Research On the Theories
of Exchange Rate Regimes
Guobing Shen
Associate Professor of World
Economy & International Finance
Guobingshen@yahoo.com.cn
Institute of World Economy
School of Economics
Fudan University
Topic Fourteen-Sixteen

Theories of Exchange Rate Regime
and the Choice of RMB Exchange
Rate Regime

Discussing the academic articles
related to Topic 14-16
Topic 14-16: Chapter Organization
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
Copyright © Guobing Shen, Fudan University.
Slide 1-3
1: Importance and Role of Exchange Rate Regime
—Importance of Exchange Rate Regime
1.1: Importance of Exchange Rate Regime
Dubas
(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.
Copyright © Guobing Shen, Fudan University.
Slide 1-4
1: Importance and Role of Exchange Rate Regime
—Importance of Exchange Rate Regime
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-5
1: Importance and Role of Exchange Rate Regime
—Importance of Exchange Rate Regime
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-6
1: Importance and Role of Exchange Rate Regime
—Importance of Exchange Rate Regime
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
Copyright © Guobing Shen, Fudan University.
Slide 1-7
1: Importance and Role of Exchange Rate Regime
—Importance of Exchange Rate Regime
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
Copyright © Guobing Shen, Fudan University.
Slide 1-8
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 Regime
Von 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.
Copyright © Guobing Shen, Fudan University.
Slide 1-9
1: Importance and Role of Exchange Rate Regime
—Capital Controls and Role of Exchange Rate Regime
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
Copyright © Guobing Shen, Fudan University.
Slide 1-10
1: Importance and Role of Exchange Rate Regime
—Capital Controls and Role of Exchange Rate Regime
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
Copyright © Guobing Shen, Fudan University.
Slide 1-11
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 Crises
Esaka (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.
Copyright © Guobing Shen, Fudan University.
Slide 1-12
1: Importance and Role of Exchange Rate Regime
—Capital Controls, Exchange Rate Regimes and Currency Crises
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-13
1: Importance and Role of Exchange Rate Regime
—Capital Controls, Exchange Rate Regimes and Currency Crises
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-14
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 Regime
Di 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.
Copyright © Guobing Shen, Fudan University.
Slide 1-15
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-16
1: Importance and Role of Exchange Rate Regime
—
Copyright © Guobing Shen, Fudan University.
Slide 1-17
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 fullemployment 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 Regime
Exchange 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.
Copyright © Guobing Shen, Fudan University.
Slide 1-18
2: Exchange Rate Regime Choice
—Types of Exchange Rate Regime
(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.
Copyright © Guobing Shen, Fudan University.
Slide 1-19
2: Exchange Rate Regime Choice
—Types of Exchange Rate Regime
(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.
Copyright © Guobing Shen, Fudan University.
Slide 1-20
2: Exchange Rate Regime Choice
—Types of Exchange Rate Regime
Fixed and Managed Floating Exchange Rate Regime:
Under the fixed regime, the monetary authorities in advance have to preannounce 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).
Copyright © Guobing Shen, Fudan University.
Slide 1-21
2: Exchange Rate Regime Choice
—Types of Exchange Rate Regime
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-22
2: Exchange Rate Regime Choice
—De Facto Classification and Exchange rate anchor
2.2: De Facto Classification and Exchange rate anchor
The 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.
Copyright © Guobing Shen, Fudan University.
Slide 1-23
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)
Exchange rate
arrangement (Number
of countries)
U.S.
dollar
(66)
Monetary Policy Framework
Exchange rate anchor
Monetary
Inflation
aggregate targeting
target
framework
Euro
Composite
Other(7) (22)
(44)
(27)
(15)
Exchange arrangement
with no separate
legal tender (10)
Currency board
arrangement (13)
Other conventional
fixed peg
arrangement (68)
Pegged exchange rate
within horizontal
bands (3)
Crawling peg (8)
Bolivia
China
Ethiopia
Iraq
Nicaragua
Uzbekistan
Other1
(11)
Botswana
Iran, I.R.
of.
Crawling band (2)
Managed floating
with no
pre-determined path
for the exchange
rate (44)
Independently
floating (40)
Copyright © Guobing Shen, Fudan University.
Slide 1-24
2: Exchange Rate Regime Choice
—Regional Exchange Rate Regimes
2.3: Regional Exchange Rate Regimes
Dellas 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.
Copyright © Guobing Shen, Fudan University.
Slide 1-25
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-26
2: Exchange Rate Regime Choice
—Different Views of Exchange Rate Regime Choice
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-27
2: Exchange Rate Regime Choice
—Different Views of Exchange Rate Regime Choice
Carmignani, et al (2008) support the consistency view. Indicators of sociopolitical 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
Copyright © Guobing Shen, Fudan University.
Slide 1-28
2: Exchange Rate Regime Choice
—Different Views of Exchange Rate Regime Choice
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 credibilityvs-consistency dilemma, some control variables: openness, economic size,
trade concentration, economic volatility, financial development, and
ideological preferences. 1183
Copyright © Guobing Shen, Fudan University.
Slide 1-29
2: Exchange Rate Regime Choice
—Different Views of Exchange Rate Regime Choice
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
Copyright © Guobing Shen, Fudan University.
Slide 1-30
2: Exchange Rate Regime Choice
—Exchange Rate Regime Determination
2.5 Exchange Rate Regime Determination: Theory and Evidence
Kimakova (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.
Copyright © Guobing Shen, Fudan University.
Slide 1-31
2: Exchange Rate Regime Choice
—Exchange Rate Regime Determination
Frankel and Rose (1998) pointed towards the endogeneity of OCAs, or the
fact that countries may become optimal candidates for a monetary union expost, 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.355
Recent 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 Slide 1-32
Copyright © Guobing Shen, Fudan University.
2: Exchange Rate Regime Choice
—Exchange Rate Regime Determination
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-33
2: Exchange Rate Regime Choice
—Exchange Rate Regime Determination
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-34
2: Exchange Rate Regime Choice
—Exchange Rate Regime Determination
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
Copyright © Guobing Shen, Fudan University.
Slide 1-35
2: Exchange Rate Regime Choice
—The Choice of Developing & Developed Countries
2.6: The Choice of Exchange Rate Regimes in Developing &
Developed Countries
Von 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).
Copyright © Guobing Shen, Fudan University.
Slide 1-36
2: Exchange Rate Regime Choice
—The Choice of Developing & Developed Countries
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
Copyright © Guobing Shen, Fudan University.
Slide 1-37
2: Exchange Rate Regime Choice
—The Choice of Developing & Developed Countries
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-38
2: Exchange Rate Regime Choice
—The Choice of Developing & Developed Countries
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-39
2: Exchange Rate Regime Choice
—The Choice of Developing & Developed Countries
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-40
2: Exchange Rate Regime Choice
—The Choice of Developing & Developed Countries
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-41
3: China’s Exchange Rate Regime / Policy
——China’s Experience and Choices
3.1: Exchange Rate Regimes: China’s Experience and Choices
Huang 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.
Copyright © Guobing Shen, Fudan University.
Slide 1-42
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
Copyright © Guobing Shen, Fudan University.
Slide 1-43
3: China’s Exchange Rate Regime / Policy
——China’s Experience and Choices
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
Copyright © Guobing Shen, Fudan University.
Slide 1-44
3: China’s Exchange Rate Regime / Policy
——China’s Experience and Choices
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
Copyright © Guobing Shen, Fudan University.
Slide 1-45
3: China’s Exchange Rate Regime / Policy
——China’s Experience and Choices
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
Copyright © Guobing Shen, Fudan University.
Slide 1-46
3: China’s Exchange Rate Regime / Policy
——Reform of China’s Foreign Exchange System
3.2: Reform of China’s Foreign Exchange System
Gu 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.
Copyright © Guobing Shen, Fudan University.
Slide 1-47
3: China’s Exchange Rate Regime / Policy
——Reform of China’s Foreign Exchange System
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-48
3: China’s Exchange Rate Regime / Policy
——Reform of China’s Foreign Exchange System
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-49
3: China’s Exchange Rate Regime / Policy
——Reform of China’s Foreign Exchange System
(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.
Copyright © Guobing Shen, Fudan University.
Slide 1-50
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 Imbalances
Roberts 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.
Copyright © Guobing Shen, Fudan University.
Slide 1-51
3: China’s Exchange Rate Regime / Policy
——China’s Exchange Rate Policy and the Global Imbalances
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
Copyright © Guobing Shen, Fudan University.
Slide 1-52
3: China’s Exchange Rate Regime / Policy
——China’s Exchange Rate Policy and the Global Imbalances
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-53
3: China’s Exchange Rate Regime / Policy
——China’s Exchange Rate Policy and the Global Imbalances
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 longrun effects on reducing the US trade deficits with China. p.727
Copyright © Guobing Shen, Fudan University.
Slide 1-54
3: China’s Exchange Rate Regime / Policy
——China’s Exchange Rate Policy and the Global Imbalances
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-55
3: China’s Exchange Rate Regime / Policy
——China’s Exchange Rate Policy and the Global Imbalances
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-56
3: China’s Exchange Rate Regime / Policy
——China’s Exchange Rate Policy and the Global Imbalances
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”.
Copyright © Guobing Shen, Fudan University.
Slide 1-57
3: China’s Exchange Rate Regime / Policy
——China’s Exchange Rate Policy and the Global Imbalances
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 partcause of the deficit of the US. But the exogenous increase in the
politically-determined US fiscal deficit, as well as the exogenouslydetermined 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.
Copyright © Guobing Shen, Fudan University.
Slide 1-58
3: China’s Exchange Rate Regime / Policy
——China’s Exchange Rate Policy and the Global Imbalances
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-59
3: China’s Exchange Rate Regime / Policy
——China’s Exchange Rate Policy and the Global Imbalances
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
Copyright © Guobing Shen, Fudan University.
Slide 1-60
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 expost 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).
Copyright © Guobing Shen, Fudan University.
Slide 1-61
4: Estimation of China’s Exchange Rate Regime
——Assessing China’s exchange rate regime
4.1: Assessing China’s exchange rate regime
Frankel 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.
Copyright © Guobing Shen, Fudan University.
Slide 1-62
4: Estimation of China’s Exchange Rate Regime
——Assessing China’s exchange rate regime
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.
Copyright © Guobing Shen, Fudan University.
Slide 1-63
4: Estimation of China’s Exchange Rate Regime
——Assessing China’s exchange rate regime
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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4: Estimation of China’s Exchange Rate Regime
——Assessing China’s exchange rate regime
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:
Copyright © Guobing Shen, Fudan University.
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4: Estimation of China’s Exchange Rate Regime
——Assessing China’s exchange rate regime
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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4: Estimation of China’s Exchange Rate Regime
——Assessing China’s exchange rate regime
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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4: Estimation of China’s Exchange Rate Regime
——Assessing China’s exchange rate regime
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.609
Conclusions 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!
Copyright © Guobing Shen, Fudan University.
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4: Estimation of China’s Exchange Rate Regime
——Assessing China’s exchange rate regime
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
Copyright © Guobing Shen, Fudan University.
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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 Regime
Frankel (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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4: Estimation of China’s Exchange Rate Regime
——New Estimation of China’s Exchange Rate Regime
Public commentary usually failed to distinguish whether the appreciation was
attributable to a shift in basket weights away from the dollar toward nondollar 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
Copyright © Guobing Shen, Fudan University.
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4: Estimation of China’s Exchange Rate Regime
——New Estimation of China’s Exchange Rate Regime
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). 356
Because the RMB and other currencies purportedly follow variants of bandbasket-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:
Copyright © Guobing Shen, Fudan University.
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4: Estimation of China’s Exchange Rate Regime
——New Estimation of China’s Exchange Rate Regime
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.
p.357
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.
Copyright © Guobing Shen, Fudan University.
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Copyright © Guobing Shen, Fudan University.
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The End !
Copyright © Guobing Shen, Fudan University.
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