RMB Exchange Rate and Internationalization Junhui Qian 2018

Content • The evolution of RMB exchange rate regime • • Before 1994 -2005 -2015 -2017 • RMB internationalization • Objectives • Implications

2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990 1989 1988 1987 1986 1985 1984 1983 1982 1981 RMB/USD Exchange Rate (Annual) USDCNY 10 9 8 7 6 5 4 3 2 1 0

Exchange Rate Policy • In 1994, RMB official exchange rate was merged with the market rate. • The interbank foreign exchange market was established. The exchange rate was formally determined by the market. But PBC intervened heavily. • From 1995 to 2005, the RMB/USD was de facto pegged at 8. 3, with a daily fluctuation capped in [-0. 3%, 0. 3%]. • From July 2005, RMB no longer pegs USD. RMB started to appreciate gradually. From 2005 to early 2014, RMB appreciated around 37%. • In August 2010, China established the RMB offshore market (CNH market).

The Reform of the RMB Exchange Rate (since 2005) Milestones Date Main changes “ 7. 21” Reform 2005. 7. 21 Introduce the managed floating mechanism, with a [-0. 3%, 0. 3%] fluctuation band around the central parity rate. 2006. 1. 4 Introduce market makers and a new mechanism for the setting of the central parity rate. 2007. 5. 21 Widen the fluctuation band to [-0. 5%, 0. 5%]. 2008. 10. 6 Restrict volatility with the onset of the global financial crisis. 2010. 22 End of crisis mode. “ 4. 21” Reform 2012. 4. 21 Widen the fluctuation band to [-1%, 1%]; Deregulate banks’ foreign exchange dealings. “ 3. 17” Reform 2014. 3. 17 Widen the fluctuation band to [-2%, 2%]. “ 8. 11” Reform 2015. 8. 11 Let the central parity rate reflect market demand supply (previous closing rate). 2016. 2. 15 Introduce the mechanism of “closing rate plus exchange-rate movements of a basket of currencies” for setting the central parity. 2017. 5. 26 Introduce a “counter-cyclical factor” into the central parity pricing mechanism.

Why Floating Is Inevitable • China is an open, large, and diverse economy. The management of Chinese economy requires a more independent monetary policy. • Pegging is “expensive”. China has already accumulated too large a foreign reserve. • It has become a consensus to “let market play the crucial role”.

Why Floating is Difficult • Many State-Owned Enterprises (SOE) have debt denominated in foreign currencies (e. g. , USD). And they do not hedge currency risks. • Stability is a dominant concern for policy makers. • Large volatility, especially in the direction of depreciation, may result in a bad equilibrium.

1 -1 9 7 -0 5 -0 -0 17 20 3 -0 17 20 1 1 -0 17 20 9 7 -1 16 20 -0 5 -0 1 3 -0 16 20 -0 1 -1 16 20 9 -0 15 20 15 7 6, 8 20 5 -0 15 20 -0 3 -0 15 20 1 1 -0 15 20 -1 9 -0 14 20 7 5 3 -0 14 20 RMB/USD Exchange Rate (Daily) USD. CNY (Daily) 7, 2 7, 0 8. 11 Reform 6, 6 6, 4 6, 2 6, 0 5, 8 5, 6

USDX RMBX（SDR） 1 9 -1 17 20 7 -0 -0 17 20 5 3 1 -0 17 20 -0 1 -1 17 20 9 7 -0 16 20 5 -0 16 20 3 -0 16 20 1 -1 16 20 15 9 120 20 7 -0 15 20 5 -0 15 20 -0 3 -0 15 20 1 1 -0 15 20 9 -1 14 20 5 7 -0 14 20 -0 3 -0 14 20 USD and RMB Indices (2014 -2017) USD and RMB Indices 8. 11 Reform 110 100 90 80 70 60

USD and RMB Indices (2017) 105 100 95 90 85 80 2017 -01 -03 2017 -02 -03 2017 -03 -03 2017 -04 -03 2017 -05 -03 2017 -06 -03 USDX 2017 -07 -03 RMBX（SDR） 2017 -08 -03 2017 -09 -03 2017 -10 -03 2017 -11 -03

Possible Sources of the RMB Weakness in 2015 and 2016 • The unwinding of carry trade. • Corporations reduce USD debt. • Residents demand for currency diversification. • Over-valuation of RMB (against a basket of currencies). • The economic slow-down • The rising labor cost

A Trap of RMB Depreciation Expectation 基本面 Capital Flow Disequilibrium Capital Flow Restriction

Why is CNY So Strong in 2017? • USD is weak. • The Chinese economy is resilient. • The control on capital outflow is strengthened. • The CNY shorts are covering their position.

Content • The evolution of RMB exchange rate regime • • Before 1994 -2005 -2015 -2017 • RMB internationalization • Objectives • Implications

The objectives of RMB internationalization • Invoicing in RMB • Trade settlement in RMB • Investment in RMB • A reserve currency

Why RMB Internationalization? • Help reduce currency risk in trade and investment ( to accommodate the forthcoming floating of RMB) • Less need foreign exchange reserve • Seigniorage income.

International Usage of RMB Lags Behind

Benefits of RMB Internationalization to the World • The international monetary system over-relies on USD as the dominant reserve currency, but the US fiscal future is highly uncertain. (The New Triffin Dilemma) • RMB internationalization would provide an alternative reserve currency which is backed by a strong flow of fiscal revenue.

RMB Joins the SDR Basket • IMF has accepted RMB as the fifth, and the third biggest, currency in the SDR (special drawing rights) basket. • This is a symbolic achievement for RMB, but also an important one.

The Implications of RMB Internationalization • The Chinese capital market will be fully open to the world, so that international investors can trade Chinese bonds and stocks. • The Chinese outbound investment would take off • The foreign exchange reserve will decline as private outbound investment increases.