Zhang Zhixiang: International Exchange Rate Regimes and RMB Internationalization

Zhang Zhixiang: Former Director General, International Department, PBoC; Former Executive Director for China in IMF On August 15, 1971 the United States announced that dollar would no longer convert to gold at a fixed value, thus abandoning the fixed exchange rate regime under the Bretton Woods system and kicking off the floating exchange rate system at the global scale. Due to the prominence of dollar in the international monetary and financial sector, the world follows a dollar-denominated floating exchange rate regime. By the provisions of International Monetary Fund, exchange rates are divided into four categories. 1) Independent or free-floating regime such as the US dollar, Euro, Japanese Yen, and British Sterling. Over 30 currencies fall into this category. 2) Managed floating regime, which can be subdivided into crawling bands, crawling pegs and rates which are pegged with horizontal bands. Nearly 140 countries and regions belong to this category. The main features of managed floating regime is that, it is a weighted average figure based on the amount of trade and economic exchanges with other countries and regions, as well as on the market demand. RMB falls into this category. 3) The currency board system, to which Hong Kong dollar belongs. 4) The integrated currency arrangements, such as Panama’s dollarization. Nearly 40 years of floating exchange rate regime proves that turbulence derived from floating exchange rates would lead to economic instability, and even financial and economic crisis. Robert Mundell, Professor of Economics at Columbia University and the 1999 Nobel Laureate in Economics mentioned recently that there was almost no large-scale outbreak of the economic crisis at a fixed exchange rate era, but now we witness financial crisis one after another. The severest crises since 1973 include the 1982-1983 international debt crisis, the 1997-1998 Asian financial crisis and the 2008 global financial collapse. Moreover, small-scale or regional financial crisis amounted to more than 120 occurrences. In addition, the global economy has slowed down under the floating exchange rate system. See the following table. Annual Average Growth Rate around the World since 1950 Greater drawback of dollar-dominated floating exchange rate regime is the spillover effects of US monetary policy on the global economy. That the 2007 US-led subprime mortgage problem triggered the global financial crisis proved to be the case. The extended easy monetary policy in US led to real estate and financial asset bubbles and dragged the global economy into crisis. In this regard, I propose the following policy measures. First, China should adhere to a managed exchange regime in accordance with the International Monetary Fund. IMF respects member countries’ choice of a certain arrangement under the floating exchange rate regime. Second, China should promote the exchange rate formation mechanism according to national realities, to avoid the impact of sharp exchange rate fluctuations. China must withstand the pressure of large inflow of hot money and implement steadily the exchange rate reform. In April 2010, China’s position for Forex purchase increased 286.31 billion yuan over March, while trade surplus and FDI in April only added up to $ 9 billion. This indicates that more than 70% of the position for Forex purchase comes from hot money. These factors mustn’t be neglected in designing the scientific exchange rate mechanism. In addition, the large amount of foreign exchange reserve requires the country to continue to diversify its international reserve assets. For example, China actively subscribes the Special Drawing Rights (SDR) Bonds of the IMF worth no more than 50 billion. Third, China should push the RMB internationalization drive in an active but prudent manner. It should be noted that the aim of RMB internationalization is to alleviate the devastating impact of sharp exchange rate fluctuations on economic development, rather than challenging the status of the US dollar. RMB internationalization requires three steps. First, from 2010 to 2020, China should actively facilitate the use of RMB as the international trade settlement currency. This process has already begun. Lessons should be learnt, problems be solved before effectively implement this strategy. During this period, full convertibility of yuan should also be prepared. Back in 1996 and 1997, the IMF vigorously promoted liberalization of capital account, and even tried to amend its articles to empower the organization to manage capital accounts. The outbreak of Asian financial crisis postponed this agenda. Facts have proved that capital account liberalization is a systematic project; besides economic strength and ample foreign exchange reserves, sectors under the capital account liberalization should be arranged in a particular order. South Korea’s experience and lessons are worth learning from. As China deepens its financial reform, special emphasis should be put on improving banks and other financial institutions’ operational philosophy and standards. In terms of risk management, China should strengthen cooperation with IMF and regional players. In any case, early warning and risk prevention as well as the response plans are necessary. Second, from 2020 to 2030, China should provide in due time the renminbi-denominated financial settlement services. China needs to form a regional currency area of renminbi-denominated settlement, strengthen trade and economic cooperation as well as investment with ASEAN countries using RMB as the settlement currency, and build the Greater China Currency Area and ASEAN +6 Currency Area. The managed exchange rate mechanism could continue, but the range of adjustment can be appropriately expanded. At the same time, China could establish a RMB-centered stable exchange rate zone, where a stable or fixed exchange rate is applied. In terms of risk control, the priority should be regional arrangements, such as strengthening the regional repository and exploring Asian Monetary Fund mechanism. Third, from 2030 to 2040, the status of renminbi should be promoted from the trade and financial transaction settlement currency to a major reserve currency, and a renminbi-centered currency area should be established in Asia. In terms of exchange rate, renminbi could follow the free floating regime as the US dollar, euro, and other major currencies, but the RMB currency area should follow a fixed exchange rate mechanism. Yuan, as a major reserve currency, should account for 20% to 25% of global reserve currency. Currently, the US dollar, euro, yen, Britain sterling and the Swiss franc accounts for 64%, 28%, 3%, 3% and 1% of the global reserve respectively. As for risk control, a strong regional repository and regional monetary fund mechanism should play a leading role. Finance and currency are manifestations of a country’s overall economic strength. Therefore, China must nurture a large number of eligible and global leading enterprises, as well as cutting-edge science and technologies at the same time.

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