Exchange Rate Choices and China's Managed Float

In early 1994，the renminbi's official exchange rate was merged with the exchange rate of the foreign exchange adjustment market，thereby establishing a single managed float system based on market supply and demand. China’s experience stands in contrast to a completely fixed exchange rate or a completely free-floating exchange rate. After reviewing the exchange rate reforms of the past two decades or so，it is clear that a market-based exchange rate is the general objective and exchange rate policy is always about selecting the appropriate approach at the appropriate time.

There has long been much controversy over what constitutes the best exchange rate system and what policies should be applied. The general consensus is that there are advantages and disadvantages to both fixed and floating rate systems. No system fits all countries -- or even certain countries -- all of the time. For the government，a managed floating exchange rate system means foregoing the benefits of the fixed exchange rate or the free-floating exchange rate. At the same time，the government has been criticized for the cost of maintaining an exchange rate under a managed float system.

Over the past two decades，China has set various policies under the framework of a managed float，and there has been no shortage of controversy. During the Asian financial crisis，when Asian currencies depreciated sharply and the renminbi faced strong downward pressure，the West unfairly accused China of setting the stage for the crisis with its first adjustment of the renminbi exchange rate in early 1994. In order to counter this argument while safeguarding domestic financial stability and shouldering some of the responsibility of a world economic power，China chose to prevent the renminbi from depreciating. It held the currency stable at around 8.28 to one US dollar. This avoided further competitive devaluations，making an important contribution to financial stability in Asia and the rest of the world. However，eventually an appreciation of the renminbi against the US dollar and other currencies increased difficulties for Chinese exporters，which aggravated the nation's domestic deflationary trend. Obviously，holding the renminbi steady was the correct policy choice but it came at a price.

After the August 11，2015 exchange rate reform，which effectively devalued the renminbi，China once again faced pressure from capital outflows. At that point，China opted for a managed floating exchange rate，allowing the renminbi to trade in accordance with market supply and demand but with a reference to a basket of currencies. To a certain extent，this eased pressure from an overvalued renminbi due to the past appreciation of the US dollar. It promoted a balanced and reasonable exchange rate for the renminbi，although it brought about certain challenges. As the US dollar continued to strengthen in the offshore market，the renminbi’s exchange rate against the dollar continued to fall on the domestic market. This led to market panic and an acceleration of capital outflows. By the end of 2016，the renminbi exchange rate had weakened beyond seven to the dollar and the nation’s foreign exchange reserves had slipped to only a shade more than US$3 trillion. That prompted heated policy debates over whether to maintain stability in the exchange rate or stabilize foreign reserves.

The insistence on maintaining a managed floating exchange rate revealed a series of problems. But were there no risks in other exchange rate choices? Had the currency been allowed to float in the early stages，a very sharp depreciation would have been highly likely. Before the economy stabilized，it was difficult to predict when the renminbi exchange rate would touch bottom. Moreover，renminbi depreciation would have led to competitive devaluations，incurring more trade protectionism against China. That in turn would have triggered panic buying of foreign exchange on the home market，threatening the security of the banking system and causing other unforeseen risks.

There is no perfect solution to the exchange rate problem. The key is determining the target as soon as possible. In addition，the tools must match the target. We should not hastily conclude that advantages outweigh disadvantages or that risks are always controllable. Instead，it is necessary to focus on the risks that each option may present，by preparing the corresponding plans on the basis of scenario analysis and stress testing.

It is impossible to extract only the advantages when dealing with the impact of capital flows. When there is an imbalance of supply and demand on the foreign exchange market，it is necessary to let the currency appreciate or depreciate，and it may be necessary to use foreign exchange reserves to intervene in the market or strengthen capital flow management. In reality，it is impossible to maintain the exchange rate as well as reserves，and to continue the free cross-border flow of capital at the same time. The author calls this the "impossible triangle of foreign exchange policy."

During the Asian financial crisis，China chose not to depreciate the renminbi，and not to use up foreign exchange reserves to maintain exchange rate stability. Instead，it dealt with potential capital outflows by strengthening and improving foreign exchange management，including cracking down on under-reporting of exports and import fraud，as well as limiting the use of foreign exchange under the capital account.

After the exchange reform of July 21，2005 and the return of the renminbi exchange rate system to a managed floating rate，China adopted the following measures to deal with the impact of capital inflows. First，it worked to maintain the basic stability of the renminbi at a reasonable and balanced level. Eventually，the renminbi exchange rate against the US dollar began to improve gradually. Second，China worked to accumulate foreign exchange reserves in accordance with the pool theory by absorbing excess capital inflows. At the end of 2006，after making clear that China did not aim to pursue endless increases in its foreign exchange holdings，reserves still reached nearly US$3 trillion. The idea of controlling capital inflows and stepping up outflows gained support and this improved capital flow management.

Since the second quarter of 2014，and especially after the 2015 exchange reform，China experienced a long period of capital outflows. In response，China adopted a three-pronged approach. Because it had long been judged that China had sufficient foreign exchange reserves，the reserves were used as an intervention tool to bridge the gap between foreign exchange supply and demand. After the 2015 reform，market adjustments took on a bigger role，though there was a reference to a basket of currencies. The currency fluctuated inversely against the US dollar as the dollar index changed. When both the intervention and the exchange rate adjustment were not sufficient to reorder the market，China began to adjust its capital flow management policies. Especially in late 2016，the management of capital outflows was strengthened step by step，and in the process more time was gained for reform. In 2017，overseas investments of enterprises became more rational and there was a total surplus from the current account and direct investment. Foreign exchange reserves，adjusted for valuation changes，were no longer falling. This resolved the risks from capital flows，which safeguarded China’s national financial security.

The three policy instruments of exchange rate adjustment，reserve intervention and capital management are neither intrinsically good nor bad. The key is to make policy objectives clear and thus select the appropriate policy tools. Certainly，it is imperative that we pay attention to the details in managing capital flows and meet our international obligations. Meanwhile，exchange rate management buys time for reforms，but it should not be seen as a substitute for reform. Some management measures must be temporary. When the situation improves，these measures should be withdrawn in a timely manner. And that is when China should return to policy neutrality.

Credibility — the Key to Success

After the 2015 exchange reform，the mechanics of the mid-price quotation mechanism were disclosed in a move to boost transparency. This improved communication between the central bank and the market，and there were clear benefits as a result. In the second half of 2016，for example，when the renminbi fell against the US dollar，the negative impact on sentiment was less pronounced than in the past. The market understood that the weakening of the renminbi was due to a strong US dollar instead of a "currency war." Nevertheless，because nearly 90% of China's cross-border foreign currency payments were in US dollars，the significant decline in the exchange rate still had an impact on sentiment.

The key to successfully maintaining the stability of the renminbi exchange rate in 2017 was to reshape the credibility of the government role in the market. At the end of May，the counter-cyclical factor was introduced into the mid-price quotation mechanism to offset pro-cyclical behavior of the foreign exchange market. This was done to better reflect domestic economic fundamentals and take the initiative in determining exchange rate direction. In the context of the market betting on renminbi weakness and with foreign exchange in short supply，the renminbi actually appreciated by more than 6% against the US currency，aided by a stabilizing domestic economy and the unexpectedly weaker US dollar. During the same period，foreign exchange settlements by enterprises increased substantially，purchases of foreign exchange remained basically stable，and foreign exchange supply and demand were largely in balance. At the same time，the goal of securing foreign reserves was successfully achieved. Utimately，