Fixed Versus Flexible Exchange Rate in ChinaBy Hanjiang ZhangDepartment of EconomicsGeorge Mason UniversityCONTENTSI. Introduction 2II. Evolution of exchange rate regime, new trends andChina’s reform 5II.1 Evolution of international exchange rate regime 51II.2 New trends of exchange rate arrangement in development 8II.3 China’s exchange system reform 11III. General considerations regarding the choice of exchangeRegime 17III.1 Criterion of optimality 17III.2 Nature of shocks 18III.3 Structural characteristics 19IV. Fixed or flexible-------Theories on developing countriesAnd their recent lessons 21IV.1 Flexibility and domestic financial sector 22IV.2 Implication of “Optimum currency areas” 26IV.3 Credibility versus flexibility 30IV.4 Adjustment and price and wage rigidity 35IV.5 Lessons from recent emerging market crises 36IV.6 Conclusion and summary of criteria 42V. China’s exchange rate regime choice 44V.1 Current status-------tightly managed floating 44V.2 Economic environment and feasibility 47V.2.1 Domestic financial sector 47V.3 Implementation of tightly managed floating 50V.3.1 Control of capital flow 51V.3.2 Cooperation of monetary and fiscal policy (achievement ofinternal and external objective) 521994-1997 pressure of appreciation 521997-present pressure of depreciation 54V.3.3 Summary of reasons 57V.4 Reasons for future reform 57V.4.1 New environment and flexibility 57V.4.2 Consideration of exit strategy 58V.4.3 OCA and peg to U.S. dollar 60V.5 Steps of future reform 62V.5.1 Monetary and fiscal policy arrangement 63

V.5.2 Financial sector reforms 64V.5.3 Reforms in foreign exchange market 65V.5.4 Steps of capital account liberalization 67VI. Conclusion 69VII. References 712

I. IntroductionExchange rate regimes and the current international monetary are profoundlyDifferent in both conception and function from those envisioned under the BrettonWoods system. The current institutional arrangement results from the integration andliberalization of global markets. In this setting, the choice between fixed and floatingExchange rates is not dichotomous. Instead it involves a spectrum of options. Nosingle exchange-rate regime may be prescribed for all countries at all times.Getting the exchange rate right is essential for economic stability and growth inthe developing countries. This is especially true for China, where economic andfinancial reforms are underway. Although there are extensive studies and a number ofcriteria to be considered, the problem is still complicated and depends on theparticular circumstance of the developing country, especially under current globalcontext. Because their financial sectors are relatively weak, fixed exchange rates aredesirable in order to achieve currency stability. However, with increasing capitalmobility and a proliferation of trade in goods, many developing and transitionaleconomies are likely to find it desirable to move from relatively fixed exchange rateregimes to regimes of greater exchange rate flexibility.Under the “reform and open policy”, what is the appropriate exchange ratearrangement for China becomes an essential question in China’s economic reform.The exchange and payment crises of the 1990’s, China’s future membership with theWTO and its integration with world goods and financial markets raise anew this issue.However, little has been written addressing the specific questions in China. Althoughthis issue has been widely discussed in China, the literature seldom relies on advancedeconomic theories or other countries’ experiences and lessons. Therefore, this paperintroduces the general theories and criteria concerning exchange rate regime choice;examines certain aspects and lessons from developing countries; analyzes China’spresent exchange rate system and financial environment and tries to provide somepolicy implications for the future.Choosing an appropriate exchange rate regime is not an abstract question with anabsolute answer. In addition to a number of criteria, there are several other importantprinciples to consider. It is essential to recognize that a country’s exchange rateregime is one component of its general economic policy strategy, which needs to beconsistent with other components, most importantly the conduct of the monetary andfiscal policies. A country’s exchange regime should also be suitable for its economicenvironment with the ability to adapt itself to the new trends in this environment. It isimportant to know that whatever exchange rate regime a country pursues, the longtermsuccess depends on the commitment to sound economic fundamentals and astrong banking sector. China successfully maintained its exchange rate regime in thepast, even during the recent Asian crises. This is resulted from China’s success inpolicy cooperation and prudence. But within the new global environment, it is no

doubt that China should move to a more flexible exchange rate arrangement in the3future. This process should be gradual and in pace with the other financial sector'sreforms and capital account liberalization (integration with the world financialmarket).Section II describes the phases of the development of international exchange rateregime, evolution and new trends of the exchange rate arrangement for developingcountries and China’s exchange rate system reform. This section tries to give anoverall look at the international and domestic monetary and financial environmentthat China faces.Section III reviews the general considerations regarding the choice of exchangerate regimes. This section gives some general criteria and implications for choosingpolicy from the aspects of policy goals, the nature of shocks and a country’s structuralcharacteristics. This provides part of the theoretical foundations for discussing issuesfacing China.Section IV focuses on developing countries’ exchange regime choice based ontheir specific circumstances and the new global environment. This includesdiscussions of their financial sectors, implications of “optimum currency areas”,credibility versus flexibility and the effect of price and wage rigidity. The new trendsin the international monetary and financial market and their effects on developingcountries’ regime choice are also analyzed. This section tries to provide China withsome relevant criteria and lessons from studies and experiences of other developingcountries.Section V specially addresses the question of China’s exchange rate regimechoice. It describes China’s current exchange rate arrangement, analyzes its feasibilityand soundness with its current financial situation and its cooperation with monetaryand fiscal policies in different economic periods. Given current global patterns oftrade, it is necessary that China move toward a more flexible exchange rate regime inthe future. Several reasons are examined in this section. It is also pointed out that thefuture reform should be gradual at a pace in line with economic growth, financialreform and integration with the global market.

II. Evolution of Exchange Rate Regime, New Trends andChina’s ReformGetting the exchange rate right is essential for economic stability and growth indeveloping countries, especially for China, which is under its way of economic andfinancial reform and accelerating its integration with the global goods and financialmarkets. The evolution and future trends concerning exchange regimes are veryimportant to understand the internal and external environment.II.1 Evolution of international exchange rate regime.Exchange rate regimes and the current international monetary and financialsystem are profoundly different from those envisioned under the Bretton Woods4agreement. This system allowed countries to maintain a pegged exchange rate, avoidthe peg in order to avoid the undue volatility and prevent competitive devaluationwhile permitting enough flexibility to adjust to fundamental disequilibrium underinternational supervision. Capital flows were expected to play only a limited role in

financing payment imbalances. Short-term capital flows were largely controlled toinsulate the real economy from instability. The international Monetary Fund (IMF)provided temporary official financing of payment imbalances to smooth theadjustment process and avoid undue disturbances to current accounts, trade flows,output and employment.Since the creation of the IMF at Bretton Woods, the international exchange rateregime has undergone substantial changes, which may be broken into four mainphases (Mussa and Masson, April 2000). The first phase was under the aegis of theMarshall Plan and the European payments Union, characterized by reconstruction andthe gradual reduction in inconvertibility of current account transactions. By 1958,most industrialized countries returned to current account convertibility. The secondphase was the heyday of the Bretton Woods system. It was characterized by fixed,though adjustable exchange rates, the partial removal of restrictions on capital accounttransactions among industrialized countries, a gold-dollar standard centered on theUnited States and its currency and a periphery of developing country currencies thatremained largely inconvertible. The third phase is marked by the collapse of thissystem. This began with the end of convertibility of the Dollar into gold in thesummer of 1971 and ended with the collapse of the system as the major currencieswere allowed to float in early 1973.The third phase was accompanied by great changes in the world economic andpolitical environment. During the 1980s, the European currency area graduallyemerged and was coupled by increasing capital market integration. During the 1990s,developing countries gradually played a larger role in the increasing globalizedeconomy. At the same time, the collapse of the Soviet Union and other formersocialist economies signaled the beginning of their efforts to integrated with the worldeconomy. Exchange rate regimes and policies differed widely across countries. TheU.S. Dollar remained the major international currency in both goods and assets trade.The currency of the three largest industrial countries (US Dollar, Japanese Yen andEuro) floated against each other. Several medium-sized industrialized countries’currencies also floated independently. At the same time there were repeated attemptsto limit exchange variability among various European Union countries with theExchange Rate Mechanism (ERM) instituted under the European Money System(EMS). For developing and transitional countries, a mixture of exchange rate regimesprevailed, though many moved toward the adoption of more flexible exchangearrangements. Capital mobility was rising and globalization occurred at anaccelerating pace. Private capital flows came to play a major role in the financing ofcurrent account imbalances for many countries.The fourth phase is marked by the birth of the Euro at the beginning of 1999. It isan increasingly bi- or tri-polar currency system characterized by a high degree of5capital mobility and a variety of exchange rate practices across countries.From the evolution of the international exchange regime and currency system, wecan draw important lessons and analyze the new trends, which will to some extentprovide guidance for China and other developing countries facing choices concerningtheir exchange regimes. It also establishes a basis for regime choice of countries thatrely heavily on industrialized countries’ currencies for their international commerceand finance. The reasons are:

1. The world exchange regime has evolved from a hard one-currency peg to a mixtureof free floats and many in-between variations. In selecting a country’s exchangeregime, the choice is not a dichotomous one between fixed and floating. Instead itinvolves a spectrum of options. No single exchange-rate regime may be prescribedfor all countries at all times.2. Over the past two decades, exchange rates among major currencies have fluctuatedin response to market forces, with significant short-run volatility and occasionallarge medium-run swings. In addition, the exchange rates among the Euro, the Yenand the Dollar are likely to continue to exhibit significant volatility.3. The international currency system has moved from one with heavily controlledcapital mobility to a one that has allowed current account convertibility and morerecently capital account convertibility. Nowadays, capital mobility is dramaticallyincreasing and globalization has accelerated as a result of significant declines intransaction costs associated with the telecommunication and informationtechnology revolution and the attendant wave of financial innovations. Internationalprivate capital flows finance substantial current account imbalances.II.2 New trends of exchange rate arrangement in developing countriesThe trend toward great exchange rate flexibility for developing and transitionalcountries is a prominent theme in the recent evolution of the international monetarysystem. Although it accelerates nowadays, the shift from fixed to a more flexiblesystem dates back to the breakdown of the Bretton woods system in the early 1970s,when the world’s major currencies began to float. At first, most developing countriescontinued to peg their exchange rates either to a single key currency, usually the U.S.Dollar or French Franc, or to a basket of currencies. By the late 1970s, they began toshift from single currency pegs to basket pegs, such as the IMF’s special drawingright (SDR). However, developing countries have shifted away from currency pegstoward explicitly more flexible exchange rate arrangements since the early 1980s.This shift has occurred in most of the world’s major geographic regions.In 1975, 87 percent of developing countries had some type of pegged exchangerates, while only 10 percent had flexible rates (the remaining 3 percent wereaccounted for by the “limited” flexibility category). By 1985, the proportions were 71percent and 25 percent, respectively. In 1996, only 45 percent had pegged rates while52 percent had moved toward flexible regimes (Eichengreen and Masson, 1998).However it should be noted that a number of countries that officially report theirexchange rate as “flexible” have exhibited remarkable exchange rate stability against6the U.S. Dollar, including a number of Southeast Asian currencies prior to the recentcrises in the region.At the same time as the developing and transitional economies have been shiftingtheir exchange regimes toward a system with greater flexibility, many of them havebeen moving toward current account convertibility and a somewhat less dramaticliberalization of capital account restrictions. The considerations that have leddeveloping countries to shift toward more flexible exchange rate regime results fromkey changes in the internal and external economic environments.First, major currencies have moved sharply in their values. This is the key reasonwhy developing and transitional countries abandoned single-currency pegs. Onecharacteristic shared by essentially all developing countries is that the building of

their volume in international trade and finance is in terms of the major currenciesrather than their own. So in deciding their exchange arrangements, these country musttake the exchange rate fluctuations among the world’s major currencies as given.Second, capital mobility has dramatically increased. With developing countries’deeper involvement with the global economy, gross capital flows to these countrieshave risen considerably as a share of their GDP since early 1980s. Higher gross flowshave created the potential for large and sudden reversals in net flows, particularly inthe case of private flows. Net private flows to developing countries, after stayingaround 0.5 percent of GDP throughout the 1970s and 1980s, rose sharply to 3 percentof GDP in the mid-1990s, only to drop back to 1.5 percent of the GDP in 1998(Mussa and Masson, April 2000). Capital flow reversals have been associated withcurrency crises and large real economic cost. Fixed exchange regimes with occasionallarge adjustments are difficult to sustain under this circumstance. High capitalmobility necessitates an increase in flexibility of the exchange rate.Third, the developing and transitional countries have become more open to theinternational trade, typically on an increasingly diversified basis with industrializedcountries and regional partners. The average share of external trade rose to about 40percent from the late 1960s to the late 1990s. This trend has been more marked in thecase of East Asia. Maintaining a tight exchange rate link to the currency of one of themajor industrialized counties while conducting trade with other major countries canpose significant difficulties. Growing inter-regional trade linkages with countries thathave different pegs or different regimes also poses significant problems. So thedeveloping countries are likely to see that their interest lies in a policy regime withgreater flexibility.There are several other reasons that have contributed to the shift from fixed toflexible rates. For example, the acceleration of inflation among developing countriesmade the flexible exchange rate more preferable to absorb downward pressure andmaintain stability. The shifts of exports toward manufactures made developingcountries more exposed to external shocks, a flexible exchange rate will help tomitigate these shocks. The portfolio diversification, as a consequence of globalization,has markedly improved developing countries' financial markets, accelerates foreignexchange markets' development and made amore flexible exchange rates possible.7Although there are several important exceptions, this shift among developingcountries has occurred worldwide.The brief review of the history and new trends of developing countries’ exchangerate arrangements has implications for China. The external environment facing Chinaand other developing and transitional countries is the same. The new internationalmonetary and financial environment, which has influenced other developingcountries, will also affect China as it becomes increasingly involved with the globalgoods and financial market. The experiences and lessons from other developingcountries are relevant to China’s exchange regime choice and future reform.II.3 China’s exchange system reformSince the establishment of the People’s Bank of China (PBC) in December 1948and the publication of Renminbi (China’s currency), China’s exchange system hasgradually evolved.II.3.1 Phase One (1949-1972) officially determined exchange rate and a single

pegAfter the birth of the People’s Republic of China, its economy experienced atransition toward a strictly planned one between 1949 and 1952. The exchange rate ofRenminbi in this period was completely established by the People’s Bank of China(PBC is the central bank of China) with occasional adjustments according to theeconomic needs and political considerations. The PBC determined the exchange rateon the basis of the relative price level of the domestic currency, foreign currencies andthe cost of exporting. The purpose was to encourage exports, restrict imports andserve the whole economy.During this period of economic reform, the exchange rate of Renminbi wasadjusted frequently. For instance, between January 1949 and March 1950, theRenminbi/U.S. Dollar exchange rate was adjusted 49 times. With the onset of theKorean War, China ceased tying its currency to the Dollar in favor of the BritishPound.From 1953 to 1972, with the highly planned economy and the generally fixedexchange regime against major currencies, China’s exchange rate remained stable.During this period, the Renminbi/Pound exchange rate was adjusted only once from ¥6.893 /1£ to ¥ 5.908/1£. The Renminbi/Dollar exchange rate was only adjusted from¥2.4618/1$ to ¥ 2.2673/1$ in December 1971 in response to the sharp depreciation ofthe Dollar (Song, 1999).In this phase, the Renminbi exchange rate was relatively fixed as a result of itssingle currency peg. However, the computation was not based on the currency market.At the period of establishing the new country, China's capability of export is low andthe demand for import is high. Also with the political consideration, the Renminbiexchange rate was overvalued in relation to the market price.8II.3.2 Phase Two (1973- 1985): A basket peg and dual exchange rate systemAfter the collapse of the Bretton woods system in 1973, the world’s majorcurrencies began to float against each other with significant fluctuation in response tomarket forces.Because it faced increasing difficulty maintaining a single currency peg, the PBCmoved toward pegging a basket of internationally traded currencies. The externalvalue of the Renminbi was linked to a basket of international traded currencies. Theweights in the basket were based on the relative importance of the currencies inChina’s external transactions and the relative values of these currencies ininternational markets. The currencies and weights in the basket were adjusted seventimes between1973 and 1984. After the sharp depreciation in 1971, U.S. dollardepreciated again in February 1973 by 10%. It continued to depreciate during thisperiod. Renminbi / Dollar exchange rate was adjusted gradually. In 1980, theexchange rate had been adjusted from ¥2.4618 /1$ to ¥1.4480/1$, appreciated by 70%(Song, 1999).Economic policies changed much following the implementation of China’seconomic reform initiatives in 1978. In order to encourage exports and facilitate theaccounting of different trade sectors at the beginning of 1981, an internal settlementrate was introduced. All national enterprises engaged in foreign trades were requiredto execute their purchases of foreign exchange from the Bank of China (BOC is theinternational transaction bank of China.) at that rate. The rate was computed by

adding an equalization price to the official rate. The official rate was used only fornon-trade-related transactions. Thus, China had established a dual exchange ratesystem. At the end of 1981, the official Renminbi/Dollar buying and selling rateswere ¥1.7411 and ¥1.7499 respectively. At the same time, the internal settlement ratewas ¥2.8 per dollar.However, in order to comply to the single exchange-rate standard and facilitateinternational trading, the use of the internal settlement rate was discontinued at thebeginning of 1985 and all transactions were to be executed at the official ratepublished by the State Administration for Exchange Control (SAEC).II.3.3 Phase Three (1986-1993): managed floating and swap center----first steptoward market determined ratesAt the beginning of 1986, the PBC shifted its exchange rate policy from peggingto a basket of currencies to a managed floating. This was an important part of China’sfinancial reform, driven by its desire to move toward market economy.In November 1986, Chinese enterprises and foreign investment corporations inthe four Special Economic Zones (SEZs) of Shantou, Shenzhen, Xiamen and Zhuhaiwere permitted to engage in foreign exchange transactions in the Foreign ExchangeAdjustment Centers (FEACs) at the rates agreed between buyers and sellers. Theestablishment of the swap center marked the introduction of an embryo foreignexchange market in China. By October 1988, 80 swap centers had been established.The rate determined in the swap centers constantly depreciated relative to the official9rate.Meanwhile, the regulation of foreign exchange was still strict. The official rateremained unchanged at ¥3.72 per dollar from July 5, 1986 to December 15, 1989,during which time a 21.2 percent depreciation of the Renminbi was announced. At theend of 1989, the official Renminbi/Dollar exchange rate was 4.72. At this time theSAEC also had the power to control market access on the basis of “guiding prioritylists” and “retention quotas” (Mehran, Quintyn, Nordman and Laurens, 1996). It alsooperated on behalf of the PBC to intervene from time to time to stabilize the price inthe swap center.Market forces emanating from the swap center continued to put pressure on theRenminbi to depreciate. This trend accelerated with China’s expansive policy, rapideconomic growth and high inflation. By June 1993, the Renminbi/Dollar exchangerate had depreciated from 5.25 (March 1987) to 10.5. However, with theannouncement of a tight financial policy and the appointment of a new governor tothe PBC in July, the Renminbi appreciated within a week. The officialRenminbi/Dollar exchange rate was then adjusted to 5.8 by the end of 1993. Becausethe divergence between the two rates was so large, PBC officials stated that theRenminbi exchange rate would be unified within five years in an effort to facilitatetrade and smooth the process of integration with the WTO and the global market.II.3.4 Phase Four (1994-present): Unitary managed floating and current accountconvertibilityThe reform progress was much faster than it had been foreseen. On January 1,1994, the official and swap market exchange rates were unified at the prevailing swapmarket exchange rate at the end of 1993----¥8.7 per US dollar and unitary managedfloating was established in China.

An interbank foreign exchange market was also established. All regional swapmarkets were amalgamated into the Shanghai foreign exchange center. It wasmanaged by the China Foreign Exchange Trade System (CFETS). CFETS offerstrading and settlement services to its members, which include domestic banks, foreignbanks and a number of non-bank financial institutions (NBFIs). The Renminbi isprimarily traded against the US Dollar with a small portion of trading against theHong Kong Dollar and the Japanese Yen. There are no forward transactions orhedging operations in this market.During this time some older regulations were nullified while new regulationswere enacted. In the unified market, the issuance of retention quotas was terminated.The priority lists that governed the provision of foreign exchange and regulatedmarket access were abolished. Under the new regulations, domestic enterprises arerequired to conduct their sales and purchases of foreign currencies and receive currenttransaction control through authorized financial institutions. On the other hand, theforeign-funded enterprises (FFEs) may purchase or sell foreign exchange directlyfrom the CFETs. Different regulations also apply to domestic and foreign banks.Domestic banks may buy and sell foreign exchange for their customers, while foreign10banks may only sell foreign currencies against the Renminbi. Foreign banks are notallowed to operate in the domestic money market. (Mehran, Quintyn, Nordman andLaurens, 1996). Another important regulation is the “regulation of foreign exchangepurchasing, selling and providing” (Yang, Yang, 1999). This requires that domesticbanks to hold a minimum amount of liquid foreign exchange assets to ensure that theyhave adequate liquidity to meet their obligations in foreign currencies. Banks have tocover any shortfalls in these funds by the following day. However, if the foreignexchange holdings exceed the limit, these banks are required to sell the excess in theCFETS market.China’s current exchange regime is a tightly managed floating. The PBCestablishes the central target or reference rate. The fluctuation of the Renminbi/Dollarexchange rate is only permitted within a 0.3% band. The PBC is committed tomaintain a stable exchange rate through interventions in the CFETS. Theinterventions, which are carried out in Shanghai, are triggered by deviations of theRenminbi/Dollar exchange rate in the CFETS market during trading hours.This phase has also been characterized by a move toward free transactions andestablishing convertibility. In October 1993, China made an official commitment tofollow IMF guidelines by implementing current account convertibility by 2000. In1994, the requirement to obtain prior approval from the SAEC for the purchase offoreign exchange for most trades and trade related transactions conducted by domesticenterprises was rescinded. Exchange controls for current account transaction wasdelegated to the banks. Preliminary steps were taken to achieve current accountconvertibility on December 1,1996 in an effort to make China’s goods and financialmarkets more integrated with the world. It is now expected that the Renminbiconvertibility will be realized in 15 years.China’s exchange rate system has evolved over the last half century and haschanged at an accelerating speed during the past fifteen years. It has moved from onein which access to foreign exchange was highly restricted and the exchange rate wasfirmly administered to a system wherein the exchange rate was unified and stabilized

via a market based managed floating.Economic development and reform have accompanied the evolution of China’sexchange regime. As China has had little experiences with market based economicactivity, it is important to consider the institutions, which govern economic behaviorthere and in other countries as well before deciding upon the appropriate exchangerate arrangement for China. Although this question has been widely discussed inChina, the literature is seldom based on economy theory or economic history. In orderto answer this question, we should briefly review the early literature concerning theexchange regime choice to build an appropriate theoretical framework. In addition,careful examination of developing countries’ experiences should also be considered.Finally, before studying China’s case in detail, it is important to consider the eventsleading up to the recent Asian currency crisis.11

III. General Considerations Regarding the Choice ofExchange RegimeThe literature concerned the desirability and feasibility of an exchange rateregime includes a discussion of the relative merits of fixed and flexible exchange rate,“optimum currency areas” and monetary versus exchange-rate-based stabilization.This section focuses on some general considerations about the exchange regimechoice in the context of industrialized countries. For these countries, the choiceamong exchange regimes is thought to depend on the policy makers’ economicobjectives, the nature of shocks to the economy and their structural characteristics.Developing countries face these issues as well. Furthermore, they will also find thattheir choices are complicated by the presence of the balance of payments constraint,the need to protect external competitiveness and the weakness of their financialsectors. For the latter, the discussion will be specified in next section.III.1 Criterion of optimalityIn addressing the issue of optimality, a standard criterion should be specified andapplied. Here the focus will be on the relatively narrow criterion of macroeconomicsstability (minimizing the variance of real output, the price level or real consumption)in face of random transitional shocks. Minimizing this variance is thought to besocially beneficial. The policy maker’s economic objective specifies the variables tobe controlled. The typical criterion of choice has been the stability of real output.Then the question becomes one of how to manage the exchange rate so as to minimizethe variance of output around its full employment level in the face of random shocksarising from various external and domestic sources (Aghevli, Monhsin, and Montiel,1991).III.2 Nature of shocksIt is important to consider the nature of shocks that the economy is likely to besubjected to before determining whether the exchange rate should be fixed or flexible.In the face of foreign nominal shocks, the early debate between the merits of fixedand flexible exchange rates (Friedman, 1976) favored flexible exchange rates and wasbuilt around an implicit sticky-price model. It emphasized the insulation properties ofmarket-determined exchange rates. Faced with movements in the foreign price level,domestic prices can be stabilized by a suitable adjustment in the exchange rate. Thus,when foreign nominal shocks are most prominent, flexible exchange rate is desirable.

The early literature also demonstrated that when domestic shocks are important, thechoice of exchange rate regime depends on whether these shocks are monetary or real.When domestic shocks originate in the domestic money market, conventional theoryindicates that a fixed exchange rate is more effective in stabilizing the output. Adisturbance to money demand or supply would be countered by offsetting changes inthe international reserves under a fixed exchange rate. Thus it would not affect the12supply-demand conditions in the goods market. In contrast, if domestic shocksoriginate in the goods market, the flexible exchange rate would be more desirable foroutput stability. Shocks to domestic goods demand would generate offsetting changesin foreign demand through an adjustment in the exchange rate, which will moderatethe impact of the domestic shock to output (Mundell, 1962). In general, since theeconomy is likely to be faced with both nominal and real shocks originating at homeand abroad, the exchange rate regime that can stabilize domestic output efficientlywill be characterized by some intermediate degree of flexibility.III.3 Structural characteristicsThe structural characteristics of the economy such as openness to internationaltrade, the degree of capital mobility and rigidities in the labor market will affect theinsulating properties of the exchange rate regime.The degree of openness per se does not lead to an unambiguous choice of exchangerate regime. It has been argued that for a more open economy (one with a largertraded goods sector), a fixed exchange regime is preferred as it reduces the potentialcosts of engaging in international transactions that results from frequent exchange rateadjustments. Moreover openness makes a fixed exchange rate more effective inchanneling abroad a domestic monetary shock. A flexible exchange rate, especially avolatile one, may deteriorate the functions of the domestic currency in an openeconomy (Mckinnon, 1963). On the other hand, for open economies that are moreexposed to external shocks, a flexible exchange rate will help to mitigate theseshocks.Capital mobility also influences the choice of exchange rate regime (Mundell,1962). When the domestic asset market is highly integrated with world financialmarkets, domestic and foreign interest rates are linked through the interest parityrelation. The choice among exchange regimes in the face of shocks is affected by thedegree of capital mobility. In the event of a positive foreign monetary shock, aflexible exchange regime would be desirable. With a positive monetary shock, theforeign interest rate falls causing a domestic capital inflow. Under fixed exchangerates, international reserves would expand and reinforce the destabilizing effect ofhigher foreign demand operating through the current account. Under a flexibleexchange regime, the rate would appreciate and help to stabilize the output. Incontrast, for a positive real shock, a fixed exchange rate would be desirable. Aflexible exchange rate instead might exacerbate the destabilizing effect. A real foreignshock spills over to the domestic goods market and by raising foreign interest rates,causes a domestic capital outflow, a depreciation of the currency which furtherdestabilizes domestic output. Under a fixed exchange rate, the capital outflow wouldpush domestic interest rates up and dampen the impact of a higher external demand ondomestic output. With the same logic, it can be demonstrated that following adomestic monetary shock, a high degree of capital mobility makes a fixed rate more

effective in stabilizing output by limiting the destabilizing movements of domesticinterest rates. Given a domestic demand shock, in contrast, the fixed exchange rate13amplifies the destabilizing effects on output by preventing the change in the interestrate.The degree of wage rigidity also influences the effectiveness of exchange ratepolicy. The effects of a nominal devaluation on the output depend mainly on hownominal wages and prices respond to devaluation. If devaluation causes a largeincrease in the nominal wage, the change in the real wage is small. When theindexation of the wage to the general price level is high, the effect of a change in thenominal exchange rate upon the real wage and the output will be small (Arizenma andFrenkel, 1985).The above discussion on exchange regime choice provides the theoreticalframework with which to analyze China’s case. Because of the similarities betweenChina and other developing countries and the lack of attention regarding China’sexchange regime, the next section will consider the theory and practice of managingdeveloping countries’ exchange rates.

IV. Fixed Versus Flexible Exchange Rates in a DevelopingCountryIn choosing an appropriate exchange rate regime, developing countries should takesome specific circumstances into consideration: the degree of sophistication of theirfinancial sector development, the balance of payments constraint, the need to protectexternal competitiveness and the changes in the international monetary and financialenvironment. The issue is more complicated than that faced by the industrializedcountries. In order to give proper answers, a number of theories had been proposedincluding the theory of “optimum currency areas”, the asset market approach andmoney versus exchange-rate-based stabilization. This section focuses on four salienttheoretical issues related to the choice of exchange regime faced by the developingcountries, namely flexibility and the domestic financial sector, regime choice andoptimum currency areas, credibility versus flexibility and adjustment and downwardprice and wage rigidity. The last subsection will focus on lessons from recentemerging market crises.IV.1 Flexibility and domestic financial sectorOne salient difference between the developing countries and the industrializedcountries is the degree of financial sector development, which affects the choice andimplementation of the exchange rate regime.It has been argued that there are two important conditions that must be met in orderfor a flexible regime to be feasible (Wickham, 1985). First, the domestic financialsystem must be well developed. Second, the domestic asset market must be wellintegrated with the international system. Domestic and foreign currency assets are14substitutes in the private portfolios of wealth holder. Since developing countries’ assetmarkets tend to be less sophisticated and do not exhibit a high degree of integrationwith the rest of the world, flexible exchange rates seem inappropriate there.IV.1.1 Status of domestic financial sectorAn advanced financial sector is comprised of well-developed institutions,

instruments and markets and is necessary for the existence of a flexible exchange rateregime (Mehran, Quintyn, Nordman and Laurens, 1996). The institutions include theestablishment of banks and other financial intermediaries as well as the infrastructure,such as the payment system. In advanced financial systems, there are well-establishedinstitutions that efficiently and competitively coordinate the demands and supplies ofvarious financial assets. In developing countries, the predominant source of financialintermediation comes from the banking system, whose size and structure are alsolimited relative to that found in developed financial systems. Other forms ofintermediation may even be non-existent.The range of available financial instruments that facilitate investment andtrade is also an indicator of financial sector development. In industrialized countries,banks and other intermediaries deal in short-term government or private debt, bankdeposits, currency, bank loans and spot and forward markets for foreign exchange. Indeveloping countries, banks offer only a small range of financial instruments. Stocks,securities, and bills as well as forward exchange are virtually absent.Finally, effective domestic financial markets require a price mechanism toallocate assets to their highest valued use. Without price flexibility, the financialmarket is not mature enough either to support trade and investment or to affect theexchange rate regime. In advanced industrialized countries, there is a highlydeveloped market for short-term financial capital, the efficiency and depth of whichpermit rapid portfolio adjustment and arbitrage in financial assets. Foreign exchangeand other financial markets in developing countries typically are not liquid enough toensure the effective functioning of competitive markets. Import and exporttransactions are concentrated in relatively few hands and the large volume of foreigncapital flows often come from the public sector. In addition, the market structure ofthe financial sector tends to be concentrated and therefore can not provide effectivecompetition or determination of the interest and exchange rate.Accordingly, given the nature of developing countries’ financial markets, itseems apparent that exchange rate determination via the market forces is not arealistic option (Black, 1976).Another feature of developing countries’ financial sectors is the strict control onthe current and capital account transactions as well as the domestic financial market.For instance, the freedom to make and receive current payments is often curtailed byimport quotas and restrictions on access to foreign exchange. Capital inflows andoutflows are strictly controlled. Governments often want to centralize foreignexchange transactions in the central bank or use the commercial banks as heavilyregulated agents to enforce the control. The authorities directly determine the15exchange rate. In the domestic financial markets, interest rates are also directlydetermined by the monetary authority and are typically fixed. Government budgetdeficits are frequently financed through direct borrowing from the central bank or bythe sale of securities at pegged interest rates. Under such a policy environment, it isnot surprising that the development of financial sectors has been retarded.For a competitive and unified foreign exchange market to emerge, currentaccount convertibility is needed. Nonbank individuals must be given substantialfreedom to make and receive current account payments. An efficient payment clearingprocess is required. Financial intermediaries should be given greater freedom to

engage in interbank foreign exchange transactions, hold foreign assets, negotiate linesof credit and make other transactions with foreign banks. The liberalization ofdomestic interest rates is also needed to broaden both domestic and internationalintermediation and support the exchange rate. With these reforms, nonbankindividuals can also gain more direct access to the international short-term capitalmarkets through open account financing and other trade related instruments(Mckinnon, 1979).The choice of exchange regimes depends not only on the existing state offinancial sector development and integration with world financial markets but also onthe future policy toward it. An active reform and open policy is required for rapidimprovement.IV.1.2 Integration with the international marketLack of integration with the international financial market is another reason whydeveloping countries are not able to adopt a flexible exchange regime (Brason andKatseli, 1981). According to the asset market approach, the exchange rate is explainedin terms of the relative demands and supplies of domestic and foreign financial assets.Therefore, countries with integrated financial asset markets and strong financialsectors can expect a floating exchange rate to be stable in a short run (Driskill andMcCafferty, 1980).In advanced financial systems, capital account transactions are very important tostabilize the floating rate. Such transactions are the result of asset holders’ attemptingto adjust their portfolios in response to the factors affecting their desired stocks ofdomestic and foreign currency assets. In the absence of the integration with worldasset markets, the exchange rate will be determined by current account transactions.The price for traded goods will change gradually and the adjustment of trade andservice flows to relative price changes will be delayed. Thus in the periodimmediately following an exchange rate change, the terms of trade typically movesagainst the country whose currency has depreciated and offsets any effects of theexchange rate change on trade volumes.On the other hand, speculators are assumed to have a stock demand for netforeign assets that is sensitive to expected capital gains. So there will be desirablechanges in stock demands in response to the expected appreciation or depreciation.So, for dynamic stability in the foreign exchange market to obtain short-run capital16flows to expected relative asset yields are necessary. In the circumstances thatfinancial market separation prevents the possibility of speculative capital flows, thefloating rate will be unstable in short run. The flexible exchange rate is not desirablefrom this perspective. It should be pointed out that this conclusion is drawn on theassumption that the domestic financial sector is sound.Without a healthy financial sector, developing countries should not integrate withthe world financial market too quickly. Prudential policies should be undertaken. Oneimportant thing to consider here is that whatever exchange rate regime a developingcountry pursues; long-term success depends on a strong banking sector. Highintegration with the world system puts more demands on the banking system. With agenerally weak banking system and little integration with the world market,developing countries are thought to be more suited to adopt fixed exchange rates.

IV.2 Implication of “Optimum Currency Areas”It can be argued that the optimum currency area (OCA) theory ought to be thecenterpiece of international monetary economics (Krugman, 1993, p.18). It analyzesthe issue of fixed versus flexible rates from a new perspective. The theory of OCA’s,which was sought to define the conditions under which a particular area could beoptimally unified by a single currency, began with the classic paper of Mundell in1961. After that, an extensive literature expanded on the subject. There are twodistinguishing features of this theory. First, the argument is based on the principlefunctions of a currency. Exchange-rate integration improves the usefulness of acurrency. The second distinguishing feature of this theory is that the analysis beginswith recognition that there are both cost and benefits involving with each regime.Weighing the list of important determinants of optimum currency areas against oneanother gives insights into the choice between fixed and flexible exchange rateregimes.When exchange rates between major currencies are allowed to float, a developingcountry can form a currency area by pegging its currency to one of the majorcurrencies. The theory of OCA’s can then be applied to determine whether thatcurrency area is optimal.IV.2.1 Fixed exchange rates and domestic currency securityPatterns of growth and trade also affect the choice of regime. Virtually,developing countries’ transactions are determined in terms of the currencies of majorindustrialized countries rather than their own currencies. Thus, the exchange rate isimportant in computing the domestic currency price of tradable. In addition,developing countries depend on particular primary product exports, which are subjectto price cycles and real domestic supply shocks. A floating rate would render realcommodity prices highly variable even if the supply of other currencies were stable.For countries exhibiting high economic growth or a weak monetary system, theinflation rates are high and variable. Thus, the policies are uncertain.17Taking these points into consideration, OCA theory argues that developingcountries with open economies should peg in order to secure the monetary value oftheir currencies. Mundell (1961) argued that an optimum currency area will improvemoney’s effectiveness as the medium of exchange (due to a reduction in transactioncosts), a store of value (due to a reduced element in exchange risk) and the unit ofaccount (due to informational economies). In highly opened developing countries, theratio of tradable to nontradable output is large. It was argued that if a country issuesits own currency and allows it to float against that of a large trading partner, theamplitude of fluctuations in the exchange rate would likely cause a correspondingfluctuation in the domestic currency price of tradable. This in turn causes considerablevariability in both the price level and relative prices because monetary policy is onlycapable of affecting the price of nontrable. This tends to undermine the ability of adomestic currency to perform its monetary function and encourage agents in theeconomy to substitute foreign currency to domestic currency (Mckinnon, 1963;Katseli, 1981; Connolly, 1982).Despite all the benefits of having a domestic currency that serves the needs oftrade, it is not uncommon to find currency substitution. The result is that in these

developing countries the prices of some goods are quoted in foreign currency andindividuals hold stocks of foreign cash which are even used to complete domestictransaction. Currency substitution is especially prevalent in developing countries withhigh and variable inflation rates and uncertain government policy on future exchangerates.However, with a fixed exchange rate regime, the domestic price level and relativeprices would appear to be more stable. Changes in the rate of return denominated inthe domestic currency would be similar to that on foreign currencies under a peg. Afixed exchange rate, which fixes the relative price between two currencies, ensures theuse of domestic currency.IV.2.2 Incompatibility of three desiderata, criteria for OCA and peg choiceIn terms of currency security, OCA theory does point out the difficulties thatdeveloping country authority face in managing domestic currency and money policyunder a flexible regime. In principle, a government would like to have exchange ratestability to determine their monetary policy independently of other nations and allowcapital to move freely between nations until the rate of return is equalized. However,at any moment only two of the three desiderata are compatible (Cohen, 1992). Underfixed exchange regime and capital mobility, independent money policy is almostcertain to result in significant balance of payment disequilibrium sooner or later andhence provoke potential destabilizing flows of speculative capital. To maintainexchange stability, governments will then be compelled to limit either the movementof capital or their own policy autonomy. If they are unwilling to sacrifice either, theyhave to forsake the pegged exchange rate. It should be recognized that there are bothcosts and benefits involved in choosing either fixed or flexible exchange rates. Anoptimum currency area consideration can help to improve the benefits and limit the18costs.For a developing country to decide if it should peg and which currency to peg to, aseries of criteria defining an optimum currency area are available. First, the two areasmust exhibit similar inflationary patterns (Fleming, 1971). When the inflation ratesbetween a developing country and an industrialized country are similar, anequilibrium flow of current account transactions is more likely to take place and lesslikely it will need adjustment through a flexible exchange rate. Then a fixed linkbetween the two currencies would be desirable.The second to be considered is production and export diversification (Kenen,1969). A high degree of production and export diversification provides someinsulation against a variety of shocks and forestall the need to make frequent changesin the terms of trade via the exchange rate. According to this criterion, if a fixedregime is desirable for certain developing countries, the choice of a peg depends onhow concentrated its trade and capital account links are with a particularindustrialized country and the degree of similarity between their productive structures.The third criterion regards the symmetry of shocks, as asymmetric shocks are likelyto be a problem for currency union or fixed regime (Mundell, 1961; De Grauwe,1992b). If shocks facing a developing country and an industrialized country are verydifferent, the monetary policies imposed by these two countries should be different. Apegged exchange rate will force the developing country to base its monetary policy onthe industrialized country’s, which will invoke big problem and lead to an internal

balance.The final criterion relates to trade integration. The more integrated the tradepatterns between the two countries, the greater the benefits of a common currency orfixed exchange rate. That is because the reduction of transaction costs (includinghedging costs) resulting from a fixed exchange rate will improve the efficiency of thetwo highly integrated economies.IV.3 Credibility versus flexibilityOne salient aspect of developing countries’ exchange rate policies is that theexchange rate policies are generally designed to maintain external competitivenessand keep a sustainable balance of payments position. In addition, asking whichexchange regime can ease external adjustment and help to impose financial disciplineto maintain financial stability is important.An equilibrium exchange rate is defined as the relative price level between ahome country and its trading partners or the relative price of tradable to nontradablegoods (Aghevli, Monhsin and Montiel, 1991). Such rates help to maintain externalcompetitiveness and yield internal and external equilibrium. But because of a variety19of real shocks, the real exchange rate may deviate from the equilibrium level. Forexample, a major cause of deterioration in external competitiveness in mostdeveloping countries has been a high rate of domestic inflation coupled with themaintenance of a fixed nominal exchange rate. From this point of view, a flexibleexchange rate would be desirable because it can prevent the emergence of large andsustained misalignments between relative prices and thereby avoid an externalimbalance. By adopting a flexible regime, the authorities would be free to formulatetheir monetary policy in accordance with their domestic objectives, allowingexchange rate adjustments to equilibrate the balance of payments.But several questions need to be contemplated regarding flexible exchangeregimes. It has been argued that a flexible exchange rate does not free the authoritiesfrom the external constraint on their domestic policies. Under capital mobility,domestic policies greatly influence the interest rates, which will have effects on theexchange rates and the current account balance consequently. These, in turn, willconstrain the domestic policies (Turnovsky, 1976). Another issue is whether theauthorities under a flexible exchange regime can effectively use their independence inpolicy making to achieve their domestic objectives. Proponents of fixed exchangerates argue that a fixed regime can impose financial discipline that would be absentunder a flexible regime. By discouraging inflationary finance, a fixed regime wouldhelp to achieve financial stability. So it is important to consider the authority’scredibility to affect their policy when choosing an exchange regime.IV.3.1 Fixed as an anchorThe conditions under which a fixed exchange rate can be maintained imposefinancial constraints on monetary and fiscal policies (Krugman, 1979). At the sametime, adopting a fixed exchange regime can provide an unambiguous objective“anchor” for economic policy, which helps to establish the credibility of the policy forprice stability.Under fixed regimes, monetary policy must be subordinated to maintain a fixedrate. In this case, the growth rate of real output plus the world inflation rate determine

the domestic money growth rate. In order to defend the fixed parity, a minimumfraction of the domestic money supply must be backed by foreign exchange reserves.So domestic credit can not permanently exceed nominal money demand. A fixedexchange rate regime imposes a limit on the long run rate of credit growth. The largerthe initial stock of reserves, the weaker the degree of discipline imposed by the fixedregime.Fiscal policy, on the other hand, should also be kept consistent with the fixedregime. The central bank can also resort to external borrowing to replenish reservesand sustain the fixed exchange rate. But this process cannot continue permanently.The government can only borrow when it is perceived to be financially solventmeaning that the present value of the anticipated primary surplus plus seignorage is atleast as large as the present value of the public sector's net debt. So, a fixed exchangeregime imposes fiscal discipline that requires the government's primary surpluses20satisfy an intertemporal budget constraint.A fixed regime by tying the hands of the authorities enables them to maintain thebalance of payments.A fixed exchange rate is said to be desirable also because it can serve as ananchor and help the authorities to establish credibility in pursuing noninflationarypolicies. Such credibility could also be gained by other means, such as announcinginflation and monetary targets. But the exchange rate is the most desirable instrument.Because the inflation rate is not under the direct control of the authority, an inflationtarget that is not linked to specific policy commitments which can be readilymonitored is not likely to be credible. Under a monetary target, the monetaryaggregates can be monitored, but the relationship between various monetaryaggregates and inflation is quite complex. The exchange rate is readily observable atany instant, as opposed to inflation and money supply data, which are provided byauthorities with a lag. By announcing a fixed exchange rate, the authorities wouldundertake all the necessary policies to establish and maintain price stability. Thus, theexchange rate is more desirable as an anchor.IV.3.2 Credibility versus flexibilityA fixed exchange regime can impose financial discipline and successfullyprovide an anchor only if the exchange rate is fixed permanently and not adjustedperiodically. The risk is that the fixed regime would become unsustainable ifconfidence in the authorities' ability or willingness to maintain were lost. If thefinancial constraints discussed above are satisfied, the authority has the ability tomaintain the fixed regime. But this does not ensure the authority's willingness tomaintain it. Proponents of flexible exchange regimes argued that the credibility, ifabsent, is unlikely to be obtained by a fixed regime. Here, credibility is an essentialquestion.Although a fixed regime can impose financial discipline, it does not by itselfestablish the credibility of the authorities. If the credibility has been firmlyestablished, the authority may devaluate at the beginning of a program and stillconvince the public that the devaluation will not be repeated. If a fixed exchange ratecan be successfully maintained, it will ensure that the balance of payments will be metand will provide a valid policy anchor.But in situations where the authorities lack credibility, the fixed regime is unlikely

to be maintained for several reasons. First, the authorities’ incentive to devaluate maymake the fixed exchange regime non-credible. Recurrent devaluation could enable thegovernment to wipe out part of its debt denominated in the domestic currency, therebyeasing its solvency constraint. The government may also attempt to generate aninflationary “surprise” to raise domestic output and employment in the short run. Tothe extent that wage contracts are based on the expected rate of inflation, aninflationary surprise would result in lower real wages, a greater demand for labor anda higher supply of output. Another reason why an absence of credibility may lead to anonsustainable fixed regime is that without policy credibility, the private sector will21expect a high inflation rate. The authorities’ effort to maintain a fixed regime and tostabilize the price would thus introduce a negative inflationary surprise, leading tohigher-than-expected real wages and a correspondingly lower supply of output. Inthis scenario, the authorities have to abandon the official exchange rate to avoiddeflationary surprise and output contraction. The third reason is that the credibility isnot sufficient. The authorities’ commitment to a fixed regime may not be credible forlong especially when the economy is not functioning successfully. For example,maintaining high interest rates to defend the exchange rate may over time underminethe credibility of the fixed regime. An unsustainable fixed regime would only result ina sharp devaluation, a succession of financial crises and a high degree of economicinstability. By contrast, in a flexible regime, the cost of an unsustainable policy mayreveal more quickly through flexible exchange rates and prices. From this aspect, aflexible regime may exert an even stronger discipline on policy. In most developingcountries with a high and persistent inflation rate, the use of fixed exchange rates asan anchor and a provider of financial discipline has not been successful because thegovernments have little credibility and the economic fundamentals are weak.IV.4 Adjustment and price and wage rigidityIn order to maintain internal and external balance, the process of adjustment underfixed and flexible regimes is quite different. Which process is desirable depends onthe relative costs. The decision is critically influenced by the degree of flexibility inwages and prices.In general, under a flexible regime, the authorities adjust the monetary policy toobtain full employment by allowing the exchange rate adjustment to equilibrate thebalance of payments. Under a fixed regime, the authorities conduct monetary policyto achieve external equilibrium and fiscal policy to maintain internal stability. Forexample, (Flanders and Helpman, 1978), a flexible exchange rate ensures fullemployment automatically by following a foreign price shock. With a fall in theforeign currency price of tradable, the domestic price of tradable falls, which in turnreduces the relative price between tradable and nontradable. This effect is offset by achange in the exchange rate. By increasing the price of tradable relative tonontradable, depreciation simultaneously shifts aggregate demand in favor ofnontradable and aggregate supply in favor of tradable, thereby maintaining internalbalance. Depreciation improves the current account position and achieves externalbalance simultaneously. Exchange rate flexibility helps to counter the rigidity in thedomestic price of nontradable, thus allowing the equilibrium relative price ratio andfull employment to be maintained. However under a fixed exchange rate, a

downward foreign price shock reduces the domestic price for tradable causing the realexchange rate to appreciate. This generates a conflict in the adjustment of internal andexternal balance. If monetary policy were consistent with external balance,unemployment would follow. Full employment may be achieved only at a cost of abalance of payments deficit. The internal and external balance could be attained only22when authorities use expansionary fiscal policy by increasing governmentexpenditures or reducing taxes.The choice of appropriate exchange regime depends on the relative cost of the twoadjustmentsystems. Under a downward price and wage rigidity, which is common formost developing countries especially those with highly planned economies, a flexibleexchange rate is more desirable. This is because an exchange rate change, whichcorrects relative prices immediately, would avoid most of the cost of a prolongedperiod of fiscal correction due to price and wage rigidity.IV.5 Lessons from recent emerging market crisesWe have studied several issues concerning the choice of exchange rates indeveloping countries. But from a theoretical perspective, it is still not easy to saywhich regime is more desirable for developing countries in general. However, recentcrises involving emerging market economies, from the “tequila crisis” of 1995 to theAsian, Russian and Brazilian crises between 1997-1998, carry important lessons fordeveloping countries concerning exchange regimes. Many qualified observers such asEichengreen (1999) conclude that for developing countries that rely upon havingaccess to global capital markets, a fixed exchange rate is inherently crisis-prone.These countries should be encouraged out of their own interest and for the broaderinterests of the international community, to adopt more flexible exchange rateregimes.This section examines the reasons for the recent crises and their global effects andanalyzes the aftermath of the crises in order to draw up policy lessons that can beincorporated into developing countries’ exchange rate policies.IV.5.1 Reasons of the recent crisesNew financial environment facing developing countriesThe revolution in the telecommunication and information technology has beencoupled with a dramatic acceleration in innovation, liberalization and deregulation ofinternational financial markets. As a result, capital mobility has reached levels notmatched since the heyday of the gold standard. With greater capital accountliberalization and capital market integration, developing countries also experience adramatic increase in capital mobility.Developing countries with impressive growth rates and macroeconomics outlookrecently became a favorite location for the growing volume of global capital flows.The surge of capital inflows that financed investment booms is a major factor leadingup to each crisis. Another aspect is that in the most integrated global financial marketscapital flows create the potential for large and sudden reversals in flows andspeculative attacks, which have led to current crises and long run economic costs.23Fixed exchange regimeFor developing countries with important links to the modern global capital

market, fixed exchange rate regimes were clearly important factors in theirvulnerability. It is interesting to note that we could notice the fact that the developingcountries with fixed exchange regimes, such as Thailand, Malaysia, Indonesia, Korea,Russia and Brazil, were most boom-bust economies, which led to the adverse externaldevelopments in 1996. In contrast, developing countries such as Chile, Mexico, Peru,and Turkey who adopted more flexible regimes prior to the crisis performed muchbetter (Mussa, Masson and Swoboda, 2000). Fixed regimes are said to be inherentlycrisis-prone. They accumulate upward pressures and economic instability before thecrisis, and without the ability to absorb adverse shocks, which led to their collapse inthe crisis.Unhealthy economies and weak financial systemsThat being said, the exchange regime alone cannot account for the pre-crisisvulnerability and the subsequent damage. Severe problems in economic fundamentalsare important sources to consider as well. In fact, the crises stemmed from theinteraction between large capital flows leading to a boom-bust economy andweaknesses in corporate, banking and public sector governance. Several years ofrapid growth masked underlying problems associated with a long period ofintervention, administrative guidance and directed lending, which gradually erodedthe country's resistance to shocks. In Russia, the chronic incapacity to meet its fiscalresponsibilities has been a severe problem for the central government in addition tothe general culture of nonpayment and noncompliance with ordinary commercialpractices and obligations. In Asian countries, such as Thailand, Malaysia andIndonesia, optimism about the economic outlook led to rapid credit expansion. Asurge of inflows financed investment booms, particularly in real estate, which aregovernment directed projects of questionable value in many cases. Large appreciationin real exchange rates and high current account deficits under a boom-bust economyheightened the risk of crisis, which ultimately led to adverse external developmentsand a sudden reversal in 1997.Moreover, the economic impact of the chosen exchange regime also depends onthe health of the banking system. A better managed and supervised financial systemgives strong incentives for lower leverage and lower foreign exchange exposure bydomestic businesses and households. Only in this case could the government raiseinterest rates when needed to defend the exchange rate. Even if the exchange rateadjustment is needed, it could be undertaken with less damage. During the recentAsian crisis, weaknesses in the financial system contribute to setting the stage for theboom-bust cycle and culminated in a dramatic real crisis.Interaction between factorsIn countries most adversely affected by the recent crisis, the interaction betweentheir fixed exchange rate and other factors, especially banking system weaknesses24magnified the problems of their economies. Fixed exchange rates stimulate domesticfirms and financial institutions to increase their borrowing denominated in foreigncurrencies, since the expected risk is low under a fixed regime. Fast-growth andupward pressure, combined with a fixed regime, lead to a higher domestic interest raterelative to foreign rates creating an incentive to borrow foreign currency. As shorttermcredit is more cheaply and easily available, capital inflows tend to be short-termand more dangerous.

IV.5.2 The process of crisisIn short, adverse external developments and a sudden reversal in marketsentiment, which generated tremendous downward pressure on exchange rates, can beviewed as the trigger of the crisis. In response, domestic authorities have to eithergreatly increase the interest rate or keep the interest rate unchanged and adjust theexchange rate to the new equilibrium level. However, on one hand, interest rate wasunable to be changed, since this would damage the already weakened banks andbusiness. On the other hand, with large exposure to foreign-currency denominateddebts, adjustment of the exchange rate is also resisted. When this situation was clearand the authorities ran short of reserves speculative attacks overwhelmed. Once thepeg is broken, the recognition of the financial disruption and the massive depreciationare mutually reinforced. The economy will suffer a prolonged period of overlydepreciation, seriously damage in financial sectors and business and further losses inpolicy credibility.IV.5.3 Lessons and implicationsAdvantage of flexible exchange regimeMore flexible exchange rate regimes are said to be more desirable for developingcountries that exhibit greater capital account liberalization and an integrated capitalmarket. Allowing the exchange rate to appreciate gradually to accommodate upwardpressure would be a safer way to maintain long-run economic stability. With the onsetof the crisis, a flexible regime would allow large adverse shocks to be more easilydeflected or absorbed than a pegged exchange rate regime and avoid the large coststhat often accompany a breakdown of the exchange rate regime. Furthermore, aflexible exchange rate could affect expectations. As market participants are madeaware of the fact that they must manage the risks associated with positive andnegative fluctuations. Domestic financial institutions and businesses would be moreprecautionary in foreign-currency borrowing and would seek to hedge the exposure toexchange risks. Furthermore, speculative short-term capital inflows as well as thelikelihood of sharp corrections would be reduced.Consideration of the incompatibility of three policy desiderataSince there is a fundamental incompatibility in simultaneously keeping exchangerate stability, capital mobility and monetary autonomy, if the authorities choose tomaintain fixed exchange regimes, they will then be compelled to limit either the25movement of capital or their own policy autonomy (Tower and Willet, 1976). Undercapital mobility, prudent monetary policies help to limit domestic inflation,overvaluations and a loss of competitiveness. In contrast, the use of monetary policyto pursue other objectives such as stimulating economic activity during a time of highinflation will plant doubts about the sustainability of the exchange rate peg. On theother hand, if monetary independence is chosen under a fixed regime, a liberalizationof the capital account should be undertaken. However, prompt liberalization will posesignificant problems for fixed regimes.Strong fundamentals are fundamentalIt appears that exchange rate regimes cannot be singled out as the sole cause ofthe recent crisis, thus changing regimes will not necessarily mitigate future disasters.Healthy economic fundamentals are essential (Kochhar and Loungani, 1998). First,the potential for boom-bust cycles should be minimized. Maintenance of a prudent

macroeconomics policy, realistic exchange rate and a low inflation rate are needed toensure sustainable long-term growth. An appropriate cooperation between monetaryand fiscal policies would get rid of the potential profit opportunities that enticespeculators to bet against developing countries’ authorities. Second, sound financialsystems are also fundamental. Financial sector reform should be aimed at completingfinancial markets, increasing the solvency of the domestic financial system, raisingprudential standards and supervision to the highest quality and improving theefficiency of financial intermediation. Another important point is that capital accountliberalization should be orderly and properly sequenced and linked carefully to thestrengthening of the domestic financial system so that the appropriate exchange ratepolicy is met. Third, the financial difficulties in the affected countries owe much tothe close link between the government, business and banks, to the system of directlending and other quasi-fiscal activities undertaken by the government, andparticularly to the resource allocation distortions arising from these links. It isimportant to improve governance both in public policy-making and corporate sectors.In order to strengthen market forces, a strong legal framework is needed to dictate therules governing corporate behavior and ensure that creditors and shareholders facestrong incentives for responsible management.IV.6 Conclusions and Summary of CriterionIV.6.1 Criteria for choice of exchange rate regime in developing countryIn previous sections, we discussed four theories relevant to choosing exchangerate regimes in developing countries and presented some lessons to be learned fromthe recent crisis. Table 1 summarizes the implications of exchange rate arrangementsbased on a number of criteria that were discussed previously.26More flexible More fixedHigh Advance of the financialsystem Low High Capital mobilityLow High Production and exportdiversification Low High Relative to the partnercountries trade integration Low High Political integrationLow Symmetric Preponderance of shocksAsymmetric High Level of reservesLow High InflationLow High Labor mobility and nominalflexibility Low Real Type of shocksNominal IV.6.2 Important principles for exchange rate regime in developing countryIn choosing an appropriate exchange rate regime, there is no absolute answer. Inaddition to the criteria outlined above, there are several important principles toconsider. First, it is essential to recognize that a country’s exchange rate regime is

only one component of its general economic policy strategy and needs to beconsistent with other components, especially with the conduct of the monetary andfiscal policies. Second, a country’s exchange regime should suit its economicenvironment and adapt to new trends in this environment including changes in thedegree of economic integration and capital mobility. Finally, it is important to knowthat whatever exchange rate regime a country pursues, long-term success depends ona commitment to sound economic fundamentals and a strong banking sector.By juxtaposing the theoretical framework against analysis of the factors thatcaused the recent crisis, it is possible to assess China’s choice among exchangeregimes.

V. China’s Exchange Rate Regime ChoiceV.1 Current status-----tightly managed floatingThe introduction of an embryo foreign exchange market in China started with theestablishment of the Foreign Exchange Adjustment Centers (Swap Centers) in somespecified cities in November 1986 (see details in II.3.4). Under “guiding priority lists”Table 1. Criteria for choice of exchange rate regime27and “retention quotas”, the Chinese enterprises and foreign investment corporationswere permitted to engage in foreign exchange transactions in swap centers at the ratesagreed between buyers and sellers (swap center rate). As the market forces emanatingfrom the swap center continued to put pressure on the Renminbi to depreciate, thedivergence between the official exchange rate and swap center rate became too large---- The official and swap center Renminbi/Dollar exchange rate were 5.8 and 8.7respectively by the end of 1993.In order to facilitate trade and smooth the process of integration with the WTOand the global market, on January 1, 1994, the official and swap market exchangerates were unified at the prevailing swap market exchange rate. Since then, a unitarymanaged floating has been maintained in China. However, it is closer in spirit to apegged rate than a flexible one.V1.1 Exchange rate determination and float marginsThe Renminbi exchange rate is determined in the interbank foreign exchangemarket, which was also established during the exchange system reform in 1994 andmanaged by the CFETS. The CFETS offers trading and settlement services to itsmembers, which include domestic banks, foreign banks, and a number of non-bankfinancial institutions (hereafter, NBFIs). Trading in Renminbi is primarily conductedagainst the US Dollar with a small portion of trading against the Hong Kong Dollarand the Japanese Yen. Reference exchange rates are published everyday by the PBC.The exchange rates used by banks for purchases and sales of foreign currencies haveto be within a maximum margin of +/- 0.25 percent of the previous day’s referenceexchange rates. The exchange rates used in transactions between banks and theircustomers have to be within a margin of +/- 0.30 percent of the previous day’sreference exchange rates (Yang and Yang, 1999). These thin margins are what makeChina’s “floating regime” a heavily managed one.V.1.2 Regulations on the foreign exchange selling, buying and providingIn China, foreign exchange transactions and provisional activities are strictlydefined and controlled. An important regulation is the “regulation of foreign exchange

selling, buying and provision” (Yang and Yang, 1999). This decree states thatdomestic enterprises and residents are required to conduct their foreign currencytransactions through authorized financial institutions only. Foreign currency obtainedunder certain items and certain amount are required to sell. It also states that domesticbanks are required to hold a minimum amount of liquid foreign exchange assets toensure that they have adequate liquidity to meet their obligations in foreigncurrencies. Banks have to cover any shortfalls in these funds on the next day.However, if foreign exchange holdings exceed the limit, banks are required to sell theexcess in the CFETS market. Because of these restrictions on selling and buying,there are usually excess demands or supplies in the interbank market. So theinterventions are necessary.28V.1.3 Intervention of central bankIn order to affect its tightly managed floating, the PBC has established the centraltarget or reference rate. Fluctuations in the Renminbi/Dollar exchange rate are notpermitted to exceed +/- 0.3 percent in the CFETS market. The PBC is committed tomaintain the stable exchange rate in the foreign exchange market throughinterventions in the CFETS. Interventions, which are carried out in Shanghai, aretriggered by the deviations of the exchange rate of the Renminbi against the USDollar in the CFETS market during trading hours. With all these regulations andinterventions, The PBC’s has maintained a tight link to the US Dollar since mid-1995(Figure 1).V.1.4 Current account and capital account liberalizationAnother aspect of China’s current exchange rate policy is its precautions on thetransaction free and Renminbi convertibility. (1) Current account convertibility hasbeen realized. In October 1993, official commitment was made that China will acceptthe eighth item of IMF regulation, implement current account convertibility by 2000.In 1994, the requirement to obtain prior approval from the SAEC for the purchase offoreign exchange for most trades and trade related transactions conducted by domesticenterprises was rescinded. Exchange control for current transaction was delegated tothe banks. On December 1st, 1996, the current account convertibility was preaccomplished.(2) Capital account is still restricted. For example, the 27th item of the“regulation of foreign exchange selling, buying and provision” requires that anyforeign exchange sales obtained under the capital account; such as with foreigncurrencyinvestment or borrowing should obtain prior approval from the SAEC (Yangand Yang, 1999). Strict controls limit capital inflows and outflows, especially in shortterm, which helps to maintain the fixed exchange regime. China has maintained itsexchange rate peg through the turmoil of the recent Asian financial crisis and made animportant contribution to the restoration of financial stability in the region. However,with the increase in capital mobility and greater integration with world trade andfinancial markets, China should actively prepare for capital account convertibility and8.28.38.48.58.68.78.894 95 96 97 98 99 YearRenminbi/US Dollar Exchange Rate

Fig.1 Renminbi/US Dollar exchange rate between 1994 and 199929gradually move to a more flexible exchange rate regime. These proposals weighheavily in discussions of the direction of future Chinese reforms.V.2 Economic environment and feasibilityOne of the important principles concerning exchange regime choice which werediscussed in section IV was that whatever exchange rate regime a developing countrypursues, long-term success depends on a strong banking sector. When the bankingsystem is weak and less integrated with the world market, a highly flexible exchangeregime is thought to be unfeasible for developing countries. China's current exchangerate arrangement comes from its undeveloped financial sector and less open financialmarket.V.2.1 Domestic Financial SectorThe degree of domestic financial sector sophistication affects the choice andimplementation of the exchange rate regime. An advanced financial sector requires abalanced development of institutions, instruments and markets. For a flexibleexchange rate regime to be implemented, a robust, complete financial market isrequired. Presently, the Chinese financial system does not meet that characterization.However, during the past twenty years, China's financial system has developedremarkably. Much effort in financial sector reform has been devoted to institutionbuilding. In 1984, the PBC became the country's central bank. New banks werepermitted to operate alongside the state-owned specialized banks, which at the sametime were formally allowed to diversify their operations. In the late eighties and earlynineties, NBFIs emerged. After two decades of reform, China presently has a bankingsystem comprised of four specialized banks, fourteen nationwide commercial banks,seventy-two city commercial banks and about three hundred NBFIs. The first problemis that the banks in China, especially the four state-owned specialized banks, cannotbe characterized as modern, efficient banking institutions (Mehran and Quintyn,1996). Despite the significant progress made in developing a banking system, the fourstate-owned specialized banks still dominate the banking sector by holding more than70% of total deposits and loans. In addition, all the criteria and regulations that prevailin a market-oriented environment, such as banking soundness and safety have not yetbeen integrated into the supervisory framework by the authorities. A lack of marketorientedsupervision has also led to a situation wherein the four state-ownedspecialized banks have become universal banks, whose risky nature become evenmore apparent in an inadequately regulated environment. Moreover, their closerelationship with the government compelled the specialized banks to followconflicting mandates. Banks have increasingly been stimulated to become profitoriented, while at the same time they had to operate under the government instruction,mostly in the form of policy lending. The main consequence of this lending practice isthat the quality of the loan portfolios is poor. The weakness of these bankinginstitutions hampers the competitiveness and efficiency of China's financial markets.30With inefficient financial intermediation, it is difficult to implement a highly flexibleexchange regime.Financial instrument development has been concentrated on the gradual

development of capital market in China. The capital market began to develop in 1981when the Chinese government began to issue government securities. Since 1988,secondary markets in bonds and shares of stocks have been allowed to operate. Butunder these poorly developed markets, there is only a small range of financialinstruments in the market and trade in these instruments is very limited. Governmentbonds (treasury bonds) in China, was an alternative to credit plan (command loansplaned by the government) during the first few years. Other types of bonds such as,key construction bonds, special state bonds, enterprise shares and corporate bondsappeared later. But issuance was also highly controlled by the authorities. The volumeof non-government debt instruments is very limited. Since 1988, financial bonds havebeen marketable. More recently, there has been an increase in the issuance ofcertificates of deposit and commercial paper while trade in these instruments hasremained insignificant.To implement a highly flexible exchange regime, markets relying on a fullyfunctioning price mechanism should be allowed to evolve. Without price flexibility,financial markets can not mature enough either to support trade and investment or tomaintain exchange rate regime. In China, the financial market is far from developed.First, market development and liberalization have remained in the shadow of theinstitution building process. Although the four state-owned specialized banks are inprinciple free to develop activities outside their traditional fields and facilitated totransform into commercial banks, their lack of expertise, their continued relationshipwith the government and the customers' limited freedom to choose their bankingrelations have hampered them from operating competitively. The market structure ofChinese financial intermediation also tends to be concentrated. These factors havehampered the competitive process from effectively determining the interest andexchange rate. Second, the absence of nationally organized money markets, one of thesalient features of China's financial sector, is related to the administrative nature ofinterest rate setting and the lack of a modern payments and settlement infrastructure.China's interest rate structure is very complex with more than 50 rates administeredby the PBC. For example, the PBC sets rates for three and six month deposits as wellas one, two, three, five, and eight years deposits. In China, the introduction of moreresponsive interest rates has been constrained by several factors. First, therequirement that the state council give prior approval for each rate change makes theprocess cumbersome and lengthy. Second, the interest rate policy is self-conflicting:on one hand, it is directed to encourage long-term savings mobilization, but on theother hand, it is directed to facilitate borrowing by state-owned enterprises,particularly those with financial problems. This results in negative margins for thebanks and the use of indexation schemes for long-term deposits. Third, the specializedbanks rely heavily on borrowing from the PBC (up to one third of their resources).Changes in the PBC's lending rates affect the average cost of the banks' resources31directly and dramatically. With insufficient competitiveness and interest rateliberalization, the price mechanism can not operate effectively. Accordingly, China'sfinancial market does not have the necessary width and depth and thus, allowing theexchange rate to be determined by market forces is not a realistic option for China.The lack of a strong financial sector and especially a viable foreign exchange marketthat would operate with reasonable stability in the absence of guidance from

authorities makes the tightly managed floating a more desirable exchange regime forChina.V.3 Implementation of tightly managed floatingThe decision to maintain a managed floating is based on the authority’s recognition ofthe idiosyncrasies of China’s financial environment. What is impressive about thePBC’s exchange rate management since it began to track the Dollar in 1994 is that itsuccessfully maintained the peg through all the turmoil during the recent financialcrisis and contributed significantly to the restoration of financial stability in thisregion. Were it not for the authority’s astute awareness of the native of China’seconomic environment the crisis may have been prolonged.V.3.1 Control of capital flowsIn section IV, the fundamental incompatibility of maintaining exchange ratestability, capital mobility and monetary autonomy was discussed. Under the fixedexchange regime and capital mobility, independent monetary policy will almost surelyresult in significant balance of payments disequilibrium and hence provoke potentiallydestabilizing flows of speculative capital. During the recent Asian crisis, the mostadversely affected countries were those with fixed regimes and significant capitalaccount liberalization. In this setting, overly expansionary monetary policies led toboom-bust economies and significant disequlibria developed between actual exchangerates and economic fundamentals. When the disequlibrium goes beyond a certainthreshold within the most globally integrated financial markets, speculative attacksare sure to occur. To maintain exchange stability, governments will then becompelled to limit either the movement of capital or their own policy autonomy. WithChina’s fixed regime and unsophisticated financial sector, the authorities chose tocontrol capital flows unlike other Asian countries following China’s initiative to movetoward current account convertibility. Efforts to liberalize the capital account havebeen cautious. Capital account transactions have been controlled by severalregulations including strict controls limiting capital flows, especially in the short term.Without capital mobility and significant involvement in the global financial markets,China is less vulnerable than most emerging economies to a rapid and massive buildupof speculative pressure against a pegged exchange rate. This explains its relativeease in maintaining the exchange regime even throughout the crisis.32V.3.2 Cooperation of monetary and fiscal policy (Achievement of internal andexternal objective)Another important principle concerning exchange regime choice, which we haddrawn in section IV, is that it is one component that has to be consistent with thegeneral economic policy strategy, especially the conduct of monetary and fiscalpolicies. Whatever exchange rate regime a country pursues, long-term successdepends on sound economic fundamentals. Capital controls alone cannot explain thePBC’s success in maintaining the pegged rate. Without policy cooperation andeconomic development, these goods could not be accomplished.For developing countries, the macroeconomics objective is to achieve internalstability and equilibrium in the balance of payments. Under a fixed regime, theauthorities adjust monetary policy corresponding to the needs of external equilibriumand fiscal policy to maintain internal stability. Under capital mobility, the interest rate

becomes an effective policy instrument in external adjustment, but when capitalcontrols are in effect, interest rates can be freed to achieve internal objectives. InChina, the primary objective is to maintain the stability of the output and the pricelevel while keeping the exchange rate pegged.1994-1997, pressure of appreciation and inflationAfter the foreign exchange system reform in 1994, China's international tradeincreased sharply, which remarkably improved China's balance of payments status. In1993,China still had a current account deficit of $11.902 billion. However, between1994 and 1996, it was able to generate current account surplus of $7.659 billion,$1.618 billion and $7.242 billion respectively. Under its open policy, foreigninvestment increased quickly. In 1996, the capital account surplus reached $399.67million.Dual surpluses in the current account and capital accounts generated pressure onthe Renminbi to appreciate, rising 4.59% from 8.7 in 1994 to 8.3001 in early 1995.(figure.1) In order to maintain a stable exchange rate, the PBC intervened. In theforeign exchange market, the PBC bought the US Dollars and sold the Renminbi.Foreign reserves increased remarkably from $21.190 billion in 1993 to $139.890billion in 1997 by an annual rate of 60.3%. As a result of this strong intervention, theRenminbi/Dollar exchange rate was 8.3 after the second quarter of 1995. The centralbank of China successfully achieved its external objective.In the same period, as China accelerated efforts to initiate economic reform andopenness, China's economic growth reached a remarkable level. Rapid and persistenteconomic growth generated an investment boom. With a weak financial sector andundeveloped markets, underlying economic problems began to emerge. By the mid-1990s, these economies began to show classic signs of overheating. The price indexof retail goods reached 13.2% in 1993 and 21.7% in 1994, a significant rate ofincrease. On the other hand, as a result of external adjustments in the foreignexchange market (Through the Renminbi sales and the Dollar purchases), theRenminbi supply increased dramatically. Since 1994, the PBC's intervention in theforeign exchange market became the main channel for the money supply. In 1993, the33ratio of foreign exchange to total assets held by the PBC was 10.5%. By the end of1997, this ratio increased to 40.3%. External adjustments accelerated inflationarypressure.In order to maintain healthy economic fundamentals and ensure long-termgrowth, China's authority implemented tight monetary policies and fiscal policiessince 1994. This was primarily done by decreasing banking credit, buying backgovernment bonds and issuing financial bonds, etc. At the same time, supervision andprudential controls were increased for bank lending. Huge efforts were made to stopdirect lending and relationship lending. In this period, many real estate investments,especially government directed projects of questionable value were ceased. In 1995,the price index decreased by 14.8%. In 1996, this index decreased to 6.1% andreached the lowest level of 0.8% in 1997. At the same time the economy maintainedannual growth rates of 9.6% and 8.8% in 1996 and 1997, respectively. The softlanding had been successful.China’s international balance of payments between 1993 and 1996account 1993 1994 1995 1996

Current account(US$ Billion) -11.902 7.658 1.618 7.2421.trade(US$ Billion) -10.655 7.290 18.050 19.5352. Labor service (US$ Billion) 2.420 -0.969 -17.867 -14.422Capital account (US$ Billion) 23.472 32.644 38.674 39.967Capital reserve(US$ Billion) 21.199 51.620 73.597 105.029Retail price index (%) 13.2 21.7 14.8 6.1Through efforts to coordinate exchange rate and monetary policies during theperiod between 1994 and 1997, internal and external adjustments in China weresuccessful. The PBC maintained stable exchange rate. More importantly, thisdecreased the inflation rate and stifled any boom-bust tendencies, which is essentialfor economic growth and long run stability.1997-present, pressure of depreciation and depressionThe recent financial crises, which began in Thailand in 1997, quickly spread overto the rest of Asia and later resurfaced in Russia and Brazil, had negative effects oninternational trade patterns and the world economy. The negative impact quicklyspread into China. With a close trade and financial link with other Asian countries, theprevailing depreciation generated tremendous downward pressure on the Renminbi.At the end of 1997, Chinese authority was committed to keeping the exchange ratefrom depreciating. With a substantial current account surplus, large foreign exchangereserves ($139.890 billion in 1997) and controls that sharply limited short-term capitalflows, the PBC was able to maintain its exchange rate peg throughout the crisis. Butthe payoff and negative effects were substantial. As a result of deteriorating externalcompetitiveness, the growth of external trading began to slow down. The currentaccount surplus declined from $29.720 billion in 1997 to $15.667 billion in 1999.Table.1 Source: China’s statistics annual report (1993-1996)34Capital inflows began to decrease while capital outflows increased. The negativeimpact on the internal economy was also strong. Domestic demand began to declineand prices continued to decrease. In October 1997, the retail price index began todecline. A mild deflation of –0.8% in 1998 worsened to –1.3% in 1999, whichgenerated pressure to depreciate and a decline in economic activity (Cheng, 2000).A successfully maintained pegged exchange rate requires a healthy economy andsustainable growth. In order to achieve internal and external objectives, China'sauthority imposed a series of monetary and fiscal policies to increase domesticdemand and encourage exports. Monetary policy was conducted through the use ofinterest rates to affect internal adjustments given limited capital mobility. From May1996 to June 1999, the PBC decreased interest rates seven times in order to stimulatethe economy. The rate on one-year deposits was decreased from 10.98% to 2.25%; therate on short-term liquidity asset loan was decreased from 12.06% to 5.85%. Interestrates on seven other lending activities, such as consumption loans for housing andeducation and export loans were also decreased. The PBC also expanded credit forcommercial banks by increasing money supply. Officials coordinated their monetarystimulus with an expansionary fiscal policy. For instance, in 1998, the export taxdeduction rate was increased and the construction fee for residence building wasadjusted. In 1998, central government also issued 100 billion-Yuan “key constructionbonds" to state-owned specialized banks and in 1999, the bond issuance increased to210 billion Yuan. These actions were accompanied by PBC mandated increases incommercial bank credit of 100 billion Yuan and 420 billion Yuan in 1998 and 1999,

respectively.At the end of 1999, China's annual economic growth rate was 7.1%. TheRenminbi/Dollar exchange rate was maintained at 8.2793.China’s international balance of payments between 1996 and 1999Economic indicator 1996 1997 1998 1999Retail price index(%) 6.1 0.8 -2.6 -2.9GNP growth rate(%) 9.6 8.8 7.8 7.1Gross foreign trade(US$ Billion) 289.90 325.10 324.00 360.70Foreign trade surplus (US$ Billion) 12.22 40.42 43.59 29.10Current account surplus (US$ Billion) 7.242 2.972 2.932 15.667Foreign reserve (US$ Billion) 105.03 139.90 145.00 154.68Exchange rate(US$/Renminbi) 8.30 8.28 8.28 8.28International trades increased by 11.3% and exports increased by 6.1%. Foreignreserves increased from $9.8 billion to $154.7 billion. Thus, in the aftermath ofseveral crises, China was able to maintain its peg, which boosted foreign confidenceand paved the way toward higher income growth.V.3.3 Summary of reasonsChina has the same internal and external environment as other Asian countries.This begs the questions as to why China was able to maintain its peg while otherTable.2 Source: China’s statistics annual report (1996-1999)35countries failed. First, although China chose a tightly managed floating in recognitionof the fact that it has a weak financial sector, China's authorities have beenimplementing capital account liberalization gradually which has countered thepressure associated with full capital mobility. Second, China's authority exerted greatefforts to minimize the potential for boom-bust cycles before the crisis and stimulatedthe economy afterward. An appropriate coordination of monetary and fiscal policieswas successful in staving off panic among foreign investors and maintaining domesticeconomic stability. Finally, large foreign exchange reserves and a substantial currentaccount surplus ensured the ability to maintain the pegged exchange rate and thecredibility of the authority.V.4 Reasons for future reform toward flexibilityV.4.1 New environment and flexibilityThough the reform has been successful so far, there is still the issue of whatdirection it should take in the future. Now that the turmoil of financial crisis hassubsided and Asian economies are reviving, it may be time for China to consider amore flexible exchange rate regime. In China, economic reform and openness isprogressing. The increasing reliance on both the international and domestic marketsto allocate resources, including foreign exchange, means the establishment ofeffective price mechanisms is essential. Thus, a market determined foreign exchangerate is needed for financial reforms. Furthermore, Renminbi misalignments have beennegligible for nearly 6 years. Estimates of the real Renminbi/Dollar exchange rateindicates that is appreciated by 5% between 1995 and 1999. China's futuremembership with the WTO means that it must relax its restrictions on capital flowsand this will require a more flexible exchange rate.In November 1999, the Chinese and US governments reached an agreementconcerning China's membership with the WTO. This will facilitate China's entry andaccelerate its integration with the world markets. To be a member of WTO, China

must adhere to the general principles they have established by opening up its marketsfor goods and capital. Therefore, China needs to decrease import tariffs, abolish othertrade barriers and allow foreign companies to gain equal access to markets and legalprotection. China needs to open its financial markets to all member countries, allowforeign financial institutions to operate in the domestic money market and facilitatecapital flows needed for international trades and finance (Lu, 2000). With these steps,China's international trades and financial transactions will increase remarkably. As aresult, capital mobility will greatly increase. The amount of foreign exchange will alsoincrease sharply. In this setting, strict control of capital flows is impractical andcapital account liberalization is needed.Because of the incompatibility between exchange rate stability, capital mobilityand independent monetary policy, under high capital mobility, China’s decision toadopt a more flexible exchange regime will help to absorb different shocks, maintain36long-run stability and discourage speculative attacks. Under WTO, China's increasingintegration with the global trade and financial market will also bring intensivecompetition into its domestic market. Therefore, the effective allocation ofinternational resources via the market mechanisms is important and a flexible regimereflecting real supply and demand for foreign exchange is essential.V.4.2 Consideration of exit strategyThe primary issue in effective reform is timing. The problem facing China is toconsider an exit strategy.If a country exits from a fixed regime during a period of substantial downwardpressure or as a result of a speculative attack, such as the Asian crisis, the chance of asmooth transition is not good. This kind of exit is generally accompanied by asignificant loss of policy credibility, a sharp fall and substantial volatility of the realand nominal exchange rates and an extended period of declines in output.However, a country can make a successful transition to a more flexible exchangerate regime without substantial economic disruption if they make the regime shiftduring a calm period in the foreign exchange market or when there is upward pressureon the exchange rate (Eichengreen and Masson, 1998). During such times, it isunlikely that people will conclude that the authority was forced to make the regimeshift and correspondingly there should be less risk of credibility loss. Moving towardgreater exchange rate flexibility during a period of upward pressure or a surge ofcapital flows means that the exchange rate will begin its more flexible life with anappreciation. While such an appreciation may have an impact on exports, it willensure a general confidence in the authority's policy and will not affectmacroeconomics stability. These conclusions had been repeatedly proved by recentexperiences. For example, Chile, Israel and Poland have successfully moved togreater flexibility under the upward pressure of their currency, while Mexico andThailand experienced significant financial disruption and loss of policy credibilitywhen forced to abandon their fixed regimes.The time is right for China to abandon its currency peg. By choosing to exit now,the Renminbi will most likely appreciate. The first reason why it is the right time isthe sustained current accounts surplus. Through all the turmoil of recent crisis, Chinahas maintained a substantial current account surplus. With the revival of the globaleconomy, especially in Asia, export demands will continue to increase. This will

ensure a current account surplus in the future. The second reason is the improvedcapital account. Expected capital inflows will improve the capital account too.Monetary and fiscal policies aiming to stimulate internal demand and encourageexports since 1998 have been effective. China’s growing stable economy environmentand future membership with the WTO will attract external investment and capitalinflows. New economic policy aimed to stimulate development in the central andwestern regions will lead to an increasing openness in these areas and result in greatopportunities for investment, which will also attract many foreign ventures. Moreover,37if the revival of the Asian economy and the slow down of American economycontinues, capital will flow back into Asia. This is said to be a salient new trend ofglobal capital flows in the nearly future. The third reason is that there is a properstructure of foreign liabilities. By the end of 1997, foreign direct investmentaccounted for 73.3% of the total capital inflows. However, foreign liabilities onlyaccounted for 14% totaled at $130.96 billion. The structure of the foreign liabilities isgood. Medium and long-term foreign liabilities account for 86.1% but only accountfor 13.9% of short term accounts. The annual rate of reimbursement is around 8%-10% in recent years, which is far lower than the international criterion of 20%. Theliability rate (ratio of foreign liabilities to GDP) is kept at 15% annually, which is alsomuch lower than the international criterion of 25%. Moreover, China's foreignreserves have increased to $154.68 billion. With so many foreign reserves, asustainable current account surplus, increasing capital inflows and a proper foreignliability structure, a smooth transition is likely to be ensured.V.4.3 OCA theory and peg to U.S. dollarSince the foreign exchange system reform in 1994, the Renminbi has been peggedto the U.S Dollar, which gives rise to what can be considered as an "optimal currencyarea". In fact, during the nineties, almost all the major Asian countries chose to peg tothe U.S Dollar, although in different forms or with different extent. They comprisewhat has come to be known as the "Asian Dollar Area".However, to maintain a fixed exchange rate implies a sacrifice of monetaryindependence. It means that the domestic monetary authority has to impose the samemonetary policy as the country to which it pegs its currency. According to OCAtheory, for a country to decide whether to peg and which currency to peg to, a seriesof criteria need to be considered such as similarities between inflation rates,production and export diversification, symmetry among shocks, trade integration, etc.Taking these criteria into consideration could help to maximize the benefit from thepeg and minimize the cost of policy conflicts.There are big differences between the Chinese and US economies. This inevitablyleads to differences in macroeconomics policies (Zheng, 2000). Since 1997, thedownward pressure and decline in demand and output in China necessitates imposingexpending monetary and fiscal policies. However, the US experienced high economicgrowth during this time, the monetary policy needed to be tight, which is the exactopposite of what China was looking for. Policy-conflicts pose difficulties for currencypegs. Moreover, China and the US have big differences in their culture and politics,which strongly affects the expectations people form and the public’s general responseto macroeconomics policies. Even if the same policies were implemented, theoutcomes would differ. Under these circumstances, a pegged exchange rate between

the US Dollar and the Renminbi is unsustainable in the long run.By the same line of reasoning, the Asian Dollar Area is also not an optimalarrangement. Just as the Asian Dollar Area has been a failure, the Renminbi Dollarpeg is likely to be unsustainable and provides ample incentives for Chinese authority38to abandon it.With its future membership with the WTO, China is accelerating its openness tothe international trading on an increasingly diversified basis with industrializedcountries and regional partners. As recent experience in Asian has shown, maintaininga tight exchange rate link to one of the major currencies while conducting trade andfinancial transactions with other major countries can pose significant difficulties.Growing interregional trade links also pose significant problems for China's exchangerate peg, especially for any single currency peg. This is particularly evident when oneconsiders that regional partners are pegged to other currencies and sometimes forcedto abandon their peg during a crisis. With the continuing growth in trade fluctuationsamong the major currencies and other Asian countries’ moving away from their pegs,China's optimal policy choice is an exchange regime with greater flexibility.V.5 Steps of future reformOne important principle for China's foreign exchange system reform is that themove toward a more flexible exchange rate regime should be done gradually to assurethat all conditions for the successful operation of the new regime are put into placebefore its arrival. Regime shifting and capital account liberalization should inparticular be consistent with the internal policy arrangement and the financial sectorreforms.V.5.1 Monetary and fiscal policy arrangementSince a country’s exchange rate regime is one component of its general economicpolicy strategy, it needs to be consistent with the other components, most importantlythe conduct of the monetary and fiscal policies. When exiting from a regime with ahigh degree of exchange rate fixity, macroeconomics arrangement needs to beaddressed in the interest of a smooth transaction.The Renminbi/Dollar exchange rate has been tightly fixed between 8.2 and 8.3for 6 years. It has served as a key anchor for monetary policy and experiencedinflation. In establishing the new anchor, it will be important to make it credible. Alow inflation rate is a key objective of monetary policy as it can act as an anchor.Therefore, future reforms should emphasize granting operational independence to thePBC to pursue this objective. This will be helpful in maintaining policy credibility. Inaddition, improving the accuracy and timeliness of data on inflation and other keyeconomic variables are also important. Transparency will make it possible for marketparticipants to accurately process information and help them make informed decisionsat each step and exert strong discipline on policy makers and other economic agents.Finally, the PBC needs to develop the institutional and technical capacity to conductmonetary policy in a more flexible exchange rate environment. In particular, indirectinstruments of monetary management should be used in an environment with largecapital flows. Fiscal discipline is also essential for stable exchange rate behavior.Confidence in fiscal discipline is in particular important when there is a shift in the39exchange regime and an increase in uncertainty about the exchange rate. Future fiscal

policy reform should concentrate on delivering smaller deficits, which will reduce thepressure on the current account and the central bank to use finance.V.5.2 Financial sector reformsWhatever exchange rate regime a country pursues, the long-term success dependson a strong banking sector. In China, the financial sector reform should aim atimproving the efficiency of the intermediation process and strengthening the pricemechanism in the financial market. To effectively allocate economic resources andmaintain strong economic fundamentals are in particular important for a flexibleregime to perform successfully when capital mobility is high.Restructuring the banking system and fostering competition are important. China'scurrent problems with financial institutions owe much to the close links among thegovernment, state-owned enterprises and specialized banks. Strong efforts should bemade to stop the direct lending and other quasi-fiscal activities on the part of thegovernment. Resource allocation distortions arising from these links should bestopped. Modern management techniques are also important. Asset/liabilitymanagement, loan risk management and loan monitoring should be adopted byChina's commercial banks. A set of prudential ratios, norms for financial reportingand disclosure standards are also essential elements for the supervisory and regulatoryframework, which will foster prudential behavior by financial institutions. Reformsshould also emphasize getting commercial banks to respond to monetary policysignals such as interest rates. Fostering competition and liberalizing interest rates areequally important.Financial market reform should focus on interest rate liberalization, which isessential for the efficient allocation of financial resources and necessary to support themarket exchange rate under an environment of the strong capital mobility. Based onChina's current environment, reform calls for a gradual approach. Liberalizationshould focus on the interbank market, lending and deposit rate in turn. This is becausethe interbank rate market has the smallest social exposure, while it will take longer forthe public to become accustomed to a different way of setting deposit rate. In order toliberalize the interest rate gradually, the authorities should allow financial institutionsto mark up above the benchmark rate set by PBC and gradually expand the band.V.5.3 Reforms in foreign exchange marketA broad, deep and resilient foreign exchange market is important for a floatingexchange rate. Future steps toward a flexible exchange regime should be directed toestablish a genuine foreign exchange interbank market governed by regulations thatmeet the international standards.The first goal will be to increase the supervision and regulation on banks' foreignexchange operations. Moving toward a more flexible exchange regime will pose bigproblems on the financial institutions who are used to a regime with a high degree ofexchange rate fixity and unaware of the risks under the new environment. Responsible40banking should be based on the awareness of and continuous control over risks(Mehran and Quintyn, 1996). Therefore, future reforms should emphasize the modernprudential regulations for banks' foreign exchange operation and risks. China's currentminimum limit on banks' liquid foreign assets should be replaced by regulations andrisk limits. It is important that each financial institution should be given only oneglobal limit. They should also be able to internally decide the part of the limit that

could be utilized by their branches and trade foreign exchange for their own accountsat any time within these limits.Second, competition in the foreign exchange should be increased. For a flexibleexchange regime to be implemented, the free operation of the price mechanism in theinterbank market is important. The market is the most efficient allocator of resourceswhen all the participants face the same rules and regulations and correspondinglycompete on the same basis. In China's current foreign exchange market, this is not thecase yet (Yang, 1999). Foreign funded enterprises have the rights to retain foreignexchange while domestic enterprises have to surrender their foreign exchange to thefinancial institutions according to the requirement. FFEs could also purchase or sellforeign exchange directly from the CFETs, while domestic enterprises have to usefinancial institutions to affect their transactions. Different regulations also apply todomestic and foreign banks. Foreign banks are restricted in their business activities tohandle foreign exchange sales of FFEs. Addressing these issues in future reforms isimportant. It is essential for the development of the foreign exchange market to ensureequal access to the market for both domestic and foreign banks and enterprises.Third, regulations should become market friendly and trading should be facilitated.In China's current interbank market, the wholesale market does not provide directdealings between the banks. While wholesale market transactions (those between theCFETS and the banks) are settled on the next business day, retail market transactions(those between bank customers) are settled on the same day. This difference makesefficient position and risk management in banks difficult. Banks have to hold liquidfunds idle to meet the unforeseen contingencies arising from retail transactions(Mehran and Quintyn, 1996). Future reform should be directed to make the settlementperiod for retail transactions the same as the settlement period in the CFETs market,which will improve the market evolution and making. An extension on the tradinghours would provide banks with the ability to set and update buying and selling rateson customer transactions throughout the day. At the same time, it could also increasethe gross flows to the CFETs market, which would help to increase the liquidity of theexchange market.Fourth, the PBC should be less active in intervening in the foreign exchangemarket. In order to gradually introduce free market operations into interbank market,large and frequent interventions from the PBC should be prevented. Steps should betaken to relax regulations on foreign exchange selling, purchasing and provision,which imposes strict surrender requirements and liquidity limits on enterprises andbanks and consequently forces the PBC to intervene in the interbank market. Anotherstep is to widen the bands for exchange rate fluctuations and introduce the free41floating in the market. But these steps should be taken gradually rather than all atonce. Several stages can be designed and combined with efforts to strengthen thefinancial sectors.The fifth proposal is to allow forward, future and derivatives transaction. Theneed is obvious, especially when the exchange rate is allowed to fluctuate. Futurereform should focus on accelerating openness of financial sectors and encouragebanks to make use of international foreign exchange and money markets. Under thiscircumstance, the banks could quote forward rates and hedge forward transactionsacross a broad range of maturate. This reform should also be consistent with the

development of a domestic money market. Forward operations will speed upintegration between the banks' foreign exchange and domestic operations.V.5.4 Steps of capital account liberalizationAn important issue regarding reforms toward a flexible exchange rate regime iscapital account liberalization. Capital account liberalization is necessary when capitalmobility is increased in China. It will also produce significant benefits for China'seconomic growth. Although it is the essential part of China's exchange rate systemreform, the progress should be orderly and properly sequenced and linked carefully tothe strengthening of the domestic financial system so that the precondition of a soundand well-supervised financial sector and appropriate macroeconomics policies is met.As witnessed during the recent Asian crisis, prompt liberalization of the capitalaccount would pose significant problems for macroeconomics stability and theexchange regime.Given other countries' experiences and China's current situation, the propersequence of liberalization process should be to liberalize the capital flows in longtermfirst, and then to liberalize short-term capital flows. Direct investment capitalflows should be liberalized followed by indirect investment flows. Securities basedinvestment should be liberalized before bank lending based investment. Restrictionson foreign loans to domestic residents should be lifted before restrictions on domesticlending to foreigners are. Finally, financial institutions should have restrictionsremoved before the restrictions are removed from non-financial institutions andindividuals. In sum, items that have no effect on the current account balance should beliberalized first while items that affect the current account balance and may bringfrequent capital flows should be liberalized gradually and prudently.Reforms in the near future should take the following steps. For capital inflows:Restrictions on direct foreign investments should be abolished to allow free capitalinflows. Authorities should gradually liberalize foreign investments through thedomestic money market, especially the securities market. Restrictions on domesticenterprises’ borrowing from foreign financial institutions should also be graduallyrelaxed. For capital outflows: Domestic residents and institutions' foreign investmentsshould be liberalized. Domestic residents should be permitted to perform foreigninvestment within proper limits. Domestic financial institutions should be permitted to42lend to foreign residents within a reasonable limit. Prudential regulation should beimposed on foreign financial institutions’ borrowing in domestic currency.Recent experiences indicate that capital account liberalization requires ten years.Considering China's current status, some estimate that this process will take aboutfifteen years (Wu, 1999). Capital account liberalization and steps toward a flexibleexchange regime are consistent and will reinforce each other, which will speed upChina's openness and greatly benefit the economy.VI. ConclusionGetting exchange rate right is essential for economic stability and growth in thedeveloping countries, especially for China, which is engaging in economic andfinancial reform and opening up its economy. The exchange and financial crises of the1990’s, China’s future membership with the WTO and its integration with globalgoods and financial markets raise this issue anew. Combining general criterion on

exchange regime choice, specific theories on developing countries' cases and lessonsfrom recent crisis with China's specific situations, we find out that although tightlymanaged floating had made great contributions to the restoration of Asian crisis aswell as China's economic reform, China's future interests lies in an exchange regimewith more flexibility. The optimal strategy calls for an active preparation for theregime shift. Steps toward a more flexible exchange regime should be taken orderlyand linked carefully to the strengthening of the domestic financial system and capitalaccount liberalization so as to ensure the long-run success of the new exchangeregime.43

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