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An Urgent Need for a Macro-prudential System to Stabilize Exchange Rates

Feb 04 , 2016
  • Zhang Monan

    Senior Fellow, China Int'l Economic Exchanges Center

The currencies of the emerging economies including the RMB continuously declined at the beginning of 2016, and this is instability is affecting the global financial market. The global exchange rate volatility will apparently increase the risk premium of the global economy. Thus, it is urgent to build a macro-prudential system that can stabilize the exchange rates.

In understanding this round of the RMB fall and evaluating its risks, the RMB exchange rate cycle and the formation of the RMB exchange rate mechanism should be taken into consideration. On the one hand, the RMB exchange rate cycle shows that the Chinese currency has been unilaterally appreciating recently. According to the data of Bank of International Settlements, from the reform of the RMB exchange rate formation mechanism in 2005 to the end of 2015, RMB nominal effective exchange rate appreciated by 40.51% and RMB real effective exchange rate appreciated by 51.04%. At the end of 2014, the RMB real effective exchange rate index was 126.16 and the nominal effective exchange rate index was 121.53 with their annual increase at 6.24% and 6.14% respectively. Among the 61 currencies supervised by the Bank of International Settlements, the increase of RMB nominal and real effective exchange rates ranked first and second respectively and generally still remained stable despite a slight fall in 2015. Based on the FEER statistic model (mainly adjusted for the basic factors such as trade terms, capital flow, tariff level, productivity and government consumption), the current RMB real effective exchange rate has already reached an equilibrium.

On the other hand, the reform process of the RMB exchange rate formation mechanism shows that over the past 10 years, Chinese monetary officials never stopped the reform process. The exchange rate reform began in 2005 and started a market-based and managed floating exchange rate regime with reference to a basket of currencies. The RMB daily floating rate in inter-bank spot foreign exchange rate market was limited within 3/100. Thereafter, the floating range was continuously expanded to 2% in 2007, 2012 and 2014. In 2014, the RMB exchange rate against the US dollar again stepped into a narrow and balanced range. At the same time, Non-Deliverable Forwards (NDFs) presented a continuously upward momentum and a widening gap with the RMB reference rate and the gap expanded by 0.25 in February, 2015.

Especially for the purpose of strengthening the marketization and the benchmark function of the RMB central parity, the People’s Bank of China improved the central parity quotation mechanism of the RMB against the dollar on August 11, 2015. , Now, before the daily inter-bank foreign exchange market opens, the market makers will refer to the closing rate of the inter-bank foreign exchange rate market on the previous day and comprehensively consider the market demand and supply and the exchange rate changes of the major currencies when reporting their central parity quotes to the China Foreign Exchange Trade System. China’s central bank also makes it clear that it will basically withdraw from the normalized foreign exchange rate intervention, will gradually get rid of the mode of relying on the foreign exchange reserves to supply the base currency and advance the monetary pricing autonomy.

However, it is undeniable that the risk of fast and substantial RMB exchange rate adjustments within the short term should cause a high vigilance. On Jan. 1, the central parity of the RMB against the US dollar dropped to 6.5646, the lowest level since March 2011. Besides, the foreign exchange reserves declined by $107.9 billion to $3.33 trillion in December, the lowest level since 2012. The decline of the foreign reserves continuously put pressure on the RMB exchange rate.

The exchange rate fluctuations will obviously increase the risk premium of the global economy. The weakness and the completely floating exchange rates in the financial system intensify the risk exposure for the emerging market countries. The Asian financial crisis was related to the process of financial liberalization. Driven by Washington’s consensus and the IMF, the 1980s and 1990s saw the peak of global capital liberalization. Developing countries represented by Asian and Latin American countries began to make heavy use of foreign funds to develop their economies; at the same time, they did not establish a perfect firewall of capital management and they had very loose capital-flow management. In particular, those countries with a high ratio of foreign debts, a big current account deficit and a shortage of foreign exchange reserves suffered a “macro run” similar to the “bank run” till the financial crisis erupted.

Essentially, since the US is a global center, the expansion and contraction of its currency and credit will be transmitted to the world through finance and trade. Given the strong cycle of the US dollar now, non-dollar currencies certainly will fluctuate sharply. Many peripheral countries have to face Paul Krugman’s The Impossible Trinity – the hypothesis that you cannot simultaneously have a stable foreign exchange rate, free capital movement (absence of capital controls) and an independent monetary policy. A systemic risk like a new round of global currency devaluation and capital outflow could happen. In the past two years, the spree of short-term speculative capital and the RMB arbitrage rose and accumulated a lot of risks, which must not be overlooked. The Chinese monetary authority must tighten control of exchange rate volatility in both the offshore and the domestic markets, must closely watch the impact of the RMB devaluation and a potential chain reaction and must avoid a cliff-like drop of asset price and the large capital outflow. Chinese monetary authority should consider levying a Tobin Tax (an excise tax on cross-border currency transactions), strengthen security on the pre-warning mechanism for capital flow and tighten the capital account control and practice a macro-prudential management so as to really maintain Chinese financial stability and safety.

Globally, the disputes over the national currencies have been a common trouble of all nations. But it more deeply highlights a major deficiency in the global financial and monetary management mechanism. Particularly, under the background of the big global monetary and financial periodic division, it is more urgent and important to establish a new global monetary management mechanism and a more stable global exchange rate structure.

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