Exchange rate mechanism matters more for China than yuan targets

Source:Global Times Published: 2018/9/5 22:28:41

Illustration: Xia Qing/GT

Exchange rate determination is a complex process including both the exchange rate itself and its mechanism. Which one requires more attention?

The mechanism is the factor China should focus on right now.

There are many exchange rate determination theories. But years of experience have shown that no single theory can explain the real world exchange rate. Therefore, if we must choose between theory and reality, we should respect reality. We are in awe of market between model and market.

Exchange rate formation is an open system. If it is a model, the more closed a system the better. But the exchange rate is open to all sorts of influences such as financial, economic, political and psychological.

We need to focus on the exchange rate mechanism, creating factors that do not lead to exchange rate distortion, and the mechanism should represent those factors. Putting too much effort on the exchange rate target brings little gain. Exchange rates aren't set by targets.

China must commit itself to building a market-led exchange rate mechanism that can fully express the purchasing power of the yuan. The mechanism should be able to form an exchange rate system that results in effective resource allocation at the global level, with currencies of other countries.

The next step is deep reform of the yuan exchange rate mechanism. The surrounding environment is the economic and financial reform process that is also going deeper. Against this backdrop, the micro-level market structure of exchange rate formation needs work, including regulation of participants, instruments, trading and risk management. We have a lot to do on that front.

Another choice to be made involves that between stabilizing foreign reserves or the exchange rate.

The exchange rate and foreign reserves are related in many ways. There is one bridge that has to be crossed when making exchange rate policy and that is, which should be protected - the exchange rate or foreign reserves - if the exchange rate gets hit. The choice is different at different points in history, and different countries make different choices.

When people talk about exchange rates, they usually relate this issue to certain governments and their policies. For example, in terms of the yuan's rate against the US dollar, the US government and its policies are believed to play the key role.  While that's true, international private capital may be more important. Since they are profit-driven entities, holders of such capital tend to capture general trends by betting on or against the trends.

This was shown in the 2008 global financial crisis. Since the 1980s, international private capital that has no national allegiances has become the engine of the new round of globalization. These unscrupulous funds that are wealthier than many individual nations have the ability to tear down a country's economy. 

Among countries, it is possible to follow political rules. But the international private capital flows according to market forces.

Therefore, international speculative hot money is what should be watched when it comes to the exchange rate. But to fend off such attacks, the Chinese market system should be improved by initially reducing the possibility for speculation. In this way, the exchange rate can be maintained at a stable level.

In a nutshell, an exchange rate is an inseparable part of an entire economic system.

The exchange rate mechanism ought to be in line with the development of the domestic market economy.

The article was compiled from a speech by Li Yang, director-general of the National Institution for Finance and Development with the Chinese Academy of Social Sciences (CASS), at a recent forum hosted by the CASS to mark the 40th anniversary of China's reform and opening-up.
Newspaper headline: Economic conditions should drive exchange rates


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