China announced the reform of its decade-old RMB exchange rate regime last July, linking the RMB to a basket of currencies rather than the U.S. dollar alone, and allowing the RMB to appreciate 2 percent against the U.S. currency. Since then, different viewpoints on the new regime have been voiced. The People’s Bank of China, the central bank, said in a statement in late March that it would further improve the system, broadening the foreign exchange market, increasing the flexibility of the RMB exchange rate and maintaining the basic stability of the currency. In a recent interview with Caijing magazine, Wu Xiaoling, Deputy Governor of the People’s Bank of China, talks about issues related to the RMB exchange rate. Her main ideas follow:
　　Interest rates and the RMB exchange rate are important parameters for monetary allocation. Having interest rates and the exchange rate determined by the market forces of supply and demand is the direction we are adhering to.
　　The People’s Bank of China is currently pushing forward the marketization process of the RMB exchange rate at a stable pace. Great attention at home and abroad has been paid to the debut of the exchange rate reform on July 21 last year. Some think the 2 percent initial appreciation of the RMB against the U.S. dollar was inadequate and that further appreciation is necessary. In my view, we should first reach a common understanding that whether a currency’s exchange rate is high or low is hard to determine.
　　We are striving to improve the RMB exchange rate regime, looking for a market-oriented exchange rate mechanism that is basically in line with market changes. The 2005 exchange rate reform is not only an adjustment of the currency’s level but, more importantly, a regime reform that allows the RMB to be linked to a basket of currencies instead of the dollar alone and to fluctuate according to the market.
　　
　　Factors influencing marketization
　　
　　First, the demand for foreign exchange is restricted due to the strong control over the capital account, and obviously the exchange rate formed under such restricted demand is imbalanced. We are gradually relaxing regulations on foreign exchange supply under the capital account so as to ease some of the foreign exchange demand. For example, we previously did not supply foreign exchange for overseas investments by Chinese enterprises, but that situation is changing now.
　　Second, the imbalanced pattern of China’s “dual surplus” in international payments is another factor. China has achieved such a “dual surplus” continuously in recent years. We are used to calling payments deficits “imbalanced,” but actually a large surplus, which makes the supply of foreign exchange not reasonable, is also a sign of imbalance. This has something to do with our policies, such as “praising exports and restricting imports” in international trade and “easy come, hard go” in foreign exchange administration. As a result, we need to adjust our economic policies to properly limit the inflow of funds, encourage imports and carry out the “go global” strategy in order to reduce the trade and investment surpluses.
　　Third, the inflow of some speculative capital is also a factor that affects the marketization of the RMB exchange rate.
　　What the People’s Bank of China can and should do is to manage these unfavorable factors, gradually eliminate their influence and cultivate a normal supply and demand in the market. Normal supply and demand can reflect a comparatively reasonable rate for the yuan, but whether the exchange rate goes up or down should be determined by the market.
　　Since last July, several weighty measures have been introduced in China’s foreign-exchange market reform to accelerate the marketization process, one important aspect of which was the introduction on January 4 of an inquiry transaction mode in the foreign exchange market between banks and market makers. In the past, the daily central parity rate for the RMB was determined by the closing price (the weighted average price of the last five transactions) of the day before. But the new measure to calculate the yuan’s value against the U.S. dollar is to use a weighted average of the prices given by major banks, with the highest and lowest offers being excluded from the calculation.
　　In this new market framework, market makers become the hub linking all components of the foreign exchange market and their offers can reflect intensively the supply and demand fluctuations in the market.
　　
　　Risk management
　　
　　Interest rate marketization and the new RMB exchange rate regime place higher requirements for risk management on commercial banks. At present, domestic commercial banks have begun to attach more importance to improving their risk recognition capacity and strengthening technical training for their risk management and rate-setting personnel. Referring to risk calculation measures, every bank has basically set up an internal evaluation system and the prices of their products have been fixed on the basis of market changes to a certain extent.
　　In order to adapt to interest rate and exchange rate changes, the central bank has introduced several derivatives in the financial market such as forwards and swaps and expanded forward foreign exchange trading business, which provides a tool for commercial banks to manage and avoid risk. Commercial banks should strengthen their study of these derivatives to promote financial product innovation and learn to manage risk.
　　
　　RMB Exchange Rate Reform
　　
　　July 21, 2005: China reforms its RMB exchange rate mechanism by turning it into a “managed float” system based on market supply and demand with reference to a basket of currencies. With the reform, the exchange rate gains greater flexibility. It is no longer pegged only to the U.S. dollar, and can float within the range of 0.3 percent each day.
　　August 2: China’s central bank discloses its limits on the type and transaction scope of the RMB forward business versus foreign currencies, loosens the transaction deadline and allows banks to fix their own prices and conduct foreign exchange swaps for clients.
　　August 8: Non-bank financial institutions and non-financial enterprises are permitted to enter the interbank spot foreign exchange market while swap transactions of the RMB versus foreign currencies are permitted among banks.
　　August 15: The interbank RMB forward market is officially set up. So far, 64 Chinese and foreign-funded banks have become members of the forward market. Of the total, 50 are foreign-funded banks, including five banks in which funds from the United States are invested.
　　September 23: China’s central bank issues its limit on the margin of fluctuation of the interbank market exchange rate of foreign currencies aside from the U.S. dollar against the RMB. At the same time, the limit on the fluctuation margin of commercial banks’ quotations of U.S. dollars to their customers is raised to 1 percent.
　　January 4, 2006: The form of negotiated transactions and the market-maker system are introduced into the interbank foreign exchange market. The RMB central rate is based on the quotations of 15 Chinese and foreign banks as market makers so that the marketization of the RMB exchange rate is further enhanced.
　　March 10: The Foreign Exchange Trading Center of China and the Chicago Commodities Exchange reach an agreement allowing Chinese financial institutions and investors to trade exchange rate and interest rate products on the Chicago Commodities Exchange through the Foreign Exchange Trading Center of China.
　　Source: Economic Daily

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