The Appreciation of Chinese Currency and Its Impact Domestically (in China) and Internationally

Running Head : The Appreciation of Chinese Currency and Its Impact

The Appreciation of Chinese Currency and Its Impact

(Author 's Name

(Institution 's Name

S . No Table of Contents Page No

1 Preface 3

2 Abstract 3

3 Statement of The Problem 3

4 Research Questionnaire 4

5 Executive Summary 5

6 The Chinese Currency : An Introduction 7

7 Literature Review 14

8 China 's Currency Regime : A Discussion 18

9 Hypothesis Development 23

10 Methodology , Empirical Models , and Data Selection 26

11 Test Procedures

Empirical Results 29

12 China`s Exchange Rate Regime : A Critical Analysis 33

13 Conclusions Summary 50

14 Bibliography 55

15 Appendix 59

Preface

This Dissertation Research is meant for the academicians , students and those concerned with the global financial markets . The complicated international financial market is well understood by the currency regime . This report gives a deep insight of the Chinese currency vis-a-vis US Dollar in particular and other currencies in general

Abstract

This delves into various aspects of the Appreciation of Chinese currency and its impact domestically as well as internationally

There is a brief history of Chinese Currency and a detailed introduction about the ongoing debate of the currency . There is also a Literature Review of the as well as a Discussion and Research Methodology . Moreover a chapter is meant for Critical Analysis for the . A conclusion with recommendations is added along with a page of Bibliography . An Appendix is appended at the end

Rationale of the Study

The underlying motivation of this study is to draw a conclusion about the effects of the appreciation of Chinese Currency concerning China and all over the world

Statement of the Problem

The Chinese Currency has been the center of focus of international currency market . There is ongoing debate on the appreciation of Renminbi and its impact on financial scenario of the world . This dissertation discusses the impact the Chinese Currency all over the world and to the domestic finances of China

Research Questionnaire

Is the RMB undervalued ? Should China revalue its currency or let it float

Can China avoid the same pitfalls that many developing countries had fallen into upon financial liberalization ? What lessons do these experiences have to offer for China

How sensitive is the Chinese financial infrastructure to external shocks upon full convertibility ? What impact will full convertibility have on China 's financial markets ? As many emerging markets suffered from financial crises after full convertibility , how will China 's economy react to its currency 's full convertibility ? What adjustment should China make to make the transition period smoother

What are the financial linkages between China and the rest of the world Will the RMB 's convertibility have a significant impact on global financial markets ? If China does suffer a financial crisis following full convertibility , will there be any contagious effect to the rest of the world

Executive Summary

China 's economic expansion and increasing trade surplus with the United States has caused heated discussion on whether the Chinese currency , the Renminbi (RMB , is undervalued and whether China should revalue or float its currency immediately . To help understand the current debate , this provides a brief history of the Chinese currency since the founding of the People 's Republic and a summary of the main arguments in the current debate

The Renminbi , or the RMB for short , is China 's legal tender . The exchange rate of the currency has been fixed for the most part of the past half century with a few major discrete changes . It has remained at around 8 .28 Yuan to the U .S . dollar since 1994 , when China adopted a managed floating exchange rate policy

The valuation of the Chinese currency has received little attention until recently when some people claim that the currency is undervalued at its current level . The economic reform started in 1978 has changed China from a centrally planned economy toward a progressively more market-oriented economy . China 's average annual economic growth has been over 9 in the past two decades . At the turn of the new century , China has become a major trading nation in the world and a major trade partner with the United States . As a result of China 's comparative advantage in labor-intensive products , China is now a major source of labor-intensive manufactured products in the world . China has also become one of the largest beneficiaries of external investment in the world in the past decade . China has taken up current account convertibility in 1996 but maintained foreign exchange control on the capital account , mainly on capital outflows . The large inflows in foreign investment have contributed to a rapid increase of China 's international reserves in recent years

China 's increasing international reserves and the rising U .S . trade deficits with China have given rise to fears over China 's ascendancy in the world market and in particular in trade with the United States Analysts are wondering whether China 's currency undervalued so that it has given Chinese exporters an unfair advantage over their competitors Some people in the business world and their representatives in the policy-making circle find ready answers to these questions in the course of the difficulties in the U .S . economic growth and the claim that the United States has been losing jobs in the manufacturing sector to foreign countries . People in this camp dispute that RMB is undervalued and urge China to revalue or float the currency immediately

People on the other side of the debate argue that there is no convincing evidence that the RMB is undervalued and warn that an immediate revaluation or floating of the currency will hurt U .S . businesses and threaten the international monetary system in addition to the Chinese economy

The objective of this is to provide a detailed analysis of the RMB concerning its impact on China as well as globally and summarize the major arguments in the current debate

The Chinese Currency : An Introduction

Soon after the establishment of the People 's Republic of China in 1949 the value of the RMB was determined by price comparison of China 's exports , imports , and the purchasing power parity of foreign exchange remittance (Lin ,

.228 . In 1950 , the United States and other western countries put an embargo against China , which practically blocked all trade between China and the rest of the world except for the Soviet bloc . China adopted a Soviet style centrally-planned economy during the two decades since the late 1950s . China 's foreign trade regime during that period could be characterized as self-sufficient and import substitution (Lardy ,

.16 , in response to international isolation

For the time being , China established a rigorous system of foreign exchange control . As early as 1950 , Chinese law required that all foreign exchange holdings , including those of overseas Chinese , foreign travelers and foreign embassies and missions , be deposited with the Bank of China , the sole bank authorized to deal in foreign exchange (Hsiao br

.24 . Like most currencies in the world after World War II , the RMB was practically unconvertible

Meanwhile , China 's economic development , mainly China 's growing trade surplus with the United States has produced intense debate on the valuation and convertibility of the RMB since 2002 . The debate was aroused by some business leaders in the manufacturing sector in the United States and their representatives in the political circle and was joined by people in the academia . One side of the debate claims that the RMB is undervalued at its current level and should be revalued or become float immediately . People on this side think that the undervalued RMB has given Chinese exporters undue advantages over their international opponents , contributing to the U .S . trade deficit with China and to the job losses in the U .S . manufacturing industry . Some also think that the undervalued RMB may lead to deflation in neighboring countries and economic retardation in the world . The opposite side argues that the RMB should not revalue or float , at least not immediately as such a move would threaten the world economy and the international monetary system

Claims That the RMB Is Undervalued

Claims that the RMB is undervalued are based on several factors including international price comparison , U .S . trade deficits with China , and China 's increasing foreign exchange reserves

The Big Mac prices across countries have been referred to as one indication of the RMB undervaluation . In 1986 , the Economist began publishing a survey comparing the prices of Big Macs in many countries as a rough-and ready guide to whether a currency is under- or over-valued ' in the hope of making economic theory more digestible (The Economist ,

.106 . China was covered in the survey starting in 1992 . According to the Economist survey , the average price of a Big Mac in four American cities was 2 .71 in April 2003 . The cheapest burgers were those in China (at 1 .20 each ) while the dearest were those in Switzerland (at 4 .52 each . According to the survey then , the Yuan was the most undervalued currency while the Swiss franc was the most overvalued . Based on Big Mac prices , the exchange rate between the RMB and the U .S . dollar should have been 3 .65 Yuan to the dollar . The actual exchange rate was 8 .28 Yuan to the dollar , meaning that the Chinese currency was undervalued by 56 percent against the dollar

Despite the fact that Big Mac prices are not an proper guide for currency valuations (Yang , 2003 , policy makers and business executives have , nevertheless , used them to support their claims that China 's currency is undervalued (Pakko et al ,

. 3-21 . 24 In a testimony before the U .S . House of Representatives , Bender , a U .S . business executive cites the Big Mac index as proof of the RMB being undervalued (Bender 2003 . He maintained that the cheap import from China had made their product price-etitive

U .S . lawmakers have proposed legal actions against the China 's foreign exchange policy . U .S . Representative Phil English has stated that many economists estimate that the Chinese Yuan is undervalued against the dollar by as much as 40 percent ' 33 He claims that Beijing 's artificially debased currency ' has been allowing China to export to the U .S . market with a 40 percent price advantage over U .S . domestic producers . The 40 percent ' estimate has therefore become a common reference in the U .S . political arena . A bill recently introduced in the U .S . House of Representatives states that the large and growing trade surplus of the People 's Republic of China with the United States firmly suggests that the RMB is undervalued against the dollar . In recent times , economists have estimated that the RMB is undervalued against the United States dollar by as much as 40 percent . A separate bill introduced in the U .S . Senate states that the currency of the People 's Republic of China , the Yuan , is artificially pegged at a level significantly below its market value . Economists estimate the Yuan to be undervalued by between 15 percent and 40 percent or an average of 27 .5 percent . The bill then proposes that , unless a certification is made by the President to the Congress that China is no longer manipulating its currency , a rate of duty of 27 .5 percent ad valorem [be added] on any article that is the growth , product , or manufacture of the People 's Republic of China , imported directly or indirectly into the United States ' In his letter to President Bush , U .S . Senator Baucus repeated the need for formal negotiations with China to address the undervaluation of the Chinese currency . He also suggested that , should these negotiations fail , the Administration should start an investigation under section 302 (b ) of the Trade Act of 1974 into the currency manipulation issue

The current attack on China 's currency has gone beyond the United States . At the early stages of the present debate , Japan 's Vice Minister for Finance Haruhiko Kuroda blamed China of exporting deflation to its neighbors . Japan 's Finance Minister Masajuro Shiokawa argued that the fact that the (RMB 's ) exchange rate is extremely low in comparison with the U .S . dollar may be a problem (Mcgregor ,

.6 . In the same way , some European Union government officials also advised China to progressively relax the Chinese RMB 's peg to the dollar

Arguments against RMB Revaluation or Floating

People who disagree with immediate RMB revaluation or floating argue that there is no convincing proof that the RMB is undervalued and think that a revaluation or premature floating of the currency may damage U .S businesses in China and threaten the world economy

Based on analyses of U .S . - China price comparison , China 's trade capital and international reserves , it was found no confirmation that the RMB is undervalued . Inclusive of both tradable and non-tradable components in prices indices , PPP tends to overrate the value of the RMB . China 's surpluses in trade and current accounts have been quite small , and show no sign of currency misalignment . Despite the fact that China 's accumulation of international reserves appears higher than the international norm , factors other than the exchange rate (such as preferential treatment for foreign investment and control on capital outflows ) have played the main role

Robert Mundell , 1999 Nobel laureate in economics and also known as the Father of euro ' disagreed with the international pressure on China to revaluate the Yuan . According to him , to claim that China is manipulating its currency is strange ' since China has kept its currency fixed to the dollar since 1994 (Zhang ,

.5 . He saw that appreciation or floating of the RMB would involve a major change in China 's international monetary policy and has important consequences for growth and stability in China and the stability of Asia , and that China should float its currency only when sound financial means are established . He also summarized problems which will be caused in China if the Yuan appreciates by 40 percent : it will cut economic growth to 5 percent or even lower , and aggregate the country 's heavy burden of non-performing loans devaluation is likely to appear and the foreign direct investment in China will be radically cut and it will in fact lead to a weak Yuan and consequent depreciation

Stephen Roach , chief economist at Morgan Stanley , shared similar values He offered three reasons to urge the China to stay in the course - to leave RMB policy unaffected (Roach , 2003 . First , he argued that the real export dynamic in China comes far more from the conscious outsourcing strategies of western multinationals than from the speedy growth of local Chinese companies . Just about two-thirds of China 's foreign-driven export dynamic since 1994 is noticeable to the impact of multinationals alone . So he argued that revaluation of the RMB would threaten the very supply chain that has become so important to new globalized production models . Second , he thought that in contrast to common perception , China does not contend on the strength of an undervalued currency , however mainly in terms of labor costs technology , quality control , infrastructure , the improved human capital of its work force , and a passion for and commitment to reform . Thus , he foresaw that if China were to revalue the RMB upward by 10 , its exports would experience negligible loss of market share . Third , he mentioned that China has constantly restated its long-standing assurance to opening its capital account and making its currency fully convertible He argued that until there is greater progress on the road to financial reforms , it would be completely premature and dangerous for China to float its currency . Moreover these most persuasive reasons , Roach argued that there are also a number of other considerations against an RMB revaluation : an increase of imported depression pressures for a Chinese economy that is just now climbing back out of depression a possible eruption of bubbles in other asset markets , in particular property and a signal to market speculators that the RMB is now in play

International organizations have given their ruling and recommendations on the Chinese currency . The United Nations states in its annual report on trade and development that it is important that China preserve its autonomy and option to use the exchange rate , if need be , to prevent serious disruptions in certain sectors of its economy . In its release of 2003 Article IV Consultation with the People 's Republic of China , the International Monetary Fund (IMF ) concluded that most Directors noted that there was no clear evidence that the RMB was substantially undervalued at that time . As for RMB revaluation , IMF Directors argued that a currency revaluation would not by itself have a major impact on global current account disparities mainly given China 's comparatively small share in world trade . However , they believed that the quick increase of foreign exchange reserves shows some pressure on the exchange rate and imposes costs on the Chinese economy , particularly difficulties in preventing excessive monetary expansion . In this context , directors observed that increased flexibility of the exchange rate over time would be in the best interest of China

The Evolution of China 's Currency Regime : A Literature Review

The Chinese Yuan remained fixed at 8 .277 renminbi to the US dollar from August 8 , 1997 to July 21 , 2005 . In recent years , China has had a large and growing current account surplus . By 2004 , the current account surplus had risen to 4 .2 percent of China 's GDP

Some analysts have argued that the renminbi was 15 to 40 percent undervalued ( HYPERLINK "http /66 .102 .9 .104 /search ?q cache :7fjcQvSbuxAJ :www .mayin .org /ajayshah PDFDOCS /SZP2005_cny .pdf literature review on Chinese Currency Appreciati on hl en ct clnk cd 15 " \l "16 16 " Goldstein , 2003 HYPERLINK "http /66 .102 .9 .104 /search ?q cache :7fjcQvSbuxAJ :www .mayin .org /ajayshah PDFDOCS /SZP2005_cny .pdf literature review on Chinese Currency Appreciati on hl en ct clnk cd 15 " \l "16 16 . The US has experienced the biggest rise in imports from China . In 2004 , China exported USD 196 .7 billion to the US , and imported USD 35 billion from the US , resulting in a bilateral trade deficit of US at USD 162 billion . The large US China bilateral trade deficit has led to American pressure on China to revalue the Yuan . Perceiving Chinese manufactured imports as a threat to US industry , a bill was sponsored by US senators Chuck Schumer and Lindsey Graham , threatening to impose a 27 .5 percent import duty on Chinese imports , unless China revalued its currency within 6 months . On April 15 , US President George Bush called upon China to float its currency . On May 26 , US Treasury Secretary John Snow said he expected China to revalue the renminbi before October 2005

However , a rapid appreciation of the Yuan is not necessarily in the best interests of large US corporations who manufacture in China , or in the interests of US consumers who are benefiting from cheap goods and low interest rates . The pressure for greater flexibility of the renminbi from US trade and industry is thus not unanimous HYPERLINK "http /66 .102 .9 .104 /search ?q cache :7fjcQvSbuxAJ :www .mayin .org /ajayshah PDFDOCS /SZP2005_cny .pdf literature review on Chinese Currency Appreciati on hl en ct clnk cd 15 " \l "18 18

On July 21 , 2005 , the People 's Bank of China (PBC ) made a public announcement on Reforming the RMB Exchange rate regime . It revalued the Yuan by 2 per cent to 8 .11 Yuan per USD . It said China will reform the exchange regime by moving into a managed floating exchange rate regime based on market supply and demand with reference to a basket of currencies . RMB will no longer be pegged to the US dollar and the RMB exchange rate will be improved with greater flexibility ( HYPERLINK "http /66 .102 .9 .104 /search ?q cache :7fjcQvSbuxAJ :www .mayin .org /ajayshah PDFDOCS /SZP2005_cny .pdf literature review on Chinese Currency Appreciati on hl en ct clnk cd 15 " \l "17 17 " PBC , 2005e HYPERLINK "http /66 .102 .9 .104 /search ?q cache :7fjcQvSbuxAJ :www .mayin .org /ajayshah PDFDOCS /SZP2005_cny .pdf literature review on Chinese Currency Appreciati on hl en ct clnk cd 15 " \l "17 17 . Given the emphasis and experience of PBC staff in socialist economic policy , their policy process appears to have involved consulting top international experts in open economy macroeconomics and finance . The attempt appears to have been to evolve the Chinese currency regime , and not just do a one-off revaluation , so as to move towards a modern framework for open economy macroeconomics , involving an open capital account , and currency futures trading

Many scholars have argued that the best path for China was not just greater flexibility in the framework of an exchange rate that was pegged to the USD , but a shift to a basket peg HYPERLINK "http /66 .102 .9 .104 /search ?q cache :7fjcQvSbuxAJ :www .mayin .org /ajayshah PDFDOCS /SZP2005_cny .pdf literature review on Chinese Currency Appreciati on hl en ct clnk cd 15 " \l "18 18 . On 10 August , China announced that there would be a peg to a basket of currencies , and named the currencies in the basket . The PBC governor said

.the basket should be composed of currencies of the countries to which China has a prominent exposure in terms of foreign trade , external debt (interest repayment ) and foreign direct investment (dividend . And the weights respectively assigned to these currencies should also be consistent with the proportional importance of these countries in China 's external sector

China 's major trading partners are the United States , the Euro land Japan , Korea , etc , and naturally , US dollar , euro , Japanese yen and Korean won become major currencies of the basket . In addition , China also trades significantly with Singapore , UK , Malaysia , Russia Australia , Thailand , and Canada , currencies of these countries are also important in determining China 's RMB exchange rate . Generally speaking annual bilateral trade volume in excess of US 10 billion is not negligible in weight assignment , whereas that exceeding US 5 billion should also be considered as a significant factor in currency weight deliberation

The initial global response to the renminbi revaluation was very positive . It was described by some analysts as a 'watershed event HYPERLINK "http /66 .102 .9 .104 /search ?q cache :7fjcQvSbuxAJ :www .mayin .org /ajayshah PDFDOCS /SZP2005_cny .pdf literature review on Chinese Currency Appreciati on hl en ct clnk cd 15 " \l "16 16 " Blustein , 2005 HYPERLINK "http /66 .102 .9 .104 /search ?q cache :7fjcQvSbuxAJ :www .mayin .org /ajayshah PDFDOCS /SZP2005_cny .pdf literature review on Chinese Currency Appreciati on hl en ct clnk cd 15 " \l "16 16 . In the days immediately after the revaluation , there was considerable speculation in the international media on whether the 2 percent move was going to be followed by a larger move . Expectations of a rapid currency appreciation are likely to have triggered off capital flows seeking to benefit from an RMB appreciation Subsequently , the PBC issued a solemn statement ' on July 26 , saying that the move did not warrant further actions in the future ' and it had been taken taking into account the resilience of the domestic enterprise to absorb risks ( HYPERLINK "http /66 .102 .9 .104 /search ?q cache :7fjcQvSbuxAJ :www .mayin .org /ajayshah PDFDOCS /SZP2005_cny .pdf literature review on Chinese Currency Appreciati on hl en ct clnk cd 15 " \l "17 17 " PBC , 2005f HYPERLINK "http /66 .102 .9 .104 /search ?q cache :7fjcQvSbuxAJ :www .mayin .org /ajayshah PDFDOCS /SZP2005_cny .pdf literature review on Chinese Currency Appreciati on hl en ct clnk cd 15 " \l "17 17

In the period following the announcement of the change in the currency regime , the Yuan barely moved . This led to a resurgence of criticism from the US . On October 28 , US Treasury Secretary John Snow told China 's leaders that the US wanted to see another revaluation before the visit to China by George W . Bush . At the time of the revaluation , the Chinese foreign exchange market was underdeveloped , as is expected under a fixed exchange rate regime . As part of the reform of the currency regime , the Chinese central bank has taken a number of steps towards developing a foreign exchange market in China ( HYPERLINK "http /66 .102 .9 .104 /search ?q cache :7fjcQvSbuxAJ :www .mayin .org /ajayshah PDFDOCS /SZP2005_cny .pdf literature review on Chinese Currency Appreciati on hl en ct clnk cd 15 " \l "17 17 " PBC , 2005c HYPERLINK "http /66 .102 .9 .104 /search ?q cache :7fjcQvSbuxAJ :www .mayin .org /ajayshah PDFDOCS /SZP2005_cny .pdf literature review on Chinese Currency Appreciati on hl en ct clnk cd 15 " \l "17 17 ,d HYPERLINK "http /66 .102 .9 .104 /search ?q cache :7fjcQvSbuxAJ :www .mayin .org /ajayshah PDFDOCS /SZP2005_cny .pdf literature review on Chinese Currency Appreciati on hl en ct clnk cd 15 " \l "17 17

Keeping in mind the developments in the Chinese foreign exchange markets , the renewed pressure from the US and the PBC 's plan to adjust the RMB exchange rate band when necessary , there is a possibility that the Chinese currency regime will evolve further in the future . However as the PBC governor pointed out , in the future , there will be no official adjustment of the exchange rate level ( HYPERLINK "http /66 .102 .9 .104 /search ?q cache :7fjcQvSbuxAJ :www .mayin .org /ajayshah PDFDOCS /SZP2005_cny .pdf literature review on Chinese Currency Appreciati on hl en ct clnk cd 15 " \l "17 17 " PBC , 2005b HYPERLINK "http /66 .102 .9 .104 /search ?q cache :7fjcQvSbuxAJ :www .mayin .org /ajayshah PDFDOCS /SZP2005_cny .pdf literature review on Chinese Currency Appreciati on hl en ct clnk cd 15 " \l "17 17

Questions about the evolution of the Chinese currency regime are presently the subject of a vigorous debate , with several alternative strands of reasoning ( HYPERLINK "http /66 .102 .9 .104 /search ?q cache :7fjcQvSbuxAJ :www .mayin .org /ajayshah PDFDOCS /SZP2005_cny .pdf literature review on Chinese Currency Appreciati on hl en ct clnk cd 15 " \l "16 16 " Dooley and Setser HYPERLINK "http /66 .102 .9 .104 /search ?q cache :7fjcQvSbuxAJ :www .mayin .org /ajayshah PDFDOCS /SZP2005_cny .pdf literature review on Chinese Currency Appreciati on hl en ct clnk cd 15 " \l "16 16 , 2005 HYPERLINK "http /66 .102 .9 .104 /search ?q cache :7fjcQvSbuxAJ :www .mayin .org /ajayshah PDFDOCS /SZP2005_cny .pdf literature review on Chinese Currency Appreciati on hl en ct clnk cd 15 " \l "16 16 . The Bretton Woods II hypothesis ' argues that a new equilibrium relationship has come about in which Asian countries peg their currencies to the US dollar , and the US runs large current account deficits financed by official capital flows in the form of reserve accumulation from Asian countries . This school of thought argues that the Chinese currency regime will not evolve substantially , apart from token changes designed to stave off protectionism

In 2003 , the prediction about China was made : To head off trade partner commercial policy , there may be a token revaluation of up to 3 over the course of time ( HYPERLINK "http /66 .102 .9 .104 /search ?q cache :7fjcQvSbuxAJ :www .mayin .org /ajayshah PDFDOCS /SZP2005_cny .pdf literature review on Chinese Currency Appreciati on hl en ct clnk cd 15 " \l "16 16 " Dooley et al . HYPERLINK "http /66 .102 .9 .104 /search ?q cache :7fjcQvSbuxAJ :www .mayin .org /ajayshah PDFDOCS /SZP2005_cny .pdf literature review on Chinese Currency Appreciati on hl en ct clnk cd 15 " \l "16 16 , 2003 HYPERLINK "http /66 .102 .9 .104 /search ?q cache :7fjcQvSbuxAJ :www .mayin .org /ajayshah PDFDOCS /SZP2005_cny .pdf literature review on Chinese Currency Appreciati on hl en ct clnk cd 15 " \l "16 16 . On the other hand , many scholars have argued that the present situation is not an equilibrium and that this small Chinese revaluation is the beginning of a more significant evolution of the currency regime ( HYPERLINK "http /66 .102 .9 .104 /search ?q cache :7fjcQvSbuxAJ :www .mayin .org /ajayshah PDFDOCS /SZP2005_cny .pdf literature review on Chinese Currency Appreciati on hl en ct clnk cd 15 " \l "17 17 " Pocha , 2005 HYPERLINK "http /66 .102 .9 .104 /search ?q cache :7fjcQvSbuxAJ :www .mayin .org /ajayshah PDFDOCS /SZP2005_cny .pdf literature review on Chinese Currency Appreciati on hl en ct clnk cd 15 " \l "17 17 . Greater flexibility in China 's exchange rate is viewed as an essential element of a global response to the large macroeconomic imbalances in the world economy ( HYPERLINK "http /66 .102 .9 .104 /search ?q cache :7fjcQvSbuxAJ :www .mayin .org /ajayshah PDFDOCS /SZP2005_cny .pdf literature review on Chinese Currency Appreciati on hl en ct clnk cd 15 " \l "16 16 " Goldstein , 2003 HYPERLINK "http /66 .102 .9 .104 /search ?q cache :7fjcQvSbuxAJ :www .mayin .org /ajayshah PDFDOCS /SZP2005_cny .pdf literature review on Chinese Currency Appreciati on hl en ct clnk cd 15 " \l "16 16 . It is argued that it is in China 's best interest to adopt greater currency flexibility , which will be associated with a bigger currency appreciation ( HYPERLINK "http /66 .102 .9 .104 /search ?q cache :7fjcQvSbuxAJ :www .mayin .org /ajayshah PDFDOCS /SZP2005_cny .pdf literature review on Chinese Currency Appreciati on hl en ct clnk cd 15 " \l "17 17 " Roubini HYPERLINK "http /66 .102 .9 .104 /search ?q cache :7fjcQvSbuxAJ :www .mayin .org /ajayshah PDFDOCS /SZP2005_cny .pdf literature review on Chinese Currency Appreciati on hl en ct clnk cd 15 " \l "17 17 , 2005 HYPERLINK "http /66 .102 .9 .104 /search ?q cache :7fjcQvSbuxAJ :www .mayin .org /ajayshah PDFDOCS /SZP2005_cny .pdf literature review on Chinese Currency Appreciati on hl en ct clnk cd 15 " \l "17 17 Rogoff HYPERLINK "http /66 .102 .9 .104 /search ?q cache :7fjcQvSbuxAJ :www .mayin .org /ajayshah PDFDOCS /SZP2005_cny .pdf literature review on Chinese Currency Appreciati on hl en ct clnk cd 15 " \l "17 17 , 2005 HYPERLINK "http /66 .102 .9 .104 /search ?q cache :7fjcQvSbuxAJ :www .mayin .org /ajayshah PDFDOCS /SZP2005_cny .pdf literature review on Chinese Currency Appreciati on hl en ct clnk cd 15 " \l "17 17 . To the extent that such ideas do play out in the future , there is a need for closely monitoring the evolution of the Chinese currency regime

China 's Currency Regime : A Discussion

On July 21 , 2005 , China declared a 2 .1 percent appreciation of the Renminbi (RMB ) against the US dollar , a step to a managed float , and many other reforms ' Most of these reforms ' basically restated long-standing arrangements : since 1994 China has identified its currency regime as a managed float and has set a 0 .3 percent per day fluctuation limit for the RMB against the dollar

The July 21st announcement , nevertheless , did assure two potentially important alterations (i ) the RMB was hereafter to be managed with reference to a basket of currencies ' rather than being pegged to the dollar and (ii ) the exchange rate was to become more flexible ' with its value based more on market supply and demand

In fact , the July 21st developments have so far had little discernible effect . As of mid-December 2005 , the RMB dollar rate was 8 .07 , a further appreciation of only 0 .5 percent . There is also little indication of pegging to a basket rather , the RMB continues to directly track the US dollar . Moreover the central bank 's monthly intervention in the foreign exchange market in August and September remained huge at 18 billion per month --only slightly smaller than the 19 billion per month in the first half of 2005 . Briefly , China 's exchange rate system remains a greatly managed peg to the dollar - and at a dollar exchange rate very close to the level existing before the July reform

Is the RMB Under-valued

There are a number of approaches to assessing the misalignment of the RMB . The underlying balance ' approach asks what level of the real effective exchange rate would produce an equilibrium in which the underlying ' current-account position is just about equal and opposite in sign to normal ' net capital flows

During the 1999-2002 period , before there was any expectation of a currency appreciation , China ran an average capital-account surplus equal to 1 ? percent of GDP

Then , define the underlying ' current-account as the actual current-account position adjusted for both cyclical movements that make the demand for imports abnormally high or low and the lagged trade-balance effects of recent exchange rate changes

If China 's underlying current-account surplus is now in the 5-7 percent of GDP range while what is required to offset normal capital flows is an underlying current-account deficit equal to 1 ? percent of GDP , then China 's current account needs to depreciate by a huge 6 ?-8 ? percent of GDP to restore balance-of-payments equilibrium . If one does a set of simulations with a small trade model to calculate what size real effectual appreciation of the RMB would be necessary to produce such a large turnaround in the current account taking account of the high import content of China 's exports , using a plausible range for price elasticities of demand and supply , and making alternative assumptions about the second round effects of income changes on the demand for imports - the answers congregate in the upper part of the 20-40 percent range . This is somewhat larger than the estimated under-valuation for 2003-2004

China is in a nontrivial revision of its GDP accounts . Yet , with huge reserve accumulation , with persistent surpluses on both the current and capital accounts , with the real , trade-weighted RMB showing a cumulative depreciation since the dollar peak in February 2002 , with the Chinese economy running at full steam or close to it , and with Asian currency appreciation needed to reduce the excessively large US current-account deficit , it is difficult to arrive at a credible estimate that shows anything but a sizeable under-valuation for the RMB

Problems with the Current Regime

China 's current exchange rate regime has created problems for China and the global economy

First , the fixed dollar exchange rate limits the independence of China 's monetary policy and has contributed thus to the pronounced macroeconomic fluctuations of recent years . In 2003- 2004 when investment was thriving and the rate of price inflation accelerating , the central bank was reluctant to raise domestic lending rates in part since it feared that , despite controls , higher rates would attract capital inflows

Second , China 's undervalued currency has contributed to growing trade surpluses and , at least in some years , also to very large portfolio capital inflows , which appear spurred by an expectation of appreciation Massive exchange market intervention , amounting to 11 , 12 , and 14 percent of GDP in 2003 , 2004 , and the first half of 2005 , respectively has been necessary to prevent currency appreciation

The central bank cleared much of this reserve accumulation through increases in reserve requirements and open market operations . Since mid-2004 the central bank also has used administrative controls to limit bank credit creation . This approach is costly in several respects . In 2003 and the first half of 2004 , there was a bank credit spree , with the ratio of the increase in bank credit to GDP hitting a record high . This led to an investment growth , with long-term consequences for excess capacity in a number of sectors , for downward pressure on operating margins in these sectors , and potentially for non-performing loans in banks that lent heavily to support such projects . 2005 again witnessed a considerable rise of bank liquidity , reflected in growing excess reserves and declining money market rates

Third , a highly under-valued RMB encourages excess investment in tradable goods . In due course , the real exchange rate will appreciate and will lower profitability in tradable goods industries

Fourth , China is building up a large exposure to potential capital losses . A 20 percent revaluation of the RMB against the major reserve currencies would thus impose a capital loss equivalent to 8 percent of GDP

Lastly , China 's prolonged , extensive one way involvement in the foreign exchange market together with its large and growing global current account surplus produces protectionist pressure in the United States and elsewhere . One reflection is the Schumer-Graham bill in the US Senate which could lead to a uniform 27 .5 percent duty on all Chinese imports Another is the ill-considered congressional action subjecting a potential China National Offshore Oil Corporation (CNOOC ) purchase of Unocal to a special congressional review . Since over half of China 's exports go to the United States , Euroland , and Japan and since China has a long-term interest in investing abroad , such protectionist threats ought not to be taken lightly

Overall , the costs to China of maintaining an undervalued currency are already momentous and are likely to rise over time . Moreover , unlike some others (e .g , Dooley , Folkers-Landau , and Garber , 2003 , There one cannot see the growth and employment benefits of an under-valued RMB as exceeding its costs (Goldstein , 2006 Goldstein and Lardy 2005

Hypothesis Development

A significant rationale for this study is to understand the impact of changes in the value of the RMB on the value of Chinese companies in the context of China 's capital controls and its policy of pegging the RMB against the dollar . Often outdid , although no less important for the present analysis , is the relationship between the RMB and the Hong Kong dollar (HKD . Here it is important to see that Hong Kong 's currency board also pegs ' the HKD to the USD , thus de facto pegging the RMB against the HKD . In the context of China 's bilateral trade , this three-way currency arrangement is important . Table 1 lists China 's largest trading partners as of the first quarter of 2001 . While Japan was China 's largest trading partner consisting of some 18 of China 's external trade . This is analytical of the degree of the peg and its impact on the value of the RMB when expressed in terms of a trade-weighted index of the currencies of individual trading partners

As a consequence of the pegs , one would expect little correlation in the value of the RMB against these currencies with its value against the currencies of China 's other major trading partners . Ceteris paribus , a currency peg should reduce aggregate firm-level exchange rate exposure

Therefore , it is expected that Chinese firms will not exhibit major exposure elasticity against the RMB expressed as a nominal , effective exchange rate

H1 : When benchmarked against a trade-weighted index , internationally oriented Chinese companies will show little foreign exchange exposure

At the same time as the peg offers a degree of currency stability and mitigates at least one source of cash flow variability , the maintenance of multiple trading partners prevents the elimination of exchange rate risk all together , even if a portion of bilateral trade is done in the pegged currencies . Indeed , due to the de facto dollar peg , the RMB should inherit exposures corresponding with those of the appreciation or depreciation of the USD against those currencies . It is expected therefore that the value of Chinese companies will be responsive to changes in individual exchange rates and that the direction of such exposures will be experientially determined based on the international linkages of each company

H2 : Chinese companies will show exchange rate exposure to varying degrees when the RMB is measured against non-pegged currencies

Finally , there is Allayannis et al (2001b ) finding that operational strategies are not alone sufficient . Hence , for internationally oriented firms to efficiently hedge they must have access to financial derivatives that allow them to structure hedging programs in a way to reduce exposure elasticity . This presumes that active , liquid markets exist for such instruments . In the case of China , capital controls and regulatory stagnation have forced the development of on-shore markets for currency derivatives available to Chinese companies , leaving them nascent and thin (see Sawyer , 2002 . In effect , it was not until autumn 2003 that Chinese regulators completed drafting of derivatives regulations , which until then left banks offering derivatives on-shore exposed to elements of counter-party risk (see Sawyer , 2003 Off-shore a market in RMB non-deliverable forwards (NDF 's ) is growing increasingly and currently dwarfs that of the on-shore market such that RMB NDF 's represent 90 of the estimated combined turnover of on-shore forwards and off-shore NDF 's . There is presently no onshore market for currency swaps (Ma et al , 2004

The ready accessibility of derivative instruments , though , it is theless possible that the USD-HKD pegs obviate the need for Chinese firms with dominate USD or HKD transactions to hedge . Therefore , in comparison with a trade-weighted index , it is expected to find little evidence of active hedging by Chinese companies . Against individual currencies , it is expected hedging effects to be empirically determined in a manner consistent with hedging theory and so related to a firm 's proximity to financial distress

H3 : On account of deterrent to hedge USD and HKD exposures owing to the peg and subject to the availability of currency derivatives for hedging Chinese companies will display little evidence of effective foreign exchange hedging when exposures are measured relative to a trade-weighted index

Methodology , Empirical Models , and Data Selection

To test the above three Hypotheses , there is a two-step methodology of Jorion (1991 ) and He and Ng (1998 . First , to measure foreign exchange exposure , a two-factor OLS market model is used , which measures firm-level foreign exchange exposure by the use of a currency index variable (see also Bartov and Bodnar , 1994 Pritamani et al , 2003 Second , there is an analysis of exposure elasticity , by cross-sectionally regressing average firm-level accounting variables on the coefficient of the currency index from the first regression

In fact , empirical studies of Chinese corporate finance experience from limitations of data availability and reliability . To alleviate such concerns , a data source Worldscope is employed and is supplemented available fundamental data with adjusted monthly closing stock price data from Bloomberg . For currency pricing data daily RMB exchange rates is use to construct indexes of monthly returns . Besides , the monthly RMB nominal is employed to capture trade-weighted currency effects . As a market index , Dow-China 88 Index is used , which consists of the 88 largest and most liquid stocks in the Dow-China selected on the basis of market capitalization and trading liquidity , as measured by average daily turnover . The index is quoted in RMB

In designing this study , a minimum requirement of five years of monthly returns is established . Moreover , based on measures of China 's international trade since 2000 (see Table 1 ) and the interest in testing Chinese firm level exposure to the non-pegged currencies of China 's major trading partners , there is focus on the Japanese Yen , the Korean Won , the New TaiwanDollar (NTD , the British Pound (GBP , and the euro The euro is included for continuity and to capture currency effects against the European Community more generally . This dataset then runs from January 1999 through December 2003

As regards sample selection , Bartov and Bodnar (1994 , referencing previous studies of US corporations that failed to document a significant correlation between stock returns and dollars fluctuations note such findings may be the result of noise introduced into these studies through , among other things , the inclusion of firms with limited linkages to international conditions . They prescribed developing effective selection criteria to reduce or eliminate this noise . In this light recent studies have attempted to filter sample sets by including only listed multinationals ' or other listed firms ranked above some threshold of the export ratio , the ratio of net foreign sales to sales , etc

In 1999 Worldscope 's coverage of Chinese companies consisted specifically of 127 firms , which when cross-referenced against the Bloomberg database were found consistent with the 127 listed A-B , A-H or B-share firms noted above . Based on their international orientation as exhibited by their cross-listing , these firms have shown a desire perhaps a necessity , to attract foreign capital and , if paying dividends , have foreign currency-denominated cash flows (see Sun and Tong , 2000 and Chakravarty , et al , 1998 . As such it is argued that through their cross-listing , they establish , in the Chinese context clear international linkages . Consequently , using the Worldscope Chinese company dataset for 1999 , those firms are selected with A and B shares and excluded firms with A and H shares in to avoid any residual influences on returns that might be introduced by the overseas listing After collecting all relevant pricing and fundamental data for the period from 1999 to 2003 , this final dataset consists of 70 Chinese companies across 6 industry segments (i .e . approximately 85 of all the companies in this category trading in 1999 . All stock returns are calculated using A-share adjusted closing prices , i .e . a market value established by local investors in RMB

Test Procedures Empirical Results

To efficiently use the two-step regression procedure to analyze exchange rate exposure in the context of a pegged currency regime , individual time series regressions are run for each of the firms in this sample estimating exposure elasticity using the RMB NEER as a benchmark . Next to test for individual currency effects , the firm-level regressions are repeated using a vector of individual monthly currency returns . In both instances , residual exposure is tested to include the market variable in each set of time-series regressions

Of the seventy firms analyzed , in only nine cases , or 12 .9 of the sample , were exchange rate coefficients statistically significant and then at only between the 5 and 10 levels , suggesting that few Chinese companies show currency exposure relative to the market when measured against a trade-weighted index . This finding is in agreement with the influence of the peg mitigating some degree of foreign exchange exposure and also with evidence of the NEER masking exposure against non-pegged currencies

Remarkably , when the same sample was retested using the vector of individual exchange rates , twenty-four (or 34 .3 ) of the firms tested showed considerable exposure to one or more of the currencies . Among the five currencies tested , fifteen (or over 62 of the sample ) showed significant exposure to the Japanese yen , 29 .2 to the euro , 25 to the won , 16 .7 to the GBP , and 8 .3 to the NTD . As is evident from Table 2 and Table 3 China 's manufacturing base exhibits a significant value-added production component whereby Chinese firms import primary or intermediate products and export finished goods . This is discernable from the patterns of imports and exports where the same product sectors make up 60 of China 's trade sectors . Despite the fact that firms showed differently both significant positive and negative exposures to the euro , GBP , won , and NTD , the sign related with significant yen exposure was exclusively negative . This predominance suggests that the Chinese firms in the sample overwhelmingly benefited (or suffered ) from a depreciation (appreciation ) of the RMB against the yen as would firms with an export orientation

As a whole , these tests indicate that a ) the peg may contribute to reduced foreign exchange exposure for Chinese companies , but b ) Chinese corporations however remain sensitive to fluctuations in the individual currencies of China 's trading partners against which the RMB is not pegged . This is particularly evident in the case of the Japanese yen where negative exposure elasticity predominates

The second-step regressions are intended to explain the estimated exposures from the first-step using a multivariate cross-sectional model , which includes regressors capturing size , leverage , liquidity and industry effects . If hedging , by mitigating variance in firm value reduces the probability that a firm will become financially distressed and then firms with greater leverage and lower liquidity will have more motivation to hedge their foreign exchange exposure (Smith and Stulz 1985 . Therefore , following He and Ng (1998 , it is suggested that for firms that hedge , balance sheet measures of long-term debt will be negatively correlated with exposure , indicating that despite their greater financial risk , they have less exposure . In the same way , it is expected that accounting measures of liquidity - quick ratio - will be positively correlated with exposure , implying that less liquid firms with higher financial risk and who hedge will have less foreign exchange exposure . Although one might propose that small firms are more at risk to financial distress , transactional economies of scale may provide cost-efficiencies to hedging to larger firms (Nance et al , 1993 . The latter may be difficult to argue in China 's case owing to the underdevelopment of local derivatives markets . Thus , the sign of the size variable is expected to be positive indicating hedging activity by small firms

Besides , based on the results of the first-step tests and the dominance of yen exposure , there was also a test for determinants of yen-based exposure elasticity . It must be noted that for both RMB NEER and yen exposures , there was a test with and without industry dummies and it was found that the coefficients on the industry variables were largely not significant , added little explanatory power to the tests , and did not basically change the structure of the results . Moreover , as an alternative size proxy , there was also a test using the log of a firm 's net revenues and found consistently that this regressor produced nearly identical results to those reported using log of In tests for RMB NEER exposure , only the size and liquidity proxies were significant , both at the 1 level . Remarkably , the sign of the liquidity coefficient is negative and that of the leverage coefficient was positive in each case suggesting no evidence of hedging . The coefficient of the size proxy was negative , also as expected in the absence of hedging . In tests for yen exposure , only the leverage proxy was significant at conventional levels . However , the signs of all variables switch , suggesting consistently , though weakly , some evidence that Chinese firms hedge yen exposure

Since the exposure estimates used as dependent variables have both positive and negative signs , it is important to look at whether hedging proxies display consistent effects on both positive and negative coefficients . To do so , additional regressors are constructed by interacting each of the accounting variables with a dummy variable equal to 1 if the coefficient is negative (DNEER and DYEN ) and a second dummy equal to 1 minus each of these dummies (D1N and D1Y respectively (see He and Ng , 1998 . Each cross-sectional regression is repeated replacing the constants with the generated dummies and all the interacted accounting variables . Yet again for completeness industry dummies are included , which in the same way do not significantly affect the results For both currency indices , all signs remain consistent . Significance levels , on the other hand , do vary based on the sign of the exposure coefficient . For RMB NEER exposures , explanatory variables for all observations with negative exposures were not significant , whereas for observations with positive exposures the significance of the size variable held . Though weak , these results again suggested no evidence of hedging in the context of the peg . On the other hand for yen exposures explanatory variables for all observations with positive exposures were not significant , while for observations with negative exposures (i .e export sensitivity ) both the size and leverage variables were significant . These findings are consistent with Chinese exporters actively hedging yen exposures

China`s Exchange Rate Regime : A Critical Analysis

China`s exchange rate system is a work in progress . The accelerating pace of change makes efforts to analyze it like attempting to hit a moving target

For the analyst the early verdict on the effectiveness of the country`s new exchange rate system may be premature . That system is continuing to develop as officials reveal discrepancies in existing arrangements forward foreign exchange and other financial markets continue to develop , and the authorities gain experience with managing their now more flexible rate . T he analyst`s task is more difficult still for the fact that discussions of the renminbi`s management are loaded with political implications and rolled up with the state of U .S .-Chinese relations . Moreover even those who approach the question from a closely economic point of view reach different conclusions since they start from different assumptions about the objective function that the Chinese authorities should seek to exploit . For some the issue is the regime that is most fitting for the Chinese economy . Here the question is whether a currency arrangement involving greater flexibility will enable the Chinese authorities to more efficiently guide the economy as they continuing moving in the direction of a market-based monetary policy , or whether such flexibility could be destabilizing for the country`s financial system and export-led growth in the absence of prior financial reform and the further development of forward markets in foreign exchange . For others the issue is the exchange rate regime with which China can most efficiently add to the ly resolution of global disparities . Here the question is whether Chinese authorities need to allow major further appreciation so as to limit the expansion of the U .S . deficit and China`s own surplus and to work out global rebalancing with continued expansion of the world economy

The 2 .1 per cent revaluation of the renminbi has symbolic value particularly in the United States . It is suggestive of the recognition that China now shares responsibility for the stability of the global economy . At the same time it is not so large as to considerably damage the profitability of Chinese exports . A more flexible exchange rate should enable the People`s Bank of China to more efficiently adapt monetary conditions to local needs as it moves toward a more market-based financial system . Continued heavy management of the currency will reduce the danger of disproportionate volatility that could damage financial stability , exports , and economic growth . Lastly switching to a basket should help to reconcile the further dollar decline needed for the readjustment of the U .S . deficit with the export-centered nature of China`s growth model

The criticisms of the new policy regime depend on the uncertainty that remains after the recent announcement about the likely degree of exchange rate flexibility . It is related to that the authorities may not allow the rate to vary adequately to create the perception of a two-way bet and promote caution on the part of financial market participants . Measures to contain instability may encourage speculators to all line up on one side of the market , at present the side anticipating further appreciation , subjecting the economy to troublesome capital inflows and aggravating the risk of overheating . In due course an even more flexible exchange rate will become desirable , and at that point the fluctuation band retained as part of the new regime may become necessary . Frequent changes in the regime expand the band , or abandoning it wholly will then create needless questions about the consistency and credibility of policy it is argued that from this viewpoint it would have been better to eliminate the band . Given the Chinese authorities vast foreign exchange reserves , they have ample resources with which to manage the rate through intervention already the band has become a needless support . Finally , it is feared that for domestic political and economic reasons the Chinese authorities may be disinclined to accept the further appreciation of the exchange rate needed eventually to help smoothly resolve the problem of global disparities

Theory of Optimum Chinese Areas

The theory of optimum currency areas is the palpable jumping-off point for this analysis . This theory and its empirical counterpart suggest that large countries dependent on distinctive business-cycle conditions will want a more flexible exchange rate , since they can both afford and will wish to adapt monetary policy to domestic conditions . On the contrary , somewhat open economies with weak financial systems will want a less flexible rate , since volatility will be corrosive to financial stability and export growth . Here it is seen the predicament facing the Chinese authorities and the fact that there is no simple answer to the question of what exchange rate regime is right for the country . On the one hand , China is a large economy whose unusually rapid development and change subject it to unique business cycle risks . These structural factors create an evident case for a more flexible rate . In contrast the country has a high export /GDP ratio and a weak financial system These factors point toward a less flexible rate . Splitting the difference suggests a fair increase in flexibility , which was specifically the decision taken on July 21st . This framework also suggests that China will want to move over time in the direction of greater exchange rate flexibility . In the long run the country will have to deal with the problems in its financial system , and a stronger financial system will enable it to deal with more easily with the consequences of a more flexible exchange rate . Besides , China will not run savings rates of 50 per cent perpetually social demands for higher consumption standards , the development of financial markets that enable households and firms to insure themselves against market risks at lower cost , and the construction of a social safety net will make this so . It is known that economies more dependent on domestic demand and less dependent on export demand demonstrably favor a more flexible rate . The question is when China should commence its movement in this direction

The argument is that the government was correct to begin moving in the summer of 2005 . The appropriate regime given current conditions is a managed float in which the exchange rate is allowed to change more than in the last ten years . Greater flexibility will allow the authorities to more efficiently conduct the economy . It will avoid domestic interest rates and financial conditions from being dictated by interest rates and financial conditions in the rest of the world , which becomes a growing danger as the capital account continues to open through a combination of policy action and market development . Such flexibility will become all the more important as the banks are commercialized and stakes are sold to foreign investors , rendering less effective past practice of managing monetary conditions by issuing instructions to financial institutions . To be clear , the government is right to maintain that its more flexible exchange rate should still be deeply managed However the degree of intervention should drop eventually . Ten years from now , the renminbi might suitably fluctuate as freely as the South Korean won or the Brazilian real today . The question is what exchange rate regime is best for navigating this transition

It is known that frequent changes in the exchange rate regime are detrimental . Recurring changes in the regime certainly encourage speculation about changes in the currency`s level , complicating the conduct of monetary policy . The way of improving the reliability of policy is for the authorities to follow a consistent monetary policy operating strategy , something that will not be possible if they are constantly changing the exchange rate regime . This argues against moving first to a band and then later to a band-free float . It argues against successive increases in bandwidth in due course . Relatively given the exchange rate regime that will be appropriate for China ten years from now moderately managed float the government would have been better advised to remove all pretence of a band

Literature on Sequencing

The other noticeable jumping off point for this analysis is the literature on the sequencing of international monetary and financial reforms . A one-sentence summary of that literature is that exchange rate flexibility should follow capital account convertibility . Exchange rate flexibility should come first to evade creating one-way bets for speculators , who can force the authorities to discard their exchange rate commitment reluctantly , at considerable cost to their policy credibility , or to undo prior measures liberalizing the capital account which will also raise questions about the consistency of policies . If instead , the capital account is opened first , large amounts of liquidity may flow in , creating a financially-disruptive credit boom and fanning fears of a socially-disruptive inflation that can only be headed off by revaluation (Financial Times ,

.10 . Otherwise large amounts of liquidity may flow out , exhausting reserves unless the authorities devalue . Therefore , capital account liberalization should be controlled by a degree of exchange rate flexibility that creates losses in the event that expectations of revaluation or devaluation are failed avoiding one-way bets and thus preventing currency speculators from all lining up on one side of the market . This is one of the main lessons of the 1997-8 Asian financial crisis , which was aggravated by the fact that many countries in the region opened the capital account before moving to greater exchange rate flexibility rather than the other way around

From this standpoint , many were alarmed by the argument normally heard in Beijing of the need to delay the move to greater exchange rate flexibility until there was more progress in liberalizing the capital account . To the contrary , that China has now taken a modest step in the direction of greater flexibility is encouraging exactly considering the significant steps to further relax the capital account

Already the capital account is adequately porous that large amounts of portfolio capital are attracted by expectations of fast economic growth and currency appreciation . The authorities ' capacity to shield the economy from the effects of these inflows , by among other things instructing the banks not to lend , is ever more limited by the ability of that finance to evade the banking system . Greater exchange rate flexibility , which forces international investors to think twice before all lining up on one side of the market , will not remove these risks although it should satisfy them to some extent

Similarly , there is already scope for disrupting capital outflows in future circumstances where there is a sharp retardation in growth , new problems emerge in the financial system , or there is a geopolitical dispute with the United States . Rather than giving way , the authorities may then be inclined to position their reserves to defend the exchange rate . Both theory and evidence propose that this would be a losing battle even for a central bank with 1 trillion of reserves in the absence of controls , even this difficult war chest is nothing compared to the resources that can be activated by the markets

This observation also points to the major lesson of the literature on exit strategies : countries should exit from a peg while the going is good . They should exit while development is strong , capital is flowing in , and expectations are for appreciation (Eichengreen and Masson et al 1998

Exiting reluctantly , on the contrary , is almost always expensive . It forces the authorities to unwillingly discard their obligation to defend the peg , contradicting previous policy statements and diminishing their credibility , something that is unavoidably harmful to confidence stability and growth . The literature on exit strategies also suggests that development can be supported by expanding domestic demand , most reasonably through the realization of expansionary fiscal initiatives at the same time the growth of external demand is being slowed by the appreciation of the currency . This fiscal expansion is most likely to be feasible and confidence enhancing rather than threatening when the underlying condition of the economy is strong . Recent work also suggests that a non-disruptive exit to greater flexibility is easier to engineer a...