## wpiea2019050

## Source details

**Canonical URL:** [wpiea2019050](https://www.imf.org/-/media/files/publications/wp/2019/wpiea2019050.pdf)

## Other formats

- [Markdown version](/-/media/files/publications/wp/2019/wpiea2019050.pdf.md)
- [Structured JSON version](/-/media/files/publications/wp/2019/wpiea2019050.pdf.json)

---

### I. INTRODUCTION — purpose and constraints
- Objective: provide an overview of the evolution of China’s exchange rate regime from 2005 onwards, identify unique constraints to a floating exchange rate, and analyze supporting conditions and policies needed for a smooth adjustment.
- Key China-specific constraints to greater exchange-rate flexibility:
  - Large pool of renminbi (RMB) savings seeking diversification; M2 at around 200 percent of GDP.
  - Herding behavior creating vulnerability to large depreciation events.
  - Potential for sudden RMB movements to lead to regional spillovers (renminbi influences exchange rates of countries representing about 30 percent of global GDP; renminbi ranked seventh with a share of about 1.5 percent in worldwide payments in 2017).

### Key recommendations to support transition to greater exchange-rate flexibility
- Exchange-rate regime and FX intervention:
  - Allow a greater role for market forces in the current exchange rate regime.
  - Make central parity formation for the daily trading band (the ‘fix’) mechanical and transparent.
  - Use FX intervention guided by the need to limit excessive volatility; avoid sustained one-way intervention.
  - Do not modulate capital flow management measures (CFMs) to help manage the exchange rate; CFMs should not substitute for exchange-rate flexibility.
- FX market deepening and risk management:
  - Phase out regulations that stifle FX market activity (for example, the reserve requirement on forwards).
  - Encourage participation by various types of institutions in the interbank FX market to improve efficiency and depth.
  - Allow exchange-rate flexibility to create two-way risk; educate market participants and encourage hedging; facilitate development of hedging instruments.
- Monetary and institutional reforms:
  - Grant the People’s Bank of China (PBC) operational independence and authority to set interest rates.
  - Establish an explicit policy interest rate subject to longer-term government goals; strengthen interest-rate based policy framework.
  - Improve transparency and clarity of policy communication; regularize communication (publish macroeconomic forecasts, hold regular press conferences, publish policy communications in English).
- Additional governance and market-role recommendations:
  - Remove balance of payments as an objective (of the central bank).
  - Reduce direct central bank market role while building exchange-rate risk management capacity and further developing the FX market.

### II. DEVELOPMENTS — summary of regime changes and mechanics
- July 21, 2005 reform:
  - Moved from fixing the yuan to a "managed floating exchange rate regime based on market supply and demand with reference to a basket of currencies."
  - De facto maintained a tight link to the U.S. dollar; the basket was not specified.
  - An immediate technical change: a 2.1 percent step revaluation of the RMB/USD rate to 8.11 yuan per dollar.
- Central parity and band mechanics (post-July 2005 changes):
  - Central parity mechanism with RMB/USD allowed to fluctuate in a daily band of +/-0.3 percent around the central parity (previous day’s close).
  - Wider band of +/-1.5 percent against other interbank market currencies: the Euro, Hong Kong dollar, and Yen.
  - Subsequent band and mechanism adjustments:
    - September 2005: trading band for non-U.S. dollar currencies widened to +/- 3 percent.
    - January 2006: daily central RMB/USD parity formation changed to a trimmed weighted average of quotes from market-making banks; CFETS (an affiliate of PBC) announces central parity.
    - May 2007: daily band around central RMB/USD parity widened to +/-0.5 percent.
    - April 2012: band widened to +/-1 percent.
    - March 2014: band widened to +/-2 percent.
  - Parallel steps: liberalize and develop FX markets; establish markets for currency forwards and swaps; expand market participants.

### Flexibility suspended and practical behavior during crises
- During the global financial crisis authorities emphasized a stable RMB/USD; renewed emphasis on flexibility announced June 2010 without de jure changes.
- Observed behavior and outcomes:
  - RMB/USD rate fairly stable on a daily basis; daily changes generally did not approach band edges.
  - Central parity rate barely moved day-to-day even when spot closed at a distance from central parity.
  - Heavy intervention to moderate appreciation: FX reserves increased from US$ 733 billion in July 2005 to a peak of US$ 3.99 trillion in June 2014.
  - RMB exchange rate with Europe and Japan was significantly more volatile than the RMB/USD rate.

### De facto regime characterization and appreciation (Jul 2005 – Jul 2015)
- De jure: adjustable basket peg; de facto: crawling peg to the USD during that decade.
- Managed appreciation:
  - Relative to the U.S. dollar: RMB appreciated by 26 percent from July 2005 to July 2015.
  - Effective appreciation: 44 percent nominal, 58 percent real.
- Managed appreciation generated expectations of continued appreciation, leading to capital inflows and carry trades.

### Market sentiment shift and turbulence (2014–2016)
- Late 2014–March 2015:
  - One-year-ahead forward premium on dollars widened from near zero in summer of 2014 to around -3 percent in March 2015 in both onshore and offshore NDF markets.
  - IMF’s 2015 External Sector Report assessed the RMB in summer 2015 to no longer be undervalued.
- August 11, 2015 (announcement & immediate market reaction):
  - PBC changed the RMB/USD central parity quoting mechanism; announcement coincided with a 1.9 percent depreciation of the RMB relative to the dollar.
  - RMB/USD rate depreciated by a further 1 percent on August 12, then stabilized mid-August to end-September.
  - VIX rose to a four year high and capital outflows accelerated.
- Capital flow shifts (2013–2015):
  - Capital and financial account swung from inflows of almost US$ 300 billion in 2013 to outflows of US$ 400 billion from mid-2014 to mid-2015.
  - Capital outflows doubled from an average of around US$ 100 billion in Q3–Q4 2014 to a quarterly average of US$ 200 billion in the second half of 2015.
  - Deterioration in capital account was a US$ 900 billion swing in annual capital account flows between 2013 and 2015.
  - Three main drivers: (i) unwinding of carry trades (likely over half of the swing), (ii) foreign asset acquisition by residents through official channels, and (iii) some “capital flight” (unrecorded outflows). Reversal of residents’ net acquisition of external liabilities, in the form of debt repayment, accounted for US$ 500 billion.
- PBC response late 2015–early 2016:
  - FX intervention and CFMs used to stem outflows; international reserves fell by US$ 321 billion in the second half of 2015.
  - Substantial FX intervention in January and February 2016 to stabilize the currency.
  - REER depreciated by 6.8 percent from August 2015 to December 2016.
  - Enforcement of existing CFMs tightened; measures introduced included a reserve requirement on banks’ FX forward transactions.

### Institutional guidance, indices, and regime adjustments (2015–2018)
- CFETS and indices:
  - December 2015: CFETS published the “CFETS exchange rate index”, dating back to December 31, 2014.
  - RMB exchange rate indices based on the SDR and the BIS currency baskets were also published.
- Central parity quoting mechanics and CCAF:
  - Banks guided to base daily RMB/USD central parity quotes on the “previous closing rate plus changes in the currency basket”.
  - February 2017 technical modification: banks offset cross-rate developments that took place only overnight (rather than during the previous day and overnight).
  - May 26, 2017: CFETS asked market-making banks to include a “counter-cyclical adjustment factor” (CCAF) in central parity quotes to reduce “irrational” depreciation expectations and “pro-cyclical” herding behavior.
  - CCAF set to neutral in January 2018; re-activated in August 2018 amid renewed depreciation pressure.
  - Pass-through from the previous day’s RMB/USD closing rate to the current day’s central parity rate declined after CCAF introduction.

### Mid-2016 to end-2017: stabilization and de facto adjustable basket peg
- Capital flow and reserves (early 2017):
  - Capital outflows abated in early 2017; FX intervention tapered off and reserves began to increase in February 2017 (partly due to valuation effects from a weaker dollar).
  - FX reserves rose by US$ 129 billion in 2017, after declining by US$ 833 billion in the previous two years.
- Exchange-rate behavior:
  - After depreciating against the CFETS basket by 10 percent from mid-2015 to mid-2016, the RMB was broadly stable against the CFETS basket until end-2017.
  - With CFETS index publication and central parity quoting formula in place, China effectively transitioned to a de facto adjustable basket peg.
  - Clark (2017) finds central parity rate became predictable and responsive to market forces, but intraday RMB/USD movements were more influenced by FX intervention than by the central parity mechanism.

### First half of 2018 and increasing flexibility
- Movements and policy (April–August 2018):
  - RMB/USD rate depreciated by 2.5 from late April to mid-June, and a further 7.5 percent through mid-August.
  - RMB depreciated by 1 percent against the CFETS basket until mid-June, and then a further 5.5 percent until mid-August.
  - Significant capital outflows did not materialize in summer 2018, unlike previous episodes.
- August 2018 measures:
  - PBC reinstituted a reserve requirement of 20 percent for banks’ FX forwards transactions, encouraged banks to avoid “herd behavior”, and re-activated the counter-cyclical factor in central parity quotes.
  - RMB appreciated versus the U.S. dollar and CFETS basket somewhat after mid-August and then stabilized.
- Current characterization:
  - Compared to 2005, the RMB is more flexible with respect to the U.S. dollar and now linked to the CFETS basket.
  - Flexibility has increased particularly since the beginning of 2018, but volatility remains lower than other floating currencies.
  - The exchange rate is managed in the short-run but allowed to adjust in response to market forces in the longer run.
  - IMF’s 2018 External Sector Report assesses the RMB in 2017 to be broadly in line with fundamentals and desirable policies.
  - FX reserves stood at 97 percent of the IMF’s composite Assessing Reserve Adequacy metric unadjusted for CFMs; and at 157 percent of the metric adjusted for CFMs.
- Internationalization:
  - Offshore RMB market established in Hong Kong SAR in 2010; other offshore centers developed.
  - RMB included in the IMF’s SDR basket in 2015.
  - Financial liberalization measures preceded SDR inclusion, including relaxing interest rate controls and permitting full participation by foreign central banks and sovereign wealth funds in the domestic bond market.

### Historical exchange-rate episodes and macro context
- Growth and REER:
  - Real GDP growth: fell from 7.8 percent in 2013 to 7.3 in 2014 and to 6.9 in 2015.
  - RMB appreciated by 14 percent in real effective terms between end-2013 and July 2015 (despite PBC keeping RMB steady against the U.S. dollar).
- Capital outflows and composition (2014–2015):
  - Capital outflows doubled from an average of around US$ 100 billion in Q3–Q4 2014 to a quarterly average of US$ 200 billion in the second half of 2015.
  - Annual capital account swing between 2013 and 2015: US$ 900 billion.
  - Reversal of residents’ net acquisition of external liabilities accounted for US$ 500 billion of the swing.

### Structural vulnerabilities and “fear of floating”
- Typical fear-of-floating factors:
  - Misalignment concerns exist though REER estimated broadly in line with fundamentals.
  - Aggregate corporate debt about 160 percent of GDP; only 6 percentage points of this denominated in foreign currencies.
  - For the four largest banks, 11 percent of liabilities were in FX in 2015, with offsetting FX assets; individual bank gross FX exposure ranged from 26 percent of total liabilities (Bank of China) to 5 percent (Agricultural Bank of China).
- China-specific constraints:
  - Large pool of RMB savings (M2 around 200 percent of GDP) could trigger sizeable outflows if a small fraction switch to foreign assets.
  - Exporters reduced conversion of foreign-currency income to renminbi after August 2015 and have not reverted to previous patterns.
  - Herding and unfamiliarity with two-way movements make expectations sensitive, risking abrupt outflows, funding shocks, fire sales, and large-scale redemptions of short-term investments.

### Progress on supporting conditions for exchange-rate flexibility
- FX market structure and gaps:
  - CFETS interbank currency market: 632 current members of the spot market, 32 designated market makers (as of data point).
  - CFETS trades in twenty-four currencies but over 95 percent of daily trading volume still in CNY/USD.
  - FX forwards, swaps, and options introduced in 2005, 2006, and 2011 respectively.
  - China’s average daily FX turnover as a share of exports and imports is just 1¾ percent (BIS Triennial Central Bank Survey 2016).
  - Renminbi liquidity is higher offshore; domestic liquidity and depth remain low versus floating countries.
  - Share of FX derivatives transactions in average daily FX turnover in China rose from 10 percent in 2007 to 60 percent in 2016.
  - Use of hedging instruments by Chinese firms remains below cross-country averages for typical maturities; medium- and longer-maturity derivatives pricing is challenging.
- Institutional capacity and nominal anchor:
  - PBC has multiple objectives (price stability, boost economic growth, promote employment, maintain balance of payments, promote reform and market development) and lacks operational authority.
  - China has moved toward a market-based monetary framework: the 7-day reverse repo rate used to send policy signals and the 7-day interbank repo rate as operating target, while official policy rates remain published benchmarks.
  - Lack of transparency and clarity in communication can trigger market turbulence (example: brief or unclear announcements such as August 2015).

### Policy recommendations (explicit)
- FX market and exchange-rate flexibility:
  - Allow sufficient exchange rate flexibility to improve market efficiency.
  - Create two-way exchange-rate risk to avoid one-directional sentiment and deter speculative capital inflows.
  - Encourage broader institutional participation in the interbank FX market to improve depth and price discovery.
- Market participant capacity and derivatives:
  - Educate market participants about FX risks and encourage hedging.
  - Monitor derivatives use to prevent sizeable leveraged bets that could destabilize markets.
  - Standardize derivative products traded among banks; ensure accounting standards for fair valuation and reliable legal contract enforcement.
  - Promote market transparency and high reporting standards.
  - Further develop the government bond market to improve benchmarks for credit pricing and hedging instruments.
- Monetary and institutional framework:
  - Grant the PBC operational independence and develop an explicit policy rate; State Council to set overall goals but not specific interest rates or monetary targets.
  - PBC should guide the short-term interbank rate and allow longer-term rates to be market-determined.
  - Strengthen the interest-rate based framework by: (1) formally acknowledging the framework, (2) dropping publication of benchmark lending rates, (3) gradually reducing distortionary high reserve requirements (offset as needed by open-market operations), (4) basing PBC lending facility access on clearly defined collateral rules, and (5) aligning lending instruments to PBC monetary objectives.
  - Improve and regularize communication: clarify objectives and instruments, publish forecasts and models, provide simultaneous English communications, hold regular press conferences, and establish a regular MPC meeting schedule for policy interest rate decisions.

### Central parity formation, FX intervention, and communication (operational guidance)
- Central parity formation:
  - Often set to offset some of the previous day’s exchange rate movements, particularly when the CCAF is in use.
  - Opaque central parity formation shifts undue focus onto the parity and can lead market participants to infer policy intentions from the rate rather than from explicit PBC statements.
  - Recommendation: central parity formation should be mechanical and transparent; the quote formula should be consistent over time.
- FX intervention and communication:
  - Intervention is more effective intraday at dampening volatility than central parity adjustments (Clark (2017) finding).
  - Use direct FX intervention and explicit PBC communication to affect the exchange rate when needed to limit excessive volatility.
  - Publish information on PBC’s FX intervention to improve market understanding and policy credibility.
  - Use only one instrument to manage the exchange rate where possible to simplify operations and facilitate future moves toward less active management.
- CFMs and guidance:
  - CFMs should be consistently and transparently enforced and clearly communicated.
  - CFMs should not be used to actively manage the capital flow cycle or substitute for exchange-rate flexibility.
  - Provide market guidance on economic trends and their implications for the real exchange rate to help form expectations.

### International experience and lessons for transition
- Examples and timelines of gradual transitions to free float:
  - Chile: about 15 years.
  - Israel: 20 years (de facto free float achieved in 12 years; formal free float in 20 years).
  - Poland: 10 years.
  - Russia: 9 years.
- Typical transition stages:
  - Start with crawling pegs, move to wider horizontal/crawling bands, use intervention near band edges, gradually widen bands and reduce intervention until effective float achieved.
- Supporting prerequisites:
  - Deep, liquid FX and domestic financial markets, including liquid short-term interbank money and government securities markets.
  - Prudential and supervisory frameworks that monitor and limit FX exposures; incorporate FX exposures in capital requirements; maintain FX liquidity requirements; conduct stress testing.
  - Operational capacity to affect short-term interest rates and well-functioning interbank and securities markets.
  - Appropriate transparency on intervention strategies and preparation for greater flexibility; advance communication of regime changes where beneficial.

*Source: Excerpts from the IMF content unit wpiea2019050 (PDF chapter/section).*

### References .............................................................................................................

### wpiea2019050 - References

### I. INTRODUCTION — purpose and constraints
- Objective: provide an overview of the evolution of China’s exchange rate regime from 2005 onwards, identify unique constraints to a floating exchange rate, and analyze supporting conditions and policies needed for a smooth adjustment.
- Key constraints to greater flexibility specific to China:
  - Large pool of renminbi (RMB) savings seeking diversification.
  - Herding behavior creating vulnerability to large depreciation events.
  - Potential for sudden RMB movements to lead to regional spillovers.

### Key recommendations to support transition to greater exchange rate flexibility
- Allow a greater role for market forces in the current exchange rate regime:
  - Make central parity formation for the daily trading band (the ‘fix’) mechanical and transparent.
  - Use FX intervention guided by the need to limit excessive volatility.
  - Do not modulate capital flow management measures (CFMs) to help manage the exchange rate.
- Deepen the foreign exchange (FX) market:
  - Phase out regulations that stifle FX market activity, such as the reserve requirement on forwards.
  - Allow more exchange rate flexibility as a key step.
- Improve management of FX risks:
  - Allow exchange rate flexibility to create a sense of two-way risk.
  - Educate market participants about FX risks.
  - Encourage hedging and facilitate development of hedging instruments.
- Develop an alternate monetary policy anchor:
  - Grant the People’s Bank of China (PBC) operational independence and authority to set interest rates.
  - Establish an explicit policy interest rate subject to longer-term government goals.
  - Strengthen interest-rate based policy framework and increase clarity and frequency of communication.
- Additional governance and market-role recommendations (as listed in source):
  - Improve transparency and clarity of policy communication.
  - Tolerance for exchange rate flexibility and PBC authority to act in FX market.
  - Remove balance of payments as an objective.
  - Reduce role of central bank; build up exchange rate risk management capacity; further develop FX market.

### II. DEVELOPMENTS — summary of regime changes and mechanics
- July 21, 2005 reform announcement:
  - China moved from fixing the yuan to a "managed floating exchange rate regime based on market supply and demand with reference to a basket of currencies."
  - The basket of currencies was not specified; de facto maintained a tight link to the U.S. dollar.
- Central parity and band mechanism established (post-July 2005):
  - Central parity mechanism with RMB/USD allowed to fluctuate in a daily band of +/-0.3 percent around the central parity (previous day’s close).
  - Wider band of +/-1.5 percent against other interbank market currencies: the Euro, Hong Kong dollar, and Yen.
  - PBC would “make adjustment of the RMB exchange rate band when necessary according to market development as well as the economic and financial situation.”
- Immediate technical change:
  - A 2.1 percent step revaluation of the RMB/USD rate to 8.11 yuan per dollar accompanied the July 2005 reform.

### Fine-tuning of central parity rate and trading bands
- September 2005: trading band for non-U.S. dollar currencies widened to +/- 3 percent.
- January 2006: daily central RMB/USD parity formation changed to a trimmed weighted average of quotes from market-making banks (quotes based on banks’ views of market supply and demand). Quotes are given to and the central parity rate is announced by China Foreign Exchange Trading System (CFETS), an affiliate of PBC.
- May 2007: daily band around central RMB/USD parity widened to +/-0.5 percent.
- April 2012: band widened to +/-1 percent.
- March 2014: band widened to +/-2 percent.
- Parallel steps: liberalize and develop FX markets, establish markets for currency forwards and swaps, expand number of market participants.

### Flexibility put on hold during global financial crisis and practical behaviour
- After focusing on a stable RMB/USD during the global financial crisis, authorities announced renewed emphasis on exchange rate flexibility in June 2010, without de jure changes to the system.
- Despite the "managed floating" designation, the RMB exchange rate was considerably less volatile than other floating exchange rates.
- Observed facts:
  - RMB/USD rate was fairly stable on a daily basis; daily changes generally did not approach band edges.
  - Central parity rate barely moved day-to-day even when spot closed at a distance from central parity.
  - China intervened heavily to moderate appreciation; FX reserves increased from US$ 733 billion in July 2005 to a peak of US$ 3.99 trillion in June 2014.
  - RMB exchange rate with Europe and Japan was significantly more volatile than the RMB/USD rate.

### De facto regime characterization and appreciation (Jul 2005 – Jul 2015)
- De jure description: adjustable basket peg; de facto functioning as a crawling peg to the USD during the decade following July 2005.
- Managed and gradual appreciation relative to the dollar produced substantial effective appreciation:
  - Relative to the U.S. dollar: RMB appreciated by 26 percent from July 2005 to July 2015.
  - In effective terms: appreciation was 44 percent nominal, 58 percent real.
- Managed appreciation created expectations of continued appreciation, leading to capital inflows and carry trades.

### Market sentiment shift in 2014–2015
- Late 2014: accelerating effective appreciation due to U.S. dollar strength and PBC keeping bilateral RMB/USD broadly stable, with intervention shifting from FX purchases to growing sales.
- Market view: rising sense that the RMB was becoming overvalued.
- One-year-ahead forward premium on dollars:
  - Widened from near zero in summer of 2014 to around -3 percent in March 2015 in both onshore and offshore (Hong Kong SAR) non-deliverable forwards (NDF) markets.
- IMF’s 2015 External Sector Report assessed the RMB in the summer of 2015 to no longer be undervalued.

### Change in balance of payments toward end of period
- Capital and financial account swung from inflows of almost US$ 300 billion in 2013 to outflows of US$ 400 billion from mid-2014 to mid-2015 (led by a change in short-term investment flows).
- Current account surplus widened from 1.5 percent of GDP in 2013 to [text ends in provided content].

*Source: wpiea2019050 - References (excerpt of main text).*

### 2.7 percent of GDP in 2015, due to falling import demand as growth slowed, as well as from

### wpiea2019050 - 2.7 percent of GDP in 2015, due to falling import demand as growth slowed, as well as from

### Historical exchange-rate episodes and market response
- Growth and real exchange-rate context
  - Real GDP growth in China fell from 7.8 percent in 2013 to 7.3 in 2014 and further to 6.9 in 2015.
  - The RMB appreciated by 14 percent in real effective terms between end-2013 and July 2015 (despite the PBC keeping the RMB steady against the U.S. dollar).
- August 2015 announcement and immediate turbulence (Aug 11, 2015)
  - PBC changed the RMB/USD central parity quoting mechanism; the announcement coincided with a 1.9 percent depreciation of the RMB relative to the dollar.
  - The RMB/USD rate depreciated by a further 1 percent on August 12, before stabilizing in a narrow range from mid-August until end-September.
  - The VIX rose to a four year high and capital outflows accelerated.
- Capital outflows and composition (2014–2015)
  - Capital outflows doubled from an average of around US$ 100 billion in the third and fourth quarters of 2014 to a quarterly average of US$ 200 billion in the second half of 2015.
  - The deterioration in the capital account was a US$ 900 billion swing in annual capital account flows between 2013 and 2015.
  - Three main drivers of the swing: (i) an unwinding of carry trades, (ii) foreign asset acquisition by residents (through official channels), and (iii) some “capital flight” (unrecorded outflows).
  - Unwinding carry trades likely represented over half of the swing; reversal of residents’ net acquisition of external liabilities, in the form of debt repayment, accounted for US$ 500 billion.
- PBC and policy response (late 2015 – early 2016)
  - FX intervention used to stabilize the exchange rate in conjunction with CFMs to stem outflows.
  - International reserves fell by US$ 321 billion in the second half of 2015.
  - Substantial FX intervention in January and February of 2016 to stabilize the currency.
  - REER depreciated by 6.8 percent from August 2015 to December 2016.
  - Enforcement of existing CFMs tightened (including on overseas direct investment and offshore RMB lending) and measures introduced, e.g., a reserve requirement on banks’ FX forward transactions.

### Institutional guidance, indices, and regime adjustments
- CFETS and index publication
  - In December 2015, CFETS published the “CFETS exchange rate index”, dating back to December 31, 2014, to guide the market on the basket of currencies that was the focus of policy.
  - RMB exchange rate indices based on the SDR and the BIS currency baskets were also published.
- Central parity quoting mechanism and formula guidance
  - Banks were guided to base daily RMB/USD central parity quotes on the “previous closing rate plus changes in the currency basket”.
  - The “changes in the currency basket” referred to the adjustment in the RMB/USD rate needed to offset the impact of changes in cross-rates among basket currencies during the previous trading day and overnight.
  - A technical modification was made in February 2017: banks were to offset cross-rate developments that took place only overnight (rather than during the previous day and overnight) to avoid “double counting”.
- Counter-cyclical adjustment factor (CCAF)
  - On May 26, 2017, CFETS asked market-making banks to include a “counter-cyclical adjustment factor” (CCAF) in their central parity quotes to reduce “irrational” depreciation expectations and “pro-cyclical” herding behavior.
  - The CCAF was set to neutral in January 2018, but remained available to be reactivated; it was re-activated in August 2018 amid renewed depreciation pressure.
  - Pass-through from the previous day’s RMB/USD closing rate to the current day’s central parity rate declined after the introduction of the CCAF.

### Mid-2016 to end-2017: stability vs CFETS basket
- Capital flow and reserve dynamics (early 2017)
  - Capital outflows abated in early 2017, reflecting CFMs, a pickup in external borrowing, the global economic recovery, improved growth outlook for China, and a weaker U.S. dollar.
  - FX intervention tapered off in early 2017 and reserves began to increase in February 2017 (partly due to valuation effects from a weaker dollar).
  - FX reserves rose by US$ 129 billion in 2017, after declining by US$ 833 in the previous two years.
- Exchange-rate behavior
  - After depreciating against the CFETS basket by 10 percent from mid-2015 to mid-2016, the RMB was broadly stable against the CFETS basket until the end of 2017.
  - With CFETS index publication and the central parity quoting formula in place, China effectively transitioned to a de facto adjustable basket peg.
  - Clark (2017) finds the central parity rate became predictable and responsive to market forces, but intraday RMB/USD movements were more influenced by FX intervention than by the central parity mechanism.

### First half of 2018 and increasing flexibility
- Depreciation pressures and movements (April–August 2018)
  - RMB/USD rate depreciated by 2.5 from late April to mid-June, and a further 7.5 percent through mid-August.
  - The RMB depreciated by 1 percent against the CFETS basket until mid-June, and then a further 5.5 percent until mid-August.
  - Significant capital outflows did not materialize in summer 2018, unlike previous depreciation episodes.
- Policy measures in August 2018
  - PBC reinstituted a reserve requirement of 20 percent for banks’ FX forwards transactions, encouraged banks to avoid “herd behavior”, and re-activated the counter-cyclical factor in central parity quotes.
  - RMB appreciated versus the U.S. dollar and CFETS basket somewhat after mid-August and then stabilized.
- Current characterization of the regime
  - Compared to 2005, the RMB is more flexible with respect to the U.S. dollar and now linked to the CFETS basket of currencies.
  - The RMB/USD rate continues to trade in a narrow range intraday; flexibility has increased particularly since the beginning of 2018, but volatility remains lower than other floating currencies.
  - The exchange rate is managed in the short-run but allowed to adjust in response to market forces in the longer run.
  - IMF’s 2018 External Sector Report assesses the RMB in 2017 to be broadly in line with fundamentals and desirable policies.
  - FX reserves stood at 97 percent of the IMF’s composite Assessing Reserve Adequacy metric unadjusted for CFMs; and at 157 percent of the metric adjusted for CFMs.
- Internationalization of the RMB
  - Offshore RMB market established in Hong Kong SAR in 2010; other offshore centers developed.
  - RMB included in the IMF’s SDR basket in 2015.
  - Financial liberalization measures instituted as a precursor to SDR inclusion, including relaxing interest rate controls and permitting full participation by foreign central banks and sovereign wealth funds in the domestic bond market.

### Key structural vulnerabilities and “fear of floating”
- Typical fear-of-floating factors
  - Misalignment concerns: the exchange rate does not seem managed to advantage exporters and the REER is estimated to be broadly in line with fundamentals, though concerns about potential misalignment remain.
  - Foreign-currency liabilities: aggregate FX exposures appear contained. Corporate debt is about 160 percent of GDP, but only 6 percentage points of this is denominated in foreign currencies.
  - Banks’ FX exposures: for the four largest banks, 11 percent of liabilities were in FX in 2015, with an offsetting amount of FX assets; individual bank gross FX exposure ranged from 26 percent of total liabilities (Bank of China) to 5 percent (Agricultural Bank of China).
- China-specific constraints on flexibility
  - Large pool of RMB savings seeking diversification and herding behavior increases vulnerability to large depreciation events.
    - M2 at around 200 percent of GDP.
    - Even a small fraction of households switching to foreign assets could lead to sizeable capital outflows.
    - Exporters reduced conversion of foreign currency income to renminbi after August 2015 and have not reverted to previous patterns; FX settlement as a share of foreign receipts exhibits a downward trend in the supplied chart.
  - Herding and lack of accustomed two-way exchange-rate movements make expectations sensitive and risk abrupt outflows, funding shocks, fire sales, and large-scale redemptions of short-term investments.
  - As a systemic country, potential external spillovers and co-movements: renminbi influences exchange rates of countries representing about 30 percent of global GDP; renminbi ranked seventh with a share of about 1.5 percent in worldwide payments in 2017.

### Progress on supporting conditions for exchange-rate flexibility
- FX market development and current gaps
  - CFETS interbank currency market expanded participation; 632 current members of the spot market, 32 designated market makers (as of data point).
  - CFETS trades in twenty-four currencies but over 95 percent of daily trading volume still in CNY/USD.
  - FX forwards, swaps, and options introduced in 2005, 2006, and 2011 respectively.
  - Limits on selling-buying spreads loosened; trading hours extended; cash settlement/netting of FX forwards allowed starting in 2018.
  - Liquidity and depth remain low versus floating countries:
    - China’s average daily FX turnover as a share of exports and imports is just 1¾ percent (BIS Triennial Central Bank Survey 2016).
    - Renminbi liquidity is higher offshore.
  - Market concentration and limited two-way movement impede participant experience and price discovery.
- Hedging instruments and usage
  - Share of FX derivatives transactions in average daily FX turnover in China rose from 10 percent in 2007 to 60 percent in 2016.
  - Use of hedging instruments by Chinese firms remains below cross-country averages for typical maturities; medium- and longer-maturity derivatives pricing is challenging.
  - Low liquidity in the medium and long end of the yield curve limits the reference function of government bonds for other instruments.
- Institutional capacity and nominal anchor
  - PBC has multiple objectives (price stability, boost economic growth, promote employment, maintain balance of payments, promote reform and market development) and lacks operational authority.
  - China has moved toward a market-based monetary framework, with the 7-day reverse repo rate used to send policy signals and the 7-day interbank repo rate as the operating target, while official policy rates remain published benchmarks.
  - Lack of transparency and clarity in communication causes uncertainty; brief or unclear announcements (e.g., August 2015) can trigger market turbulence.

### Policy recommendations (from the source)
- FX market and exchange-rate flexibility
  - Allowing sufficient exchange rate flexibility is a key step to improve efficiency of the market.
  - Create a sense of two-way risk in the exchange rate so that the exchange rate can appreciate or depreciate, to avoid one-directional sentiment and deter speculative capital inflows.
  - Encourage various types of institutions to participate in the interbank FX market to improve efficiency and depth.
- Market participant capacity and derivatives
  - Educate market participants about FX risks and encourage hedging to set the stage for increased exchange rate flexibility.
  - Monitor the use of derivatives closely to prevent sizeable leveraged bets that could destabilize markets.
  - Standardize derivative products traded among banks, ensure accounting standards for fair valuation, and maintain a reliable legal system for contract enforcement.
  - The central bank should promote market transparency and, with other regulators, high reporting standards.
  - Further develop the government bond market to improve benchmarks for credit pricing and proper pricing of hedging instruments.
- Monetary and institutional framework
  - Grant the PBC operational independence and develop an explicit policy rate, while the State Council sets overall goals for monetary policy (but not specific interest rates or monetary targets).
  - The PBC should guide the short-term interbank rate clearly and allow longer-term rates to be market-determined.
  - Strengthen the interest-rate based framework by: (1) formally acknowledging the framework, (2) dropping publication of benchmark lending rates, (3) gradually reducing distortionary high reserve requirements (offset as needed by open-market operations), (4) basing pricing and access to PBC lending facilities on clearly defined collateral rules (not supervisory criteria), and (5) aligning lending instruments more closely to PBC monetary policy objectives.
  - Improve and regularize communication: clarify objectives and instrument links, publish macroeconomic forecasts and information on models/frameworks, publish policy communications simultaneously in English, hold regular press conferences and a regular schedule of MPC meetings for policy interest rate decisions.

*Source: Excerpts from the IMF content unit wpiea2019050 (PDF chapter/section) provided in the prompt.*

### section II, the central parity is often set at a value that offsets some of the previous day’s

### wpiea2019050 - section II, the central parity is often set at a value that offsets some of the previous day’s

### Central parity formation, FX intervention, and communication
- The central parity is often set at a value that offsets some of the previous day’s exchange rate movements, particularly when the countercyclical adjustment factor is in use.
- When needed to limit excessive volatility, using only direct FX intervention and explicit PBC communication to affect the exchange rate is preferable to guiding it through the central parity rate or other forms of moral suasion.
- Rationale and findings:
  - Intervention is more effective: Clark (2017) found that FX intervention to dampen volatility during the trading day has a greater impact on exchange rate movements than the central parity mechanism.
  - The central parity rate can signal an intention to limit movement in a particular direction at the start of the trading day but, if there is enough pressure in that direction, FX intervention will be necessary in any case to limit it.
  - An opaque central parity formation shifts undue focus onto the central parity itself, leading market participants to try to interpret policy intentions through the rate instead of actual PBC statements.
  - Using only one instrument to manage the exchange rate is simpler and would facilitate the move towards less active management of the exchange rate in the future.
  - PBC communication to give context to exchange rate moves and provide guidance on economic factors shaping its future path is important.

### Policy recommendations (explicit)
- Central parity formation should be mechanical and transparent, and the quote formula should be consistent over time.
- FX intervention should be limited to minimizing excessive volatility, and sustained one-way intervention should be avoided.
- Publishing information on the PBC’s FX intervention would improve market understanding and strengthen the credibility of the policy framework.
- CFMs should be consistently and transparently enforced and clearly communicated, and they should not be used to actively manage the capital flow cycle and substitute for exchange rate flexibility.
- Providing guidance to the market on economic trends and their implications for the real exchange rate in the longer term would also help the market form expectations.

### Conclusion: direction for China’s exchange rate regime
- Reform progress:
  - China’s exchange rate regime has undergone gradual reform since the move away from a fixed exchange rate in 2005.
  - Regular steps towards greater exchange rate flexibility have been taken, accompanied by moves to increase participation and improve efficiency in the FX market.
  - As a result, the exchange rate has become more flexible over time, but it is still carefully managed.
  - Depth and liquidity in the FX market is relatively low compared to other countries with de jure floating currencies.
- Recommended next steps:
  - Allowing for greater two-way flexibility of the exchange rate is a critical next step.
  - Key measures to allow a greater role for market forces:
    - Make central parity formation for the daily trading band mechanical and transparent.
    - Limit the use of FX intervention to preventing excessive volatility.
    - Do not modulate CFMs to help manage the exchange rate.
  - Complementary reforms:
    - Further develop the FX market.
    - Improve FX risk management.
    - Develop an alternate monetary policy anchor by continuing to modernize the monetary policy framework.

### International experience and lessons for transition to flexibility
- Examples and timelines:
  - Chile, Israel, Poland, and Russia are examples of countries with gradual and, for the most part, orderly transitions to free floating exchange rates.
  - Time table to free float:
    - Chile: about 15 years.
    - Israel: 20 years (de facto free float achieved in 12 years; formal free float in 20 years).
    - Poland: 10 years.
    - Russia: 9 years.
  - The benefits of greater flexibility began at an early stage in the transition.
  - Many countries moved through several adjustments to avoid disorderly episodes while building supporting elements of a flexible regime.
- Typical process stages observed:
  - Adoption of crawling pegs initially to balance reducing inflation and safeguarding competitiveness.
  - Move to more flexible exchange rates within pre-announced horizontal or crawling bands, with direct FX market intervention used near band edges to smooth volatility.
  - Gradual widening of bands combined with decreased FX intervention until the exchange rate effectively floated freely; formal no-intervention policies used as floating was approached.
- Supporting conditions and institutional prerequisites:
  - Developing a deep and liquid FX market:
    - Central banks stimulated FX market development by widening trading bands, reducing their market role, and removing obstacles to market activity.
    - Presence of complementary financial markets, including liquid short-term interbank money and government securities markets, supported deep derivatives markets for hedging.
    - Precautions when liberalizing derivative transactions included prudential and supervisory rules to mitigate excessive risk taking.
  - Capacity to monitor, regulate, and manage exchange rate risks:
    - Private sector capacity to manage FX risk exposures was reasonable in most countries at the time of float.
    - Strengthened prudential and supervisory frameworks, explicit regulation and reporting of banks’ FX exposures, incorporation of FX exposures in capital requirements, maintenance of FX liquidity requirements, and stress testing were used.
  - An alternative nominal anchor and monetary policy framework:
    - Adoption of full-fledged inflation targeting (IT) frameworks followed lengthy transition periods.
    - Operational capacity to affect short term interest rates was generally well advanced when moving to a free float.
    - Central banks fostered well-functioning, liquid securities and interbank money markets by reducing the issuance of nonmarketable securities; using central bank bills and other marketable securities for monetary operations; creating appropriate infrastructure; setting standards (for example, for repurchase (repo) contracts, reference rates); and deregulating markets (for example, by removing credit ceilings and liberalizing deposit-loan rates).
  - Transparency and communication:
    - Determining appropriate transparency in communicating exchange rate strategy was an important challenge.
    - Countries tended to be more transparent about intervention strategy and preparation for greater flexibility when faced with credibility problems.
    - Abandoning undisclosed inner bands increased transparency and credibility of monetary policy and intervention strategies.
    - In Poland, regime changes were communicated in advance to provide market participants time to prepare, while some operational decisions were conveyed the day before or not announced at all to help avoid speculative activities.

*Source: wpiea2019050 - section II, the central parity is often set at a value that offsets some of the previous day’s*

---


_Source: https://www.imf.org/-/media/files/publications/wp/2019/wpiea2019050.pdf_