Managing the Managed Float in China

Abstract

Despite the promising reform objectives announced on 21 July 2005, there remain much uncertainty and controversy surrounding China’s managed floating regime and its future. Hence, this research aims to provide a comprehensive analysis of the key issues raised over the course of the post-reform era.

We begin by investigating whether the flexibility of RMB has increased following the reform announcement. A daily-based flexibility indicator is developed to more accurately detect the extent to which the Chinese currency is market-driven. This indicator is then utilized in a Markov switching model. The subsequent results suggest that the RMB flexibility has switched between two distinctive regimes, confirming that RMB flexibility did increase after the 2005 reform, while the so-called Fear of Floating was also apparent. Additionally, we discuss possible driving factors underlying the evolution of the RMB flexibility.

Next, we consider another crucial aspect of the current managed floating regime, the equilibrium exchange rate level for RMB. The NATREX approach is selected, as we argue that it represents the most suitable solution for the purpose of our research. The empirical findings reveal not only the exogenous fundamental factors that have impacted the real exchange rate of RMB in the manner predicted by the NATREX model, but also evidence that the presumed portfolio channel did not work effectively for China in the sample period, which is contrary to the findings of previous studies.

Looking ahead, we argue that the Reference Rate system could be a promising option for China. From the managerial aspect, we propose an optimal exchange rate management for China, which takes the presence of heterogeneous agents into consideration. We demonstrate that this strategy, once adopted, offers the optimal trade-off between the cost of intervention and the cost of no intervention.