By Xia Bin & Chen Daofu, Research Institute of Finance of DRC

Research Report No 159, 2010

I. Choosing Exchange Rate Regime Is Essentially Choosing Monetary Stability Regime

The monetary performance of a nation is finally determined by four external financial variables including monetary policy, financial supervision, microscopic behavior and exchange rate, not just by the monetary policy alone. The two main influence factors to monetary performance of China are exchange rate regime and capital account management resulting from external economy and finance. As the exchange rate regime being the core component of monetary regime, the choice of exchange rate regime would be influenced and restricted by monetary stability regime. And it is required that the exchange rate regime has the quality of the monetary stability regime, so that the exchange rate of one currency against another foreign currency could be defined and maintained according to relevant regulations. And thus the international trade and financial activities shall be promoted.

From the historical perspective of international monetary and financial development, the exchange rate regime was developed from the monetary regime. During the period of noble metallic standard regime, the currency had its intrinsic value and the par value of exchange possessed endogenous stability, so obviously the exchange rate regime was endogenous fixed exchange rate regime and the world paid little attention to the choice of exchange rate regime. After the First World War, owing to the gold and foreign exchange control imposed by various countries, the international gold standard fixed exchange rate regime completely collapsed, and then the international monetary regime and exchange rate regime entered a turbulent period.

The exchange rate regime is one of the important regimes connecting the economy of a nation with external economies. Only when the monetary stability is ensured, can there be a solid foundation and relevant significance for the fusion of money and financial markets of a nation with external ones and their expansion. Choosing between fixed exchange rate regime and floating exchange rate regime is actually choosing monetary stability regime. And the stability is basically determined by the government's weighing of currency value stability, full employment and the goal of balance of payments equilibrium, as well as the confidence level of market to the weighing. The Revolution of Economic Policies: Retrospection and Rumination by Robert Mundell concludes through detailed analysis that policy options are made not just through simply choosing the fixed exchange rate regime or floating exchange rate regime, but through choosing the norms of various currencies. Under different exchange rate regimes, various countries have different transmitting regimes in economic cycles, and thus the degrees of freedom and urgencies in choosing stable economic policies are different.

To be specific, under fixed exchange rate regime, the stability of currency is achieved by virtue of currency value stability (in gold standard regime, the price of gold) of key currencies (such as international major reserve currencies) of a responsible major economy; while under floating exchange rate regime, the stability of currency is achieved by virtue of other regimes including monetary standard (by Milton Friedman), commodity standard (by Thomas Attwood, Irving Fisher or Frank Graeme) and salary standard (by Robert Mundell) (i.e. self-support of currency).

II. Managed Float: Choice in the Strategic Transitional Period

In the context of international monetary regime, the current international monetary regime is a market-oriented loose regime with U.S. dollar, Euro, pound and yen as major reserve and settlement currencies, exchange rates between major currencies floating freely and free choices of reserve currency, exchange rate regime and exchange rate regulatory mechanism among various countries. Meanwhile, it can be expected that in the next 10, 20 or even 30 years, there will be no fundamental changes in the basic pattern of “one key currency and multiple secondary currencies” related to the international monetary regime. But the power of key currency U.S. dollar (accounting for about 65% of the world's current reserve currencies) is relatively weakening, and the strength of secondary currencies including Euro, yen and pound is improving. The content of multiple secondary currencies is being enriched. Renminbi, or even the expanding SDR and other currencies shall be added to it. Thus, the contest for dominance in the international monetary regime shall become increasingly fierce and obvious. It indicates that common and effective coordination of monetary exchange rates of various countries shall still be hard to achieve, exchange rates between the world's major currencies shall be more turbulent, and uncertainty of the future of world economy shall increase.

From the aspect of China's constantly developing economy and finance, China is a major economy with a large population, and has formed close links with the world economy and become more market-oriented. As long as China keeps on with its effective reform and opening up, its economy still has great potential to maintain relatively rapid growth in the globe in the next 10 years. But the future growth pattern will face totally different challenges from those in the past. The economic growth shall have to be converted from extensive and export-oriented growth to intensive and domestic-demand-oriented growth. The domestic financial industry develops slowly, and the market-oriented reform of economy and democratic reform have not been achieved yet. On the one hand, there is an urgent need for further participation in the financial globalization for the sustainable economic development of China; on the other hand, "path dependence" and the complex reality determines that in the global environment of increasing economic uncertainties, attention shall be paid to the security of state finance and economy with further participation in the financial globalization, and the financial globalization is bound to be finite.

In this foreseeable environment, simply choosing the strict fixed exchange rate of single currency peg or selecting a fully floating exchange rate (polar solution), shall not be in the interests of China. Currently, it isn't suitable for China to carry out the strict fixed exchange rate regime, nor is China qualified to act as the key international currency economy to adopt the fully floating exchange rate regime. In the strategic transitional period, Renminbi still needs to take advantage of key currencies such as U.S. dollar to become an important currency in Asia.

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