Fixed Versus Flexible Exchange Rate in China

By Hanjiang Zhang Department of Economics George Mason University CONTENTS

I. Introduction 2 II. Evolution of exchange rate regime, new trends and Chinas reform 5
II.1 Evolution of international exchange rate regime 5
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II.2 New trends of exchange rate arrangement in development 8 II.3 Chinas exchange system reform 11

III. General considerations regarding the choice of exchange Regime 17

III.1 Criterion of optimality 17 III.2 Nature of shocks 18 III.3 Structural characteristics 19

IV. Fixed or flexible-------Theories on developing countries And their recent lessons 21

IV.1 Flexibility and domestic financial sector 22 IV.2 Implication of Optimum currency areas 26 IV.3 Credibility versus flexibility 30 IV.4 Adjustment and price and wage rigidity 35 IV.5 Lessons from recent emerging market crises 36 IV.6 Conclusion and summary of criteria 42 V. Chinas exchange rate regime choice 44 V.1 Current status-------tightly managed floating 44 V.2 Economic environment and feasibility 47 V.2.1 Domestic financial sector 47 V.3 Implementation of tightly managed floating 50 V.3.1 Control of capital flow 51 V.3.2 Cooperation of monetary and fiscal policy (achievement of internal and external objective) 52 1994-1997 pressure of appreciation 52 1997-present pressure of depreciation 54 V.3.3 Summary of reasons 57 V.4 Reasons for future reform 57 V.4.1 New environment and flexibility 57 V.4.2 Consideration of exit strategy 58 V.4.3 OCA and peg to U.S. dollar 60 V.5 Steps of future reform 62 V.5.1 Monetary and fiscal policy arrangement 63

V.5.2 Financial sector reforms 64 V.5.3 Reforms in foreign exchange market 65 V.5.4 Steps of capital account liberalization 67 VI. Conclusion 69 VII. References 71
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I. Introduction
Exchange rate regimes and the current international monetary are profoundly Different in both conception and function from those envisioned under the Bretton Woods system. The current institutional arrangement results from the integration and liberalization of global markets. In this setting, the choice between fixed and floating Exchange rates is not dichotomous. Instead it involves a spectrum of options. No single exchange-rate regime may be prescribed for all countries at all times. Getting the exchange rate right is essential for economic stability and growth in the developing countries. This is especially true for China, where economic and financial reforms are underway. Although there are extensive studies and a number of criteria to be considered, the problem is still complicated and depends on the particular circumstance of the developing country, especially under current global context. Because their financial sectors are relatively weak, fixed exchange rates are desirable in order to achieve currency stability. However, with increasing capital mobility and a proliferation of trade in goods, many developing and transitional economies are likely to find it desirable to move from relatively fixed exchange rate regimes to regimes of greater exchange rate flexibility. Under the reform and open policy, what is the appropriate exchange rate arrangement for China becomes an essential question in Chinas economic reform. The exchange and payment crises of the 1990s, Chinas future membership with the WTO and its integration with world goods and financial markets raise anew this issue. However, little has been written addressing the specific questions in China. Although this issue has been widely discussed in China, the literature seldom relies on advanced economic theories or other countries experiences and lessons. Therefore, this paper introduces the general theories and criteria concerning exchange rate regime choice; examines certain aspects and lessons from developing countries; analyzes Chinas present exchange rate system and financial environment and tries to provide some policy implications for the future. Choosing an appropriate exchange rate regime is not an abstract question with an absolute answer. In addition to a number of criteria, there are several other important principles to consider. It is essential to recognize that a countrys exchange rate regime is one component of its general economic policy strategy, which needs to be consistent with other components, most importantly the conduct of the monetary and fiscal policies. A countrys exchange regime should also be suitable for its economic environment with the ability to adapt itself to the new trends in this environment. It is important to know that whatever exchange rate regime a country pursues, the longterm success depends on the commitment to sound economic fundamentals and a strong banking sector. China successfully maintained its exchange rate regime in the past, even during the recent Asian crises. This is resulted from Chinas success in policy cooperation and prudence. But within the new global environment, it is no

doubt that China should move to a more flexible exchange rate arrangement in the
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future. This process should be gradual and in pace with the other financial sector's reforms and capital account liberalization (integration with the world financial market). Section II describes the phases of the development of international exchange rate regime, evolution and new trends of the exchange rate arrangement for developing countries and Chinas exchange rate system reform. This section tries to give an overall look at the international and domestic monetary and financial environment that China faces. Section III reviews the general considerations regarding the choice of exchange rate regimes. This section gives some general criteria and implications for choosing policy from the aspects of policy goals, the nature of shocks and a countrys structural characteristics. This provides part of the theoretical foundations for discussing issues facing China. Section IV focuses on developing countries exchange regime choice based on their specific circumstances and the new global environment. This includes discussions of their financial sectors, implications of optimum currency areas, credibility versus flexibility and the effect of price and wage rigidity. The new trends in the international monetary and financial market and their effects on developing countries regime choice are also analyzed. This section tries to provide China with some relevant criteria and lessons from studies and experiences of other developing countries. Section V specially addresses the question of Chinas exchange rate regime choice. It describes Chinas current exchange rate arrangement, analyzes its feasibility and soundness with its current financial situation and its cooperation with monetary and fiscal policies in different economic periods. Given current global patterns of trade, it is necessary that China move toward a more flexible exchange rate regime in the future. Several reasons are examined in this section. It is also pointed out that the future reform should be gradual at a pace in line with economic growth, financial reform and integration with the global market.

II. Evolution of Exchange Rate Regime, New Trends and Chinas Reform
Getting the exchange rate right is essential for economic stability and growth in developing countries, especially for China, which is under its way of economic and financial reform and accelerating its integration with the global goods and financial markets. The evolution and future trends concerning exchange regimes are very important to understand the internal and external environment. II.1 Evolution of international exchange rate regime. Exchange rate regimes and the current international monetary and financial system are profoundly different from those envisioned under the Bretton Woods
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agreement. This system allowed countries to maintain a pegged exchange rate, avoid the peg in order to avoid the undue volatility and prevent competitive devaluation while permitting enough flexibility to adjust to fundamental disequilibrium under international supervision. Capital flows were expected to play only a limited role in

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

1. The world exchange regime has evolved from a hard one-currency peg to a mixture of free floats and many in-between variations. In selecting a countrys exchange regime, the choice is not a dichotomous one between fixed and floating. Instead it involves a spectrum of options. No single exchange-rate regime may be prescribed for all countries at all times. 2. Over the past two decades, exchange rates among major currencies have fluctuated in response to market forces, with significant short-run volatility and occasional large medium-run swings. In addition, the exchange rates among the Euro, the Yen and the Dollar are likely to continue to exhibit significant volatility. 3. The international currency system has moved from one with heavily controlled capital mobility to a one that has allowed current account convertibility and more recently capital account convertibility. Nowadays, capital mobility is dramatically increasing and globalization has accelerated as a result of significant declines in transaction costs associated with the telecommunication and information technology revolution and the attendant wave of financial innovations. International private capital flows finance substantial current account imbalances. II.2 New trends of exchange rate arrangement in developing countries The trend toward great exchange rate flexibility for developing and transitional countries is a prominent theme in the recent evolution of the international monetary system. Although it accelerates nowadays, the shift from fixed to a more flexible system dates back to the breakdown of the Bretton woods system in the early 1970s, when the worlds major currencies began to float. At first, most developing countries continued to peg their exchange rates either to a single key currency, usually the U.S. Dollar or French Franc, or to a basket of currencies. By the late 1970s, they began to shift from single currency pegs to basket pegs, such as the IMFs special drawing right (SDR). However, developing countries have shifted away from currency pegs toward explicitly more flexible exchange rate arrangements since the early 1980s. This shift has occurred in most of the worlds major geographic regions. In 1975, 87 percent of developing countries had some type of pegged exchange rates, while only 10 percent had flexible rates (the remaining 3 percent were accounted for by the limited flexibility category). By 1985, the proportions were 71 percent and 25 percent, respectively. In 1996, only 45 percent had pegged rates while 52 percent had moved toward flexible regimes (Eichengreen and Masson, 1998). However it should be noted that a number of countries that officially report their exchange rate as flexible have exhibited remarkable exchange rate stability against
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the U.S. Dollar, including a number of Southeast Asian currencies prior to the recent crises in the region. At the same time as the developing and transitional economies have been shifting their exchange regimes toward a system with greater flexibility, many of them have been moving toward current account convertibility and a somewhat less dramatic liberalization of capital account restrictions. The considerations that have led developing countries to shift toward more flexible exchange rate regime results from key changes in the internal and external economic environments. First, major currencies have moved sharply in their values. This is the key reason why developing and transitional countries abandoned single-currency pegs. One characteristic shared by essentially all developing countries is that the building of

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

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

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

An interbank foreign exchange market was also established. All regional swap markets were amalgamated into the Shanghai foreign exchange center. It was managed by the China Foreign Exchange Trade System (CFETS). CFETS offers trading and settlement services to its members, which include domestic banks, foreign banks and a number of non-bank financial institutions (NBFIs). The Renminbi is primarily traded against the US Dollar with a small portion of trading against the Hong Kong Dollar and the Japanese Yen. There are no forward transactions or hedging operations in this market. During this time some older regulations were nullified while new regulations were enacted. In the unified market, the issuance of retention quotas was terminated. The priority lists that governed the provision of foreign exchange and regulated market access were abolished. Under the new regulations, domestic enterprises are required to conduct their sales and purchases of foreign currencies and receive current transaction control through authorized financial institutions. On the other hand, the foreign-funded enterprises (FFEs) may purchase or sell foreign exchange directly from the CFETs. Different regulations also apply to domestic and foreign banks. Domestic banks may buy and sell foreign exchange for their customers, while foreign
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banks may only sell foreign currencies against the Renminbi. Foreign banks are not allowed to operate in the domestic money market. (Mehran, Quintyn, Nordman and Laurens, 1996). Another important regulation is the regulation of foreign exchange purchasing, selling and providing (Yang, Yang, 1999). This requires that domestic banks to hold a minimum amount of liquid foreign exchange assets to ensure that they have adequate liquidity to meet their obligations in foreign currencies. Banks have to cover any shortfalls in these funds by the following day. However, if the foreign exchange holdings exceed the limit, these banks are required to sell the excess in the CFETS market. Chinas current exchange regime is a tightly managed floating. The PBC establishes the central target or reference rate. The fluctuation of the Renminbi/Dollar exchange rate is only permitted within a 0.3% band. The PBC is committed to maintain a stable exchange rate through interventions in the CFETS. The interventions, which are carried out in Shanghai, are triggered by deviations of the Renminbi/Dollar exchange rate in the CFETS market during trading hours. This phase has also been characterized by a move toward free transactions and establishing convertibility. In October 1993, China made an official commitment to follow IMF guidelines by implementing current account convertibility by 2000. In 1994, the requirement to obtain prior approval from the SAEC for the purchase of foreign exchange for most trades and trade related transactions conducted by domestic enterprises was rescinded. Exchange controls for current account transaction was delegated to the banks. Preliminary steps were taken to achieve current account convertibility on December 1,1996 in an effort to make Chinas goods and financial markets more integrated with the world. It is now expected that the Renminbi convertibility will be realized in 15 years. Chinas exchange rate system has evolved over the last half century and has changed at an accelerating speed during the past fifteen years. It has moved from one in which access to foreign exchange was highly restricted and the exchange rate was firmly administered to a system wherein the exchange rate was unified and stabilized

via a market based managed floating. Economic development and reform have accompanied the evolution of Chinas exchange regime. As China has had little experiences with market based economic activity, it is important to consider the institutions, which govern economic behavior there and in other countries as well before deciding upon the appropriate exchange rate arrangement for China. Although this question has been widely discussed in China, the literature is seldom based on economy theory or economic history. In order to answer this question, we should briefly review the early literature concerning the exchange regime choice to build an appropriate theoretical framework. In addition, careful examination of developing countries experiences should also be considered. Finally, before studying Chinas case in detail, it is important to consider the events leading up to the recent Asian currency crisis.
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III. General Considerations Regarding the Choice of Exchange Regime

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

The early literature also demonstrated that when domestic shocks are important, the choice of exchange rate regime depends on whether these shocks are monetary or real. When domestic shocks originate in the domestic money market, conventional theory indicates that a fixed exchange rate is more effective in stabilizing the output. A disturbance to money demand or supply would be countered by offsetting changes in the international reserves under a fixed exchange rate. Thus it would not affect the
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supply-demand conditions in the goods market. In contrast, if domestic shocks originate in the goods market, the flexible exchange rate would be more desirable for output stability. Shocks to domestic goods demand would generate offsetting changes in foreign demand through an adjustment in the exchange rate, which will moderate the impact of the domestic shock to output (Mundell, 1962). In general, since the economy is likely to be faced with both nominal and real shocks originating at home and abroad, the exchange rate regime that can stabilize domestic output efficiently will be characterized by some intermediate degree of flexibility. III.3 Structural characteristics The structural characteristics of the economy such as openness to international trade, the degree of capital mobility and rigidities in the labor market will affect the insulating properties of the exchange rate regime. The degree of openness per se does not lead to an unambiguous choice of exchange rate regime. It has been argued that for a more open economy (one with a larger traded goods sector), a fixed exchange regime is preferred as it reduces the potential costs of engaging in international transactions that results from frequent exchange rate adjustments. Moreover openness makes a fixed exchange rate more effective in channeling abroad a domestic monetary shock. A flexible exchange rate, especially a volatile one, may deteriorate the functions of the domestic currency in an open economy (Mckinnon, 1963). On the other hand, for open economies that are more exposed to external shocks, a flexible exchange rate will help to mitigate these shocks. Capital mobility also influences the choice of exchange rate regime (Mundell, 1962). When the domestic asset market is highly integrated with world financial markets, domestic and foreign interest rates are linked through the interest parity relation. The choice among exchange regimes in the face of shocks is affected by the degree of capital mobility. In the event of a positive foreign monetary shock, a flexible exchange regime would be desirable. With a positive monetary shock, the foreign interest rate falls causing a domestic capital inflow. Under fixed exchange rates, international reserves would expand and reinforce the destabilizing effect of higher foreign demand operating through the current account. Under a flexible exchange regime, the rate would appreciate and help to stabilize the output. In contrast, for a positive real shock, a fixed exchange rate would be desirable. A flexible exchange rate instead might exacerbate the destabilizing effect. A real foreign shock spills over to the domestic goods market and by raising foreign interest rates, causes a domestic capital outflow, a depreciation of the currency which further destabilizes domestic output. Under a fixed exchange rate, the capital outflow would push domestic interest rates up and dampen the impact of a higher external demand on domestic output. With the same logic, it can be demonstrated that following a domestic monetary shock, a high degree of capital mobility makes a fixed rate more

effective in stabilizing output by limiting the destabilizing movements of domestic interest rates. Given a domestic demand shock, in contrast, the fixed exchange rate
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amplifies the destabilizing effects on output by preventing the change in the interest rate. The degree of wage rigidity also influences the effectiveness of exchange rate policy. The effects of a nominal devaluation on the output depend mainly on how nominal wages and prices respond to devaluation. If devaluation causes a large increase in the nominal wage, the change in the real wage is small. When the indexation of the wage to the general price level is high, the effect of a change in the nominal exchange rate upon the real wage and the output will be small (Arizenma and Frenkel, 1985). The above discussion on exchange regime choice provides the theoretical framework with which to analyze Chinas case. Because of the similarities between China and other developing countries and the lack of attention regarding Chinas exchange regime, the next section will consider the theory and practice of managing developing countries exchange rates.

IV. Fixed Versus Flexible Exchange Rates in a Developing Country

In choosing an appropriate exchange rate regime, developing countries should take some specific circumstances into consideration: the degree of sophistication of their financial sector development, the balance of payments constraint, the need to protect external competitiveness and the changes in the international monetary and financial environment. The issue is more complicated than that faced by the industrialized countries. In order to give proper answers, a number of theories had been proposed including the theory of optimum currency areas, the asset market approach and money versus exchange-rate-based stabilization. This section focuses on four salient theoretical issues related to the choice of exchange regime faced by the developing countries, namely flexibility and the domestic financial sector, regime choice and optimum currency areas, credibility versus flexibility and adjustment and downward price and wage rigidity. The last subsection will focus on lessons from recent emerging market crises.

IV.1 Flexibility and domestic financial sector

One salient difference between the developing countries and the industrialized countries is the degree of financial sector development, which affects the choice and implementation of the exchange rate regime. It has been argued that there are two important conditions that must be met in order for a flexible regime to be feasible (Wickham, 1985). First, the domestic financial system must be well developed. Second, the domestic asset market must be well integrated with the international system. Domestic and foreign currency assets are
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substitutes in the private portfolios of wealth holder. Since developing countries asset markets tend to be less sophisticated and do not exhibit a high degree of integration with the rest of the world, flexible exchange rates seem inappropriate there. IV.1.1 Status of domestic financial sector An advanced financial sector is comprised of well-developed institutions,

instruments and markets and is necessary for the existence of a flexible exchange rate regime (Mehran, Quintyn, Nordman and Laurens, 1996). The institutions include the establishment of banks and other financial intermediaries as well as the infrastructure, such as the payment system. In advanced financial systems, there are well-established institutions that efficiently and competitively coordinate the demands and supplies of various financial assets. In developing countries, the predominant source of financial intermediation comes from the banking system, whose size and structure are also limited relative to that found in developed financial systems. Other forms of intermediation may even be non-existent. The range of available financial instruments that facilitate investment and trade is also an indicator of financial sector development. In industrialized countries, banks and other intermediaries deal in short-term government or private debt, bank deposits, currency, bank loans and spot and forward markets for foreign exchange. In developing countries, banks offer only a small range of financial instruments. Stocks, securities, and bills as well as forward exchange are virtually absent. Finally, effective domestic financial markets require a price mechanism to allocate assets to their highest valued use. Without price flexibility, the financial market is not mature enough either to support trade and investment or to affect the exchange rate regime. In advanced industrialized countries, there is a highly developed market for short-term financial capital, the efficiency and depth of which permit rapid portfolio adjustment and arbitrage in financial assets. Foreign exchange and other financial markets in developing countries typically are not liquid enough to ensure the effective functioning of competitive markets. Import and export transactions are concentrated in relatively few hands and the large volume of foreign capital flows often come from the public sector. In addition, the market structure of the financial sector tends to be concentrated and therefore can not provide effective competition or determination of the interest and exchange rate. Accordingly, given the nature of developing countries financial markets, it seems apparent that exchange rate determination via the market forces is not a realistic option (Black, 1976). Another feature of developing countries financial sectors is the strict control on the current and capital account transactions as well as the domestic financial market. For instance, the freedom to make and receive current payments is often curtailed by import quotas and restrictions on access to foreign exchange. Capital inflows and outflows are strictly controlled. Governments often want to centralize foreign exchange transactions in the central bank or use the commercial banks as heavily regulated agents to enforce the control. The authorities directly determine the
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exchange rate. In the domestic financial markets, interest rates are also directly determined by the monetary authority and are typically fixed. Government budget deficits are frequently financed through direct borrowing from the central bank or by the sale of securities at pegged interest rates. Under such a policy environment, it is not surprising that the development of financial sectors has been retarded. For a competitive and unified foreign exchange market to emerge, current account convertibility is needed. Nonbank individuals must be given substantial freedom to make and receive current account payments. An efficient payment clearing process is required. Financial intermediaries should be given greater freedom to

engage in interbank foreign exchange transactions, hold foreign assets, negotiate lines of credit and make other transactions with foreign banks. The liberalization of domestic interest rates is also needed to broaden both domestic and international intermediation and support the exchange rate. With these reforms, nonbank individuals can also gain more direct access to the international short-term capital markets through open account financing and other trade related instruments (Mckinnon, 1979). The choice of exchange regimes depends not only on the existing state of financial sector development and integration with world financial markets but also on the future policy toward it. An active reform and open policy is required for rapid improvement. IV.1.2 Integration with the international market Lack of integration with the international financial market is another reason why developing countries are not able to adopt a flexible exchange regime (Brason and Katseli, 1981). According to the asset market approach, the exchange rate is explained in terms of the relative demands and supplies of domestic and foreign financial assets. Therefore, countries with integrated financial asset markets and strong financial sectors can expect a floating exchange rate to be stable in a short run (Driskill and McCafferty, 1980). In advanced financial systems, capital account transactions are very important to stabilize the floating rate. Such transactions are the result of asset holders attempting to adjust their portfolios in response to the factors affecting their desired stocks of domestic and foreign currency assets. In the absence of the integration with world asset markets, the exchange rate will be determined by current account transactions. The price for traded goods will change gradually and the adjustment of trade and service flows to relative price changes will be delayed. Thus in the period immediately following an exchange rate change, the terms of trade typically moves against the country whose currency has depreciated and offsets any effects of the exchange rate change on trade volumes. On the other hand, speculators are assumed to have a stock demand for net foreign assets that is sensitive to expected capital gains. So there will be desirable changes in stock demands in response to the expected appreciation or depreciation. So, for dynamic stability in the foreign exchange market to obtain short-run capital
16

flows to expected relative asset yields are necessary. In the circumstances that financial market separation prevents the possibility of speculative capital flows, the floating rate will be unstable in short run. The flexible exchange rate is not desirable from this perspective. It should be pointed out that this conclusion is drawn on the assumption that the domestic financial sector is sound. Without a healthy financial sector, developing countries should not integrate with the world financial market too quickly. Prudential policies should be undertaken. One important thing to consider here is that whatever exchange rate regime a developing country pursues; long-term success depends on a strong banking sector. High integration with the world system puts more demands on the banking system. With a generally weak banking system and little integration with the world market, developing countries are thought to be more suited to adopt fixed exchange rates.

IV.2 Implication of Optimum Currency Areas

It can be argued that the optimum currency area (OCA) theory ought to be the centerpiece of international monetary economics (Krugman, 1993, p.18). It analyzes the issue of fixed versus flexible rates from a new perspective. The theory of OCAs, which was sought to define the conditions under which a particular area could be optimally unified by a single currency, began with the classic paper of Mundell in 1961. After that, an extensive literature expanded on the subject. There are two distinguishing features of this theory. First, the argument is based on the principle functions of a currency. Exchange-rate integration improves the usefulness of a currency. The second distinguishing feature of this theory is that the analysis begins with recognition that there are both cost and benefits involving with each regime. Weighing the list of important determinants of optimum currency areas against one another gives insights into the choice between fixed and flexible exchange rate regimes. When exchange rates between major currencies are allowed to float, a developing country can form a currency area by pegging its currency to one of the major currencies. The theory of OCAs can then be applied to determine whether that currency area is optimal. IV.2.1 Fixed exchange rates and domestic currency security Patterns of growth and trade also affect the choice of regime. Virtually, developing countries transactions are determined in terms of the currencies of major industrialized countries rather than their own currencies. Thus, the exchange rate is important in computing the domestic currency price of tradable. In addition, developing countries depend on particular primary product exports, which are subject to price cycles and real domestic supply shocks. A floating rate would render real commodity prices highly variable even if the supply of other currencies were stable. For countries exhibiting high economic growth or a weak monetary system, the inflation rates are high and variable. Thus, the policies are uncertain.
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Taking these points into consideration, OCA theory argues that developing countries with open economies should peg in order to secure the monetary value of their currencies. Mundell (1961) argued that an optimum currency area will improve moneys effectiveness as the medium of exchange (due to a reduction in transaction costs), a store of value (due to a reduced element in exchange risk) and the unit of account (due to informational economies). In highly opened developing countries, the ratio of tradable to nontradable output is large. It was argued that if a country issues its own currency and allows it to float against that of a large trading partner, the amplitude of fluctuations in the exchange rate would likely cause a corresponding fluctuation in the domestic currency price of tradable. This in turn causes considerable variability in both the price level and relative prices because monetary policy is only capable of affecting the price of nontrable. This tends to undermine the ability of a domestic currency to perform its monetary function and encourage agents in the economy to substitute foreign currency to domestic currency (Mckinnon, 1963; Katseli, 1981; Connolly, 1982). Despite all the benefits of having a domestic currency that serves the needs of trade, it is not uncommon to find currency substitution. The result is that in these

developing countries the prices of some goods are quoted in foreign currency and individuals hold stocks of foreign cash which are even used to complete domestic transaction. Currency substitution is especially prevalent in developing countries with high and variable inflation rates and uncertain government policy on future exchange rates. However, with a fixed exchange rate regime, the domestic price level and relative prices would appear to be more stable. Changes in the rate of return denominated in the domestic currency would be similar to that on foreign currencies under a peg. A fixed exchange rate, which fixes the relative price between two currencies, ensures the use of domestic currency. IV.2.2 Incompatibility of three desiderata, criteria for OCA and peg choice In terms of currency security, OCA theory does point out the difficulties that developing country authority face in managing domestic currency and money policy under a flexible regime. In principle, a government would like to have exchange rate stability to determine their monetary policy independently of other nations and allow capital to move freely between nations until the rate of return is equalized. However, at any moment only two of the three desiderata are compatible (Cohen, 1992). Under fixed exchange regime and capital mobility, independent money policy is almost certain to result in significant balance of payment disequilibrium sooner or later and hence provoke potential destabilizing flows of speculative capital. To maintain exchange stability, governments will then be compelled to limit either the movement of capital or their own policy autonomy. If they are unwilling to sacrifice either, they have to forsake the pegged exchange rate. It should be recognized that there are both costs and benefits involved in choosing either fixed or flexible exchange rates. An optimum currency area consideration can help to improve the benefits and limit the
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costs. For a developing country to decide if it should peg and which currency to peg to, a series of criteria defining an optimum currency area are available. First, the two areas must exhibit similar inflationary patterns (Fleming, 1971). When the inflation rates between a developing country and an industrialized country are similar, an equilibrium flow of current account transactions is more likely to take place and less likely it will need adjustment through a flexible exchange rate. Then a fixed link between the two currencies would be desirable. The second to be considered is production and export diversification (Kenen, 1969). A high degree of production and export diversification provides some insulation against a variety of shocks and forestall the need to make frequent changes in the terms of trade via the exchange rate. According to this criterion, if a fixed regime is desirable for certain developing countries, the choice of a peg depends on how concentrated its trade and capital account links are with a particular industrialized country and the degree of similarity between their productive structures. The third criterion regards the symmetry of shocks, as asymmetric shocks are likely to be a problem for currency union or fixed regime (Mundell, 1961; De Grauwe, 1992b). If shocks facing a developing country and an industrialized country are very different, the monetary policies imposed by these two countries should be different. A pegged exchange rate will force the developing country to base its monetary policy on the industrialized countrys, which will invoke big problem and lead to an internal

balance. The final criterion relates to trade integration. The more integrated the trade patterns between the two countries, the greater the benefits of a common currency or fixed exchange rate. That is because the reduction of transaction costs (including hedging costs) resulting from a fixed exchange rate will improve the efficiency of the two highly integrated economies.

IV.3 Credibility versus flexibility

One salient aspect of developing countries exchange rate policies is that the exchange rate policies are generally designed to maintain external competitiveness and keep a sustainable balance of payments position. In addition, asking which exchange regime can ease external adjustment and help to impose financial discipline to maintain financial stability is important. An equilibrium exchange rate is defined as the relative price level between a home country and its trading partners or the relative price of tradable to nontradable goods (Aghevli, Monhsin and Montiel, 1991). Such rates help to maintain external competitiveness and yield internal and external equilibrium. But because of a variety
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of real shocks, the real exchange rate may deviate from the equilibrium level. For example, a major cause of deterioration in external competitiveness in most developing countries has been a high rate of domestic inflation coupled with the maintenance of a fixed nominal exchange rate. From this point of view, a flexible exchange rate would be desirable because it can prevent the emergence of large and sustained misalignments between relative prices and thereby avoid an external imbalance. By adopting a flexible regime, the authorities would be free to formulate their monetary policy in accordance with their domestic objectives, allowing exchange rate adjustments to equilibrate the balance of payments. But several questions need to be contemplated regarding flexible exchange regimes. It has been argued that a flexible exchange rate does not free the authorities from the external constraint on their domestic policies. Under capital mobility, domestic policies greatly influence the interest rates, which will have effects on the exchange rates and the current account balance consequently. These, in turn, will constrain the domestic policies (Turnovsky, 1976). Another issue is whether the authorities under a flexible exchange regime can effectively use their independence in policy making to achieve their domestic objectives. Proponents of fixed exchange rates argue that a fixed regime can impose financial discipline that would be absent under a flexible regime. By discouraging inflationary finance, a fixed regime would help to achieve financial stability. So it is important to consider the authoritys credibility to affect their policy when choosing an exchange regime. IV.3.1 Fixed as an anchor The conditions under which a fixed exchange rate can be maintained impose financial constraints on monetary and fiscal policies (Krugman, 1979). At the same time, adopting a fixed exchange regime can provide an unambiguous objective anchor for economic policy, which helps to establish the credibility of the policy for price stability. Under fixed regimes, monetary policy must be subordinated to maintain a fixed rate. In this case, the growth rate of real output plus the world inflation rate determine

the domestic money growth rate. In order to defend the fixed parity, a minimum fraction of the domestic money supply must be backed by foreign exchange reserves. So domestic credit can not permanently exceed nominal money demand. A fixed exchange rate regime imposes a limit on the long run rate of credit growth. The larger the initial stock of reserves, the weaker the degree of discipline imposed by the fixed regime. Fiscal policy, on the other hand, should also be kept consistent with the fixed regime. The central bank can also resort to external borrowing to replenish reserves and sustain the fixed exchange rate. But this process cannot continue permanently. The government can only borrow when it is perceived to be financially solvent meaning that the present value of the anticipated primary surplus plus seignorage is at least as large as the present value of the public sector's net debt. So, a fixed exchange regime imposes fiscal discipline that requires the government's primary surpluses
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satisfy an intertemporal budget constraint. A fixed regime by tying the hands of the authorities enables them to maintain the balance of payments. A fixed exchange rate is said to be desirable also because it can serve as an anchor and help the authorities to establish credibility in pursuing noninflationary policies. Such credibility could also be gained by other means, such as announcing inflation and monetary targets. But the exchange rate is the most desirable instrument. Because the inflation rate is not under the direct control of the authority, an inflation target that is not linked to specific policy commitments which can be readily monitored is not likely to be credible. Under a monetary target, the monetary aggregates can be monitored, but the relationship between various monetary aggregates and inflation is quite complex. The exchange rate is readily observable at any instant, as opposed to inflation and money supply data, which are provided by authorities with a lag. By announcing a fixed exchange rate, the authorities would undertake all the necessary policies to establish and maintain price stability. Thus, the exchange rate is more desirable as an anchor. IV.3.2 Credibility versus flexibility A fixed exchange regime can impose financial discipline and successfully provide an anchor only if the exchange rate is fixed permanently and not adjusted periodically. The risk is that the fixed regime would become unsustainable if confidence in the authorities' ability or willingness to maintain were lost. If the financial constraints discussed above are satisfied, the authority has the ability to maintain the fixed regime. But this does not ensure the authority's willingness to maintain it. Proponents of flexible exchange regimes argued that the credibility, if absent, is unlikely to be obtained by a fixed regime. Here, credibility is an essential question. Although a fixed regime can impose financial discipline, it does not by itself establish the credibility of the authorities. If the credibility has been firmly established, the authority may devaluate at the beginning of a program and still convince the public that the devaluation will not be repeated. If a fixed exchange rate can be successfully maintained, it will ensure that the balance of payments will be met and will provide a valid policy anchor. But in situations where the authorities lack credibility, the fixed regime is unlikely

to be maintained for several reasons. First, the authorities incentive to devaluate may make the fixed exchange regime non-credible. Recurrent devaluation could enable the government to wipe out part of its debt denominated in the domestic currency, thereby easing its solvency constraint. The government may also attempt to generate an inflationary surprise to raise domestic output and employment in the short run. To the extent that wage contracts are based on the expected rate of inflation, an inflationary surprise would result in lower real wages, a greater demand for labor and a higher supply of output. Another reason why an absence of credibility may lead to a nonsustainable fixed regime is that without policy credibility, the private sector will
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expect a high inflation rate. The authorities effort to maintain a fixed regime and to stabilize the price would thus introduce a negative inflationary surprise, leading to higher-than-expected real wages and a correspondingly lower supply of output. In this scenario, the authorities have to abandon the official exchange rate to avoid deflationary surprise and output contraction. The third reason is that the credibility is not sufficient. The authorities commitment to a fixed regime may not be credible for long especially when the economy is not functioning successfully. For example, maintaining high interest rates to defend the exchange rate may over time undermine the credibility of the fixed regime. An unsustainable fixed regime would only result in a sharp devaluation, a succession of financial crises and a high degree of economic instability. By contrast, in a flexible regime, the cost of an unsustainable policy may reveal more quickly through flexible exchange rates and prices. From this aspect, a flexible regime may exert an even stronger discipline on policy. In most developing countries with a high and persistent inflation rate, the use of fixed exchange rates as an anchor and a provider of financial discipline has not been successful because the governments have little credibility and the economic fundamentals are weak.

IV.4 Adjustment and price and wage rigidity

In order to maintain internal and external balance, the process of adjustment under fixed and flexible regimes is quite different. Which process is desirable depends on the relative costs. The decision is critically influenced by the degree of flexibility in wages and prices. In general, under a flexible regime, the authorities adjust the monetary policy to obtain full employment by allowing the exchange rate adjustment to equilibrate the balance of payments. Under a fixed regime, the authorities conduct monetary policy to achieve external equilibrium and fiscal policy to maintain internal stability. For example, (Flanders and Helpman, 1978), a flexible exchange rate ensures full employment automatically by following a foreign price shock. With a fall in the foreign currency price of tradable, the domestic price of tradable falls, which in turn reduces the relative price between tradable and nontradable. This effect is offset by a change in the exchange rate. By increasing the price of tradable relative to nontradable, depreciation simultaneously shifts aggregate demand in favor of nontradable and aggregate supply in favor of tradable, thereby maintaining internal balance. Depreciation improves the current account position and achieves external balance simultaneously. Exchange rate flexibility helps to counter the rigidity in the domestic price of nontradable, thus allowing the equilibrium relative price ratio and full employment to be maintained. However under a fixed exchange rate, a

downward foreign price shock reduces the domestic price for tradable causing the real exchange rate to appreciate. This generates a conflict in the adjustment of internal and external balance. If monetary policy were consistent with external balance, unemployment would follow. Full employment may be achieved only at a cost of a balance of payments deficit. The internal and external balance could be attained only
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when authorities use expansionary fiscal policy by increasing government expenditures or reducing taxes. The choice of appropriate exchange regime depends on the relative cost of the twoadjustment systems. Under a downward price and wage rigidity, which is common for most developing countries especially those with highly planned economies, a flexible exchange rate is more desirable. This is because an exchange rate change, which corrects relative prices immediately, would avoid most of the cost of a prolonged period of fiscal correction due to price and wage rigidity.

IV.5 Lessons from recent emerging market crises

We have studied several issues concerning the choice of exchange rates in developing countries. But from a theoretical perspective, it is still not easy to say which regime is more desirable for developing countries in general. However, recent crises involving emerging market economies, from the tequila crisis of 1995 to the Asian, Russian and Brazilian crises between 1997-1998, carry important lessons for developing countries concerning exchange regimes. Many qualified observers such as Eichengreen (1999) conclude that for developing countries that rely upon having access to global capital markets, a fixed exchange rate is inherently crisis-prone. These countries should be encouraged out of their own interest and for the broader interests of the international community, to adopt more flexible exchange rate regimes. This section examines the reasons for the recent crises and their global effects and analyzes the aftermath of the crises in order to draw up policy lessons that can be incorporated into developing countries exchange rate policies. IV.5.1 Reasons of the recent crises New financial environment facing developing countries The revolution in the telecommunication and information technology has been coupled with a dramatic acceleration in innovation, liberalization and deregulation of international financial markets. As a result, capital mobility has reached levels not matched since the heyday of the gold standard. With greater capital account liberalization and capital market integration, developing countries also experience a dramatic increase in capital mobility. Developing countries with impressive growth rates and macroeconomics outlook recently became a favorite location for the growing volume of global capital flows. The surge of capital inflows that financed investment booms is a major factor leading up to each crisis. Another aspect is that in the most integrated global financial markets capital flows create the potential for large and sudden reversals in flows and speculative attacks, which have led to current crises and long run economic costs.
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Fixed exchange regime For developing countries with important links to the modern global capital

market, fixed exchange rate regimes were clearly important factors in their vulnerability. It is interesting to note that we could notice the fact that the developing countries with fixed exchange regimes, such as Thailand, Malaysia, Indonesia, Korea, Russia and Brazil, were most boom-bust economies, which led to the adverse external developments in 1996. In contrast, developing countries such as Chile, Mexico, Peru, and Turkey who adopted more flexible regimes prior to the crisis performed much better (Mussa, Masson and Swoboda, 2000). Fixed regimes are said to be inherently crisis-prone. They accumulate upward pressures and economic instability before the crisis, and without the ability to absorb adverse shocks, which led to their collapse in the crisis. Unhealthy economies and weak financial systems That being said, the exchange regime alone cannot account for the pre-crisis vulnerability and the subsequent damage. Severe problems in economic fundamentals are important sources to consider as well. In fact, the crises stemmed from the interaction between large capital flows leading to a boom-bust economy and weaknesses in corporate, banking and public sector governance. Several years of rapid growth masked underlying problems associated with a long period of intervention, administrative guidance and directed lending, which gradually eroded the country's resistance to shocks. In Russia, the chronic incapacity to meet its fiscal responsibilities has been a severe problem for the central government in addition to the general culture of nonpayment and noncompliance with ordinary commercial practices and obligations. In Asian countries, such as Thailand, Malaysia and Indonesia, optimism about the economic outlook led to rapid credit expansion. A surge of inflows financed investment booms, particularly in real estate, which are government directed projects of questionable value in many cases. Large appreciation in real exchange rates and high current account deficits under a boom-bust economy heightened the risk of crisis, which ultimately led to adverse external developments and a sudden reversal in 1997. Moreover, the economic impact of the chosen exchange regime also depends on the health of the banking system. A better managed and supervised financial system gives strong incentives for lower leverage and lower foreign exchange exposure by domestic businesses and households. Only in this case could the government raise interest rates when needed to defend the exchange rate. Even if the exchange rate adjustment is needed, it could be undertaken with less damage. During the recent Asian crisis, weaknesses in the financial system contribute to setting the stage for the boom-bust cycle and culminated in a dramatic real crisis. Interaction between factors In countries most adversely affected by the recent crisis, the interaction between their fixed exchange rate and other factors, especially banking system weaknesses
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magnified the problems of their economies. Fixed exchange rates stimulate domestic firms and financial institutions to increase their borrowing denominated in foreign currencies, since the expected risk is low under a fixed regime. Fast-growth and upward pressure, combined with a fixed regime, lead to a higher domestic interest rate relative to foreign rates creating an incentive to borrow foreign currency. As shortterm credit is more cheaply and easily available, capital inflows tend to be short-term and more dangerous.

IV.5.2 The process of crisis In short, adverse external developments and a sudden reversal in market sentiment, which generated tremendous downward pressure on exchange rates, can be viewed as the trigger of the crisis. In response, domestic authorities have to either greatly increase the interest rate or keep the interest rate unchanged and adjust the exchange rate to the new equilibrium level. However, on one hand, interest rate was unable to be changed, since this would damage the already weakened banks and business. On the other hand, with large exposure to foreign-currency denominated debts, adjustment of the exchange rate is also resisted. When this situation was clear and the authorities ran short of reserves speculative attacks overwhelmed. Once the peg is broken, the recognition of the financial disruption and the massive depreciation are mutually reinforced. The economy will suffer a prolonged period of overly depreciation, seriously damage in financial sectors and business and further losses in policy credibility. IV.5.3 Lessons and implications Advantage of flexible exchange regime More flexible exchange rate regimes are said to be more desirable for developing countries that exhibit greater capital account liberalization and an integrated capital market. Allowing the exchange rate to appreciate gradually to accommodate upward pressure would be a safer way to maintain long-run economic stability. With the onset of the crisis, a flexible regime would allow large adverse shocks to be more easily deflected or absorbed than a pegged exchange rate regime and avoid the large costs that often accompany a breakdown of the exchange rate regime. Furthermore, a flexible exchange rate could affect expectations. As market participants are made aware of the fact that they must manage the risks associated with positive and negative fluctuations. Domestic financial institutions and businesses would be more precautionary in foreign-currency borrowing and would seek to hedge the exposure to exchange risks. Furthermore, speculative short-term capital inflows as well as the likelihood of sharp corrections would be reduced. Consideration of the incompatibility of three policy desiderata Since there is a fundamental incompatibility in simultaneously keeping exchange rate stability, capital mobility and monetary autonomy, if the authorities choose to maintain fixed exchange regimes, they will then be compelled to limit either the
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movement of capital or their own policy autonomy (Tower and Willet, 1976). Under capital mobility, prudent monetary policies help to limit domestic inflation, overvaluations and a loss of competitiveness. In contrast, the use of monetary policy to pursue other objectives such as stimulating economic activity during a time of high inflation will plant doubts about the sustainability of the exchange rate peg. On the other hand, if monetary independence is chosen under a fixed regime, a liberalization of the capital account should be undertaken. However, prompt liberalization will pose significant problems for fixed regimes. Strong fundamentals are fundamental It appears that exchange rate regimes cannot be singled out as the sole cause of the recent crisis, thus changing regimes will not necessarily mitigate future disasters. Healthy economic fundamentals are essential (Kochhar and Loungani, 1998). First, the potential for boom-bust cycles should be minimized. Maintenance of a prudent

macroeconomics policy, realistic exchange rate and a low inflation rate are needed to ensure sustainable long-term growth. An appropriate cooperation between monetary and fiscal policies would get rid of the potential profit opportunities that entice speculators to bet against developing countries authorities. Second, sound financial systems are also fundamental. Financial sector reform should be aimed at completing financial markets, increasing the solvency of the domestic financial system, raising prudential standards and supervision to the highest quality and improving the efficiency of financial intermediation. Another important point is that capital account liberalization should be orderly and properly sequenced and linked carefully to the strengthening of the domestic financial system so that the appropriate exchange rate policy is met. Third, the financial difficulties in the affected countries owe much to the close link between the government, business and banks, to the system of direct lending and other quasi-fiscal activities undertaken by the government, and particularly to the resource allocation distortions arising from these links. It is important to improve governance both in public policy-making and corporate sectors. In order to strengthen market forces, a strong legal framework is needed to dictate the rules governing corporate behavior and ensure that creditors and shareholders face strong incentives for responsible management.

IV.6 Conclusions and Summary of Criterion

IV.6.1 Criteria for choice of exchange rate regime in developing country In previous sections, we discussed four theories relevant to choosing exchange rate regimes in developing countries and presented some lessons to be learned from the recent crisis. Table 1 summarizes the implications of exchange rate arrangements based on a number of criteria that were discussed previously.
26 More flexible More fixed High Advance of the financial system Low High Capital mobility Low High Production and export diversification Low High Relative to the partner countries trade integration Low High Political integration Low Symmetric Preponderance of shocks Asymmetric High Level of reserves Low High Inflation Low High Labor mobility and nominal flexibility Low Real Type of shocks Nominal

IV.6.2 Important principles for exchange rate regime in developing country In choosing an appropriate exchange rate regime, there is no absolute answer. In addition to the criteria outlined above, there are several important principles to consider. First, it is essential to recognize that a countrys exchange rate regime is

only one component of its general economic policy strategy and needs to be consistent with other components, especially with the conduct of the monetary and fiscal policies. Second, a countrys exchange regime should suit its economic environment and adapt to new trends in this environment including changes in the degree of economic integration and capital mobility. Finally, it is important to know that whatever exchange rate regime a country pursues, long-term success depends on a commitment to sound economic fundamentals and a strong banking sector. By juxtaposing the theoretical framework against analysis of the factors that caused the recent crisis, it is possible to assess Chinas choice among exchange regimes.

V. Chinas Exchange Rate Regime Choice

V.1 Current status-----tightly managed floating
The introduction of an embryo foreign exchange market in China started with the establishment of the Foreign Exchange Adjustment Centers (Swap Centers) in some specified cities in November 1986 (see details in II.3.4). Under guiding priority lists
Table 1. Criteria for choice of exchange rate regime

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and retention quotas, the Chinese enterprises and foreign investment corporations were permitted to engage in foreign exchange transactions in swap centers at the rates agreed between buyers and sellers (swap center rate). As the market forces emanating from the swap center continued to put pressure on the Renminbi to depreciate, the divergence between the official exchange rate and swap center rate became too large--- The official and swap center Renminbi/Dollar exchange rate were 5.8 and 8.7 respectively by the end of 1993. In order to facilitate trade and smooth the process of integration with the WTO and the global market, on January 1, 1994, the official and swap market exchange rates were unified at the prevailing swap market exchange rate. Since then, a unitary managed floating has been maintained in China. However, it is closer in spirit to a pegged rate than a flexible one. V1.1 Exchange rate determination and float margins The Renminbi exchange rate is determined in the interbank foreign exchange market, which was also established during the exchange system reform in 1994 and managed by the CFETS. The CFETS offers trading and settlement services to its members, which include domestic banks, foreign banks, and a number of non-bank financial institutions (hereafter, NBFIs). Trading in Renminbi is primarily conducted against the US Dollar with a small portion of trading against the Hong Kong Dollar and the Japanese Yen. Reference exchange rates are published everyday by the PBC. The exchange rates used by banks for purchases and sales of foreign currencies have to be within a maximum margin of +/- 0.25 percent of the previous days reference exchange rates. The exchange rates used in transactions between banks and their customers have to be within a margin of +/- 0.30 percent of the previous days reference exchange rates (Yang and Yang, 1999). These thin margins are what make Chinas floating regime a heavily managed one. V.1.2 Regulations on the foreign exchange selling, buying and providing In China, foreign exchange transactions and provisional activities are strictly defined and controlled. An important regulation is the regulation of foreign exchange

selling, buying and provision (Yang and Yang, 1999). This decree states that domestic enterprises and residents are required to conduct their foreign currency transactions through authorized financial institutions only. Foreign currency obtained under certain items and certain amount are required to sell. It also states that domestic banks are required to hold a minimum amount of liquid foreign exchange assets to ensure that they have adequate liquidity to meet their obligations in foreign currencies. Banks have to cover any shortfalls in these funds on the next day. However, if foreign exchange holdings exceed the limit, banks are required to sell the excess in the CFETS market. Because of these restrictions on selling and buying, there are usually excess demands or supplies in the interbank market. So the interventions are necessary.
28

V.1.3 Intervention of central bank In order to affect its tightly managed floating, the PBC has established the central target or reference rate. Fluctuations in the Renminbi/Dollar exchange rate are not permitted to exceed +/- 0.3 percent in the CFETS market. The PBC is committed to maintain the stable exchange rate in the foreign exchange market through interventions in the CFETS. Interventions, which are carried out in Shanghai, are triggered by the deviations of the exchange rate of the Renminbi against the US Dollar in the CFETS market during trading hours. With all these regulations and interventions, The PBCs has maintained a tight link to the US Dollar since mid-1995 (Figure 1). V.1.4 Current account and capital account liberalization Another aspect of Chinas current exchange rate policy is its precautions on the transaction free and Renminbi convertibility. (1) Current account convertibility has been realized. In October 1993, official commitment was made that China will accept the eighth item of IMF regulation, implement current account convertibility by 2000. In 1994, the requirement to obtain prior approval from the SAEC for the purchase of foreign exchange for most trades and trade related transactions conducted by domestic enterprises was rescinded. Exchange control for current transaction was delegated to the banks. On December 1st, 1996, the current account convertibility was preaccomplished. (2) Capital account is still restricted. For example, the 27th item of the regulation of foreign exchange selling, buying and provision requires that any foreign exchange sales obtained under the capital account; such as with foreigncurrency investment or borrowing should obtain prior approval from the SAEC (Yang and Yang, 1999). Strict controls limit capital inflows and outflows, especially in short term, which helps to maintain the fixed exchange regime. China has maintained its exchange rate peg through the turmoil of the recent Asian financial crisis and made an important contribution to the restoration of financial stability in the region. However, with the increase in capital mobility and greater integration with world trade and financial markets, China should actively prepare for capital account convertibility and
8.2 8.3 8.4 8.5 8.6 8.7 8.8 94 95 96 97 98 99 Year

Renminbi/US Dollar Exchange Rate

Fig.1 Renminbi/US Dollar exchange rate between 1994 and 1999

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gradually move to a more flexible exchange rate regime. These proposals weigh heavily in discussions of the direction of future Chinese reforms.

V.2 Economic environment and feasibility

One of the important principles concerning exchange regime choice which were discussed in section IV was that whatever exchange rate regime a developing country pursues, long-term success depends on a strong banking sector. When the banking system is weak and less integrated with the world market, a highly flexible exchange regime is thought to be unfeasible for developing countries. China's current exchange rate arrangement comes from its undeveloped financial sector and less open financial market. V.2.1 Domestic Financial Sector The degree of domestic financial sector sophistication affects the choice and implementation of the exchange rate regime. An advanced financial sector requires a balanced development of institutions, instruments and markets. For a flexible exchange rate regime to be implemented, a robust, complete financial market is required. Presently, the Chinese financial system does not meet that characterization. However, during the past twenty years, China's financial system has developed remarkably. Much effort in financial sector reform has been devoted to institution building. In 1984, the PBC became the country's central bank. New banks were permitted to operate alongside the state-owned specialized banks, which at the same time were formally allowed to diversify their operations. In the late eighties and early nineties, NBFIs emerged. After two decades of reform, China presently has a banking system comprised of four specialized banks, fourteen nationwide commercial banks, seventy-two city commercial banks and about three hundred NBFIs. The first problem is that the banks in China, especially the four state-owned specialized banks, cannot be characterized as modern, efficient banking institutions (Mehran and Quintyn, 1996). Despite the significant progress made in developing a banking system, the four state-owned specialized banks still dominate the banking sector by holding more than 70% of total deposits and loans. In addition, all the criteria and regulations that prevail in a market-oriented environment, such as banking soundness and safety have not yet been integrated into the supervisory framework by the authorities. A lack of marketoriented supervision has also led to a situation wherein the four state-owned specialized banks have become universal banks, whose risky nature become even more apparent in an inadequately regulated environment. Moreover, their close relationship with the government compelled the specialized banks to follow conflicting mandates. Banks have increasingly been stimulated to become profit oriented, while at the same time they had to operate under the government instruction, mostly in the form of policy lending. The main consequence of this lending practice is that the quality of the loan portfolios is poor. The weakness of these banking institutions hampers the competitiveness and efficiency of China's financial markets.
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With inefficient financial intermediation, it is difficult to implement a highly flexible exchange regime. Financial instrument development has been concentrated on the gradual

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

authorities makes the tightly managed floating a more desirable exchange regime for China.

V.3 Implementation of tightly managed floating

The decision to maintain a managed floating is based on the authoritys recognition of the idiosyncrasies of Chinas financial environment. What is impressive about the PBCs exchange rate management since it began to track the Dollar in 1994 is that it successfully maintained the peg through all the turmoil during the recent financial crisis and contributed significantly to the restoration of financial stability in this region. Were it not for the authoritys astute awareness of the native of Chinas economic environment the crisis may have been prolonged. V.3.1 Control of capital flows In section IV, the fundamental incompatibility of maintaining exchange rate stability, capital mobility and monetary autonomy was discussed. Under the fixed exchange regime and capital mobility, independent monetary policy will almost surely result in significant balance of payments disequilibrium and hence provoke potentially destabilizing flows of speculative capital. During the recent Asian crisis, the most adversely affected countries were those with fixed regimes and significant capital account liberalization. In this setting, overly expansionary monetary policies led to boom-bust economies and significant disequlibria developed between actual exchange rates and economic fundamentals. When the disequlibrium goes beyond a certain threshold within the most globally integrated financial markets, speculative attacks are sure to occur. To maintain exchange stability, governments will then be compelled to limit either the movement of capital or their own policy autonomy. With Chinas fixed regime and unsophisticated financial sector, the authorities chose to control capital flows unlike other Asian countries following Chinas initiative to move toward current account convertibility. Efforts to liberalize the capital account have been cautious. Capital account transactions have been controlled by several regulations including strict controls limiting capital flows, especially in the short term. Without capital mobility and significant involvement in the global financial markets, China is less vulnerable than most emerging economies to a rapid and massive buildup of speculative pressure against a pegged exchange rate. This explains its relative ease in maintaining the exchange regime even throughout the crisis.
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V.3.2 Cooperation of monetary and fiscal policy (Achievement of internal and external objective) Another important principle concerning exchange regime choice, which we had drawn in section IV, is that it is one component that has to be consistent with the general economic policy strategy, especially the conduct of monetary and fiscal policies. Whatever exchange rate regime a country pursues, long-term success depends on sound economic fundamentals. Capital controls alone cannot explain the PBCs success in maintaining the pegged rate. Without policy cooperation and economic development, these goods could not be accomplished. For developing countries, the macroeconomics objective is to achieve internal stability and equilibrium in the balance of payments. Under a fixed regime, the authorities adjust monetary policy corresponding to the needs of external equilibrium and fiscal policy to maintain internal stability. Under capital mobility, the interest rate

becomes an effective policy instrument in external adjustment, but when capital controls are in effect, interest rates can be freed to achieve internal objectives. In China, the primary objective is to maintain the stability of the output and the price level while keeping the exchange rate pegged. 1994-1997, pressure of appreciation and inflation After the foreign exchange system reform in 1994, China's international trade increased sharply, which remarkably improved China's balance of payments status. In 1993,China still had a current account deficit of $11.902 billion. However, between 1994 and 1996, it was able to generate current account surplus of $7.659 billion, $1.618 billion and $7.242 billion respectively. Under its open policy, foreign investment increased quickly. In 1996, the capital account surplus reached $399.67 million. Dual surpluses in the current account and capital accounts generated pressure on the Renminbi to appreciate, rising 4.59% from 8.7 in 1994 to 8.3001 in early 1995. (figure.1) In order to maintain a stable exchange rate, the PBC intervened. In the foreign exchange market, the PBC bought the US Dollars and sold the Renminbi. Foreign reserves increased remarkably from $21.190 billion in 1993 to $139.890 billion in 1997 by an annual rate of 60.3%. As a result of this strong intervention, the Renminbi/Dollar exchange rate was 8.3 after the second quarter of 1995. The central bank of China successfully achieved its external objective. In the same period, as China accelerated efforts to initiate economic reform and openness, China's economic growth reached a remarkable level. Rapid and persistent economic growth generated an investment boom. With a weak financial sector and undeveloped markets, underlying economic problems began to emerge. By the mid1990s, these economies began to show classic signs of overheating. The price index of retail goods reached 13.2% in 1993 and 21.7% in 1994, a significant rate of increase. On the other hand, as a result of external adjustments in the foreign exchange market (Through the Renminbi sales and the Dollar purchases), the Renminbi supply increased dramatically. Since 1994, the PBC's intervention in the foreign exchange market became the main channel for the money supply. In 1993, the
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ratio of foreign exchange to total assets held by the PBC was 10.5%. By the end of 1997, this ratio increased to 40.3%. External adjustments accelerated inflationary pressure. In order to maintain healthy economic fundamentals and ensure long-term growth, China's authority implemented tight monetary policies and fiscal policies since 1994. This was primarily done by decreasing banking credit, buying back government bonds and issuing financial bonds, etc. At the same time, supervision and prudential controls were increased for bank lending. Huge efforts were made to stop direct lending and relationship lending. In this period, many real estate investments, especially government directed projects of questionable value were ceased. In 1995, the price index decreased by 14.8%. In 1996, this index decreased to 6.1% and reached the lowest level of 0.8% in 1997. At the same time the economy maintained annual growth rates of 9.6% and 8.8% in 1996 and 1997, respectively. The soft landing had been successful.
Chinas international balance of payments between 1993 and 1996 account 1993 1994 1995 1996

Current account(US$ Billion) -11.902 7.658 1.618 7.242 1.trade(US$ Billion) -10.655 7.290 18.050 19.535 2. Labor service (US$ Billion) 2.420 -0.969 -17.867 -14.422 Capital account (US$ Billion) 23.472 32.644 38.674 39.967 Capital reserve(US$ Billion) 21.199 51.620 73.597 105.029 Retail price index (%) 13.2 21.7 14.8 6.1

Through efforts to coordinate exchange rate and monetary policies during the period between 1994 and 1997, internal and external adjustments in China were successful. The PBC maintained stable exchange rate. More importantly, this decreased the inflation rate and stifled any boom-bust tendencies, which is essential for economic growth and long run stability. 1997-present, pressure of depreciation and depression The recent financial crises, which began in Thailand in 1997, quickly spread over to the rest of Asia and later resurfaced in Russia and Brazil, had negative effects on international trade patterns and the world economy. The negative impact quickly spread into China. With a close trade and financial link with other Asian countries, the prevailing depreciation generated tremendous downward pressure on the Renminbi. At the end of 1997, Chinese authority was committed to keeping the exchange rate from depreciating. With a substantial current account surplus, large foreign exchange reserves ($139.890 billion in 1997) and controls that sharply limited short-term capital flows, the PBC was able to maintain its exchange rate peg throughout the crisis. But the payoff and negative effects were substantial. As a result of deteriorating external competitiveness, the growth of external trading began to slow down. The current account surplus declined from $29.720 billion in 1997 to $15.667 billion in 1999. Table.1 Source: Chinas statistics annual report (1993-1996)
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Capital inflows began to decrease while capital outflows increased. The negative impact on the internal economy was also strong. Domestic demand began to decline and prices continued to decrease. In October 1997, the retail price index began to decline. A mild deflation of 0.8% in 1998 worsened to 1.3% in 1999, which generated pressure to depreciate and a decline in economic activity (Cheng, 2000). A successfully maintained pegged exchange rate requires a healthy economy and sustainable growth. In order to achieve internal and external objectives, China's authority imposed a series of monetary and fiscal policies to increase domestic demand and encourage exports. Monetary policy was conducted through the use of interest rates to affect internal adjustments given limited capital mobility. From May 1996 to June 1999, the PBC decreased interest rates seven times in order to stimulate the economy. The rate on one-year deposits was decreased from 10.98% to 2.25%; the rate on short-term liquidity asset loan was decreased from 12.06% to 5.85%. Interest rates on seven other lending activities, such as consumption loans for housing and education and export loans were also decreased. The PBC also expanded credit for commercial banks by increasing money supply. Officials coordinated their monetary stimulus with an expansionary fiscal policy. For instance, in 1998, the export tax deduction rate was increased and the construction fee for residence building was adjusted. In 1998, central government also issued 100 billion-Yuan key construction bonds" to state-owned specialized banks and in 1999, the bond issuance increased to 210 billion Yuan. These actions were accompanied by PBC mandated increases in commercial bank credit of 100 billion Yuan and 420 billion Yuan in 1998 and 1999,

respectively. At the end of 1999, China's annual economic growth rate was 7.1%. The Renminbi/Dollar exchange rate was maintained at 8.2793.
Chinas international balance of payments between 1996 and 1999 Economic indicator 1996 1997 1998 1999 Retail price index(%) 6.1 0.8 -2.6 -2.9 GNP growth rate(%) 9.6 8.8 7.8 7.1 Gross foreign trade(US$ Billion) 289.90 325.10 324.00 360.70 Foreign trade surplus (US$ Billion) 12.22 40.42 43.59 29.10 Current account surplus (US$ Billion) 7.242 2.972 2.932 15.667 Foreign reserve (US$ Billion) 105.03 139.90 145.00 154.68 Exchange rate(US$/Renminbi) 8.30 8.28 8.28 8.28

International trades increased by 11.3% and exports increased by 6.1%. Foreign reserves increased from $9.8 billion to $154.7 billion. Thus, in the aftermath of several crises, China was able to maintain its peg, which boosted foreign confidence and paved the way toward higher income growth. V.3.3 Summary of reasons China has the same internal and external environment as other Asian countries. This begs the questions as to why China was able to maintain its peg while other Table.2 Source: Chinas statistics annual report (1996-1999)
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countries failed. First, although China chose a tightly managed floating in recognition of the fact that it has a weak financial sector, China's authorities have been implementing capital account liberalization gradually which has countered the pressure associated with full capital mobility. Second, China's authority exerted great efforts to minimize the potential for boom-bust cycles before the crisis and stimulated the economy afterward. An appropriate coordination of monetary and fiscal policies was successful in staving off panic among foreign investors and maintaining domestic economic stability. Finally, large foreign exchange reserves and a substantial current account surplus ensured the ability to maintain the pegged exchange rate and the credibility of the authority.

V.4 Reasons for future reform toward flexibility

V.4.1 New environment and flexibility Though the reform has been successful so far, there is still the issue of what direction it should take in the future. Now that the turmoil of financial crisis has subsided and Asian economies are reviving, it may be time for China to consider a more flexible exchange rate regime. In China, economic reform and openness is progressing. The increasing reliance on both the international and domestic markets to allocate resources, including foreign exchange, means the establishment of effective price mechanisms is essential. Thus, a market determined foreign exchange rate is needed for financial reforms. Furthermore, Renminbi misalignments have been negligible for nearly 6 years. Estimates of the real Renminbi/Dollar exchange rate indicates that is appreciated by 5% between 1995 and 1999. China's future membership with the WTO means that it must relax its restrictions on capital flows and this will require a more flexible exchange rate. In November 1999, the Chinese and US governments reached an agreement concerning China's membership with the WTO. This will facilitate China's entry and accelerate its integration with the world markets. To be a member of WTO, China

must adhere to the general principles they have established by opening up its markets for goods and capital. Therefore, China needs to decrease import tariffs, abolish other trade barriers and allow foreign companies to gain equal access to markets and legal protection. China needs to open its financial markets to all member countries, allow foreign financial institutions to operate in the domestic money market and facilitate capital flows needed for international trades and finance (Lu, 2000). With these steps, China's international trades and financial transactions will increase remarkably. As a result, capital mobility will greatly increase. The amount of foreign exchange will also increase sharply. In this setting, strict control of capital flows is impractical and capital account liberalization is needed. Because of the incompatibility between exchange rate stability, capital mobility and independent monetary policy, under high capital mobility, Chinas decision to adopt a more flexible exchange regime will help to absorb different shocks, maintain
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long-run stability and discourage speculative attacks. Under WTO, China's increasing integration with the global trade and financial market will also bring intensive competition into its domestic market. Therefore, the effective allocation of international resources via the market mechanisms is important and a flexible regime reflecting real supply and demand for foreign exchange is essential. V.4.2 Consideration of exit strategy The primary issue in effective reform is timing. The problem facing China is to consider an exit strategy. If a country exits from a fixed regime during a period of substantial downward pressure or as a result of a speculative attack, such as the Asian crisis, the chance of a smooth transition is not good. This kind of exit is generally accompanied by a significant loss of policy credibility, a sharp fall and substantial volatility of the real and nominal exchange rates and an extended period of declines in output. However, a country can make a successful transition to a more flexible exchange rate regime without substantial economic disruption if they make the regime shift during a calm period in the foreign exchange market or when there is upward pressure on the exchange rate (Eichengreen and Masson, 1998). During such times, it is unlikely that people will conclude that the authority was forced to make the regime shift and correspondingly there should be less risk of credibility loss. Moving toward greater exchange rate flexibility during a period of upward pressure or a surge of capital flows means that the exchange rate will begin its more flexible life with an appreciation. While such an appreciation may have an impact on exports, it will ensure a general confidence in the authority's policy and will not affect macroeconomics stability. These conclusions had been repeatedly proved by recent experiences. For example, Chile, Israel and Poland have successfully moved to greater flexibility under the upward pressure of their currency, while Mexico and Thailand experienced significant financial disruption and loss of policy credibility when forced to abandon their fixed regimes. The time is right for China to abandon its currency peg. By choosing to exit now, the Renminbi will most likely appreciate. The first reason why it is the right time is the sustained current accounts surplus. Through all the turmoil of recent crisis, China has maintained a substantial current account surplus. With the revival of the global economy, especially in Asia, export demands will continue to increase. This will

ensure a current account surplus in the future. The second reason is the improved capital account. Expected capital inflows will improve the capital account too. Monetary and fiscal policies aiming to stimulate internal demand and encourage exports since 1998 have been effective. Chinas growing stable economy environment and future membership with the WTO will attract external investment and capital inflows. New economic policy aimed to stimulate development in the central and western regions will lead to an increasing openness in these areas and result in great opportunities for investment, which will also attract many foreign ventures. Moreover,
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if the revival of the Asian economy and the slow down of American economy continues, capital will flow back into Asia. This is said to be a salient new trend of global capital flows in the nearly future. The third reason is that there is a proper structure of foreign liabilities. By the end of 1997, foreign direct investment accounted for 73.3% of the total capital inflows. However, foreign liabilities only accounted for 14% totaled at $130.96 billion. The structure of the foreign liabilities is good. Medium and long-term foreign liabilities account for 86.1% but only account for 13.9% of short term accounts. The annual rate of reimbursement is around 8%10% in recent years, which is far lower than the international criterion of 20%. The liability rate (ratio of foreign liabilities to GDP) is kept at 15% annually, which is also much lower than the international criterion of 25%. Moreover, China's foreign reserves have increased to $154.68 billion. With so many foreign reserves, a sustainable current account surplus, increasing capital inflows and a proper foreign liability structure, a smooth transition is likely to be ensured. V.4.3 OCA theory and peg to U.S. dollar Since the foreign exchange system reform in 1994, the Renminbi has been pegged to the U.S Dollar, which gives rise to what can be considered as an "optimal currency area". In fact, during the nineties, almost all the major Asian countries chose to peg to the U.S Dollar, although in different forms or with different extent. They comprise what has come to be known as the "Asian Dollar Area". However, to maintain a fixed exchange rate implies a sacrifice of monetary independence. It means that the domestic monetary authority has to impose the same monetary policy as the country to which it pegs its currency. According to OCA theory, for a country to decide whether to peg and which currency to peg to, a series of criteria need to be considered such as similarities between inflation rates, production and export diversification, symmetry among shocks, trade integration, etc. Taking these criteria into consideration could help to maximize the benefit from the peg and minimize the cost of policy conflicts. There are big differences between the Chinese and US economies. This inevitably leads to differences in macroeconomics policies (Zheng, 2000). Since 1997, the downward pressure and decline in demand and output in China necessitates imposing expending monetary and fiscal policies. However, the US experienced high economic growth during this time, the monetary policy needed to be tight, which is the exact opposite of what China was looking for. Policy-conflicts pose difficulties for currency pegs. Moreover, China and the US have big differences in their culture and politics, which strongly affects the expectations people form and the publics general response to macroeconomics policies. Even if the same policies were implemented, the outcomes would differ. Under these circumstances, a pegged exchange rate between

the US Dollar and the Renminbi is unsustainable in the long run. By the same line of reasoning, the Asian Dollar Area is also not an optimal arrangement. Just as the Asian Dollar Area has been a failure, the Renminbi Dollar peg is likely to be unsustainable and provides ample incentives for Chinese authority
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to abandon it. With its future membership with the WTO, China is accelerating its openness to the international trading on an increasingly diversified basis with industrialized countries and regional partners. As recent experience in Asian has shown, maintaining a tight exchange rate link to one of the major currencies while conducting trade and financial transactions with other major countries can pose significant difficulties. Growing interregional trade links also pose significant problems for China's exchange rate peg, especially for any single currency peg. This is particularly evident when one considers that regional partners are pegged to other currencies and sometimes forced to abandon their peg during a crisis. With the continuing growth in trade fluctuations among the major currencies and other Asian countries moving away from their pegs, China's optimal policy choice is an exchange regime with greater flexibility.

V.5 Steps of future reform

One important principle for China's foreign exchange system reform is that the move toward a more flexible exchange rate regime should be done gradually to assure that all conditions for the successful operation of the new regime are put into place before its arrival. Regime shifting and capital account liberalization should in particular be consistent with the internal policy arrangement and the financial sector reforms. V.5.1 Monetary and fiscal policy arrangement Since a countrys exchange rate regime is one component of its general economic policy strategy, it needs to be consistent with the other components, most importantly the conduct of the monetary and fiscal policies. When exiting from a regime with a high degree of exchange rate fixity, macroeconomics arrangement needs to be addressed in the interest of a smooth transaction. The Renminbi/Dollar exchange rate has been tightly fixed between 8.2 and 8.3 for 6 years. It has served as a key anchor for monetary policy and experienced inflation. In establishing the new anchor, it will be important to make it credible. A low inflation rate is a key objective of monetary policy as it can act as an anchor. Therefore, future reforms should emphasize granting operational independence to the PBC to pursue this objective. This will be helpful in maintaining policy credibility. In addition, improving the accuracy and timeliness of data on inflation and other key economic variables are also important. Transparency will make it possible for market participants to accurately process information and help them make informed decisions at each step and exert strong discipline on policy makers and other economic agents. Finally, the PBC needs to develop the institutional and technical capacity to conduct monetary policy in a more flexible exchange rate environment. In particular, indirect instruments of monetary management should be used in an environment with large capital flows. Fiscal discipline is also essential for stable exchange rate behavior. Confidence in fiscal discipline is in particular important when there is a shift in the
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exchange regime and an increase in uncertainty about the exchange rate. Future fiscal

policy reform should concentrate on delivering smaller deficits, which will reduce the pressure on the current account and the central bank to use finance. V.5.2 Financial sector reforms Whatever exchange rate regime a country pursues, the long-term success depends on a strong banking sector. In China, the financial sector reform should aim at improving the efficiency of the intermediation process and strengthening the price mechanism in the financial market. To effectively allocate economic resources and maintain strong economic fundamentals are in particular important for a flexible regime to perform successfully when capital mobility is high. Restructuring the banking system and fostering competition are important. China's current problems with financial institutions owe much to the close links among the government, state-owned enterprises and specialized banks. Strong efforts should be made to stop the direct lending and other quasi-fiscal activities on the part of the government. Resource allocation distortions arising from these links should be stopped. Modern management techniques are also important. Asset/liability management, loan risk management and loan monitoring should be adopted by China's commercial banks. A set of prudential ratios, norms for financial reporting and disclosure standards are also essential elements for the supervisory and regulatory framework, which will foster prudential behavior by financial institutions. Reforms should also emphasize getting commercial banks to respond to monetary policy signals such as interest rates. Fostering competition and liberalizing interest rates are equally important. Financial market reform should focus on interest rate liberalization, which is essential for the efficient allocation of financial resources and necessary to support the market exchange rate under an environment of the strong capital mobility. Based on China's current environment, reform calls for a gradual approach. Liberalization should focus on the interbank market, lending and deposit rate in turn. This is because the interbank rate market has the smallest social exposure, while it will take longer for the public to become accustomed to a different way of setting deposit rate. In order to liberalize the interest rate gradually, the authorities should allow financial institutions to mark up above the benchmark rate set by PBC and gradually expand the band. V.5.3 Reforms in foreign exchange market A broad, deep and resilient foreign exchange market is important for a floating exchange rate. Future steps toward a flexible exchange regime should be directed to establish a genuine foreign exchange interbank market governed by regulations that meet the international standards. The first goal will be to increase the supervision and regulation on banks' foreign exchange operations. Moving toward a more flexible exchange regime will pose big problems on the financial institutions who are used to a regime with a high degree of exchange rate fixity and unaware of the risks under the new environment. Responsible
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banking should be based on the awareness of and continuous control over risks (Mehran and Quintyn, 1996). Therefore, future reforms should emphasize the modern prudential regulations for banks' foreign exchange operation and risks. China's current minimum limit on banks' liquid foreign assets should be replaced by regulations and risk limits. It is important that each financial institution should be given only one global limit. They should also be able to internally decide the part of the limit that

could be utilized by their branches and trade foreign exchange for their own accounts at any time within these limits. Second, competition in the foreign exchange should be increased. For a flexible exchange regime to be implemented, the free operation of the price mechanism in the interbank market is important. The market is the most efficient allocator of resources when all the participants face the same rules and regulations and correspondingly compete on the same basis. In China's current foreign exchange market, this is not the case yet (Yang, 1999). Foreign funded enterprises have the rights to retain foreign exchange while domestic enterprises have to surrender their foreign exchange to the financial institutions according to the requirement. FFEs could also purchase or sell foreign exchange directly from the CFETs, while domestic enterprises have to use financial institutions to affect their transactions. Different regulations also apply to domestic and foreign banks. Foreign banks are restricted in their business activities to handle foreign exchange sales of FFEs. Addressing these issues in future reforms is important. It is essential for the development of the foreign exchange market to ensure equal access to the market for both domestic and foreign banks and enterprises. Third, regulations should become market friendly and trading should be facilitated. In China's current interbank market, the wholesale market does not provide direct dealings between the banks. While wholesale market transactions (those between the CFETS and the banks) are settled on the next business day, retail market transactions (those between bank customers) are settled on the same day. This difference makes efficient position and risk management in banks difficult. Banks have to hold liquid funds idle to meet the unforeseen contingencies arising from retail transactions (Mehran and Quintyn, 1996). Future reform should be directed to make the settlement period for retail transactions the same as the settlement period in the CFETs market, which will improve the market evolution and making. An extension on the trading hours would provide banks with the ability to set and update buying and selling rates on customer transactions throughout the day. At the same time, it could also increase the gross flows to the CFETs market, which would help to increase the liquidity of the exchange market. Fourth, the PBC should be less active in intervening in the foreign exchange market. In order to gradually introduce free market operations into interbank market, large and frequent interventions from the PBC should be prevented. Steps should be taken to relax regulations on foreign exchange selling, purchasing and provision, which imposes strict surrender requirements and liquidity limits on enterprises and banks and consequently forces the PBC to intervene in the interbank market. Another step is to widen the bands for exchange rate fluctuations and introduce the free
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floating in the market. But these steps should be taken gradually rather than all at once. Several stages can be designed and combined with efforts to strengthen the financial sectors. The fifth proposal is to allow forward, future and derivatives transaction. The need is obvious, especially when the exchange rate is allowed to fluctuate. Future reform should focus on accelerating openness of financial sectors and encourage banks to make use of international foreign exchange and money markets. Under this circumstance, the banks could quote forward rates and hedge forward transactions across a broad range of maturate. This reform should also be consistent with the

development of a domestic money market. Forward operations will speed up integration between the banks' foreign exchange and domestic operations. V.5.4 Steps of capital account liberalization An important issue regarding reforms toward a flexible exchange rate regime is capital account liberalization. Capital account liberalization is necessary when capital mobility is increased in China. It will also produce significant benefits for China's economic growth. Although it is the essential part of China's exchange rate system reform, the progress should be orderly and properly sequenced and linked carefully to the strengthening of the domestic financial system so that the precondition of a sound and well-supervised financial sector and appropriate macroeconomics policies is met. As witnessed during the recent Asian crisis, prompt liberalization of the capital account would pose significant problems for macroeconomics stability and the exchange regime. Given other countries' experiences and China's current situation, the proper sequence of liberalization process should be to liberalize the capital flows in longterm first, and then to liberalize short-term capital flows. Direct investment capital flows should be liberalized followed by indirect investment flows. Securities based investment should be liberalized before bank lending based investment. Restrictions on foreign loans to domestic residents should be lifted before restrictions on domestic lending to foreigners are. Finally, financial institutions should have restrictions removed before the restrictions are removed from non-financial institutions and individuals. In sum, items that have no effect on the current account balance should be liberalized first while items that affect the current account balance and may bring frequent capital flows should be liberalized gradually and prudently. Reforms in the near future should take the following steps. For capital inflows: Restrictions on direct foreign investments should be abolished to allow free capital inflows. Authorities should gradually liberalize foreign investments through the domestic money market, especially the securities market. Restrictions on domestic enterprises borrowing from foreign financial institutions should also be gradually relaxed. For capital outflows: Domestic residents and institutions' foreign investments should be liberalized. Domestic residents should be permitted to perform foreign investment within proper limits. Domestic financial institutions should be permitted to
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lend to foreign residents within a reasonable limit. Prudential regulation should be imposed on foreign financial institutions borrowing in domestic currency. Recent experiences indicate that capital account liberalization requires ten years. Considering China's current status, some estimate that this process will take about fifteen years (Wu, 1999). Capital account liberalization and steps toward a flexible exchange regime are consistent and will reinforce each other, which will speed up China's openness and greatly benefit the economy.

VI. Conclusion
Getting exchange rate right is essential for economic stability and growth in the developing countries, especially for China, which is engaging in economic and financial reform and opening up its economy. The exchange and financial crises of the 1990s, Chinas future membership with the WTO and its integration with global goods and financial markets raise this issue anew. Combining general criterion on

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