Yi Gang, deputy governor of the People's Bank of China (PBOC) and administrator of the State Administration of Foreign Exchange (SAFE), recently accepted an interview with Hu Shuli, executive editor-in-chief of China Reform. The interview, published in issue no. 8 (2010) of China Reform and appearing on www.caing.com, is presented here as follows.
The Best Choice for the RMB Exchange Rate Regime
Ultimate Goal and Timetable
Hu Shuli (hereinafter referred to as Hu): On June 19, 2010, the Peoples Bank of China announced the decision to further the reform of the RMB exchange rate formation mechanism on the basis of the 2005 reform. Why now? What do you think of the achievements that the exchange rate reform has made so far?
Yi Gang (hereinafter referred to as Yi): Chinas exchange rate regime is a floating one, which is based on market supply and demand and subject to adjustment and management against a basket of currencies. In fact, this is the best choice at present for the Chinese socialist market economy. How have we arrived at this conclusion? The reform of the exchange rate regime began in 1994, when exchange rates were unified on January 1 and the foreign exchange market was established soon thereafter. From 1994 to 1996, the RMB fluctuated in both directions and appreciated by about 5 percent, from 1: 8.71 to 1: 8.28 against the USD. Then, after the outbreak of the Asian financial crisis, as the Thai Baht and the Korean Won experienced huge depreciations, China refused to devalue the RMB, resulting in a stable 1: 8.28 from 1997 to 2005. We still believed in the benefits of the exchange rate reform and that a managed floating currency is the right exchange rate mechanism for China, but the existence of inertia or path dependencemade reform very difficult. Then, on July 21, 2005, the reform started again and we had three years of fluctuations up until 2008.
During this period, the RMB was in fact subject to two-way fluctuations and followed the direction of the currency basket. But in 2008, a series of events occurred, including the outbreak of the sub-prime mortgage crisis.Soon thereafter Bear Stearns went under, and Lehman Brothers declared bankruptcy on September 15, 2008, pushing the financial crisis to a climax. From then on, the RMB remained near the level of RMB 6.83 against the USD, with minor fluctuations, until June 19 of this year, when we again launched the RMB exchange rate reform.
Looking back on history, it is clear that we have never lost sight of this mechanism; we were just interrupted by the outbreak of the crisis and other factors. Nevertheless, this is the best choice for China, a choice that we should uphold.
Hu: What is the ultimate goal?
Yi: Our ultimate goal is to make the RMB a convertible currency. This is the goal that was made in the fall of 1993, at the Third Plenary Session of the 14th CPC Central Committee.
Hu: What is the relationship between a convertible RMB and its exchange rate? Is its free convertibility based on free floating? Or is the RMB freely convertible under a managed floating exchange rate mechanism?
Yi: This question can be very theoretical. Usually a convertible currency has a freely floating exchange rate.
At the Bretton Woods Conference, it was agreed that the major currencies would be pegged to the U.S. dollar, which in turn was pegged to gold at US$35 per ounce. This in fact was a fixed exchange rate system. But when the Bretton Woods system collapsed in the 1970s, the peg to gold was abandoned along with the fixed exchange rate system. In theory, convertible currencies should have a floating exchange rate because the mechanism for a floating exchange rate can act as a stabilizer for the convertible currency. In other words, the float ensures its convertibility. If the USD is always pegged to gold, it is impossible to achieve convertibility between the two. In contrast, if the USD is floating, sustainable convertibility can be achieved.
Another extreme example lies in the Currency Board system practiced in Hong Kong and other regions. It is a special arrangement that gives the Currency Board no power to effect monetary policy. It can only be implemented in a small and fully open economy, and should be considered an exception that proves the rule. Generally, a convertible currency should have a very flexible exchange rate mechanism. A relatively developed country, or a mature emerging economy, should eventually choose to exercise monetary policies independently and to ensure the free flow of capital. To do so, it has to eliminate the fixed exchange rate. That is the case in the U.S. and in the Euro Zone, where the USD and the Euro are allowed to fluctuate widely according to the market situation.
Hu: When can the RMB become convertible? Is there a timetable?
Yi: We dont have an official timetable for RMB convertibility in China. But according to an IMF study, for an average country, it takes about 7 to 10 years to transition to capital account convertibility from current account convertibility, which China achieved in 1996.
Now, 15 years later, China still hasnt achieved capital account convertibility, and we do not have a timetable. People can make their own judgments based on international practices. The main reason is China is too big and our development is too uneven, which makes the problem very complicated and it is difficult to achieve a consensus.
Hu: In terms of currency appreciation, we all know that there are both external pressures and domestic needs. Comprehensively, what are the reasons that the RMB still cannot have a floating exchange rate?
Yi: What really makes a currencys exchange rate float is the real effective exchange rate, which can be altered in two ways. The first is to adjust the nominal exchange rate, and the other is to increase domestic prices. In face of appreciation pressures, we do not have to adjust the nominal exchange rate because inflation can change the real effective exchange rate.
Both methods have been used by China in the past decade, with adjustments in both the nominal exchange rates and prices. The surge in the housing prices is a good example.
Hu: Now after several rounds of exchange rate reform, peoples expectations of a RMB appreciation should be pretty low now. Do we still need to continue the adjustment via inflation?
Yi: It is safe to say that the pressure has weakened. In the recent decade, housing prices have gone through the roof in Beijing and Shanghai. In fact, commodity prices as a whole have greatly increased. These price hikes are actually adjustments against imbalances. Ten years ago, if you converted USD into RMB and bought property in China, you could make a lot of money, but now it is no longer a very lucrative deal. The same is true for other assets. All these indicate that, compared with ten years ago, the RMB exchange rate is now much closer to an equilibrium level.
Now, the exchange rate is not likely to fluctuate sharply and we are in a position to maintain a flexible exchange rate regime and to keep the exchange rate stable at a reasonable level of equilibrium.
Every coin has two sides. The constant increase in labor productivity in China has determined the overall trend in currency value. Under such a trend, appreciation can curb inflation; a bit more appreciation would mean a bit less inflation. So if the nominal exchange rate remains the same, the result will be more inflation. Some might argue that the Chinese people do not need imported goods, so a RMB appreciation will result in no benefits. This is wrong. Take soya beans as an example. Over half of the soya beans consumed in China are imported, and bean products are in high demand. Even soya bean pulp is needed to breed pigs, which means soya beans are somehow related to pork prices. If the RMB does not appreciate, then the prices of soya beans, bean oil, and bean pulp will be at least 20 percent higher than they are now. At present, these soya products are becoming very expensive on the international market, but the price increase is not that apparent in China. Why? Because the RMB has gone up and soya prices are mostly calculated in USD. It is the same for crude oil and iron ore, which, believe it or not, are also closely related to every household. So a currency appreciation can control imported inflation.
In addition, many Chinese people travel abroad or send their children to study overseas. They are also the beneficiaries, but they are the silent majority.The small number of people who do not gain from the RMB appreciation mainly work in the export industry. They are the ones who complain loudly that they will lose their jobs and their lives will become miserable.
Before the exchange rate reform in 2005, the relevant department made an that the cost was RMB 8.11 for state-owned enterprises and RMB 8.07 for private enterprises. If the cost is higher than the exchange rate, then the enterprises will suffer losses. If that were the case, when the RMB exchange rate jumped to RMB 8.11 on the first day of the launch of the foreign exchange reform in 2005, export enterprises would have had massive losses. But during the period from 2005 to 2008 since the reform, Chinas exports have been growing at an annual rate of over 20 percent. In other words, the adjustment of the foreign exchange rate did not hurt exports; on the contrary, during these years, exports witnessed substantial growth, along with industrial upgrading, technological progress, product upgrading, and the increase of added value of Chinese products.
So we should view this question dynamically. The government is trying all methods to formulate sound policies and to create an enabling environment. For example, instruments for hedging and forward settlement and sales of foreign exchange are offered to help import and export enterprises to hedge against risks.
Another misconception is that a RMB appreciation means losses in our foreign exchange reserves. In 2007, when the RMB was appreciating very rapidly, some observers said that the loss of foreign exchange reserves in one quarter would be worth one aircraft carrier. Now, we have 2.45 trillion USD in foreign exchange reserves (equivalent to more than RMB 16 trillion). With the RMB going up, the foreign exchange reserves, in RMB terms, would appear to be less in number, but that does not mean the money is gone. We would suffer some losses if we were to convert the foreign exchange reserves from USD to RMB, but we havent converted yet, so there is no such loss. Such a calculation is conversion on book value only.
If such a calculation has to be done, we might as well do the math by calculating how much we will have earned if all RMB assets are put into USD. Take the financial and housing assets in China as an example; the total value of those assets would be RMB 200 trillion (over ten times that of the foreign exchange reserves). If the RMB appreciates and these assets are marked in USD, we can gain at least ten aircraft carriers. But of course, the truth is we neither gain nor lose.
Hu: Thats right. They did not take into account the RMB assets. In addition, Chinese peoples savings can increase in value as well.
Yi: Right, so we have to look at the issue comprehensively. Right now, we have neither gained nor lost anything. It is the different reporting currencies that are creating the different impressions. Of course, inflation in the U.S. can lead to weakened purchasing power of Chinas foreign exchange reserves. That can be considered a loss, but over the years, the rate of return of foreign exchange reserves has always been higher than the rate of inflation in the U.S.
Hu: The abnormality of the foreign exchange rate would exert pressures on resources and the environment. Can you elaborate on that?
Yi: If the nominal exchange rate is distorted, there would be a series of consequences. The foreign exchange rate is a price, and its distortion would definitely lead to the distortion of resource allocations. We have always emphasized the importance of expanding domestic demand. If the foreign exchange rate is distorted, foreign demand would be more lucrative, and enterprises would not try to expand domestic demand. Therefore, the distortion of the foreign exchange rate hinders the expansion of consumption and growth of the services industry.
Hu: In face of the inflationary pressures, it is suggested that we should increase the interest rate, but can it replace the leverage of the foreign exchange rate?
Yi: The interest rate represents the price of capital, whereas the foreign exchange rate is the ratio of the price of one currency against other currencies. These two are interchangeable in very limited ways, and there is always the question of how far away they are from the point of equilibrium. This can trigger endless arguments, because no one knows exactly where the point of equilibrium is. In theory, it is determined by supply and demand. In the best-case scenario, both the interest rate and the foreign exchange rate are close to the point of equilibrium.
If the interest rate is increased, the currency will be stronger. Recently, many currencies have increased interest rates, but the USD, the Euro, the Japanese Yen, and the Pound have not. Foreign exchange rates and interest rates have different roles to play, so it is better that they fulfill their respective functions.
Hu: The long-term fixed exchange rate has caused a certain degree of distortion. Now the exchange rate is being changed to a floating rate. At present, aside from the mind-set problem, the greatest threat perhaps comes from speculative attacks?
Yi: Yes. So, we should continue to decrease these risks. As the market plays a greater role, it will be less lucrative to speculate on the foreign exchange rate. By then, people will give up speculation.
Hu: The foreign exchange reform has been interrupted repeatedly. Is the progress a bit too slow?
Yi: China is a big developing country. In the past three decades, China has created an economic miracle in the history of mankind. In this sense, Chinas macroeconomic policies have changed track. There might be some criticism concerning the degree of marketization or the delay of reform, but from 1994 to the present, China has maintained a high growth rate. In addition, since the 1994 inflation, so far we have not experienced another big inflation.
On the whole, Chinas macro-economic policies are almost optimal. Indeed, we have been interrupted many times, and some might even think that the foreign exchange reform is not occurring fast enough. This question is open to discussion and reflection, but it is fair to say that our macro policies are generally successful.
Hu: Why did the government choose the present time to recover the elasticity of the foreign exchange rate? Is it because it is less risky now, or because there are greater external pressures?
Yi: China has made this decision mainly based on domestic considerations. It is an independent decision. Like I said, during the global financial crisis, the exchange rate was stable for a while. In fact, the crisis is not yet completely over, as is evidenced by the European sovereign debt crisis this year, but the overall picture is much better than before. As the crisis is receding, our growth rate increased last year from 8.7 percent to 9.1 percent. For the U.S., Europe, and Japan, 2010 is also widely predicted to be a year of recovery. Given the domestic and international background, I think now is the ripe time to recover the elasticity.
Hu: But how do we evaluate the role of the foreign exchange rate reform in the external imbalance?
Yi: Foreign scholars use their own framework to analyze the issue, and they believe that the foreign exchange rate is an important factor for rebalancing. In fact, as history has shown, the foreign exchange rate is indeed important, but it is not a decisive variable, which is very clear if you look back at the history of Japan and Germany. The appreciation of the Japanese Yen and the German Mark in the 1970s and 1980s did not lead to the immediate disappearance of the trade surplus in Japan or Germany. This might be true in China as well. But this question is very tricky because of a reverse question: If Chinas trade surplus cannot be adjusted even when the RMB appreciates, then is appreciation all good and no bad? Think about it, if the RMB appreciates, I can buy foreign goods very cheap; and if even then, my trade surplus cannot be cut, I have all the benefits, right? This is a tricky question.
How to become a rule-maker?
Hu: Can China become a rule maker?
Yi: This is a huge question. We have always stressed the importance of taking part in the making of international rules. Who makes the rules for the so-called international monetary system? Apparently, major developed countries, especially the U.S. Then how did the U.S. become a rule maker? It was because the US dollar market is open, and it is the main theater for the global financial market. Naturally, whether for stocks or bonds, the rules shall be made by the authorities in charge of those markets, i.e., the U.S. and Europe. We are not yet a rule-maker, but as long as we open up the market and allow foreign players access to our turf, the Chinese monetary and regulatory authorities will then have every right to make our own rules. That is for sure.
Hu: I recently interviewed Russia's first Deputy Prime Minister Igor Shuvalov. He said that sooner or later the RMB will become a reserve currency, whereas the Russian ruble will at most be a regional currency. What do you think?
Yi: We cannot be too complacent. It will do us harm. China is still a developing country. We should bear in mind our limits.
Hu: Then is it possible for the RMB to become a reserve currency? Does the world need it?
Yi: This compliment is half flattery, half prediction. We should be modest and prudent, and keep a low profile. If the RMB is chosen by other countries to be a reserve currency, we will let it happen, because it is market demand. But we are not going to push it. I think the best way is to let things run their own course. We must not take the flattery too seriously; in fact, the RMB is still far from being a reserve currency.
Hu: Are reserve currencies chosen naturally by the market? Or do we need governments to decide which should become a reserve currency? Or is it a bit of both?
Yi: For a currency to become a reserve currency, the first most important factor is the economic strength of that country or confederation; the second is its cultural cohesion and influence; and the third is political and military power.
Economic strength is the deciding factor. As to culture, it is important to have an influential culture, whose core values will be widely accepted by other countries and regions. A reserve currency must be backed by a powerful culture and influential value system.
Do not underestimate the resilience of the US and Europe
Hu: Two years ago, in the midst of the financial crisis, many people, including some Chinese, underestimated the USD and overestimated Euro. Now, the outbreak of the recent European debt crisis seems to prove that Europe cannot be overestimated either. In the past, investors ignored the problems of the U.S.; now, they have gone from one extreme to another.
Yi: Let me just talk about Chinas foreign exchange reserve investments. We have always insisted upon the diversification of our foreign exchange reserves, on the two levels of currencies and assets. In terms of currencies, we diversify our investments across all major currencies, such as the USD, the Euro, the Japanese Yen, the Pound, and the currencies of the emerging economies. For each currency, we have to decide whether to buy bonds or other assets in order to achieve asset diversification. Back to your question, in fact, we have not underestimated the USD or the Euro. But the massive size of our reserves makes it impossible for adjustments to be made promptly. Diversification, as we have insisted upon, is in fact an asset allocation principle.
Then how is the asset allocation principle determined? It is determined by Chinas real economy, to be specific, the proportion of trade, FDI, and account settlement in Chinas real economy.
Hu: China seldom makes comments on specific investments of its foreign exchange reserves, but regarding the recent development of Fannie Mae and Freddie Mac, the authorities seem eager to make their attitudes known to the public. Why are Fannie Mae and Freddie Mac so important?
Yi: They are important because of their vital role in Americas housing market and in the stability of the financial market. Shortly after the outbreak of the sub-prime mortgage crisis, the U.S. government still relied upon these two institutions to alleviate the crisis, but as the crisis deepened, these two organizations collapsed and were taken over by the U.S. government. Now the U.S. Treasury as their biggest shareholder owns about 80 percent of their shares. Recently, they were de-listed from the NYSE, but this does not constitute a negative impact on their securities. The recent announcements were made by the State Administration of Foreign Exchange to help the public understand that the foreign exchange reserve assets are safe and our management is effective.
Hu: After the financial crisis, both Europe and the U.S. made some adjustments and changes. What do you think of their ability to recover?
Yi: I think they have strong resilience and should not be underestimated. The U.S. financial regulatory reform bill, recently signed into law, marks another milestone after the Glass-Steagall Act of 1933, and the Financial Services Modernization Act of 1999 signed by former President Clinton represents a reflection of the past several decades, especially the recent round of the financial crisis. Aside from the U.S. bill, there is also a new roadmap for a financial regulatory framework drawn up by Britain, and a series of financial regulatory standards formulated by the Financial Stability Board under the G20, the IMF, the Basel Committee, and the Bank for International Settlements. All these have formed global financial regulatory standards and a framework for the coming decade or even longer. Under such a regulatory framework, their capacity to recover is relatively strong and the speed is relatively fast.
Europe has made many contributions to the establishment of an international financial regulatory framework, but, of course, the U.S. is leading the way as it passed the regulatory reform bill.
Hu: Recently, I interviewed Michael Evans, vice chairman of Goldman Sachs. He said that Goldman Sachs is prepared to adjust its strategy. In fact, Wall Street is still resistant to the U.S. financial regulatory reform bill, but Goldman Sachs will adjust its position and embrace the reform. It has set up the Business Standards Committee, which, after investigation and research, has come up with concrete measures to change its business behavior. When talking about the lawsuit against the U.S. Securities and Exchange Commission, he said that although the case has a political bias, we must admit that we made mistakes too. Judging from his attitude, there is a possibility of mediation, but he emphasized that mediation does not mean the end, and Goldman Sachs still needs to adjust its business behavior. But from another perspective, since the financial reform bill has been spoken so highly of, why is it so difficult to implement? Why is the Republican Party so vigorously opposed to the bill?
Yi: The difficulties stem from conflicts of interests. The bill used to contain clauses that harm the interests of investment banks and commercial banks, but they have been watered down now and compromises have been made. On the whole, I think this bill is positive, and the prompt adoption of this bill is so much better than no action at all. Uncertainty would accumulate if no measure were taken. Now the launch of the bill ends the suspense, stabilizes market expectations, and can restore the market to normalcy.
Be Realistic about Chinas Economic Growth
Hu: I have a question about the macro economy. Do you think there is a big chance of a Double Dipin the world economy?
Yi: The short answer to this question, as far as I see it, is no. But a precise explanation depends on the definition of Double Dip. This year, the U.S. economic growth rate hopefully will be 2.5 percent to 3.5 percent. In Japan, the growth rate will be above zero, probably even above 2 percent; as to Europe, possibly 0.5 percent to 1.5 percent. No one would call this a Double Dip,but there are still many uncertainties, considering the worrying situation in the U.S. housing and job markets.
Hu: Chinas economic growth rate was 11.1 percent for the first half of 2010. Will it drop in the future?
Yi: For the whole year, the growth rate could reach 9 percent, which is fairly high already. Perhaps we are a bit too obsessed about high growth rates. I hope to see a more moderate approach, which can help extend the long-term growth of the Chinese economy. China has now become the second largest economy in the world. As our economic base expands, growth rates will definitely slow down. In addition, the environmental constraints have reached a bottleneck, with a host of problems concerning underground water, air, and carbon emissions. There are also resource restrictions, including the import of energy. Based on the above reasons and the general rules of economic development, there is no doubt that there will be a slowdown in our economic growth.
In the three decades after the launch of the reform and opening up, Chinas average GDP growth rate exceeded 9.5 percent. In the first decade of the new century, the rate was over 10 percent. For the second decade, I would say an average growth rate of 7 percent to 8 percent is good enough. The question is whether we can sustain such a growth rate. If in the third decade, we manage to grow at 5 percent to 6 percent, then we would have had 50 years of rapid growth, an unprecedented feat in human history.
In fact, the problem of Chinas economy lies in the quality of its growth. That is why we have been restructuring and transforming patterns of growth; we are trying to improve the quality and effects of economic growth. We should adjust our mind-set; being too impatient doesnt help.
