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

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. (i) 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. (ii) It may become increasingly difficult to sterilize the inflow over time. (iii) 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). (iv) 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. (v) 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. (vi) From a longer-run perspective, prices of goods and services in China are low--not just low relative to the US (0.23), but also low by the standards of a Balassa--Samuelson relationship estimated across countries (which predicts 0.36). In this specific sense, the yuan was undervalued by ∼35 percent in 2000, and is by at least as much as that today. The study finds that, typically across countries, such gaps are corrected halfway, on average, over the subsequent decade. These six 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. However, the specific changes announced by the Chinese authorities in July 2005 have not yet resulted in a de facto abandonment of the dollar peg (JEL classification: F41). Copyright 2006, Oxford University Press.