In the tricky matter of sequencing exchange rate flexibility and capital account liberalization, which is the cart and which is the horse? A recently released IMF Policy Discussion Paper (No. 05/1) argues that for China, a more flexible exchange rate regime is the higher priority and in its own interest. Greater flexibility would allow China to operate a more independent monetary policy, which would provide a useful buffer against domestic and external shocks. Greater exchange rate flexibility and steps to ensure a more stable and robust financial system would then put China in a position to pursue substantial capital account liberalization, say authors Eswar Prasad, Thomas Rumbaugh, and Qing Wang.
But does a move toward exchange rate flexibility necessarily involve a revaluation? Estimating equilibrium exchange rates is a difficult endeavor, especially for a developing economy like China that is undergoing substantial structural change. Indeed, analyses by IMF staff show that existing techniques provide a wide range of estimates of the equilibrium value of the renminbi, with a substantial degree of uncertainty associated with each of those estimates.
Many observers have interpreted the recent surge in reserve accumulation as clear evidence of the renminbi’s undervaluation. However, the increase in reserves appears to have been significantly influenced by inflows of speculative capital, suggesting that the evidence on whether the renminbi is substantially undervalued in terms of fundamentals is far from conclusive. The medium-term trend in the real exchange rate, the authors observe, is even harder to predict as it will depend on a variety of factors with potentially offsetting effects.
Thus, although the renminbi might be expected to appreciate initially with a move toward more flexibility, there is no obvious reason why such a move should involve a significant revaluation. The paper also sees no need to move to the immediate adoption of a free float. It notes that an initial move toward flexibility could take the form of a widening of the renminbi trading band, a peg to a currency basket, or some combination of these. With capital controls in place, greater exchange rate flexibility seems unlikely to subject China’s banking system to substantial stress, although the weaknesses in the system argue for taking a cautious and gradual approach to capital account liberalization.
Capital controls tend, of course, to have their effectiveness eroded over time, which could make a phased move toward flexibility increasingly complicated as time passes. And the experiences of other countries clearly show the merits of making a move toward flexibility when the domestic economy is growing rapidly and the country’s external position is strong. All of this suggests that a relatively early move toward greater exchange rate flexibility would be in China’s best interest.
Copies of IMF Policy Discussion Paper No. 05/1, Putting the Cart Before the Horse? Capital Account Liberalization and Exchange Rate Flexibility in China, are available for $15.00 each from IMF Publication Services. See page 32 for ordering details. The full text is also available on the IMF’s website (www.imf.org).