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Centrally Controlled Exchange Rate System Essay

In its first quarterly meeting in 2008, the People’s Bank of China argued that at present China’s economy maintained a steady and rapid development momentum, but problems such as a potential rebound of fixed asset investment, excess money and credit supply and excessive liquidity were not adequately addressed, accompanied by a palpable pressure of price hike. Weighing the monetary policy stance and measures for the coming periods, the Monetary Policy Committee held the view that a tight monetary policy should be implemented.

Improvement of the managed floating exchange rate regime should be effected, continuously following the principle of “making it a self-initiated, controllable and gradual process”. Market supply and demand of foreign exchange should be allowed to play a greater role in the process of increasing RMB exchange rate flexibility, with a view to keeping the RMB exchange rate basically stable at an adaptive and equilibrium level. Exchange rate flexibility may have many beneficial effects.

Among them, it can bring monetary policy independence. An independent interest rate policy is a key tool for improving domestic macroeconomic management and promoting stable growth and low inflation. As the Chinese economy becomes more exposed to global influences through its rising trade and financial linkages in

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the world economy, it will become more exposed to external shocks. Monetary policy is typically the first line of defense against macroeconomic shocks.

Three experiences of the other Asian countries, that is, Thailand, Korea and Malaysia proved that a liberalised capital account before having a flexible exchange rate was dangerous. As a member of the WTO, it was imperative that China should choose a more flexible exchange rate regime in future. But before this can happen, the domestic financial sector especially the banking sector needs to be liberalized. The country recently announced the intention to switch to a free floating system and indicated that financial liberation now is a policy priority.

Along with china gradual economic reform since 1970, its exchange rate regime has also evolved. The regime has changed from a centrally planned administrative mechanism to a dual rate system , then to a managed float with narrow band, afterwards to a managed float with a very narrow band- peg to US dollar and finally to a peg against a basket of currencies. Before 1979 the exchange rate system of China was centrally planned. The central government had the monopoly power to determine the value of the currency.

The exchange rate regime only served as a central accounting device. Under this exchange rate system, only some state owned enterprises could sign export and import contracts (Zhang, 1999). The exchange rate system could not affect the current account balance, because the amounts of imports and of exports were decided on by the central government. Should the domestic importers want to import goods, firstly the import goods must be approved by the central government and then they could buy foreign exchange (using the official exchange rate) from government.

If the traders would make a loss in international trade transactions, the government would subsidise them. Under this exchange rate regime, the domestic importers and exporters did not have any incentives to maximize profits because they could not keep any profits which they earned, while on the other hand, they never suffered any real losses. Following policy reforms, the Yuan started to reform from a centralized control system to a system according to which the exchange rate was decided by the market forces of demand and supply.

This was done to bring down the overvalued Yuan in order to promote exports. The Chinese government established the State Administration of Foreign Exchange (SAFE) to control the foreign exchange market in 1979. At the same time, a retention system was introduced to promote export performance. Under this system, the domestic exporters do not need to hand in all of the profits to the central government. Instead they could retain a certain amount of foreign exchange which they earned on the trade transaction.

In turn, importers buy the foreign exchange from those exporters at the official exchange rate, to pay their suppliers. Besides the retention system, the Chinese government introduced the dual exchange rate system in 1981 to promote the country’s export performance: an official rate for non trade related transactions and an internal settlement rate (ISR) for authorized current account transaction, both rates being fixed by government.

Through this, the Yuan devalued much. Importers did not face much problem from this devaluation, as the overvalued Yuan gave them high profits. The exporter, in turn, made much more profit than in the previous system, as they benefited from the ISR rate which was lower than the official rate. But Banks were confused which rate to apply: the ISR or the official rate? In 1985, the Chinese government abolished the ISR, which ended the era of the dual exchange rate system.

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