research on theory of exchange rate regime

Guobing ShenGuobing Shen Associate Professor of World Associate Professor of World

Economy & International FinanceEconomy & International [email protected] [email protected]

Institute of World EconomyInstitute of World Economy

School of EconomicsSchool of Economics

Fudan UniversityFudan University

Research On the Theories of Exchange Rate Regimes

Topic FourTopic Fourteen-Sixteenteen-Sixteen

Theories of Exchange Rate Regime and the Choice of RMB Exchange Rate Regime

Discussing the academic articles related to Topic 14-16

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Copyright © Guobing Shen, Fudan University.

1: Importance and Role of Exchange Rate Regime

2: Exchange Rate Regime Choice

3: China’s Exchange Rate Regime / Policy

4: Estimation of China’s Exchange Rate Regime

Topic 14-16: Chapter Organization

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1: Importance and Role of Exchange Rate Regime —Importance of Exchange Rate Regime

1.1: Importance of Exchange Rate RegimeDubas (2009) finds that for developing countries, an intermediate exchange rate regime (a regime between a pure float and a hard peg) is most effective in preventing exchange rate misalignment. Additionally, the choice of an exchange rate regime as a means to limit misalignment matters for developing countries, but does not seem to matter for developed countries. Even though floats may help eliminate rigidities in an economy and fixes may aid in establishing credibility and combating inflation, intermediate regimes may be a more appropriate choice for developing countries. The estimation of exchange rate misalignment has been a practice for some time, yet there is still no consensus as to the best approach for estimation. It is extremely difficult to obtain the precise degree of misalignment of a currency. Fundamental equilibrium exchange rates (FEERs) rely on estimates of the real exchange rate that would simultaneously achieve internal and external balance in an economy. Behavioral equilibrium exchange rates (BEERs) are estimated such that the equilibrium real exchange rate is determined by estimating the relationship between the real exchange rate and a set of fundamental determinants, and only permanent changes in those fundamentals drive the equilibrium real exchange rate.

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Exchange rates may develop their own short-term and medium-term dynamics that have little to nothing to do with the fundamentals. Obviously floating rates are a viable option, but it is not at all clear that they are also desirable. Fixed exchange rates are certainly an option for a developing country. Depending on the nature and severity of the shocks a country faces, it may in fact be a reasonable choice. The intermediate exchange rate arrangements provide monetary authorities with the widest scope for minimizing exchange rate misalignment in emerging markets.The developing countries tend to experience larger degrees of misalignment overall. For these countries, intermediate regimes perform the best in terms of limiting misalignment. Fixed regimes are second, and floating regimes again lead to the largest degree of misalignment. However, for developed countries, the exchange rate regime does not matter. Intermediate regimes tend to exhibit less misalignment (according to a three-way classification) and thus may be a powerful policy tool to prevent or combat large degrees of under- or overvaluation.

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Coudert and Dubert (2005) show that pegs are associated with weaker growth than floating exchange rate regimes. Having long supported fixed exchange rate regimes as a weapon in the fight against inflation, the IMF turned to “corner” solutions, based on hard pegs-currency boards or dollarisation-or pure floats, in the late nineties. After the Argentine crisis in 2001–2002, the IMF has stopped recommending currency boards as a credible solution and has switched to its current doctrine of floating arrangements with inflation targeting. In theory, the nominal regime should be able to influence inflation, by creating an external anchor for the currency, and thus have a neutral impact on long-term growth. However, in the medium run, keeping exchange rates fixed may bring about real appreciation and affect macroeconomic performance.

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A widespread “fear of floating” among emerging countries is stemming from the inability of floating exchange rates to stabilize their economic shocks. The “currency mismatch” in domestic agents’ balance sheets provides an incentive for stabilizing the currency, since any depreciation is costly. Floating systems feature a highly volatile nominal exchange rate and low level of intervention by monetary authorities on the forex market. Conversely, pegged regimes display low volatility in the nominal exchange rate and large swings in reserves resulting from interventions by the central bank.-Pure float: high variance in the exchange rate, low volatility in official reserves;-Managed float: high variance in the exchange rate, high volatility in official reserves;-Crawling peg: strictly positive trend in the annual exchange rate; low volatility in the detrended exchange rate; - Peg: no trend in the annual exchange rate, low volatility in the nominal exchange rate without trend. p.879

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China was able to maintain the peg because of rigorous exchange rate controls, and also because of a former devaluation in 1994. Macroeconomic performance may be a function of the exchange rate regime, but the reverse may also be true, i.e. economic conditions themselves may drive certain choices of exchange rate regimes. Pegs are associated with lower inflation, while devaluation has a large inflationary effect. The Asian countries loosened their exchange rate policies in the aftermath of the 1997 devaluations.On one hand, pure floats do not allow better performances than crawling pegs. On the other hand, managed floats produce moderate growth performances and high inflation. Finally, crawling pegs appear to be a reasonable option: they yield average GDP growth and intermediate results in terms of inflation. p.893

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1: Importance and Role of Exchange Rate Regime —Capital Controls and Role of Exchange Rate Regime

1.2: Capital Controls and Role of Exchange Rate RegimeVon Hagen and Zhou (2005) find that exchange rate regime choices strongly influence the imposition or removal of capital controls, but the feed-back effect is weak. There is a hump-shaped relationship between exchange rate regime flexibility and capital control intensity. With capital movements under check, intermediate exchange arrangements such as conventional pegs, crawling pegs or bands, and target zones remain a viable and attractive option for many countries. While fixed and flexible regimes can live with high capital mobility, intermediate regimes are expected to be associated with higher intensity of capital controls. Without the protection of capital controls, a fixed exchange rate, though consistent with economic fundamentals, may not be sustainable if market perceptions of its viability change. Most recent studies take advantage of a much more detailed classification of capital transactions by the IMF, and they use the disaggregated information about the existence of controls on each category to construct almost continuous indices for the intensity of capital controls. From the perspective of crises prevention, countries with higher risk of currency crises due to pegged or tightly managed exchange rates or high current account deficits are found to be more prone to impose capital controls.

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The choice of exchange rate regimes depends on a number of country characteristics and policy variables. Specifically, the size of the economy measured in terms of real GDP, the degree of openness, and the commodity concentration. ERR choices strongly influence the choice of capital controls. The intensity of capital controls increases in the desired flexibility of exchange rate regimes. This finding is consistent with the implication of the impossible trinity in the sense that, if countries switch from fixed regimes to intermediate ones, capital controls will be intensified to help sustain the exchange rate regimes. Many developing and transition economies declare floating rates as official regimes, but in practice control or manage the exchange rates heavily to avoid large volatility. Greater central bank independence and the liberalization of current account contribute to the removal of capital controls, but larger size of the government and larger external debts make capital controls more intensive. Governments in transition economies have imposed capital controls as part of a strategy to develop new financial institutions and markets under some protection from foreign competition and the volatility of international capital movements. p.239

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The choice of exchange rate regimes precedes the choice of capital controls, and governments tend to use capital controls to help manage their declared exchange rate regimes. Countries that are highly open to foreign trade, diversified in commodity structure of trade, and have sufficient international reserves are more likely to adopt fixed-rate regimes. The exchange rate regime choices do influence the intensity of capital controls in a hump-shaped way. The results of the model provide evidence for a non-monotonic relationship between capital controls intensity and exchange rate regime choices. The overall evidences suggest that intermediate regimes are associated with the most intensive capital controls, and hard pegs are associated with the most liberal capital accounts. Advances in the development of financial institutions, current account surpluses, and heavy burden of external debt are associated with tighter capital controls in transition economies. p.243

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1: Importance and Role of Exchange Rate Regime—Capital Controls, Exchange Rate Regimes and Currency Crises

1.3: Capital Controls, Exchange Rate Regimes and Currency CrisesEsaka (2009) finds no evidence that, as the bipolar view argues, intermediate regimes have a significantly higher probability of currency crises than both hard pegs and free floats. Hard pegs with capital account liberalization have a significantly lower probability of currency crises than intermediate regimes with capital controls and free floats with capital controls. According to the bipolar view, intermediate regimes have a lack of verification and transparency for exchange rate policies; they cannot sufficiently obtain credibility of currencies, thereby causing speculative attacks and currency crises. Williamson (2000) suggested that intermediate regimes could help prevent misalignments and provide greater flexibility to cope with shocks, while hard pegs and free floats could generate misalignments that could damage their sustainability. According to the BBC(basket, band, crawling) rules, intermediate regimes are substantially less prone to currency crises.

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Which types of exchange rate regimes are more susceptible to speculative attacks and currency crises? Currency crises are generally defined as episodes of a large depreciation (nominal or real) in exchange rates, caused by speculative attacks. A crucial insight of the trilemma is that policymakers need to consider the choice of policy stance toward capital flows simultaneously when they choose their exchange rate regime. It is important to explicitly take into account the existence of capital controls. Under capital controls, the probability of currency crises for hard pegs (9.2 percent) is lower than that for intermediate regimes (11.0 percent) and that for free floats (12.2 percent). Under no capital controls, the probability of currency crises for hard pegs (3.9 percent) is lower than that for intermediate regimes (4.8 percent) and that for free floats (6.3 percent). Hard pegs under liberalized capital accounts are likely to be the least susceptible to currency crises compared with other regimes.

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Esaka (2009) confirmed that intermediate regimes do not significantly increase the probability of currency crises compared with both hard pegs and free floats. Hard pegs with no capital controls significantly decrease the likelihood of currency crises compared with intermediate regimes and free floats with capital controls. The probability of currency crises increases with greater monetary policy autonomy. Hard pegs with capital account liberalization abandon monetary policy autonomy and have strict discipline for monetary and macroeconomic policies, and thus are substantially less prone to speculative attacks and currency crises compared with other regimes.

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1: Importance and Role of Exchange Rate Regime —Interest Rates and Role of Exchange Rate Regime

1.4: Interest Rates and Role of Exchange Rate RegimeDi Giovanni and Shambaugh (2008) show that high foreign interest rates have a contractionary effect on annual real GDP growth in the domestic economy, but this effect is centered on countries with fixed exchange rates. This loss of autonomy implies a potential channel through which foreign interest rates can affect pegs and floats differently, with pegs being directly affected by foreign interest rates and floats insulated from these rates.The present paper uncovers the impact of major country interest rates on other countries while paying particular attention to the way the exchange rate regime may affect the transmission. Foreign interest rates should not have a direct effect on the domestic economy. However, they may operate through some channel and have an indirect impact either by affecting domestic interest rates or other variables that contribute to annual GDP growth. Pegs are more affected than floats, consistent with an interest rate channel. Furthermore, exchange rate regime is the most dominant characteristic driving the relationship between base rates and GDP growth.

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1: Importance and Role of Exchange Rate Regime —Interest Rates and Role of Exchange Rate Regime

The base interest rate will potentially move the domestic exchange rate and affect the economy through an exchange rate change channel. An increase in the base rate may cause the base currency to appreciate against all other currencies (that float) meaning that any floating country will depreciate against the base. While interest rates in base countries may have an effect on other countries’ real economies, this impact only exists for pegged countries. Countries without a fixed exchange rate show no relationship between annual real GDP growth and the base interest rate, but countries with a fixed exchange rate grow 0.1 to 0.2 percentage points slower when base interest rates are 1 percentage point higher. Pegged countries do not respond to any world interest rate, but only the rate of the country to which they peg. Pegging forces a country’s interest rates to follow the base country rates, which may generate more volatility in GDP by eliminating countercyclical monetary policy as an option.

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1: Importance and Role of Exchange Rate Regime —

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2: Exchange Rate Regime Choice—Types of Exchange Rate Regime

The main issue in the choice of exchange rate regime is whether exchange rate adjustment can help to keep the economy near to a full-employment equilibrium. Pegged regimes experience less exchange rate volatility but have less freedom to set their own interest rates. Exchange rate pegs have not infrequently been used as a means of stopping inflation.2.1: Types of Exchange Rate RegimeExchange rate regimes range from a pure float (no intervention) to various forms of peg and ultimately a common currency. The exchange rate regime classifications are based on the eight-regime classification scheme of the IMF. The eight regimes are: (1) exchange arrangements with no separate legal tender, (2) currency board, (3) conventional fixed peg, (4) pegged exchange rates within horizontal bands, (5) crawling pegs, (6) crawling bands, (7) managed floating, and (8) independently floating.

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(1) no separate legal tender: The currency of another country circulates as the sole legal tender (formal dollarization), or the member belongs to a currency union in which the same legal tender is shared by the members of the union.(2) currency board: A monetary regime based on an explicit legislative commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate, combined with restrictions on the issuing authority to ensure the fulfillment of its legal obligation.(3) conventional fixed: The country pegs its currency within margins of ±1 percent or less vis-à-vis another currency; a cooperative arrangement, such as the ERM II; or a basket of currencies, where the basket is formed from the currencies of major trading or financial partners and weights reflect the geographical distribution of trade, services, or capital flows.(4) horizontal bands: The value of the currency is maintained within certain margins of fluctuation of more than ±1 percent around a fixed central rate or the margin between the maximum and minimum value of the exchange rate exceeds 2 percent.

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(5) crawling pegs: The currency is adjusted periodically in small amounts at a fixed rate or in response to changes in selective quantitative indicators, such as past inflation differentials vis-à-vis major trading partners, differentials between the inflation target and expected inflation in major trading partners.(6) crawling bands: The currency is maintained within certain fluctuation margins of at least ±1 percent around a central rate—or the margin between the maximum and minimum value of the exchange rate exceeds 2 percent—and the central rate or margins are adjusted periodically at a fixed rate or in response to changes in selective quantitative indicators.(7) managed floating: The monetary authority attempts to influence the exchange rate without having a specific exchange rate path or target.(8) independently floating: The exchange rate is market-determined, with any official foreign exchange market intervention aimed at moderating the rate of change and preventing undue fluctuations in the exchange rate, rather than at establishing a level for it.

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Fixed and Managed Floating Exchange Rate Regime: Under the fixed regime, the monetary authorities in advance have to pre-announce their target foreign currencies, that is, composition and shares of currency basket, and their target level of exchange rates. According to the preannouncement rule, the monetary authorities have to intervene in the foreign exchange market to fix the exchange rate to the pre-announced target rate. In contrast, under the managed floating, they do not need to pre-announce their exchange rate policy rule. Even though the monetary authorities have an intention to peg their home currency to the US dollar, they do not need to make their exchange rate policy clear in advance. Accordingly, the fixed regime has transparency and accountability while the managed floating is not so clearly transparent or accountable (Frankel, Schmukler and Serven 2000).

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Reference to a currency basket under managed floating and peg to a currency basket under the fixed regime: The former has weaker transparency and accountability compared with the latter. Under the weak transparency and accountability of exchange rate policy rule, it may be easy for the monetary authority to conduct unclear exchange rate policy and manipulation. Unclear exchange rate policy and possibility of manipulation in the exchange rate policy would decreases credibility of the monetary authorities. Under such a situation, the monetary authorities cannot enjoy honey moon effects in which market participants follow the monetary authorities’ intention of exchange rate policy.

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2: Exchange Rate Regime Choice—De Facto Classification and Exchange rate anchor

2.2: De Facto Classification and Exchange rate anchorThe classification system is based on the members’ actual, de facto arrangements as identified by IMF staff, which may differ from their officially announced arrangements. The scheme ranks exchange rate arrangements on the basis of their degree of flexibility and the existence of formal or informal commitments to exchange rate paths. It distinguishes among different forms of exchange rate arrangements, in addition to arrangements with no separate legal tender, to help assess the implications of the choice of exchange rate arrangement for the degree of independence of monetary policy.The monetary authority stands ready to buy or sell foreign exchange at given quoted rates to maintain the exchange rate at its predetermined level or within a range (the exchange rate serves as the nominal anchor or intermediate target of monetary policy). These regimes cover exchange rate regimes with no separate legal tender, currency board arrangements, fixed pegs with or without bands, and crawling pegs with or without bands.

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2: Exchange Rate Regime Choice—De Facto Classification and Exchange rate anchor

De Facto Classification of Exchange Rate Regimes and Monetary Policy Frameworks (Data as of April 31, 2008)

Monetary Pol i cy Framework Exchange rate anchor Monetary

aggregate target

I nfl at i on target i ng f ramework

Other1 Exchange rate

arrangement (Number of countri es)

U. S. dol l ar (66)

Euro (27)

Composi te (15)

Other(7) (22) (44) (11)

Exchange arrangement wi th no separate l egal tender (10)

Currency board arrangement (13)

Other conventi onal fi xed peg

arrangement (68)

Pegged exchange rate wi thi n hori zontal

bands (3)

Crawl i ng peg (8) Bol i vi a Chi na Ethi opi a I raq Ni caragua Uzbeki stan

Botswana I ran, I . R. of .

Crawl i ng band (2) Managed fl oati ng

wi th no pre-determi ned path

f or the exchange rate (44)

I ndependentl y fl oati ng (40)

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2: Exchange Rate Regime Choice —Regional Exchange Rate Regimes

2.3: Regional Exchange Rate RegimesDellas and Tavlas (2005) find that a regional fixed exchange rate regime tends to decrease global exchange rate volatility if there is sufficient symmetry in the world economy. The results tend to be more ambiguous in the presence of asymmetries. They are mostly interested in the global implications of a regional fixed exchange rate regime, in particular, whether such a regime leads to a global reduction of exchange rate volatility or simply transfers the volatility from one part of the global system to another. In particular, the reduction in volatility is greater when the “ins” have more flexible labor markets than the “outs”. Positive co-movements in productivity across countries tend to increase global exchange rate volatility under a regional fixed regime.

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2: Exchange Rate Regime Choice —Different Views of Exchange Rate Regime Choice

2.4: Different Views of Exchange Rate Regime Choice Carmignani, Colombo and Tirelli (2008) show that a stable socio-political environment and an efficient political decision-making process are a necessary prerequisite for choosing a peg and sticking to it, challenging the view that sees the exchange rate as a commitment device. Policymakers seem rather concerned with regime sustainability in the face of adverse economic and socio-political fundamentals. Ever since the demise of the Bretton Woods system, economists have disagreed over the relative merits of fixed and flexible exchange rates. In the profession and among laymen, the consensus shifted from the ‘‘naive’’ enthusiasm for flexible exchange rates in the late sixties, to the preference for fixed rates in the early eighties and for intermediate regimes in the early nineties. After the Asian crisis the consensus changed again embracing the bipolar view of exchange rate regimes, i.e. either irrevocably fixed rates (currency board, dollarization) or truly flexible rates. p.1178.

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Calvo and Reinhart (2002) challenged this bipolar view, suggesting that many countries follow de facto a regime which is different from what officially declared. On the one hand, pegs are often announced but not implemented in practice. On the other hand, several countries seem to ‘‘fear of floating’’ adopting de facto a peg (or a regime close to it) while officially declaring a float. The credibility view of the regime choice: governments that suffer from a credibility deficit can signal their commitment to ‘‘tough’’ policies by appropriately choosing the exchange rate regime. However, these strategies may backfire if the underlying fundamentals do not support the regime choice. In contrast, the consistency view maintains that governments should pick the regime that best fits with the underlying economic and political fundamentals. In other words, the consistency view calls for retaining the option of flexibility when the potential inflation bias is stronger.

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Carmignani, et al (2008) support the consistency view. Indicators of socio-political risk and political fragmentation are positively related to the chances of observing a de facto float. In line with the predictions of the consistency view, socio-political unrest and political fragmentation increase the chances that a promise to implement a peg will be broken.The credibility view implies that the exchange rate regime is an instrument for governments to address credibility-deficits and dynamic inconsistency problems. Thus, in a situation where the political system per se would generate inefficient macroeconomic outcomes, the exchange rate regime could discipline monetary and fiscal policy by limiting political discretion. In contrast, a number of contributions argue that the credibility of announced policies crucially depends on the changing economic and socio-political environment. The disciplining effect of the exchange rate regime can at best be temporary and, without fixing the underlying fundamentals, this approach is bound to fail. This approach is labeled as the consistency view. p.1179

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Economic factors affecting the exchange rate regime choice: liability dollarization and inflation. The credibility view claims that liability dollarization strengthens an announced peg by raising the cost of reneging on it. The consistency view reverses this argument, as the combination of liability dollarization and exchange rate commitment generates lock-in effects: when adverse shocks render the peg unsustainable, the delayed devaluation is amplified and may cause a financial meltdown. The credibility view emphasizes the role of the exchange rate as a nominal anchor, whereas the consistency view argues that high inflation countries should be careful in adopting a peg as the erosion of external competitiveness would undermine the credibility of the peg. Political factors: three channels link politics to the choice of exchange rate regime: the electoral cycle, government termination and socio-political unrest, and institutional arrangements concerning the decision-making process. In addition to the variables linked to the credibility-vs-consistency dilemma, some control variables: openness, economic size, trade concentration, economic volatility, financial development, and ideological preferences. 1183

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Among the de facto peggers, the chances that the regime is announced increase if countries are relatively small, have lower liability dollarization, are less prone to social political risk, have an upcoming election and a less fragmented political system. Carmignani, et al (2008) has shown that the exchange rate regime is chosen consistently with a set of underlying economic and socio-political conditions. In particular, socio-political variables explain not only the regime choice, but also why some regimes are announced and why they are subsequently sustained or reneged upon. In choosing the exchange rate regime, policymakers seem to be concerned with its future sustainability. This is a wise approach as adverse economic and socio-political fundamentals raise the chances that regime choices will be reversed. p.1193

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2: Exchange Rate Regime Choice —Exchange Rate Regime Determination

2.5 Exchange Rate Regime Determination: Theory and EvidenceKimakova (2008) shows how a small open economy reliant on foreign sources of financing is likely to opt for a stable regime. Furthermore, a stable political environment with a high degree of accountability is conducive to choosing a flexible regime. The findings suggest that flexible rather than fixed exchange rate regimes provide more fiscal discipline. The paper builds a theoretical framework for explaining exchange rate regime choices through the interaction of monetary and fiscal policies, credibility issues, political uncertainty and financial markets microstructure. Among the most prominent normative theories of regime choice is the theory of Optimal Currency Areas (OCA) developed by Mundell (1961) and McKinnon (1963). Optimal regime choice has been linked to the source of the economic shocks, real or nominal, and the degree of capital mobility. The main ideas on regime choice included adopting a floating regime if real shocks prevail, while a fixed regime should be preferable under nominal shocks. Countries could hope to achieve only two out of three possible regime characteristics.

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Frankel and Rose (1998) pointed towards the endogeneity of OCAs, or the fact that countries may become optimal candidates for a monetary union ex-post, even if they do not qualify ex-ante. The reason is that the currency union may enhance trade and the correlation of shocks in member states. p.355Recent empirical explorations have demonstrated that exchange rate regime choice is no longer viewed as a binary decision between fix and float. Real world exchange rate regimes exhibit a large degree of heterogeneity, even within the same official category. Fixed exchange rates can get realigned frequently or fluctuate in a relatively wide band, while some floats may behave more like a peg. This observation has led to a thorough re-examination of the current and historical exchange rate regime classifications. Almost half of official pegs are not de facto pegs, and over half of official managed floats are pegs or limited flexibility arrangements. This evidence challenges the previously accepted notion that exchange rate regimes have in general become more flexible in the post-Bretton Woods period. Theoretical efforts have largely continued to mirror this narrow focus on normative issues of regime choice. p.355

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Empirical papers on de facto regime classifications have consistently found that only a handful of countries have truly floating regimes which tend to be large economies. Most countries for which the small-open-economy context is relevant exhibit some form of intermediate regimes. This paper suggests that searching for the single ‘optimal’ or most superior exchange rate regime might be misguided. Countries differ in their economic and institutional characteristics (with respect to other countries or over time), and thus their optimal or preferred (perhaps even socially suboptimal) choice of exchange rate regime might vary as well. p.356 Measures of de facto regime flexibility show most of the countries continue to limit the flexibility of exchange rates relative to reserves or interest rates. Regime choice in a small open economy: Empirical research typically fails to support the validity of the relative PPP assumption in the short run. However, recent empirical studies provide evidence in favor of relative PPP in the long run.

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Foreign investors have a preference for exchange rate stability. This is the case for both domestic and foreign currency denominated debt. In the case of foreign currency debt issues, maintaining the fixed exchange rate regime reduces the probability of debt rescheduling or default. Under a fixed exchange rate regime, a currency crisis may take place when the shadow exchange rate jumps and foreign exchange reserves are depleted as foreign investors withdraw from the domestic market. Expectations of a crisis may become self-fulfilling. Political preference for output stimulus and a high level of domestic currency debt held by resident and non-resident investors provide incentives for inflating or choosing a flexible regime. The existence of a traditional Phillips curve and the potential for output stimulus through inflation surprises point in the direction of a more flexible regime. Lack of credibility enhances the benefits of accommodating policies, and thus the motivation for implementing a more flexible arrangement.

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Alesina and Wagner (2006) empirically investigate the determinants of discrepancies between de jure and de facto exchange rate regimes. First, foreign liabilities are a key factor behind the observed ‘fear of floating’. Second, a U-shaped relationship between institutional quality and exchange rate regimes: countries that float tend to be either very low in terms of institutional quality, or have very high institutional quality (and they choose to float).The model integrates elements of output stimulus, credibility, political uncertainty, currency structure of debt and financial market development as factors affecting regime choice. The model shows how a small open economy reliant on foreign sources of financing is likely to opt for a stable regime. A stable political environment with a high degree of accountability is conducive to choosing a flexible regime. The findings suggest that flexible rather than fixed regimes provide more fiscal discipline by limiting the incentives for excessive borrowing. p.367

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2: Exchange Rate Regime Choice —The Choice of Developing & Developed Countries

2.6: The Choice of Exchange Rate Regimes in Developing & Developed CountriesVon Hagen and Zhou (2007): The collapse of the Bretton Woods System in 1973 provided countries with a far wider range of choices than before, but many countries continued to apply some kind of exchange rate pegs. Since the mid-1980s a trend toward more flexible regimes has emerged. However, independently floating exchange rates remain rare in the developing world. Instead, various types of intermediate arrangements have been adopted in attempts to combine exchange rate stability with policy flexibility. The Optimum Currency Area (OCA) theory of the 1960s views the exchange rate primarily as an expenditure-switching device and develops a list of criteria for favoring fixed-rate against flexible-rate regimes, such as the absence of asymmetric demand shocks, high factor mobility (Mundell, 1961), small economic size and high economic openness (McKinnon, 1963), and high production diversity (Kenen, 1969).

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The literature of the 1970s focuses on the automatic-stabilizer property of exchange rates and concludes that fixed-rate (flexible-rate) regimes perform better in terms of output stability if nominal (real) shocks are the main source of disturbances. The literature in the 1980s discusses the possibility of using exchange rates as nominal anchor to improve the credibility of the domestic monetary authority’s efforts to contain inflation. A comprehensive approach covering a wide range of regime determinants is adopted by recent studies.Countries that have selected a particular exchange rate regime in the past are more likely to select the same regime in the future. Macro economic conditions or constraints relevant to current regime choices are affected by past regime choices. Past regime choices have a genuine structural effect, and this structural dynamic linkage between past and current regime choices is labelled “true” state dependence. Alternatively, regime choices may be correlated over time simply because the economic and political factors impacting them are correlated over time. This type of dynamic linkage between past and current regime choices is labelled “spurious” state dependence. p.1074

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If regime choices are truly state dependence, one-time policy actions or other macro economic shocks that have led to the adoption of an exchange rate regime have persistent effects on the probability of choosing that regime in later periods. With spurious state dependence, in contrast, the determinants of exchange rate regime choices are not affected by short-term macro economic developments and policy efforts in the long run. Von Hagen and Zhou (2007) consider four groups of potential regime determinants: OCA fundamentals, stabilization considerations, currency crises factors, and political and institutional features.

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Husain, Mody and Rogoff (2005) think that for developing countries with little exposure to international capital markets, pegs are notable for their durability and relatively low inflation. In contrast, for advanced economies, floats are distinctly more durable and also appear to be associated with higher growth. For emerging markets, the exchange regime does not appear to have a systematic effect on inflation or growth. The popular notion that pegged exchange rates are problematic everywhere is misplaced. Fixed regimes in poorer developing countries with little access to international capital are associated with lower inflation and higher durability. Emerging markets do appear to experience crises more frequently under pegged regimes. And for advanced economies, flexible rates may offer significantly greater durability and slightly higher growth, without generating higher inflation. Exchange rate regimes are a sufficiently broad sweeping and complex topic that further research is needed to cement and understand their microeconomic underpinnings.

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Masson (2001) indicate that the intermediate cases will continue to constitute a sizable fraction of actual exchange rate regimes. Exchange rate regimes, like other aspects of economic policy, are not chosen once and for all. In fact, history shows us that countries change their regimes frequently, either voluntarily or involuntarily. Regimes intermediate between a hard fix and a clean float may also be chosen as part of a regional integration strategy. Transitions between regimes may also reflect the shifting preferences of policymakers. For many developing countries, the exchange rate regime is not necessarily stable, but fluctuates among various alternative intermediate regimes, depending on the relative weight given to sustaining activity or limiting inflation, and on the shocks hitting the economy.

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The official classification often does not correspond to the reality of exchange rate fluctuations. Based on actual exchange rate and reserves behavior, there are frequent transitions away from fixed rates, to both the intermediate regime and to floats, and the transitions from floats are mainly to the intermediate regimes. As a result, the hollowing out hypothesis in either form is soundly rejected, and the invariant distribution implies proportions of roughly 0.2, 0.4, and 0.4, for the three regimes, implying some future increase in the proportion of fixes and intermediate regimes, at the expense of floats. The evidence of transitions suggests that intermediate regimes will continue to constitute an important fraction of actual exchange rate regimes.

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3: China’s Exchange Rate Regime / Policy——China’s Experience and Choices

3.1: Exchange Rate Regimes: China’s Experience and ChoicesHuang and Wang (2004) find that while the current regime of a de facto peg to the U.S. dollar adopted in 1994, combined with other supporting mechanisms, have served China’s economy well, globalization and financial integration will lead China toward more liberal exchange rate regimes. The process of moving towards more flexibility should be undertaken cautiously, taking into consideration risk factors, including those related to market speculation, capital flight, macro-economic fundamentals and the stability of China’s financial system.Two related issues: RMB exchange rates and exchange rate regimes. What exchange rate levels are appropriate? Towards what exchange rate regimes should China move? Along with China’s gradual economic reform since the 1970s, its exchange rate regime has evolved in an experiment of gradualism. The regime changed from a centrally planned administrative mechanism to a dual-rate system, then to a managed float with a narrow band, and finally to a managed float with a very narrow band—a de facto peg to the U.S. dollar.

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3: China’s Exchange Rate Regime / Policy ——China’s Experience and Choices

In late 1979, China started to permit state-owned enterprises (SOEs) to trade foreign exchange retention quota through Bank of China branches. In 1981, China introduced a dual exchange rate system: an official rate for non-trade-related transactions and an internal settlement rate for authorized current account transactions. Following the discontinuation of the internal settlement rate in 1985, all transactions were settled at the official rate. The official rates were adjusted from time to time to reflect exchange rate movements of the currencies in the basket. After special economic zones, China reintroduced a dual-exchange-rate system in 1986. Foreign and Chinese enterprises in special economic zones were permitted to trade foreign exchange in the so-called swap centers. The swap centers formed a platform for a market mechanism outside the central plan and at market rates, and they played a useful role in smoothing the transition to a market economy. China had one official foreign exchange rate and many market exchange rates because of imperfect arbitrage between swap centers. These market rates generated new market distortions and became a source of corruption in the late 1980s and early 1990s. p.337

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The swap center rate rose to RMB 8.7 per dollar at the end of 1993, although the official rate remained at RMB 5.7 per dollar. The widening gap between the official and market rates called for exchange rate regime reform. On January 1, 1994, China adopted a new managed-float regime with a narrow band. Under this new regime, a single unified rate at the swap centers was set at RMB 8.7 per dollar. To support the new regime, China introduced a new trading system, the China Foreign Exchange Trade System, and established the Shanghai interbank foreign exchange market in early 1994. RMB began to appreciate through 1994 and the first part of 1995, reaching RMB 8.3 per dollar (by about 5%) in May 1995 and remaining around 8.3 until May 1997, and finally appreciating to 8.28 in October 1997.Although the regime is still a managed float, China has essentially operated its system as a de facto peg to the dollar since 1994. Unlike other Asian currencies, the RMB did not depreciate during the Asian crisis. p.338

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Frankel (1999) believed that no single currency regime is right for all countries or at all times, and the choice of exchange-rate arrangement should depend on the particular circumstances facing the country in question. Moreover, an exchange rate regime is unlikely to be successful unless accompanied by solid fundamentals. This suggests that what regime is right for China depends on China’s own circumstances, and circumstances of the regional and international environment. In an integrated world economy, a country can meet only two out of three goals simultaneously: exchange-rate stability, monetary independence, or financial-market integration. If China wants to maintain monetary independence, it will face a tradeoff between financial market integration and exchange rate stability. As long as sterilization can be managed, this managed-float regime allows a certain degree of flexibility while keeping exchange rate fluctuations within a narrow band. China’s recent experience suggests that this regime has worked reasonably well, but China has experienced increasing difficulties in sterilizing capital inflows. 340

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Since the Asian crisis, some Asian economies have managed their exchange rates by keeping them closely in line with the U.S. dollar. A new basket peg is one option for moving in the direction of increasing flexibility. Widening the band is another option for moving in this direction. An important issue in adopting this option is related to market expectation and speculation. If expectations for RMB appreciation and increasing flexibility remain strong in the marketplace, hot money may continue to enter China. Since globalization will push China toward further financial integration, it should move decisively towards increasing exchange rate flexibility. The process and pace of moving towards more flexibility should be deliberate. In particular, China should avoid the mistakes made by other developing and emerging market economies that rushed into opening the capital account and made their currencies convertible, often leading to currency and banking crises when hot money left their economies. p.341

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3: China’s Exchange Rate Regime / Policy ——Reform of China’s Foreign Exchange System

3.2: Reform of China’s Foreign Exchange SystemGu and Zhang (2006) stress the necessity of capital controls in China’s gradual foreign exchange reform and the importance of credible government policy in guiding market expectations. China had adopted a fixed exchange rate regime in the form of a peg of the RMB to the US dollar before July 2005, but has since changed to a basket peg with a managed trading band. Large amounts of hot money that entered China for speculation have caused substantial real estate bubbles in many large cities. The government has been forced to buy up excess foreign exchange to maintain the RMB’s stability, thereby increasing the money supply. Faced with the consequent inflation pressure, the central bank has had to use monetary tools to reduce the money supply. However, this sterilization action might sooner or later become less effective as speculation continues.

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Under sterilization, persistent external surpluses (or rising Forex reserves) are possible, because the link between the external imbalance and the equilibrating change in monetary shocks is broken under capital immobility or the RMB’s inconvertibility.A large revaluation (25-40%) that aims at solving the persistent imbalance once and for all will leave no room for any further appreciation speculation. However, this ambitious external equilibrating could seriously disrupt the internal equilibrium, and might reduce output and increase unemployment to intolerable levels. No one is sure what magnitude of adjustment should be chosen. If the government engaged in revaluations of small amounts frequently and irregularly, a vicious circle would be formed. It is likely for China to lessen its external imbalance through tightening capital controls and reducing net exports.

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Four policy recommendations for China’s Forex system reform:(1) China must retain tight restrictions on capital flows. China is far from being ready to float its exchange rate and its monetary policy shouldn’t be powerless to affect economic activity. China cannot give up capital controls but has to live with external imbalances. (2) Macro policy must be conducted by influencing market expectations. The government should provide the markets with good information on its economic fundamentals and macro policy to anchor market expectations. China cannot afford to accept any large revaluation because of potential mass unemployment and drastic economic slowdown.(3) Government policy must be made creditable to be effective. It must adopt an independent Forex policy by strongly resisting any foreign pressure for a substantial revaluation of the RMB. A managed trading band must be set explicitly as a credible target to commit the government to exchange rate stability.

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(4) The Forex system must be reformed in a prudent and gradual manner. Notwithstanding the ultimate goal of the RMB’s full convertibility and a floating exchange rate, the path towards this goal must be a gradual and steady one. China needs certain capital controls to subdue capital flight. Capital account liberalization must proceed gradually because of the immaturity of China’s financial system. A substantial revaluation of the RMB or a quick switch to a floating exchange rate is neither politically feasible nor economically sensible for China. China needs a limited and gradual reform of the Forex system.

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3: China’s Exchange Rate Regime / Policy ——China’s Exchange Rate Policy and the Global Imbalances

3.3: China’s Exchange Rate Policy and the Global ImbalancesRoberts and Tyers (2003) find that more flexibility would be beneficial to China and that this benefit can be expected to increase as capital mobility increases. Although China has classified the currency regime as a ‘managed float’, in reality, the exchange rate policy has not been uniform. From 1986 to 1994, three different rates were effective at the same time: the ‘official’ rate (an often adjusted peg), ‘swap’ market rates (unofficial floating rates) and the ‘effective’ exchange rates actually faced by exporters (weighted averages of official and unofficial rates). China’s performance during the Asian currency crisis has been well documented. China’s decision not to devalue was widely applauded for preventing a further round of competitive devaluations. The natural alternative to any kind of fixed regime is a floating exchange rate, the classic advantage of which is that it helps insulate real activity from external shocks by appreciating automatically when the shock is beneficial and depreciating when it is adverse. In addition, a flexible policy gives the monetary authority the independence to respond quickly to domestic and external shocks as required.

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Fixed and flexible regimes can work in practice depending on the strength of policy-makers’ commitment to macroeconomic stability and the specific characteristics of the country concerned. The theory of OCA focuses on the country characteristics that would make fixed rates an attractive option. If trade with the US constituted the bulk of China’s trade, a fixed exchange rate might exert a powerful stabilizing effect on the price level. However, as capital mobility increases and interest rates are liberalized, preserving the peg will ultimately mean abandoning any remaining monetary policy independence. China’s macroeconomic record suggests this is not the case.As China’s capital markets become globally integrated, a pegged exchange rate will: (i) erode the independence of monetary policy; (ii) magnify variation in prices and output; and (iii) increase the risk of speculative attacks on the currency under adverse regional or domestic conditions. The Chinese government should pursue a considerably more flexible exchange rate policy to avoid the harmful consequences that a fixed exchange rate policy entails when the economy is subjected to shocks. p.180

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Xu (2008) finds that there is no evidence that changes in the exchange rate cause the trade deficit to rise in the short run, but a statistically significant long-run relationship between the RMB/dollar exchange rate and the US trade deficit with China is detected. As the value of the dollar declines (or RMB appreciates), ceteris paribus, so does the trade deficit. Hence, there is a need for China to adjust its exchange rate policy to help reduce the ever mounting US trade deficit. Among the great concerns in the US, some have attributed the growing US trade deficit to China’s exchange rate policy. The weakened RMB spurs US imports from China and undercuts US exports to China, contributing to a widening trade gap between the two countries and job losses in American manufacturing. However, China fiercely disputes the allegation, and argues that the stable RMB exchange rate benefits not only China but also the rest of the world.

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The results of Xu (2008) reveal a long-run relationship between the RMB/dollar exchange rate and the US trade deficit with China. An appreciation of the US dollar or a depreciation of RMB will contribute to higher long-run US trade deficits with China, ceteris paribus. If China revalues its currency as proposed by the US, although the US trade deficit with China may change little in the short run, it will certainly decrease in the long run. As long as RMB is not a convertible currency, it is hard for the dispute between the US and China on China’s exchange rate policy to disappear. The small revaluation in RMB may not have short-run effects on the growing US trade deficit with China. But it will have long-run effects on reducing the US trade deficits with China. p.727

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Gu and Zhang (2006) believe that to lessen the expected revaluation, China will have to decrease its trade surplus by expanding imports from the countries having large trade deficits. From the perspective of anchoring expectations, it would pay China to increase its imports (shortrun action) rather than revalue its currency (long-run consequence). The adjustment to disequilibrium could be a very long process. China need not be worried much about the prospects of prolonged external disequilibrium permitted by capital controls. Instead, the government must attach great importance to a reduction in the portfolio risk of its rising Forex reserves. China needs to reduce its dependence of economic growth on exports by discouraging private savings and expanding domestic demand. When the economy grows larger and becomes less dependent on external factors, China will be less vulnerable to foreign pressure and will have greater control over its economic destiny.

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Stricter capital control softens revaluation pressure, restrains speculative attacks, reduces external imbalances, and permits a BP surplus to be sustained for a longer time. Capital control itself serves as a strong, credible signal to the markets of China’s determination to maintain the stability of its exchange rate. pp.61-63.Corden (2009) The Western argument was that, if the RMB were allowed to float, it would appreciate substantially more and this would reduce China’s high current account surplus as well as the US deficit. In this view the Chinese exchange rate regime and policy have been (more or less) the causes of the current account imbalance. It is implied that the Chinese exchange rate intervention caused the Chinese current account surplus and at least played a role in causing the overall US current account deficit. However, many kinds of exchange rate regimes are compatible with a current account surplus.

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Exchange rate regimes are not really connected with global current account imbalances. Both the US and Japan have floating rate regimes; and in the case of Japan there is only occasional intervention. Thus, a floating rate regime between them is obviously no inhibition to a current account imbalance. Why did China’s current account surplus increase? The steep increase in the surplus from 2005 was not the result of deliberate shifts in exchange rate policy and was, indeed, not easily predictable. The primary purpose of Chinese exchange rate policy is to maintain employment in export industries and related employment in urban areas. Large variations in the exchange rate would lead to speculation and “China’s immature and fragile financial system would not be able to bear those risks”.

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Two parts of Chinese exchange rate policy: one is exchange rate protection, namely a policy designed to maintain profitability and employment in the export sector by means of undervaluation of the exchange rate. The other is to maintain a stable exchange rate, avoiding both a floating rate and sharp changes in a fixed-but-adjustable rate. Through the world general equilibrium process involving a sharp decline in the world real interest rate, the surplus of China was a part-cause of the deficit of the US. But the exogenous increase in the politically-determined US fiscal deficit, as well as the exogenously-determined surpluses of savings glut countries other than China, also contributed to explaining the US deficit. When China exports goods to other countries in exchange for importing bonds and other financial instruments especially from the US – it is engaging in inter-temporal trade. There are likely to be gains from this kind of trade as from the usual trade in goods and services.

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The causes of the current crisis: is China to blame? The current world credit crisis has its origin in the excessive credit expansion in the US and elsewhere, and in turn this has had its underlying origin in the high savings of the “savings glut” countries, which includes China. This credit expansion led to excessive leverage, the housing booms, in general, to irresponsible lending by financial intermediaries and to excessive borrowing by households, private equity and non-financial firms. While in the developing country debt crises of the 1980s and 1990s the blame was generally put on the borrowers, this time some would put the blame on the original lenders – i.e. the net savers, especially China. However, high savings need not – and should not – lead to crises.

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What has gone wrong to create the disastrous world credit crisis? First, there was the “savings glut” coming principally from Japan, China, the oil exporters and Germany. Then there was the lack of sufficient demand for funds for fruitful investment for a variety of special reasons. Finally, there was the response in the world capital market, leading to excessive leverage, unwise lending and so on. But there has been another factor explaining the crisis. The “fatal flaw” has been the invention and use of new financial instruments that have been poorly understood and have created a serious information problem. Instead of the declining phase of a US housing bubble having an adverse financial impact, the manner of financing through securitization of mortgages and their purchase worldwide created a worldwide financial crisis. F439-F440

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3: China’s Exchange Rate Regime / Policy ——The next stage of China’s reform of exchange rate regime?

3.4: What should be the next stage of China’s reform of exchange rate regime? First, the monetary authorities should seriously consider how to implement the current managed floating rate system with reference to the currency basket and very small band. It is not necessary that the monetary authorities should pre-announce all of their exchange rate policy rules under the managed floating. However, the monetary authorities should have ex-post transparency and accountability for their exchange rate policy. They should consider ex-post announcement of their intervention in foreign exchange markets.Second, the monetary authorities should widen the band in order to make more flexible exchange rates of the Chinese yuan against each components of the currency basket. Third, they should go toward floating exchange rate system while they prepare for deregulating capital control by allowing forward and future foreign exchange transactions, interest rate swap, and domestic firms’ borrowing foreign currencies and foreign firms’ borrowing the Chinese yuan not only inside Chine but also outside China and offshore markets. Ogawa and Sakane (2006, p.55-56).

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4: Estimation of China’s Exchange Rate Regime——Assessing China’s exchange rate regime

4.1: Assessing China’s exchange rate regimeFrankel and Wei (2007): In 2005 China announced a switch to a new exchange rate regime. The exchange rate would be set with reference to a basket of other currencies, with numerical weights unannounced, allowing a movement of up to ± 0.3% within any given day. Within 2005, the de facto regime remained a peg to a basket that put virtually all weight on the dollar. Subsequently there has been a modest but steady increase in flexibility with some weight shifted to a few non-dollar currencies – but not those one might expect.The US Treasury as a catalyst for RMB speculation: Political pressure from the US Treasury may have played a role in the origin of the entire economic question of yuan appreciation. Origins of the language of manipulation: after the Members of the Fund ratified the move to floating exchange rates in the Jamaica Communiqué of January 1976, they agreed a framework for mutual surveillance under what is called the ‘1977 Decision on Surveillance over Exchange Rate Policies’, and they amended Article IV in 1978.

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Principle (A) of the 1977 Decision and Clause 3 of Section 1 of Article IV both require that each member shall ‘avoid manipulating exchange rates or the international monetary system in order to prevent effective balance of payments adjustment or to gain an unfair competitive advantage over other members.’ Since the end of the Bretton Woods system there have been few cases of countries having been pushed into revaluing or floating upward. The United States has since 2003 been pressuring China to abandon its peg to the dollar and allow the RMB to appreciate, and some have claimed that China’s refusal to do so constitutes unfair manipulation of the currency for competitive advantage. The Chinese have largely resisted the pressure to appreciate, even though many economists think an abandonment of the peg may be in their own interest. A fixed exchange rate is a legitimate choice for any country under Article IV. Smaller countries with long-time fixed exchange rates would never be accused of manipulation. The Treasury verdicts are driven heavily by the US bilateral deficit with the country in question, though some of the other variables also turn out to be quite important.

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Chinese new exchange rate regime – after a minor initial revaluation of 2.1% – would be set with reference to a basket of other currencies, allowing a movement of up to ± 0.3% in bilateral exchange rates within any given day. What is the current exchange rate regime in China? If a country announces the adoption of a basket peg but does not reveal the exact weighting of the component currencies, how would one verify if the authorities’ actions are consistent with their words? The Chinese currency continues to assign heavy weight to the US dollar, but there are signs of some modest but steady increase in flexibility since the spring of 2006. There is some evidence that US officials’ complaints tend to be associated with gradual reductions in the weight of the dollar in the RMB currency basket. This trend is modest, however, and there is no evidence that such complaints have led the Chinese to revalue the RMB relative to the currency basket. As is often the case with currency baskets, the weights were not made public. Speculation ensued after the announcement about which currencies were in the new reference basket and what their weights were.

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Zhou Xiaochuan stated that the major currencies in the basket are the US dollar, the euro, the yen and the Korean won. We will label these four as the first-tier currencies in the basket. In addition, the rest of the currencies in the basket are the Singapore dollar, the British pound, the Malaysian ringgit, the Russian ruble, the Australian dollar, the Thai baht and the Canadian dollar. The last seven will be labeled as the second-tier currencies. These currencies were chosen because of their economies’ importance for China’s current account. p.595 The value of the RMB against the euro and the yen fluctuates a lot, mostly a reflection of the fluctuation in the value of the US dollar against these other two currencies. The daily movement of the dollar/RMB had been tiny, despite the announced switch to a managed floating rate. Since the spring of 2006, however, there has been a visible increase in the daily movement, with daily changes exceeding 0.1% frequently. 596 Frankel and Wei (2007) include a constant term to allow for the likelihood of a trend appreciation in the RMB, whether against the dollar alone or a broader basket. If the RMB is pegged to currencies X1, X2 . . . and Xn, with weights equal to w1, w2 . . . and wn, then:

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If the exchange rate is truly governed by a strict basket peg, then we should be able to recover the true weights precisely, so long as we have more observations than candidate currencies, and the equation should have a perfect fit. p.598 If the exchange rate is truly a basket peg, the choice of numeraire currency is immaterial; we estimate the weights accurately regardless. If the true regime is a target zone or a managed float centred on a reference basket, where the authorities intervene to an extent that depends on the magnitude of the deviation, then the error term represents shocks in demand for the currency that the authorities allow to be partially reflected in the exchange rate (but only partially, because they intervene if the shocks are large). Of the 11 currencies that are supposedly in the basket, only two currencies receive weights that are steady enough throughout the sample period to show up with positive and significant weights: the US dollar (90% weight) and Malaysian ringgit (5% weight). Surprisingly, the two major non-dollar currencies, the euro and the yen, receive zero weight in the basket.

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It appears China is more concerned with preserving trade competitiveness against major Asian rivals than with minimizing variability vis-à-vis the world’s most important currencies or China’s most important export markets. Despite the official pronouncement that China has ceased its particular link to the US dollar, the sample-wide estimated weight on the dollar is still 90%. It is striking that the behavior of the Chinese RMB since 21 July 2005 closely resembles that of a known dollar pegger. In the first 6 months following the announced shift by the Chinese central bank to a managed floating regime with reference to a basket of 11 currencies, China gave such a heavy weight to the US dollar. In the spring of 2006, some weight in the basket was shifted to other currencies, particularly the Malaysian ringgit, the Korean won, the Russian ruble and the Thai baht. p.602 Since the fall of 2006, in addition to the lesser weight on the dollar, the association between the RMB and the reference currency basket has become looser. The choice of the numeraire is irrelevant if the currency is strictly pegged to a currency basket. However, if the value of the currency relative to the basket is allowed to fluctuate, different numeraires might generate different point estimates.

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There is no evidence of an association between the complaints from US officials and appreciation of the RMB relative to the currency basket. There is evidence that cumulative complaints are associated with a reduction in the RMB basket’s weight on the US dollar. p.604 There is evidence of a gradual decline in the RMB’s weight on the US dollar, but there is no evidence of a steady appreciation of the RMB relative to the whole basket. Could the steady decrease in the dollar weight that we find produce important flexibility in the future if it continues? It is hard to judge the importance of the parameter estimates by just looking at them, especially for estimates from a non-linear specification. p.609Conclusions regarding the recent Chinese exchange rate regime: within 2005 there was very little change in the de facto regime despite the announced policy change in July. Not only did the true weight on the dollar in the basket remain close to one, but the tightness of the fit was similar to that of the Hong Kong dollar, which is on a currency board!

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In 2006, the de facto regime began to put a significant but still small weight on some non-dollar currencies. These were not primarily the yen or euro as one would expect, but rather the currencies of other Asian developing countries (the won and the ringgit). The RMB regime is better described as a basket peg with weights on non-dollar currencies that, though starting out very small in 2005, rose gradually in 2006. A cooperative agreement would entail concrete steps by the US to raise national saving, together with a decision by China jointly with other Asian countries, and oil-exporters which are running even larger surpluses, to allow their currencies to appreciate simultaneously. 613 China’s exchange rate regime is recently characterized by more flexibility, but is not a dramatic change from past practices. There remains a high basket weight on the US dollar. 615 Frankel and Wei (2007) conclude that renminbi behaviour has changed, but not dramatically. There is nothing in economic theory that says that countries with fixed exchange rate manipulate the exchange rate. A further difficulty is that there is no consensus on whether the RMB is actually undervalued. 622

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4: Estimation of China’s Exchange Rate Regime——New Estimation of China’s Exchange Rate Regime

4.2: New Estimation of China’s Exchange Rate RegimeFrankel (2009): by mid-2007, the RMB basket had switched a substantial part of the US dollar’s weight onto the euro. The implication is that the appreciation of the RMB against the US dollar during this period was due to the appreciation of the euro against the dollar, not to any upward trend in the RMB relative to its basket. The Chinese currency had been effectively pegged to the US dollar at the rate of 8.28 RMB /dollar from 1997 until 21 July 2005. On that date, the People’s Bank of China proclaimed, after a minor initial revaluation of 2.1%, a switch to a managing float regime with reference to a basket of other currencies, with numerical weights unannounced, allowing a movement of up to +/–0.3% within any given day. The major currencies in the basket were the US dollar, the euro, the yen and the Korean won. These currencies were chosen because of their economies’ importance for China’s current account. Still not announced were the weights on these currencies, or the frequency and the criteria with which these weights might be altered. 347

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Public commentary usually failed to distinguish whether the appreciation was attributable to a shift in basket weights away from the dollar toward non-dollar currencies, to a greater degree of exchange rate flexibility, or to a trend appreciation. The weight inference technique is very simple: one regresses changes in the value of the local currency, RMB, against changes in the values of the dollar, the euro, the yen and other currencies that are candidate constituents of the basket. 348

One can recover the implicit weight on the value of the won by adding the estimated weights on the non-dollar currencies, and subtracting the sum from 1. p.350 Flexibility shows up in the form of a positive trend in the value of the RMB, which, although very slight, is statistically significant in many months. In many of the estimation intervals, the won or the yen seem to be the currencies that make up the non-dollar share. When we include the full array of 10 currencies in the basket, the Malaysian ringgit joins the list of those that are occasionally significant. p.351

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Calvo and Reinhart (2002) and Levy-Yeyati and Sturzenegger (2003, 2005): Their classification schemes count as a de facto floater a country that has high variability of the exchange rate, relative to variability of reserves, and count as fixed a country that has low variability of the exchange rate relative to reserves. The Exchange Market Pressure is defined as the percentage increase in the value of the currency plus the increase in reserves (a fraction of the monetary base). 355 A coefficient of 0 signifies a completely fixed exchange rate (no changes in the value of the currency), and a high coefficient signifies a floating rate (few changes in reserves). 356Because the RMB and other currencies purportedly follow variants of band-basket-crawl, it is important to have available a technique that can cover both dimensions, inferring weights and inferring flexibility. New estimation:

where Δempt denotes the percentage change in exchange market pressure. We define the percentage change in total exchange market pressure by:

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The w(j) coefficients capture the de facto weights on the constituent currencies. The coefficient δ captures the de facto degree of exchange rate flexibility.

It follows that the appreciation of the RMB against the dollar in 2007 was attributable to the appreciation of the euro against the dollar, not to a trend effective appreciation of the RMB.

p.357

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The End !

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