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Managing the exchange rate float of the renminbi is a major challenge for the Chinese authorities.
On one hand, the fast economic growth and rapid change of the economic fundamentals have put more pressure on authorities to adjust the exchange rate policy.
On the other hand, it is not easy to deal with the contradictions between the demand to adjust the rates and other policy targets.
For example, the potential impact on China's exports and employment brought by changes in the exchange rate is unpredictable.
If the adjustment did not meet the market expectations, it would trigger more serious speculation on the movement of the renminbi.
But if the exchange rate remains unchanged, the expectation of a renminbi appreciation would put China's external surplus to an even higher level and erode the external balance for the Chinese economy. It would also threaten the independence of domestic monetary policy and affect the internal balance.
Chinese authorities are therefore urged to balance the pros and cons and make a rational choice on the matter.
As proven by theory and practices, when the economic fundamentals of a country -- including technological advancement, the depth of opening-up and international demand -- experienced drastic changes, its foreign exchange rates should be modified accordingly.
That means though the authorities can peg the exchange rates at a certain level in the short term, it is unlikely to manoeuvre the movement of the rate in the medium and long run.
Experience in some overseas countries during times of fast economic expansion also shows that the practice of deliberately lowering the price of the local currency and commodities not only hurt macro economic stability in the short term, but also affected the sustainable and balanced development of the economy in the medium and long term.
China's authorities, also caught in a similar dilemma, should set clear targets for the exchange rate policy.
Based on the latest development on forex rate theories and relevant discussions, policy targets appear to be mainly focused on three aspects: Striking the internal and external balance of the macro economy; lowering the exposure brought by adjustments in the exchange rates on domestic enterprises and institutions; and finally, maintaining stability in China's import costs and export competitiveness.
To meet the first target, the monetary authorities need to monitor the renminbi equilibrium exchange rate, which refers to the exchange rate level that complies with the internal and external balance of the macro economy.
The second target requires the authorities to monitor the exchange rate between renminbi and US dollar.
Since most of China's foreign trade and investments are denominated in US dollars, a more stable exchange rate of renminbi against US dollar will lessen the foreign exchange exposure.
Regarding the third policy target, authorities should keep an eye on the trade weighted exchange rate, or the effective exchange rate.
The stability of such rates directly affects the stability of China's export competitiveness and import costs.
However, different policy targets of the exchange rate scheme put different requirements on the rate adjustment.
Then the question is how to strike a balance between the targets and find the best solution?
In the three targets mentioned above, there are no major contradictions between the first two targets.
For example, to reach the internal and external balance of the macro economy does not demand very frequent adjustments of the renminbi exchange rate against US dollar.
The equilibrium exchange rate itself is a medium-term concept. It is impossible to keep the real effective exchange rate at the same level with an equilibrium exchange rate. So long as the two can keep the same pace during a certain period, like one or two years, it can ensure the internal and external balance of the macro economy.
Meanwhile, to minimize the exposure of exchange rate adjustments to micro institutions, it does not require a fixed exchange rate of renminbi against US dollar either.
Low-frequency exchange rate adjustment, every six months or a year, can satisfy the needs of enterprises to reduce their exposure to the exchange rate.
Therefore, to reach the first two policy targets, it is only necessary to adapt the renminbi exchange rate against US dollar to the same level of equilibrium exchange rate at one time and then maintain low-frequency adjustments of the rate based on that level.
But when that is done, if the US dollar exchange rates against Japanese yen, Euro and other major world currencies went through big fluctuations, it would also trigger changes in the real effective exchange rate of renminbi, which would harm the third policy target -- the stability of China's export competitiveness and import costs.
How, then, can that contradiction be settled?
In the near term, the phenomenon is unlikely to occur.
After a sharp appreciation of the US dollar against Euro and Japanese yen in 2002 and 2003, there is little room for any major fluctuation of the exchange rates of US dollar in the near term. Then the moving range of renminbi real effective exchange rate would be limited too.
Even if the US dollar exchange rates became unstable against the major currencies in the world, through the low-frequency adjustment of renminbi rate against the US dollar, the real effective exchange rate of renminbi could still be stabilized. And the stability of China's export competitiveness and import cost would also be guaranteed.
Therefore, to meet all the three targets of China's exchange rate policy, an appropriate scheme for the renminbi exchange rate reform in the medium term is to first adjust the rate to a level close to the equilibrium exchange rate, based upon market expectations, expert calculation and trends of the US dollar.
The second step is to keep a low-frequency adjustment of renminbi exchange rate in the medium term and actively promote the construction of the domestic financial markets and forward foreign exchange market as well as the reform on the foreign exchange management scheme.
Finally, monetary authorities should gradually let the market forces to decide the value of renminbi.
Meanwhile, authorities should make greater efforts to help stabilize domestic prices and reduce restrictions on the implementation of monetary policies brought by the exchange rate scheme.
(China Business Weekly October 8, 2004)
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