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On the Renminbi: The Choice between Adjustment under a Fixed Exchange Rate and Adustment under a Flexible Rate

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  • Frankel, Jeffrey

    (Harvard U)

Abstract

Summary of key points: · A fixed exchange rate and a flexible exchange rate each have its own advantages. · A country should have the right to choose the regime best suited to its circumstances. · Nevertheless, the de facto dollar peg may now have outlived its usefulness for China. · China’s economy has recently crossed over into the overheating side of internal balance, and appreciation would help easy inflationary pressure. · A second reason to allow appreciation and thereby reduce the balance of payments surplus is that, although foreign exchange reserves are a useful shield against currency crises, by now China’s current level is fully adequate, and US treasury securities do not pay a high return. · Another reason is that it becomes increasingly difficult to sterilize the inflow over time, exacerbating inflation. · Although external balance could be achieved by expenditure reduction, e.g., by raising interest rates, the existence of two policy goals (external balance and internal balance) in general requires the use of two independent policy instruments (e.g., the real exchange rate and the interest rate). · While a very small open economy might be able to rely on adjustment in the price level, and thus to keep the exchange rate fixed, a large economy like China is better off achieving adjustment in the real exchange rate via flexibility in the nominal exchange rate. · There are other arguments for flexibility as well. The experience of other emerging markets suggests that it is better to exit from a peg when times are good and the currency is strong, than to wait until times are bad and the currency is under attack. · Since May 2004, investors’ demand for emerging market debt has suddenly begun to ease, in anticipation of an imminent period of rising US interest rates. It might be worth waiting to see if China’s balance of payments surplus persists after the tightening of US monetary policy has begun, before further financial liberalization. · From a longer-run perspective, prices of goods and services in China are low -- not just low relative to the United States (.23), but also low by the standards of a Balassa-Samuelson relationship estimated across countries (which predicts .36). · In this specific sense, the yuan was undervalued by approximately 35% in 2000, and is by at least as much today. · Typically across countries, such gaps are corrected halfway, on average, over the subsequent decade. · The correction could take the form of either inflation or nominal appreciation, but the latter is preferable. · These arguments for increased exchange rate flexibility need not imply a free float. China is a good example where, contrary to the popular “corners hypothesis,” an intermediate exchange rate regime like a target zone is more appropriate.

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Bibliographic Info

Paper provided by Harvard University, John F. Kennedy School of Government in its series Working Paper Series with number rwp04-037.

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Date of creation: Aug 2004
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Handle: RePEc:ecl:harjfk:rwp04-037

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  1. Jose De Gregorio & Alberto Giovannini, 1993. "International Evidence on Tradables and Nontradable Inflation," NBER Working Papers 4438, National Bureau of Economic Research, Inc.
  2. Irving B. Kravis & Robert E. Lipsey, 1988. "National Price Levels and the Prices of Tradables and Nontradables," NBER Working Papers 2536, National Bureau of Economic Research, Inc.
  3. Jeffrey A. Frankel, 1992. "Liberalization of Korea's foreign exchange markets," Pacific Basin Working Paper Series 92-08, Federal Reserve Bank of San Francisco.
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  5. Frankel, Jeffrey, 2003. "Experience of and Lessons from Exchange Rate Regimes in Emerging Economies," Working Paper Series rwp03-011, Harvard University, John F. Kennedy School of Government.
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  8. Morris Goldstein, 2004. "Adjusting China's Exchange Rate Policies," Working Paper Series WP04-1, Peterson Institute for International Economics.
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  10. John Williamson, 2001. "The Case for a Basket, Band and Crawl (BBC) Regime for East Asia," RBA Annual Conference Volume, in: David Gruen & John Simon (ed.), Future Directions for Monetary Policies in East Asia Reserve Bank of Australia.
  11. Andrew K. Rose, 2000. "One money, one market: the effect of common currencies on trade," Economic Policy, CEPR & CES & MSH, vol. 15(30), pages 7-46, 04.
  12. Kenneth Rogoff, 1996. "The Purchasing Power Parity Puzzle," Journal of Economic Literature, American Economic Association, vol. 34(2), pages 647-668, June.
  13. Barry J. Eichengreen & Inci Ötker & A. Javier Hamann & Esteban Jadresic & R. B. Johnston & Hugh Bredenkamp & Paul R. Masson, 1998. "Exit Strategies," IMF Occasional Papers 168, International Monetary Fund.
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