Renminbi from Marketization to Internationalization

Zhongxia Jin, Yue Zhao, Haobin Wang

• Publisher: Routledge
• Year: 2022
• ISBN:
  9781000618006
• Edition: 1
• Topic: Betriebswirtschaft
• Subtopic: Business allgemein

This study looks into the significance of a floating exchange rate regime, further development of the foreign exchange derivatives market, and concurrent internationalization of the Renminbi (RMB) for a resilient, open, and growing Chinese economy.

The first chapter analyzes the macroeconomic impact of foreign exchange intervention based on empirical studies on 26 economies, explaining why most countries favor a floating exchange rate regime under the existing international monetary system. The second chapter discusses the macroeconomic and microeconomic conditions that would facilitate a successful transition to a floating exchange rate. The final two chapters discuss the importance of further developing the foreign exchange derivatives market in China and explores paths toward further opening-up of the capital market and internationalization of the RMB under a floating exchange rate. Based on the authors' decades of reflections and systematic analysis on real cases both in China and abroad, the title sheds lights on China's exchange rate issues and research on exchange rate policy.

This book will be an essential reference for scholars, students, professionals, and policymakers interested in exchange rate, currency internationalization, the financial market, especially the derivatives market, and the Chinese economy.

1The Macroeconomic Impact of Foreign Exchange InterventionCross-Country Empirical Studies

DOI: 10.4324/9781003305668-1

The Macroeconomic Impact of Foreign Exchange Intervention: Background and Methodology

Mainstream views regarding the optimal choice of exchange rate policies have evolved over time, and the issue is still a matter of significant debate. In the early 1990s, a fixed exchange rate (pegged to the US dollar or German mark) was a popular option for developing countries, especially those transitioning toward market economies. However, the capital account crises and exchange rate collapse that took place in the late 1990s revealed the vulnerability of a fixed exchange rate and resulted in the wide perception that simple pegs might be too risky and that a country should either adopt a hard peg via monetary unions or currency boards, or use a free-floating exchange rate without government intervention (Ghosh and Ostry, 2009).

The collapse of the Argentine peso in 2002 once again shifted mainstream views with regard to the optimal choice of an exchange rate regime by raising new doubts about the viability of hard pegs. Discussions about the merits of an intermediate exchange rate regime followed suit. Yi and Tang (2001) proposed an expanded version of the “impossible trinity” and showed that a country does not have to fully give up any one of the trinity conditions (i.e., a fixed exchange rate, free capital mobility, or monetary independence). The authors argued that it is possible to achieve a combination of the three conditions proportionately. Their proposal suggested that an exchange rate regime does not necessarily have to be a clean float or a hard peg, but in practice, can be an intermediate regime that lies in between the two.

Husain et al. (2005) found that exchange rate regimes across countries have not exhibited an obvious tendency to evolve toward either a clean float or a hard peg. Instead, intermediate regimes have demonstrated greater sustainability over time. They also found that the merits of a free-floating regime tend to become more prominent as an economy matures. In the early stage of economic development, a fixed exchange rate has the benefit of serving as a nominal anchor that keeps inflation in check. However, as an economy matures and its policy credibility improves, the price-stabilizing function of a fixed exchange rate becomes less important. A free-floating regime, on the other hand, appears more beneficial as mature economies with a free-floating exchange rate tend to achieve superior economic performance. The 2009 International Monetary Fund (IMF) review of exchange rate regimes similarly pointed out that the appropriate choice of exchange rate regime should depend on country-specific contexts: A rigid exchange rate regime helps anchor inflation expectations and sustain economic output, but simultaneously puts greater constraints on macroeconomic policies, increases vulnerability to crises, and impedes macroeconomic adjustments against external shocks (Ostry and Ghosh, 2009).

More recently, especially since the global financial crisis and the subsequent massive scale of unconventional monetary easing, economies have increased the use of capital controls and foreign exchange intervention (FXI) to manage the heightened volatility of exchange rates and capital flows. Some studies have provided a theoretical justification for the use of sterilized FXI, even for economies that adopt inflation-targeting (IT) regimes (Alla et al., 2017; Benes et al., 2013; Cavallino, 2019; Ostry et al., 2015). Another large body of empirical studies has analyzed the effectiveness of FXI in stabilizing the exchange rate (e.g., Adler et al., 2015; Blanchard et al., 2016; Daude et al., 2014; Fratzscher et al., 2015).

Despite the potential merits of using FXI,¹ most studies do recognize that FXI is not a free lunch and should be used only under very rare circumstances. Recent literature, however, has paid less attention to the potential costs associated with FXI.² Although China has significantly reduced its intervention in the foreign exchange market in recent years, understanding the macroeconomic consequences of FXI remains important so as to gain insights that may help with China’s macroeconomic management.

We set out to investigate both the effectiveness and potential consequences of FXI by drawing from international experiences and a China-specific context. Based on vector autoregression (VAR) analyses across 26 countries, we show that while FXI is effective in mitigating nominal exchange rate fluctuations in the short run, its impact on the real exchange rate is less significant. Our results suggest that while FXI can limit adjustments of the nominal exchange rate, it simultaneously induces the real exchange rate to adjust through domestic prices, which may not be conducive to countering the impact of external shocks. Specifically, we find that in the face of external financial shocks, countries with more intensive use of FXI experience greater general and asset price volatility. We further examine China’s macroeconomic responses to external shocks over the past decades and find that they were broadly consistent with the international experiences of intervening countries.

The simple methodological framework adopted in this chapter is meant to examine a broad set of macroeconomic variables and has limitations. We hope that our findings serve to motivate more structural analysis on FXI’s macroeconomic impact in the future.

Empirical methodology: A key challenge in estimating the macroeconomic impact of FXI arises from the endogenous nature of FXI: FXI is often triggered by contemporaneous changes in macroeconomic variables, such as the exchange rate, yet the implementation of FXI will in turn affect the same macroeconomic variables, making it difficult to identify the causal impact from FXI. Many studies have resorted to the use of either instrumental variables to identify the exogenous variations in FXI, or the use of high-frequency data and event-study techniques to resolve reverse causality. We adopt a methodology similar to that in Blanchard et al. (2015), which constructs a capital flow measure deemed exogenous from the perspective of individual economies, and study whether exchange rates in countries with or without FXI exhibit different responses to the capital flow measure. We apply the methodology to investigate the impulse response of additional macroeconomic variables to FXI and compare the findings to a case study in the context of China.³ Our reduced-form VAR is meant to capture how countries with varying degrees of FXI differ in their macroeconomic responses broadly; further research can deploy more robust structural vector autoregression (SVAR) to investigate the underlying transmission mechanisms.

The empirical results suggest that in the face of external shocks, FXI can mitigate nominal exchange rate fluctuations, but it has limited impact on the real exchange rate. Moreover, in the face of external shocks, countries with FXI experience greater general and asset price volatility compared to countries with a free-floating exchange rate. The results also suggest that although FXI may be effective in stabilizing the nominal exchange rate, the real exchange rate may achieve self-adjustments through domestic prices, but painful domestic consequences are likely in the course of adjustment. We find that the macroeconomic responses to external shocks in China were broadly consistent with the international experiences of intervening count...