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

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  • Jeffrey Frankel

Abstract

Fixed and flexible exchange rates each have advantages, and a country has the right to choose the regime suited to its circumstances. Nevertheless, several arguments support the view that the de facto dollar peg may now have outlived its usefulness for China. (1) China's economy is on the overheating side of internal balance, and appreciation would help easy inflationary pressure. (2) 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. (3) It becomes increasingly difficult to sterilize the inflow over time, exacerbating inflation. (4) 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). (5) A large economy like China can achieve adjustment in the real exchange rate via flexibility in the nominal exchange rate more easily than via price flexibility. (6) The experience of other emerging markets points toward exiting from a peg when times are good and the currency is strong, rather than waiting until times are bad and the currency is under attack. (7) 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. The paper finds that, typically across countries, such gaps are corrected halfway, on average, over the subsequent decade. These seven arguments for increased exchange rate flexibility need not imply a free float. China is a good counter-example to the popular "corners hypothesis" prohibition on intermediate exchange rate regimes.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 11274.

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Date of creation: Apr 2005
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Handle: RePEc:nbr:nberwo:11274

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  1. Morris Goldstein, 2004. "Adjusting China's Exchange Rate Policies," Working Paper Series, Peterson Institute for International Economics WP04-1, Peterson Institute for International Economics.
  2. Holger C. Wolf & Alberto Giovannini & Jose De Gregorio, 1994. "International Evidenceon Tradables and Nontradables Inflation," IMF Working Papers, International Monetary Fund 94/33, International Monetary Fund.
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  7. Dornbusch, Rudiger, 1973. "Devaluation, Money, and Nontraded Goods," American Economic Review, American Economic Association, American Economic Association, vol. 63(5), pages 871-80, December.
  8. Ronald McKinnon & Gunther Schnabl, 2003. "The East Asian Dollar Standard, Fear of Floating, and Original Sin," Working Papers, Hong Kong Institute for Monetary Research 112003, Hong Kong Institute for Monetary Research.
  9. Michael P. Dooley & David Folkerts-Landau & Peter Garber, 2003. "An Essay on the Revived Bretton Woods System," NBER Working Papers 9971, National Bureau of Economic Research, Inc.
  10. Bela Balassa, 1964. "The Purchasing-Power Parity Doctrine: A Reappraisal," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 72, pages 584.
  11. Andrew K. Rose, 2000. "One money, one market: the effect of common currencies on trade," Economic Policy, CEPR;CES;MSH, CEPR;CES;MSH, vol. 15(30), pages 7-46, 04.
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  13. Jeffrey A. Frankel, 1992. "Liberalization of Korea's foreign exchange markets," Pacific Basin Working Paper Series, Federal Reserve Bank of San Francisco 92-08, Federal Reserve Bank of San Francisco.
  14. John Williamson, 2001. "The Case for a Basket, Band and Crawl (BBC) Regime for East Asia," RBA Annual Conference Volume, Reserve Bank of Australia, in: David Gruen & John Simon (ed.), Future Directions for Monetary Policies in East Asia Reserve Bank of Australia.
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