Abstract: In this article, the authors discuss the costs of foreign exchange intervention and the necessity for China to transition toward a free-floating exchange rate regime, develop its foreign exchange (FX) derivatives market and continue to promote the use of domestic currency in international transactions in the face of various challenges in the international market. Several policy implications can be drawn. First, the successful transition toward a free-floating exchange regime requires sound monetary and fiscal discipline. Second, market-based prudential regulation will be critical to ensuring the stability and sustainability of the FX derivatives market. Last but not least, the use of domestic currency in international transactions has to be promoted and will become inevitable under complex international environment so that China can better deal with the impact of external shocks.
While the world is undergoing profound changes unseen in a century, China is faced with complex challenges and policy choices. The tariffs and technological blockade imposed by the US have worsened China's terms of trade with the US; some regional free trade agreements that exclude China have been formed; and financial sanctions have become a possibility.
To overcome these challenges, it is necessary for China to adopt a flexible exchange rate regime, develop its foreign exchange (FX) derivatives market and continue to promote the use of domestic currency in international transactions. Continued and massive foreign exchange intervention will bring unnecessary macroeconomic costs. It will be even more necessary to adopt a flexible exchange rate regime when faced with increasing external shocks. Transitioning towards a “clean float” is a goal in the right direction for China’s exchange rate reform and also the foundation for further opening-up China’s capital market and reducing excessive reliance on major reserve currencies.
I. The cost of intervention in foreign exchange rate market
First of all, foreign exchange intervention brings direct costs, such as persistent balance of payment imbalances that cannot be corrected in a timely manner, the loss of foreign exchange reserves, the underdevelopment of foreign exchange market, and the conflicting goals between monetary policy and exchange rate stabilization. Foreign exchange intervention can also incur indirect yet significant macroeconomic costs, such as its distortions on general prices, real interest rates and asset prices. Cross-country empirical study shows that while foreign exchange intervention is effective in stabilizing nominal exchange rate in the short term, the effect remains uncertain in the medium to long term. Furthermore, its impact on the real exchange rate is quite limited. In the face of external shocks, although foreign exchange intervention can help reduce the fluctuations in nominal exchange rate, it may impede appreciation or depreciation expectations from being reflected in the formation process of market prices and prolong risk-free arbitrage trading, thereby causing continued capital inflows or outflows. At the same time, foreign exchange intervention could increase real interest rate and subsequently the opportunity cost of investing in the stock and real estate markets, resulting in unintended declines in asset prices. Last but not least, foreign exchange intervention is ineffective in stemming capital outflows. Empirical study shows that foreign exchange intervention is ineffective in mitigating capital outflow pressure; on the contrary, it can accelerate net capital outflows.
While the above-mentioned costs can occur even when the central bank takes measures to sterilize the side-effects of foreign exchange intervention, the costs can become more obvious when the central bank does nothing. In fact, sterilization measures themselves can have side effects. For instance, if the central bank issues central bank notes, it will bear the additional financing costs; if the central bank raises the reserve requirement ratio, the cost will be passed on to the commercial banks who will in turn pass the costs on to the real economy by raising lending rates. If the commercial banks attempt to circumvent the cost resulting from rising reserve requirement through innovative measures, they can shift their businesses from on-balance sheet to off-balance sheet, or to non-bank financial institutions, which can result in shadow banking activities and increase financial risks.
Foreign exchange intervention also hinders the development and normal operation of the risk management market. Foreign exchange intervention could result in two different exchange rates in Chinese mainland and Hong Kong, leading to multiple currency practices (MCP) as defined by the International Monetary Fund (IMF). Neither overvaluation nor undervaluation caused by foreign exchange intervention is conducive to the use of domestic currency in international transactions. In the face of fickle global capital flows, foreign exchange intervention measures intended for stabilizing the nominal exchange rate of Chinese yuan against the US dollar can bring cyclical disturbances to more important domestic priorities such as achieving inflation target and reducing reliance on major reserve currencies. Interventions in the FX forward market can also inhibit the market from developing its own exchange rate risk management capability.
Three major reforms to China’s exchange rate regime that took place in 1994, 2005 and 2015 had, to varying degrees, served to reduce long-existing economic imbalances and cushion the negative impact of external shocks. The three reforms have shown that equilibrium exchange rates must be determined by the market rather than being judged subjectively. In the face of external shocks, however, the three reforms have each been interrupted by foreign exchange intervention measures intended for stabilizing the nominal exchange rate at the expense of domestic macroeconomic distortions. The associated costs to the economy are often neglected or underestimated.
Since the end of 2016 and especially after the outbreak of the COVID-19 in 2020, the People's Bank of China has considerably reduced its regular interventions in the foreign exchange market. Although the exchange rate of the Chinese yuan experienced larger fluctuations, China’s net capital outflow has been the lowest among all emerging market countries. Foreign exchange restrictions in China were less stringent compared with those in 2015. Meanwhile, China’s foreign trade performance tops most other economies. These recent developments have demonstrated the rationality and feasibility of implementing a more flexible exchange rate regime.
II. The successful transition to a free-floating exchange rate regime requires sound monetary and fiscal discipline
There is no internationally accepted value benchmark like gold under the existing international monetary system, and it is impossible for different countries to have the same price levels and economic cycles. As an independent large open economy, China cannot join a currency zone dominated by another major currency. In such a context, China must abandon the expectation that bilateral nominal exchange rate could be fairly stable. Instead, it should adopt a floating exchange rate and ensure the stability of the purchasing power of RMB against a basket of major goods and services by unswervingly implementing sound monetary and fiscal policies. This means that the central bank must hold on to the goal of maintaining price stability and financial stability. Different exchange rate regimes require different sets of economic policy rules. The implementation of floating exchange rate regime must be accompanied by more timely and adequate adjustment of domestic monetary policy and interest rates.
With a more flexible exchange rate system, it is necessary to avoid large macroeconomic imbalances and the accumulation of huge risks in the financial system, especially to avoid external sector imbalance and fiscal imbalance such as continuous large current account deficits, excessive reliance on short-term capital inflows and external debt, etc. The core of macro-prudential management under a clean floating exchange rate regime involves three tasks: controlling aggregate money supply, controlling public debt, especially net public debt, and controlling total external debt including short-term external debt. Some recent studies have shown that in order to fully play the role of a flexible exchange rate as a "buffer", it is important to avoid excessively high levels of external debt and severe currency mismatches.
This research project conducts a systematic evaluation on the robustness of China's macroeconomy with two methods, namely the Vulnerability Assessment and the Systemic Risk Assessment, two methodological frameworks developed by the IMF.
With the Vulnerability Assessment, we have compared various indicators of China with safety thresholds and corresponding indicators of emerging market economies. Overall, China’s external sector is relatively robust, but considering various actual or contingent liabilities, the level of China’s forex reserves is not that high. In extreme cases, the attempt to rely on forex reserves to maintain a certain exchange rate level will not pay off. China’s financial sector is generally sound, but the capital adequacy ratio needs to be improved. The current risk-weighted capital adequacy ratio is 14.2%, which is higher than the requirement stipulated by the Basel Accords and the risk threshold calculated by the IMF, but still lower than the average level of developing countries.
The Systemic Risk Assessment is applied to quantitatively examine the performance of China and G20 countries in multiple relevant fields through horizontal, vertical and panel comparisons. The results show that China’s public sector debt is manageable. At present, the proportion of external debt in public debt is lower than that of most G20 countries, but the rapid growth in external debt is worthy of attention. While the financial sector shows no sign of systemic risks, the high default probability of some financial institutions deserves timely attention.
In the current challenging external environment and with the gradual opening of the capital market, it is necessary for China to strengthen macro-prudential supervision of the capital account. In particular, when faced with large capital inflows during a tidal-wave-like cycle, we could set aside part of the foreign exchange reserves to establish a Securities Market Stabilization Fund (SMSF) in a timely manner to deal with inevitable cyclical reversal. In the process of gradually liberalizing the capital account, the free floating of Renminbi should be gradually realized to its full extent so as to allow the exchange rate to adapt and adjust to the two-way capital flows. It is also important to overcome the fear over exchange rate overshooting which is normal for exchange rate in search of equilibrium. The practice of gradual appreciation or depreciation cannot stem overshooting. On the contrary, it may attract large-scale risk-free arbitrage trading due to prolonged appreciation or depreciation expectations, thereby causing even larger-scale overshooting. The more flexible the exchange rate is in normal time, the better it can deal with large shocks in crisis.
III. Manage exchange rate risk with market-based approach: develop FX derivatives market
In recent years, the development of China’s FX derivatives market has achieved some progress, but it is still a weak link in China’s ongoing transition toward a floating exchange rate regime and the further opening-up of the Chinese capital market. Although China’s OTC FX derivatives market is equipped with electronic trading platforms with online products that can meet the demands of large customers and some of the small- and medium-sized customers, it’s still faced with such shortcomings as high review and approval requirement, non-transparent quotations, and incomplete customer statistics that cannot be centrally monitored by the central bank. International experience shows that foreign exchange futures market, although relatively small in scale, has an indispensable role to play in serving cross-border securities investors and small- and medium-sized enterprises, price discovery, and supplying liquidity, etc. and is an important supplement to the spot market and the OTC market.
Prudential regulation is crucial to ensuring the stability and sustainability of the FX derivatives market. The administratively oriented “no-speculation requirement” needs to be gradually shifted to a market-oriented risk management principle. Regulators can adopt various measures to effectively contain risks within a certain range, including setting a quota for the maximum speculative transactions, above which proofs for “non-speculation” are required, in the early stage of FX futures market development, adjusting margin requirement, placing limits on open position, trading volumes and banks’ credit lines for futures traders, etc. Further arrangements such as local currency settlement and cash delivery could also help reduce risks. To promote wider use of FX derivatives among businesses, it’s important to improve the accounting system that underpins the FX derivatives market, encouraging more use of the hedge accounting approach among enterprises.
IV. Floating exchange rate and the use of RMB in international transactions
As long as Renminbi can float freely and China continues to develop the existing FX forward market, promote the establishment of FX futures market, and keep aggregate money supply and external debt well under control, the Chinese capital market can gradually open up wider. The opening-up of China’s capital market has been well under way in recent years, although there have been doubts over its substantive progress despite the numerous announced plans and programs. China should elevate the share of foreign capital in its capital market capitalization from the current 2-3% to around 10%, the average level in emerging markets.
China should strive to break the bottlenecks restricting the development of the Renminbi bond market from multiple dimensions in order to open it up further. Policy proposals include further easing of market access, facilitating the issuance of Panda bonds and investment in inter- bank bond market by foreign market participants, and allowing foreign investors to engage in more types of bond transactions such as bond repurchases and participation in the government bond futures market; improving the liquidity and trading efficiency of the bond market through measures such as enhancing the market making mechanism, diversifying the investor base, improving the maturity structure of government bonds, and aligning taxation rules; developing the interest rate and FX derivatives markets to improve the risk management capabilities of market participants; developing accounting, auditing and legal frameworks that are compatible with international standards; improving the default resolution mechanism and reducing on the perception of implicit guarantees; and issuing Renminbi-denominated government bonds and central bank bills in the offshore market on a regular basis.
To further open up the stock market, China should attract foreign investments into the secondary market via channels such as global index investors, the China Stock Connect, QFII and RQFII to increase the share of foreign investors to the average level of emerging markets. Besides, China needs to step up the opening of the international board to attract high-quality companies from developed countries to go public in China to form an international blue-chip board, as well as high-growth businesses from countries of the Belt and Road Initiative and other emerging markets to form an emerging market growth board.
The opening-up of Chinese capital market needs a series of supporting measures. First, improve the bond and stock futures markets and build market-based mechanisms to enable investors to manage price fluctuation risk; second, establish SMSF when the capital market sees large inflows; third, credit ratings, accounting and information disclosure need to follow international standards.
In a world brimming with rigorous and complicated challenges, much wider use of Renminbi in international transactions is not a subordinate target that can be sacrificed, but an urgent major issue related to whether China's economy can effectively alleviate the impact of external shocks.
