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China's Key Exchange Rate Regime and Reform Direction

China's exchange rate regime and reform direction

The People's Bank of China announced its plan to enhance the RMB exchange rate flexibility by further strengthening reform of China's exchange rate regime on June 19, 2010. (In fact, China abandoned the dollar peg and has moved back into a managed floating exchange rate regime with reference to the Multiple Currency Basket Peg System which took effect in July 2005.)
China's current managed floating exchange regime is a 'limited floating exchange system' which reflects the following three variables at the same time : market supply and demand, Multiple Currency Basket Peg System and the government's intervention
As the Multiple Currency Basket Peg System or effective exchange rate is expected to play an important role in determining basic rate in the future and daily fluctuations in exchange rates has become wider, the appreciation of the RMB exchange rate is expected to continue, but the rate will further move both up and down

China's foreign exchange market related policy and reform direction

Under the Residual Foreign Exchange Distribution System implemented before 1994, the government determined a residual portion of foreign exchange for exporters and
non-exporters and allowed the Foreign Exchange Distribution Center at a designated area to distribute a residual portion of foreign exchange. China's real foreign exchange market has been promoted since 1994 when the Inter-bank Foreign Exchange Market System was introduced
The foreign exchange market means an inter-bank foreign exchange market. The market players are foreign exchange banks. The key function of the foreign exchange market is to adjust shortages and surpluses of foreign currencies for foreign exchange banks through sales and purchase of foreign currencies
China's current foreign exchange market has been significantly developed based on the "Inter-bank Foreign Exchange Regulations" and " Regulations on Foreign Exchange Market Trading for Chinese Foreign Currency Trading Center" promulgated in 1996. However, The market is still immature because there are many limitations on qualification for market players and trade scope and only 8 foreign currencies are traded
However, qualification for market players, trade scope and the number of products and foreign currencies traded in the market will expand in the future and a foreign exchange broker system will be introduced

RMB trade settlement system

Chin's trade settlement was carried out mainly in US dollar before the global financial crisis. RMB trade settlement was available only in Japan. However, China has tried to expand RMB settlement in cross-border trade since 2000
Five cities including Shanghai and Guangzhou launched a pilot program on renminbi
cross-border settlement in trade with Hon Kong, Macao and ASEAN members in April, 2009. In June, 2010, the program covered additional 18 provinces and the pilot program was no longer restricted to Hon Kong, Macao and ASEAN members
The RMB trade settlement is carried out through RMB clearing banks in Hong Kong or Macao, or commercial banks in China Ultimate goal of China's exchange rate regime reform: To make the yuan a fully convertible currency
Liberalization and marketization play an important role in the foreign exchange market. China set the ultimate goal of its exchange rate regime reform to make the yuan a fully convertible currency since early 1980s when market economy system was introduced in China
The ultimate goal implies making the he yuan a fully convertible currency in both current transactions and capital transactions. To achieve this goal, adequate level of foreign exchange rate, sufficient international clearing capabilities, sound financial and monetary policies and stable macroeconomic environments are required
When China had been proceeding with such reform to achieve the goal, the global financial crisis happened and some raised doubts about appropriateness of the goal. However, since liberalization and marketization play a significant role in trade balance and economically balanced growth as well as development of the financial market, the reform will gradually or continuously proceed

Impacts of Exchange Rate System Reform on China

Economic impacts

In the mid to long term, China's exchange rate reform will contribute to accelerating economic model shift from export and fixed capital investment oriented to domestic consumption oriented model, and industrial restructuring
In addition, such reform will not only eliminate global imbalance but also expand consumption expenditures worldwide. As China is highly likely to emerge as financial hegemony, such reform will significantly contribute to China's higher global position

Impacts on China's financial market and financial sector

The exchange rate system reform plays an critical role in promoting the financial market and accelerating market opening, especially contributing to globalization of China's stock market, promotion and opening of the bond market, opening of the financial industry and RMB globalization
As there is a concern over the inflow of hot money with RMB appreciation, regulations on inflow and outflow of capital will be strengthen. However, China's foreign investment is highly likely to expand, which will accelerate RMB globalization

Impacts on Republic of Korea and Implications

Impacts on domestic economy and financial market

As China's economic growth model has been shifted since the exchange rate regime reform, China's economic growth momentum is expected to slow down. Accordingly, Republic of Korea is required to keep eyes on expected pressure on economic slowdown with focus on export
As China's powerful money started to flow into domestic bond and securities markets, Korea should make preparation for fluctuation of won exchange rates and the financial market

Impacts on domestic financial sector and implications

Domestic market should manage risk exposure to China caused by China's macroeconomic adjustment. In particular, insolvency of domestic exporters dependent on China's low cost competitiveness and real estate and securities markets should be prevented
With strengtened regulations on hot money and emergence of China risk, Korea's investment in China will inevitably decrease. However, based on improved purchase power resulting from RMB appreciation, China money will further flow into Korea
Domestic market should take prompt measures for increased bushiness opportunities in China resulting from growth of China's consumer credit market and expanded RMB settlement service