The Evolution of the People’s Republic’s Exchange Rate Policy

The renminbi was introduced by Mao Tse-tung’s Communist forces as they gained territory from the Nationalist government under Chiang Kai-shek during the Chinese Civil War. Chairman Mao proclaimed the formation of the People’s Republic of China on October 1, 1949.

Table 1.1. EarlyRenminbiExchangeRateFluctuations, '950'95'

* These figures are for “old” renminbi convertible into today's renminbi on a 1:10,000 basis (see text).

Source: Cheng (1954, pp. 120-122).

the Hong Kong dollar over this same three-month period (Table 1.1).^[3] The renminbi’s official foreign exchange value gradually recovered after March 1950 before the People’s Republic’s effective exclusion from trade with the West following its November 1951 entry into the Korean War. The share of China’s trade with non-communist countries plunged from 74% in 1950 to 28% in 1952 (Durdin, 1953, p. 14) and complete monopoly control of the foreign exchange system followed in 1956. China’s share in world trade stood at only 1.5% in 1953 and declined even further to just 0.6% in 1977 on the eve of the economic reforms launched under Deng Xiaoping (Wu, 2005, p. 292).

After 1951, the exchange rate with the US dollar was adjusted in December 1952, January 1953, and January 1955 (Zhang, 2003, p. 55), but otherwise remained constant until a succession of appreciations against the dollar were employed during the 1970s (see Table 1.2). The Table 1.2 exchange rate values reflect the currency reform of February 1955, under which all past renminbi issues were called in and replaced with “new” renminbi at the rate of 1:10,000 (Jao, 1967-1968, p. 111). The 1952 and 1972 exchange rates of 2.26 and 2.25 RMB/$US are, in reality, almost unchanged from the last May 22,1951, data point given in Table 1.1 - with 22,270 RMB/$US in the old currency being equivalent to 2.23 RMB/$US in new currency. Inter­national trade remained under monopoly control by the government from 1956 until 1978. Under the planned economy regime, the exchange rate was fixed at an artificially overvalued level to support the state’s empha­sis on import substitution, and stringent foreign exchange controls were maintained (Lardy, 1992, chapter 2; Zhang, 2003, pp. 46-48). Zhang (2001) estimates that, except for a brief period between 1971 and 1973, the renminbi essentially remained overvalued throughout the 1957-1977 period.

Gradual liberalization took place after 1978, accompanied by a series of devaluations in the official exchange rate that progressively moved the rate from 1.56 RMB/$US in 1979 to 5.76 RMB/$US in 1993.^[4] Although the offi­cial exchange rate remained overvalued in the early post-1978 period, an internal settlement rate that applied only to trade transactions was estab­lished in January 1981 at a rate of 2.80 RMB/$US as compared to an official rate of just 1.53 RMB/$US at that time.

Table 1.2. Renminbi/US Dollar exchange rate, 1952-2007

Note: Data are average values over the course of each year.

Sources: 1952-1956 data are from Lardy (1992, p.

permitted in some localities in 1980, with more regularized foreign currency “swap” markets developing by 1985-1986. This practice was spearheaded by foreign-funded enterprises that, as part of the Chinese government’s drive to attract more foreign investment, were allowed to swap foreign exchange among themselves in the coastal cities and the newly established Special Economic Zones like Shenzhen. Access to the swap market remained lim­ited for domestic firms until April 1988, when quota controls on foreign exchange retention rights were abolished and domestic enterprises began to enjoy an essentially level playing field with foreign-funded enterprises (Lardy, 1992, p. 60; Lu and Zhang, 2000, p. 125).

Trading volumes in the swap market increased markedly after the 1988 abolition of quota controls and accelerated further with the December 1991 removal of all restrictions on domestic enterprises and residents’ ability to sell foreign exchange into the swap market (World Bank, 1994, pp. 31­32; Lin and Schramm, 2004, pp. 84-87). Transaction volumes in the swap market rose from $US 4.2 billion in 1987 to $US 8.6 billion in 1989 and $US 25 billion in 1992 (World Bank, 1994, p. 32). By September 1988 the Shanghai swap market price was seen as reflecting actual supply and demand for the currency. A “marginal pricing auction” mechanism was employed, under which the price was adjusted in response to any excess demand or supply at the starting price - with a switch to a standard “Dutch auction” ensuing in August 1990 (Lu and Zhang, 2000, p. 125). Although swap market rates still varied significantly from city to city, considerable convergence with the black market rate appears to have been achieved by the end of the 1980s (see Lardy, 1992, pp. 57-66). Moreover, Lu and Zhang (2000) point to a causal relationship between the swap rate and the official exchange rate over the 1988-1992 period, implying that the swap market helped facilitate the adjustment of the official exchange rate in a direction consistent with market forces.

The continued gap between the official exchange rate and the more- market-determined swap rate was closed on January 1, 1994, as part of a comprehensive reform of the official exchange rate system. At that time, the official exchange rate and the swap market rate were unified at a rate of 8.70 RMB/$US, which represented the prevailing secondary market rate at the end of 1993.^{[5] [6] The change from the 1993 official exchange rate of 5.76 implied a devaluation of nearly 50%. However, Lardy (2005a, p. 43n) demonstrates that this greatly exaggerates the actual impact of the exchange rate revision. If 80% of all current account transactions were already based on the swap rate, the weighted average effect of the exchange rate change would amount to only 10% ((0% ? 80%) + (50% ? 20%)).5 The 1994 reform also replaced the foreign exchange swap market with an interbank foreign exchange market that, for the first time, offered a single, unified sec­ondary market for the renminbi. This interbank market was implemented under the Shanghai-based China Foreign Exchange Trading System, which began operations on April 4, 1994.6 Access was initially provided only to domestic enterprises, however, and foreign-funded enterprises still had to use the swap centers until July 1996; only then were they finally permitted to purchase foreign currency on demand on the interbank market (Zhang, 1999, pp. 10-11). In December 1996 the renminbi became fully convertible on the current account (Zhang, 2006, p. 14).}

As the new arrangements eliminated any remaining scope for the author­ities maintaining balance through foreign exchange controls on current account transactions, exchange rate pressure emerged as a potentially important source of monetary and price fluctuations. The effect of 1994’s $US 30.5 billion balance of payments surplus on the renminbi/US dollar exchange rate, for example, was contained only via People’s Bank of China dollar purchases that tripled China’s reserve holdings to $US 77.9 billion (Lin and Schramm, 2004, p. 89). Although the absolute level of reserve holdings reached in 1994 pales in comparison with the $US 1,202 billion that had been amassed by the end of the first quarter of2007 (see Chapter 2), there certainly seems to be a parallel in terms of the monetary consequences. Recent reserve inflows pushed Chinese money growth up near 20%; while the 1994 intervention added to inflationary pressures whereby the growth rate of consumer prices reached 24.2% in 1994, up from 14.6% the previous year (Chapter 3). A key difference, though, is that post-2002 expansionary pressures were seemingly being manifested more in sharp run ups in asset prices rather than goods price inflation (see Chapters 2 and 8 on this issue).