, namely to support weak domestic
demand, is not appropriate in China’s situation. In fact the Chinese economy
is expanding at a very high rate, with a government trying to maintain
control on the growth rate. The positive effect on the export position that a
undervalued currency has can therefore be dangerous in the case of China, as
domestic demand is everything but weak. On of the more appropriate reasons
for the maintenance of the low value of the RMB is therefore probably that
the government was afraid for a slowdown in growth due to the spreading of
SARS a couple of years ago. As is has turned out that the negative impacts
on the economy have been limited, this argument seems to be no longer valid,
and a change in policy is therefore required. The real danger namely lies in
the credit growth created by the massive inflow of funds into China, due to
a current account surplus caused by strong exports, and huge capital inflows
as a result of speculation on a revaluation. This in fact has lead to a boost
in credit, which will create excess lending and a sharp increase in bad loans
because banks will use the excess funds to lend money to the public and to
companies. Especially with the opening of the capital markets scheduled for
early 2007 under the WTO-entry guidelines, is will be essential for China
to keep on reforming the banking system in order to compete with foreign
13
bank; a jump in bad credit is therefore probably the worst that can happen to
the current reforms. The current exchange rate regime is therefore a serious
enemy of the bank reform as a whole.
Inflation risk is one of the other negative impacts of the continuing under-
valuation of the RMB. With the booming Chinese economy already signaling
the first signs of inflationary pressures, a continued undervaluation of the
currency will keep on stimulating exports and therefore creating inflation.
Furthermore the ongoing capital inflow will make it even harder to control
inflation. Currently China is one of the biggest importers and exporters of
the world. Although its economy still needs a significant number of reforms,
it has good access to the world markets. It is therefore in China’s inter-
est to maintain these relationships with the rest of the world, and to avoid
trade disputes which could harm China’s access to the export market. In the
light of the growing pressure from the US and other countries to revaluate
the RMB, it becomes clear that also when they don’t revalue, the current
Chinese export position can not be sustained.
Finally the reluctance of China to adjust its currency regime has created
a situation in which all the Asian countries (even those with a floating rate
regime) try to avoid their currency from appreciating against the US$, as
this would hurt their export position compared to China. The Asian region
is therefore characterized by undervalued currencies; a situation that could
have severe impacts on the world economy as it deepens the trade deficit of
the US with the rest of the world. A Chinese revaluation could therefore
lead to a revaluation of multiple currencies in the region against the US$,
thereby decreasing the US trade deficit and preventing the US economy from
a hard landing. Such a hard landing would have severe negative impacts on
the Chinese economy as well.
14
The last argument mentioned is on the other hand also one of the most
important reasons for the rest of the world to continue their efforts to per-
suade the Chinese government to adjust the RMB policy, namely preventing
the US economy from a hard landing. On the other hand, a similar hard
landing of the Chinese economy caused by the prolonged undervaluation of
the RMB (as described above) would also have severe negative consequences
for the rest of the world. It is therefore in both China’s as the rest of the
world’s interest that the Chinese government changes its current exchange
rate regime, and revaluates the RMB significantly.
5 Possible Solutions to the Undervaluation
If China decides to adjust its currency regime, the question that immedi-
ately arises is of course how to implement such a revaluation, without giving
speculators a change to profit from it, and to create as less uncertainty as
possible. Goldstein (2004) outlines some of the most common strategies in
revaluating a currency. The first one is the so-called Slow Go approach, in
which the currency is revalued by only a small percentage, combined with
other reforms in the trade and capital account, or tax measures that would
be substitutes for a revaluation. The risk in such a strategy (which is the one
the market expects China’s government to adopt) is that due to the gradual
changes, it might attract additional speculative inflows by creating a sure-bet
for speculators. Furthermore it won’t be sufficient to solve excessive lending
and the risk of a hard landing for the Chinese economy.
The second strategy is to immediately open the capital markets and
15
change at once to a floating exchange rate. This is the reform proposed by
US Treasury Secretary Snow, who urges China to open its markets as soon
as possible, thereby changing to a freely floating RMB. Goldstein (2004) ar-
gues that although it would be the preferred situation in the long run, it is
definitely not the optimal strategy for current China due to the state of its
banking system. A too sudden change to liberalized capital markets would
pose a severe threat to the fragile Chinese banks as they are not ready yet
for free capital flows.
An optimal reform therefore should consist of two stages, namely a sharp,
one-shot revaluation of the RMB combined with a peg to a currency basket
and a wider trading band, followed by a reform of the banking system which
should in the end result in liberalized capital flows and a floating exchange
regime. The first step would relief both the political as economic pressure
from the RMB, and is the only way to avoid further massive capital inflows
initiated by speculative reasons. The second step is necessary to make the
banks well-capitalized and solvent enough to cope with the opportunities and
threats of liberalized capital flows. An opening of the capital account before
the banks are fully reformed could ruin the current reforms.
6 Conditions for a Fixed Exchange Rate and
the Case of China
The last issue to be addressed regarding a possible reform of China’s currency
and capital flows regime is the question which regime the government should
adopt after the proposed two-step reform as described above. Whereas some
16
advocate for a completely free-floating currency, the Chinese government is
likely to keep some kind of control on its currency, which might turn out to
be a new peg to the US$, but at a different rate than the current one. It
is however questionable if such a renewed peg would be sustainable in the
long run. Williamson (2004) namely describes the necessary conditions for
a fixed exchange rate, and possible discrepancies between these criteria and
China’s position. First of all the economy has to be small and open, so that
it makes sense to peg the currency to a larger currency area (such as the
US). This is for example the case for Hong Kong, which is very small and
it therefore relies heavily on trade with other countries. China however has
a strong import and export market and is a relatively open economy, but
it is definitely not small. The second criterion that is violated by China is
that the bulk of trade should be undertaken with the country the currency
is pegged to (or countries that have also pegged to that currency). This is
also not the case for China, which has a sizable trade relation with the US,
but it’s definitely not the major part of its imports and exports.
Due to these problems a new fixed exchange rate regime after eventual
reforms is probably not the optimal strategy. More appropriate solutions to
the Chinese situation could therefore be something in between fixed rates
and fully floating, such as an adjustable peg with a large band, or a broad
currency basket in close cooperation with other Asian countries. 1
1See for example Policy Brief 05-1: A Currency Basket for East Asia, Not Just China[pdf] by John Williamson, Institute for International Economics August 2005.
17
7 The Hong Kong Dollar
An interesting case related to the Chinese currency issue is the situation of
Hong Kong, which currency (HK$) is also linked to the US$. Although its
government is not under such pressure as China’s to adjust the current ex-
change rate regime, the question whether it should abandon the linked rate
to the US$ is an ongoing debate. The last part of this paper will there-
fore focus on the HK$ by discussing the current peg with the US$, and by
comparing the Hong Kong currency with the Chinese RMB to discuss the
potential influence of changes in China’s currency regime on Hong Kong.
The Hong Kong economy is of course completely different than China’s in a
large number of aspects, this paper will therefore only focus on the exchange
rate aspects.
One of the main differences between Hong Kong’s currency regime and
that of China is the fact that Hong Kong has a currency board instead of
a Central Bank. A currency board does not operate as a separate entity
(such as a central bank), but it is a rule-based exchange mechanism with a
explicit commitment to convert domestic currency into the linked currency
and vice versa. This means that the Hong Kong currency board provides
the market with a rate at which market participants can buy the HK$ from
the currency board, and a rate at which they can sell. An important aspect
of this system is that the whole monetary base must be backed by foreign
reserves (US$). This ensures that the currency board will never run out of
reserves to guarantee the fixed exchange rate, as all the Hong Kong Dollars
are fully backed by foreign reserves. The peg therefore works as a rule-based
mechanism, whereas in countries with a Central Bank the currency peg is
only supported, and not fully guaranteed.
The start of the current peg to the US$ of Hong Kong’s currency goes
18
back to 1983, when the official rate of 7.8 HK$ for 1 US$ was set, a rate that
is still the actual peg. This decision followed a period of economic turmoil,
with sharp changes in inflation, exchange rates and GDP growth caused by
the uncertainty about the political future of Hong Kong. Nowadays the total
value of external trade is more than 250% of GDP, which makes the Hong
Kong economy vulnerable to shocks in exchange rates. As the US$ is the
main currency in which transactions are settled, it was a logical step to peg
to the US$, which leads to a stable exchange rate and less uncertainty. Other
advantages of the peg includes the fact that it prevents the government from
using the currency to finance fiscal deficits (printing money), and that is
leads to an automatic adjustment of the balance of payments (as changes in
changes in money supply lead to changes in the interest rate due to the fixed
exchange rate, which influences the demand for the currency).
The most important disadvantage of the link is the fact that Hong Kong
has to follow the US monetary policy, even at times when the economies
are in a completely different part of the economic cycle. This could lead
to periods of for example contractionary monetary policy during a period of
recession in Hong Kong when there is in fact need for expansionary measures.
Furthermore, due to the currency board, there is no Central Bank which can
operate as a lender of last resort for the banking system (such as the Federal
Reserve for the US banks).
During the 22 years in which the peg has existed, there have been two
significant attacks on the HK$. The first one was in 1987 when prolonged
weakness of the US$ led to an undervaluation of the HK$. This induced
speculators to deposit money in HK$, as there was strong pressure to reval-
uate the currency. The Hong Kong government solved the crisis by using the
threat of a negative interest rate; the threat itself was enough to scare spec-
19
Figure 3: The HK$/US$ Exchange Rate, data source: Federal Reserve
ulators. The second attack was during the Asian financial crisis. Combined
with continuing strength in the US$, the HK$ was under severe pressure to
devaluate (as the other Asian currencies did). The government intervened
by buying up to 80 billion HK$ of equity, through which both the equity
market as well as the currency market were strongly supported. China on
the other hand has seen four major devaluations in the period in which Hong
Kong had a fixed exchange rate. None of these moves have had impact on
the exchange rate of the Hong Kong Dollar.
Although China is a very important trade partner of Hong Kong (44%
of Hong Kong’s trade is with China, see Williamson (2004)) and some ar-
gue that Hong Kong should adopt the RMB as well in the future (due to
political reasons), history thus shows that the two currencies are relatively
unrelated to each other. This is mainly caused by two aspects: the difference
in exchange rate regimes and the different economic situation. The Hong
20
Figure 4: The RMB/US$ Exchange Rate, data source: Federal Reserve
Kong currency board is a very strong rule-based mechanism to support the
exchange rate, whereas the RMB is much more influenced by political is-
sues, as well as discrepancies between China’s economy and the US economy,
which lead to unsustainable imbalances. The Hong Kong economy on the
other hand is much more developed, and behaves more in line with the US
economy. The influence of a potential revaluation of the Chinese RMB will
therefore have very limited consequences on the HK$. Based on the strong
position of the Hong Kong currency board as well as their history of main-
taining the peg (for more than 22 years already) it is not assumable that
Hong Kong will choose to abandon this link after a Chinese revaluation. The
economic situation is too different and it is not in accordance with Hong
Kong’s monetary past.
21
8 Conclusion
The Chinese currency (RMB) has a long history of a fixed currency regime,
characterized by a number of significant devaluations. Recently however, the
US is urging China to revaluate its currency, as its artificial undervaluation
is one of the major causes of the ever-growing current account deficit of the
US. After a long period of political and economic pressure the Chinese gov-
ernment finally decided to revalue the RMB by 2.1% in July 2005. Although
this looks like a good first step, it is questionable whether such a slow-go
reform will be able to solve the current imbalances. A gradual revaluation of
the RMB will namely lead to strong capital inflows, caused by speculators
who expect China to increase the value of the RMB even further in the fu-
ture. The main risk of the current undervaluation is probably the excessive
lending caused by the flood of funds going into China, on both the current
account as well as the capital account. Strong exports (due to cheap la-
bor and an undervalued home-currency) have led to a strong surplus on the
current account, whereas the expectation of revaluation has initiated strong
speculative capital inflows. This excessive supply of credit could pose a se-
rious threat to the current bank reforms. Furthermore a revaluation would
prevent both the US and the Chinese economy of a hard landing, by reducing
global payment imbalances, as well as inflationary pressure in China. Prob-
ably the best way to achieve such a reform is a two-step strategy: China’s
government should first revaluate the RMB with a sharp one-shot increase,
followed by further reforms in the banking sector before opening the capital
markets. An approach as suggested by the US Treasury Secretary Snow of
an immediate opening of the capital flows is therefore not the right way, as
China’s banks are not ready yet for a full liberalization of capital flows. A
revaluation should preferably be followed by a system somewhere in between
22
floating rates and fixed rates (such as a broad currency basket or an ad-
justable peg), as a new fixed rate regime is unlikely to be sustainable in the
long run due to the size of China’s economy and the differences with the US.
Finally a change in China’s currency regime will probably not influence the
HK$, as Hong Kong has a long history of its own US$ peg and a much more
developed economy.
References
[1] Goldstein, M. 2004. Ajusting China’s Exchange Rate Policies. Working
Paper, Institute for International Economics.
[2] Hong Kong Monetary Autority. 2000. HKMA Background Brief No.1:
Hong Kong’s Linked Exchange Rate System.
[3] Lardy, N.R. 2005. Exchange Rate and Monetary Policy in China, Cato
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