Signs of modest but steady increase in flexibility in Chinese exchange rate regime

Jeffrey Frankel, Shang-Jin Wei, 23 April 2007

The authors of CEPR DP6264 analyse the precise nature of China's exchange rate regime from July 2005 to early 2007 and make some surprising discoveries.

The nature of the regime governing the Chinese exchange rate is a key global monetary issue that bears directly on what may well become one of the key features of international political economy in the 21st century: the rise of China and its likely long-run challenge to the hegemony of the United States. But what do we know about the nature of the regime?
In July 2005 China announced a switch in its exchange rate regime whereby its currency, until then effectively pegged to the US dollar, would instead be pegged to a 'basket' of foreign currencies. The following month, the 11 currencies comprising this basket were revealed. Their weighting, however, and the frequency and criteria with which these weights might be altered were not disclosed.

The authors of CEPR DP6264 analyse the precise nature of China's exchange rate regime from July 2005 to early 2007 and make some surprising discoveries. Of the 11 currencies supposedly in the basket, the only currencies with statistically significant weights over the period are the US dollar (90%) and the Malaysian ringgit (5%). The two major non-dollar currencies, the euro and the yen, receive zero weight in the basket, perhaps an indication that the Chinese authorities are more concerned with preserving trade competitiveness against major Asian rivals than with minimising variability against the world's major currencies or China's most important export markets.

Looking in more detail, they find that in the first six months following the shift to the basket peg, the currency was still in effect pegged to the dollar. Since February 2006, however, some weight in the basket has shifted away from the dollar to other currencies, particularly those of Malaysia, Korean, Russia and Thailand. This has occurred to the extent that if the Korean won and the Malaysian ringgit were to stop appreciating against the dollar, or even to reverse, it is likely that the Chinese currency will also do so.

The authors also find evidence of a slight increase in flexibility in the association between the RMB and the reference currency basket. As the Chinese leaders gradually become more comfortable with the idea, this may be an indication of more to come.

CEPR DP6264 Assessing China's Exchange Rate Regime

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URL: http://www.cepr.org/DP6264
Topics: Exchange rates
Tags: basket peg, China, exchange rate regime