Adjusting China's Exchange Rate Policies

In this paper the author argues that China's exchange rate policy is seriously flawed given its current macroeconomic circumstances and its longer-term policy objectives. The main conclusions are the following: (i) the RMB is significantly under-valued; (ii) China has been "manipulating" its currency, contrary to the IMF rules of the game; (iii) it is in China's own interest, as well as in the interest of the international community, for China to initiate an appreciation of the RMB soon; and (iv) China should neither stand pat with its existing currency regime nor opt for a freely floating RMB and completely open capital markets. Instead, China should undertake a "two step" currency reform. Step one would involve a switch from a unitary peg to the US dollar to a basket peg, a 15-25 percent appreciation of the RMB, and wider margins around the new peg. Existing controls on China's capital outflows would be either maintained or liberalized only marginally, at least in the short run. Step two, to be implemented later when China's banking system is considerably stronger than it is today, would involve a transition to a "managed float," along with a significant liberalization of China's capital outflows.