Renminbi Exchange Rates and Relevant Institutional Factors

In recent years, China has experienced rapid social and economic development. Against this backdrop, growing pressure for renminbi appreciation emerged and China's trade surplus and foreign reserves increased rapidly. This article explains the development of the RMB exchange rate by examining productivity growth and institutional factors, such as the transformation of the foreign exchange rate system and legal reforms to strengthen the hale of law. Development of the Renminbi Exchange Rate On January 1, 1994, China unified the "dual" exchange rate regime into a single one. The official rate before January 1, 1994 was 5.8 RMB per USD and 8.7 RMB per USD after exchange rate unification. Some observers argued that China depreciated the RMB by 40 percent in 1994. However, that argument is a misconception. Before 1994, China was still under the "dual" exchange rate regime, under which 80 percent of the foreign exchange trading volume was at the market rate, and only 20 percent at the official rate. The 8.7 RMB per USD rate was basically the market rate at the end of 1993. During 1993, the supply of foreign exchange mainly consisted of two sources: (1) joint-venture firms that were 'allowed to retain their foreign exchange, and (2) domestic export companies that had excess foreign exchange retained under the foreign exchange retention system. Under the "dual" exchange rate regime, if a firm needed foreign exchange to import, it could obtain foreign exchange through three channels: (1) buy foreign exchange at the market rate, (2) buy a quota from the market and use the quota to purchase foreign exchange at the official rate, and (3) apply for a quota from the State Administration of Foreign Exchange (SAFE) and use the quota to buy foreign exchange at the official rate. The price of a quota was roughly the difference between the official and the market rates. My estimation is that the weighted average of the RMB exchange rate depreciated by 4 percent vis-a-vis the dollar in 1993, compared with the 8.7 RMB per USD as the starting rate of the new regime at the beginning of 1994 (Table 1). The trade surplus in 1994 was very modest, only $5.4 billion. And the trade surplus for 1995-2004 was fairly stable, indicating that the RMB/USD exchange rate was close to its equilibrium level. the appreciation pressure afterward was partly driven by the productivity gains and the institutional reasons explained in this article, and partly by the weakening of U.S. dollar; especially since 2002. Since 1994, China has been promoting market-oriented reform of the RMB exchange rate mechanism. Three stages can be delineated: 1. 1994-96: a single and managed floating exchange rate regime based on market supply and demand. During this period, the nominal BMB/USD exchange rate rose by nearly 5 percent. 2. 1997-2005: after the 1997-98 Asian financial crisis China maintained a stable exchange rate at 8.28 RMB per USD. 3. July 2005-present: China reformed the RMB exchange rate regime by moving to a managed float based on market supply and demand with reference to a basket of currencies. The new system features and expanded floating band, an improved spot rate formation mechanism, the establishment of a forward market, reformed open market operations, and a more market-oriented foreign exchange management mechanism. From July 21, 2005, to the end of November 2007, the RMB appreciated by a total of 12 percent against the USD. According to the Bank for International Settlements, the nominal effective exchange rate index for the RMB increased by 40.9 percent from January 1994 to February 2002, decreased by 13.1 percent from February 2002 to July 2005, and rose again by 2.1 percent from July 2005 to November 2007. The real effective exchange rate index for the RMB rose by 58 percent from January 1994 to February 2002, decreased by 16.5 percent from February 2002 to July 2005, and then rose by 6. …