Renminbi Exchange Rate Reform: A Look Back and a Look Ahead

Since China embarked on its reform and opening-up policy in 1979，the renminbi exchange rate regime has undergone a transformation that has taken it from a single official rate to a dual-track system that ultimately gave way to a single market-based rate. There were significant policy milestones along the way and five distinct phases. The following article traces that journey and points to the future path ahead.

01 The Renminbi in a Planned Economy First Phase (1979-1980)

The renminbi's exchange rate against the US dollar strengthened from 1.755 to one dollar in 1977 to 1.534 at the end of 1980，mainly benefiting from dollar weakness. Although the renminbi  was not pegged to the US dollar，the exchange rate had little influence on resource allocation and the currency was largely a tool for financial planning under a centrally managed economy.

02 Dual-track Mechanism Second Phase (1981-1993)

The dual-track phase covered two distinct periods. Between 1981 and 1984，a rate for foreign trade-related internal settlement existed alongside of the official exchange rate. The official exchange rate for the renminbi was 1.5 to the dollar，while the trade-related rate was 2.8 to the US unit. This second rate for trade was designed to encourage exports and earn badly needed foreign exchange. On January 1，1985，the separate rate was abolished and the official exchange rate was brought to the trade-rate level. In November of the same year，the foreign exchange swap market rate was formed. Foreign-funded enterprises and Chinese companies in the special economic zones in Shenzhen，Zhuhai，Xiamen and Shantou were allowed to buy and sell foreign exchange under a "retention quota" at foreign exchange swap centers. The retention quotas were allocated to Chinese exporters as a percentage of the foreign exchange they earned. These foreign exchange transactions were priced according to market supply and demand. Thus，this dual-track mechanism for the renminbi included an administered official exchange rate and a market-determined swap rate. This system was in place from 1985 to 1993.

During this period，the renminbi exchange rate was more obviously affected by China's macro-economic situation，including inflation. The nominal and real effective exchange rates gradually lost ground，ending a period of overvaluation of the renminbi. Meanwhile，the renminbi's effect on resource allocation increased significantly and there was a greater influence on China's trade balance.

03 Unified Renminbi Rate and the Asian Financial Crisis Third Phase (1994-July 2005)

Once again there was an effort to unify different exchange rates. On January 1，1994 the official renminbi exchange rate and the foreign exchange swap market rate were merged. The People's Bank of China (PBOC) began to set a daily reference rate for the renminbi against the US dollar. Trading was allowed within a range of 0.3% above or below the daily reference rate. In accordance with the market-based，managed floating rate mechanism，a series of adjustments to the market framework were made，specifically related to an interbank foreign exchange market and the settlement and sale of foreign exchange.

The reform in 1994 had a number of significant effects. China posted a trade surplus of US$5.39 billion in 1994，reversing a deficit recorded in the first half of the year. Foreign direct investment reached US$33.7 billion，up 22.5% from the previous year. The surplus on the current account coupled with net direct investments stood at 4.8%，5.3% and 8.2% of GDP over the next three years，respectively. The balance of foreign exchange reserves grew from $21.2 billion at the end of 1993 to $105 billion at the end of 1997. This accumulation of foreign exchange buttressed China as it faced the Asian financial crisis in 1997 and helped steady the economy as the country entered the World Trade Organization in 2001.

China was struggling against the effects of the Asian financial crisis between 1997 and 2001. The 1997 crisis erupted in Thailand and then spread to other regional economies. It savaged  regional currencies and roiled global financial markets. Despite the turmoil，China kept its pledge not to devalue the renminbi. Instead，it maintained strict regulation of capital movements and applied a proactive fiscal policy. The policies helped stabilize market expectations and prevented capital outflows. However，there was a downside as the nominal and real effective exchange rates of the renminbi against other key currencies actually climbed 26.3% and 13.1%，respectively，during this period，as the US dollar index surged 34%. This led to considerable deflationary pressure in China.

China's accession to the WTO at the end of 2001 helped the nation's exports and economic development. Loose monetary policies in the US from 2001，when the economy was weakened by the effects of the September 11 attack and the bursting of the dot-com bubble，led to a 33% fall in the US dollar index between 2001 and 2005. This triggered a wave of international capital out of  the US and other developed markets into emerging economies，including China. The ratio of China's current account and net direct investment surpluses to GDP rose from 4.8% in 2000 to 9.8% in 2005. Over that period，the renminbi held steady at 8.27 to the US dollar，the nominal and real effective exchange rates against other key currencies dropped by 17.5% and 19.5%，respectively，returning to the levels of 1994. Expectations of renminbi depreciation were scaled back，and appreciation expectations began to emerge. There were growing voices from the international community，including Japan and the United States，for renminbi appreciation.

04 Renminbi Upswing Fourth Phase (July 2005 - August 2015)

On July 21，2005，China moved to what was officially described as a "managed floating exchange rate regime based on market supply and demand with reference to a basket of currencies." The Chinese currency was revalued by 2% against the US currency，from 8.2765 to one dollar to 8.11，which served as the "central parity" the day after the revaluation. Each day a renminbi central parity rate would be set for the following working day based on that day's closing price instead of the weighted average price in the interbank market. The following day，the renminbi exchange rate could fluctuate against the dollar within a band of plus or minus 0.3% around the central parity.

Following the July 2005 announcement，the renminbi was generally on a stronger path，reaching 6.04 to the dollar in early 2014，although there were modest bouts of depreciation between June 2008 and June 2010. During that period，the renminbi rate moved within a tight band in the aftermath of the 2008 global financial crisis. The renminbi resumed its climb in June 2010 after the PBOC announced that it intended "to proceed further with reform of the renminbi exchange rate regime and enhance the renminbi exchange rate flexibility."   

The ratio of China's current account surplus to GDP was generally in decline as the renminbi strengthened. The ratio fell to 1.5% of GDP in 2013，from a high of 10.1% in 2007. China thereby realized a basic equilibrium in its international balance of payments. 

The PBOC also took other critical steps in this period. The limit on the daily movement of the renminbi against the US dollar was widened in May 2007，April 2012 and March 2014，ultimately to 2% above and below the parity rate. The aim was to change market expectations of unilateral renminbi depreciation，and promote two-way movement in the exchange rate.

05 Two-way Renminbi Movement Fifth Phase (August 2015 to the present)

On Aug 11，2015，the PBOC announced a major improvement to the formation of the renminbi's central parity rate against the US dollar，by taking into consideration the closing rate on the inter-bank foreign exchange market of the previous day. The central parity rate that day was set at 6.2298，down 1.9% from 6.1162 the previous day. In December the same year，China introduced a renminbi exchange rate composite index. The new index，released by the China Foreign Exchange Trade System，was calculated by comparing the renminbi to the average value of 13 key foreign currencies，including the US dollar，the euro and the Japanese yen，which were weighted according to the volume of trade with China from their respective countries. The PBOC noted that this was to keep the renminbi exchange rate basically stable against these currencies. Then in February 2017 and again in August 2018，the PBOC introduced a "counter-cyclical adjustment factor" when setting the renminbi parity rate，and strengthened the macro-prudential regulation of international capital，in order to cushion pro-cyclical movements and avert overreaction in the foreign exchange market.

Since 2015，China has moved to a managed floating exchange rate that Chinese authorities describe as "based on market supply and demand with reference to a basket of currencies." According to this official definition，the factors which determi