Bangkok--Jan 20--Aziam Burson-Marsteller
China’s Foreign Exchange Management Regime
With the old regime cracking, a long-awaited reform plan is probably on the way.
China’s current system for managing foreign exchange (FX) has three basic components — a fixed-quota system; a monopoly price-setting mechanism; and a narrow floating band. Under the regime, Chinese exporting companies and commercial banks are allowed to keep only certain amounts of foreign currencies (30% of the previous year’s annual FX income in general). Whenever their FX holdings surpass their quotas, they must sell the “excess” FX holdings at an inter-bank trading centre in Shanghai (fixed-quota system). Meanwhile, the People’s Bank of China (PBoC) works as a market maker at that trading centre, setting the official exchange rate (monopoly price-setting mechanism). It then allows trading within a pretty narrow band (+/-0.3%) around that target rate (narrow floating band).
A faltering regime
This framework of foreign exchange management was designed at a time when China’s financial market was relatively closed and small — it had limited economic impact beyond the country’s borders. With China’s economy opening up and becoming more pivotal globally, the drawbacks of the regime have become apparent.
First, the fixed-quota system limits the FX holdings of Chinese companies, and requires the PBoC to buy all excess holdings from the banking system. Such a system may help the government to curb capital outflows, and avoid potential financial crises during a vulnerable period. But for a country enjoying robust export growth and attracting massive capital inflows, this system is prone to result in unwanted surges in the central bank’s FX reserves. And indeed this has happened. As foreign direct investment (FDI) hit a record US$60.6bn in 2004, and exports totaled US$593.4bn, China’s FX reserves jumped US$206.6bn last year to reach US$609.9bn. The rapid accumulation of FX reserves not only poses a serious challenge to the PBoC’s reserve management operations, but also provokes criticism among foreign leaders, and damages relations with trade partners.
Second, the PBoC’s monopoly price-setting power allows the bank to keep the currency undervalued, leading to heavy market speculation. Last year, only about US$95bn of the growth in reserves could be attributed to the trade surplus and FDI inflows, while the rest of the increase remains unaccounted for. The government called these residual capital inflows “hot money”, worrying about its inflationary impact on China’s overheating economy.
Third, the central bank’s efforts to maintain the narrow floating band have created a “pipeline” which, absent countervailing action, automatically transmits capital inflows into money and credit growth.
The coming reform
China’s government has made it clear that it intends to improve the “flexibility” of its FX management this year, while maintaining “the basic stability of the currency on a reasonable and balanced level.” When talking about “flexibility”, the government hints that quota limits are likely to be raised or even removed, and commercial banks and exporting companies would be allowed to hold more foreign currencies in the future. In addition, the central bank will probably no longer set the actual exchange rate. The old monopoly price-setting system could be replaced by a system with more competitive elements, in which commercial banks may play a leading role. On the other hand, when the government vows to “maintain stability”, it suggests that the narrow floating band is unlikely to be widened substantially in the near term. Significant reform of the RMB’s trading mechanism may occur in 2005, but any change in the exchange rate is likely to be small: about a 5% appreciation by the end of this year on our current reckoning.
Any possible timing of the exchange rate reform will immediately be discarded by the PBoC, once it becomes a kind of “market anticipation”. Selecting a good time presents a dilemma: it is a test of the government’s economic management skills, in that macroeconomic conditions must be stable, and significant progress should have been made with banking reform; but the government also wants to catch the market by surprise. Timing is a political art too, challenging the leadership’s abilities to balance the demands of different interest groups. We judge some time ahead of important national meetings, global leader summits, or even around state visits to/from the US to be likely candidates. End.