Financial Reform: Progress in the Policy Versus Market Controversy
In the past two decades of reform and opening up, China has adhered to the orientation of liberalization for financial reform. Generally speaking, China has taken a road of promoting the reform through policy guidance and standardization. The financial reform was obviously accelerated in 2004. Rapid progress was made in many aspects: First, the reform of state-owned commercial banks was accelerated, and initial achievements were made in the transformation of the Bank of China and the China Construction Bank into joint stock companies. Second, an important step was taken in the liberalization of interest rates, and the upper limit for loan interest rates and the lower limit for deposit interest rates were removed. Third, the positive fiscal and monetary policies which had been implemented for many years were both replaced by moderate policies, marking the gradual improvement of the financial macro-control system. Fourth, China’s financial supervision system is being perfected, and preliminary achievements have been made in the financial supervision.
However, we should also see clearly that the in-depth contradictions and problems found in the financial system and economic operations still remain to be solved. Moreover, the degree of marketization in the financial area has to be further raised. For example, the RMB is now confronted with the tremendous pressure of appreciation; the financial supervision system remains to be further improved, and the accumulation of financial risks has affected the economic security of the country…. All this signifies the importance and urgency of the reform of the financial system.
Section 3 With an Increasingly Flexible Foreign Exchange Control System, It Is Necessary to Be Cautious in Promoting Reform of the Exchange Rate Formation Mechanism
China’s current RMB exchange rate formation mechanism came into being during the reform of the foreign exchange control system in 1994. From the beginning of the reform and the introduction of the opening-up policies in 1978 till 1994, China exercised a double-track foreign exchange policy. After the RMB exchange rate system was changed in 1994, China adopted a single, controlled floating exchange rate system. At the same time, it also adopted a system of settling and selling exchange at banks. The relatively stable exchange rate system brought many advantages to China in the early years of the reform. For example, foreign businessmen could easily work out the costs and returns on their investments in China, and this helped China to attract foreign capital. However, with subsequent changes in the economic environment in China, that system increasingly showed defects. From the end of 2003 to 2004, faced with pressure from abroad to revalue the RMB, and more and more challenges on the issue of exchange rate control, the issue of the exchange rate of the RMB became the focus of attention in 2004. China had only two alternatives: Comply with the demand to revalue the RMB and release the pressure, or adopt measures to reduce the revaluation pressure and then do what should be done. The Chinese government chose the latter, and started to reduce the revaluation pressure through reforms. On the basis of increasing the personal exchange purchase quota for residents who go abroad and the quota of foreign currency to be carried, and relaxing control measures on the use of exchange by enterprises with foreign investment and the restrictions on the administrative examination and approval for foreign exchange on a part of the capital account in 2003, China continued to relax its foreign exchange controls in 2004, thereby reducing the revaluation pressure on the RMB.
1. China gradually relaxed its foreign exchange control, and made notable achievements in the reform of the foreign exchange control system
In early 2004, in the light of the domestic and international economic situations, and the balance of payments, the Chinese government explicitly proposed the change of the control pattern of “wide receipts and constricted payments,” adjusted the exchange control policy of “being tight in domestic supply and flexible in external supply,” and changed the control concept of “laying more stress on public enterprises than on private ones” to facilitate foreign trade and investment, tightened the control over the inflow of short-term capital funds and exchange settlements, widened the capital outflow channels steadily, and made full use of the “two markets and two resources” to achieve a balance of international payments. Especially when there was a big favorable balance of payments, the State Administration of Foreign Exchange Control (SAFEC) made a timely adjustment to the policy of foreign debt control for foreign banks, strengthened the foreign debt control for enterprises with foreign investment, and exercised strict control over foreign exchange funds settlement. In order to implement the Central Government’s strategy of “going out” (expanding to the outside world), the SAFEC further simplified the approval procedure for investments abroad, relaxed the restrictions on exchange purchases for investment abroad, and expanded the experiments to reform exchange control for investment abroad to 24 provinces. (“New Policy on Foreign Exchange Control to Be Issued in 2005, Special Interview with a Senior Official of the Administration of Foreign Exchange Control,” Financial and Economic World, November 30, 2004) At the same time, it permitted transnational companies to concentrate funds for internal operations, thus not only saving the financial costs, but also providing continued financial support for enterprises “going out.” It also permitted emigrant residents to shift their legitimate property in China and foreign residents to shift their inherited legitimate property within China to outside locations, and fully supported the move by international development organizations to issue RMB bonds in China. By making these policy adjustments, China balanced the inflow and outflow of capital, and promoted its balance of international payments.
However, there are still problems in China’s foreign exchange control system. We must adapt to the new situation which has arisen after China joined the WTO. We must adhere to the general orientation of reform and opening, and to the long-term goal of making the RMB fully convertible. It is necessary to make constant improvements to the means of control over foreign exchange on the current account, and further perfect the measures to control foreign exchange on the capital account, maintain the balance of payments and the stable exchange rate of the RMB, strengthen the supervision and control over foreign exchange receipts and payments of the banks, crack down hard on illegal foreign exchange trading, consolidate and standardize the foreign exchange market order, improve financial services, and strive to create a good environment and conditions for supporting foreign trade and encouraging foreign businessmen to invest in China. Only by so doing can we finally achieve the goal of making the RMB, including the RMB on the capital account, fully convertible. In the long term, to relax control over foreign exchange is only a way of “effecting a temporary cure.” The fundamental solution is to establish a proper RMB exchange rate mechanism.
2. The RMB revaluation pressure and the deteriorating conditions for foreign trade show the necessity for the reform of the exchange rate mechanism
In fact, the adoption of the reform measures mentioned above involved arrangements and measures which had to be taken to relax the control under pressure for exchange rate revaluation. Moreover, the State Administration of Foreign Exchange Control will also adopt more reform measures to alleviate the revaluation pressure. There has been a heated controversy in the international community on the issue of the RMB exchange rate. The controversy touched mainly upon two questions: one, the exchange rate mechanism for the RMB, and two, the exchange rate level of the RMB. The Central Government has stressed the necessity of keeping the RMB relatively stable under conditions of rationality and equilibrium. Therefore, the reform of the RMB exchange rate mechanism will by no means be a simple reassessment of the exchange rate level; it will inevitably be a combination of measures, including reforming the current foreign exchange control system, perfecting the foreign exchange market, promoting financial reform, increasing the floating range of the exchange rate and market flexibility, and introducing new exchange products. Compared with the possible fluctuation of the limited nominal exchange rate level, the intensity of the reform of the exchange rate mechanism will be much greater, and its impact on the market will be much bigger.
At the same time, China also has the ability to promote exchange rate reform. With the constant increase of China’s overall national strength, continuing progress made in the reform of the financial system, and the perfection of the financial market, the conditions for the liberalization of the RMB exchange rate mechanism are ripening. The total volume of China’s imports and exports exceeded US$1,000 billion in 2004, ranking third in the world. With the further rise of the total volume of China’s imports and exports and the further perfection of the domestic market, the conditions will soon be fully in place for the reform of the exchange rate system.
With the development of the Chinese economy, China’s place in the international economy is becoming more and more important, and the RMB is becoming a hard currency in some of its surrounding countries. With this in mind, China should adopt a more flexible exchange rate system. In reality, it is not very difficult for a country to change its exchange rate mechanism. China can start by increasing the floating range for the exchange rates, and gradually turn to completely floating rates. At the same time, the government should accelerate the corresponding supporting reforms, such as an increase in the ability of the Central Bank to make and implement monetary policies to maintain the independence of its policies. We should also deepen the reform of the foreign exchange market, and establish futures and options markets, so that the investors can effectively evade exchange rate risks. Business operations of banks and non-bank financial institutions should be standardized, and monetary and financial crises should be guarded against. The clearer the process of the reform and the more transparent the steps to be taken in the reform, the smaller the economic harm caused by speculative pressure on the RMB. (“Floating Exchange Rate or Fixed Exchange Rate: Challenge to the RMB,” China Economic News Net, October 14, 2003)
It is impossible for an open economy to maintain a fixed exchange rate, free capital flow and an independent monetary policy. It can only choose two out of the three goals. China was able to maintain a fixed exchange rate for a fairly long period of time and still prevent the RMB from depreciation during the East Asian financial crisis mainly because of its control over the capital market. On the one hand, as China gradually relaxes its control over the capital account, and finally allows the free flow of capital, it will be very difficult to maintain a fixed exchange rate. On the other, it is essential for China to maintain the independence of its monetary policy. Therefore, China has to make a choice between keeping a fixed exchange rate and free capital flow. China should be cautious in determining its exchange rate system in keeping with the extent of relaxing control over capital. To adopt a fully floating exchange rate can only be a long-term and final goal.