The mystery of the Chinese exchange rate regime: basket or no basket?

ABSTRACT

Economists have taken for granted the claim made by the Chinese government that the policy shift introduced in July 2005 constituted a change in the exchange rate regime from a fixed peg to a basket peg. We demonstrate that neither the stylized facts nor the empirical evidence support the proposition of a basket peg and suggest several reasons as to why China has not adopted this regime. The results could prove useful for identifying the Chinese exchange rate regime in the aftermath of the perceived policy shift following the August 2015 devaluation.

KEYWORDS:

• China
• exchange rate regime verification
• basket peg
• crawling peg

JEL CLASSIFICATION:

• F31
• F33

Acknowledgement

We are grateful to two anonymous referees for useful comments.

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

¹ In early 2016, Raymond Nolte, chief investment officer at Skybridge Capital, a New York asset management firm, declared that ‘until there is more certainty over what’s going on in China, it’s better to stay away’ (1) (Wei and Hilsenrath 2016). Furthermore, the issue is important for Chinese firms with U.S. dollar borrowing, which have an incentive to move out of the yuan if the exchange rate regime dictates an adverse exchange rate movement.

² Daily fluctuations are measured relative to a central parity rate (Goldstein and Lardy 2006). This is made clear by The Economist (2014) suggesting that the percentage variation is measured relative to a benchmark fixed every morning by the central bank. Initially, it was not clear whether the benchmark pertained to the bilateral exchange rate against the dollar or the nominal effective exchange rate. For example, Wang (2009) argues that ‘China sets the yuan’s value based on a narrow range of fluctuation against a basket of currencies’. One would tend to think that the Chinese authorities would be more concerned about the bilateral rate against the dollar than the effective exchange rate. However, a basket peg should be associated with a band pertaining to the effective exchange rate because the primary objective of pegging to a basket is to stabilize the effective exchange rate rather than the bilateral rate against a single currency.

³ China Daily, 3 February, 2009 (http://www.chinadaily.com.cn/china/2009-02/03/content_7440106.htm).

⁴ The decline in Chinese exports was caused by the global financial crisis, not by currency appreciation. However, the exchange rate factor was still relevant even though the currency of invoicing for Chinese exports is predominantly the U.S. dollar. Fixing the yuan/dollar exchange rate means that export revenue would not translate into a progressively smaller yuan amount because of appreciation against the dollar. Wang (2009) argues that the policy shift was ‘the economically rational thing to do, so as to prop up the country’s troubled export sector in the face of the global financial crisis’.

⁵ This point is emphasized by the Financial and Tax advisory S.G. Grand in a July 2014 report on the Chinese decision to widen the band to 2%. The report talks about a ‘widening on the band in which the renminbi can trade against the U.S. dollar’ and ‘the variation of 2% that the renminbi can widen up or down per day against the U.S. dollar’ (Grand 2014).

⁶ The data were obtained from the Pacific Exchange Rate Service of the Sauder School of Business (http://fx.sauder.ubc.ca). The declared basket currencies can be found in Zhou (2005).

⁷ We must emphasize that the results showing weights that do not make sense imply that a basket peg is not what the Chinese exchange rate regime is. In the literature, the possibility of a basket peg is not discarded even though the results of estimating a basket peg model do not make sense (for example, Frankel and Wei 2007).

⁸ This is why Bleaney and Tian (2014) suggest that the root mean square error can be used to infer the exchange rate regime, arguing that the RMSE should be low for pegs and high for floats.

⁹ This is why Bayoumi (2015) argues that while the exchange rate regime seemed clear before August 2015, things became murkier on 11 August 2015. Bayoumi believes that a move towards a more flexible exchange rate requires widening of the bands and relating them to a basket of currencies rather than the dollar.