The debate on changes to the renminbi exchange rate has continued for many years.

Despite the fact that the central bank's renminbi exchange rate reform initiated from July 21, 2005 has won widespread support from both domestic and overseas financial circles, some continue to call for a further appreciation of the renminbi and a more flexible exchange rate. According to those people (especially those in the US), both China and the United States will benefit if Beijing relaxes its "rigid" currency regime and increases the flexibility of its exchange rate.

In their opinion, this would also accelerate China's transition to a market economy and guarantee the nation's long-term and sustainable prosperity.

China, however, must not show undue haste in the reform of its foreign exchange management regime.

Following the first adjustment to the renminbi exchange rate last July, China still has a trade surplus, a huge foreign exchange reserve and a fast growing economy  factors which require a revaluation of the renminbi, according to some Western analysts. Although foreign pressure for renminbi revaluation eased somewhat in the wake of the adjustment, many people continue to call for a readjustment of the Chinese currency's exchange rate.

Facing this pressure, the Chinese authorities have continued to keep a close eye on changes in foreign exchange markets and have taken initiatives to conduct systematic reforms, after taking into consideration both the domestic and international economic situations.

What many analysts and foreign governments should have noticed is that last year's renminbi reform was not merely an isolated adjustment of the currency's exchange rate, it was a comprehensive reform of the renminbi exchange rate's formation mechanism.

Since last July, a series of systematic adjustments have been made to reform the renminbi exchange rate system. For example, Chinese residents have been allowed to buy more foreign currency and the procedure has been simplified; various risk-prevention instruments and products for enterprises have been launched, such as forward foreign exchange swaps; the floating range between the renminbi and non-US dollar foreign currencies has been widened; renminbi services have been allowed to expand in Hong Kong; the mechanism for channelling renminbi back across the boundary has been strengthened; the market-maker system has been encouraged; and eligible domestic banks, funds and insurers have been allowed to invest overseas.

These measures point to the continued reform of the renminbi exchange rate formation mechanism. The Chinese authorities will closely monitor the operation of the current renminbi exchange rate mechanism to prepare for further improvements to its formation mechanism.

It should be noted that a change in the renminbi exchange rate is not what decides the trade balance between China and its trade partners. In addition, it will not prevent the further growth of China's foreign exchange reserve.

The key factors behind China's foreign trade surplus include a large supply of low-cost labour, in addition to improvements in skills and China's overall productivity and technological level. This surplus is also a consequence of continually falling transaction costs resulting from various institutional reforms.

Given these factors, Chinese-made products will remain internationally competitive for quite some time.

China's fast-expanding foreign exchange reserve is related to its trade surplus to some extent, but the main cause is its underdeveloped financial system and market, which has failed to make use of the capital to hire redundant labourers.

The reform of the renminbi exchange rate regime will be a long-term project requiring progress in the reform of China's overall financial system.

For example, China imposes strict capital controls and splits the foreign currency market from the renminbi market. As a result, while the US dollar's interest rate has been rising continually, the renminbi interest rate has not changed much. The interest rate gap has been widening. According to the general interest rate parity theory, capital should flow from countries with low rates to those with higher rates. However, given the split currency market, Chinese individuals and companies cannot hold US dollars or sell renminbi freely.

This market segregation and the outdated system of exchange settlement and sales not only restricts Chinese individuals', enterprises' and foreign investors' arbitrage, but has led to a worsening of China's balance of international payments and the growth of its foreign exchange reserve.

Therefore, giving the fast-growing foreign exchange reserve and expectations of a revaluation of the renminbi, the issue of the renminbi exchange rate is related to the separated foreign and domestic currency markets. It is of vital importance to establish a unified currency market to further improve our renminbi exchange rate formation mechanism.

On the other hand, while trying to slow the growth in the foreign exchange reserve, we need to reflect on our export and foreign capital introduction policies, such as the export tax rebate policy, favourable policies for foreign investors and the existing capital account regulation.

On that basis, we should take the initiative to make the renminbi an international currency. Issuing renminbi-denominated bonds, for example, can be considered, so the hot money entering China to speculate on renminbi revaluation can be diverted to the renminbi-denominated bond market to alleviate pressure on the Chinese currency. The move would also help unify the foreign and national currency markets and improve the renminbi exchange rate formation mechanism.

It is very difficult to predict how the renminbi exchange rate will fluctuate in the future. Meanwhile, China may continue to suffer from trade frictions with its major trade partners and see a further expansion of its foreign exchange reserves.

Facing those challenges, China is expected to push, in accordance with its own agenda, the reform of the renminbi exchange rate formation mechanism to make it more rational and flexible.

The author Yi Xianrong is a researcher with the Institute of Finance and Banking of the Chinese Academy of Social Sciences.