[A3B2 Ver: 8.07r/W] First Proofs CESIFO ifj004 Page: 1–30[28/4/06] {OUP_FPP}cesifo/ifj004.3d [OUP]On the Yuan: The Choice between Adjustmentunder a Fixed Exchange Rate and Adjustmentunder a Flexible RateJeffrey Frankel*AbstractFixed and flexible exchange rates each have advantages, and a country has the right tochoose the regime suited to its circumstances. Nevertheless, several arguments supportthe view that the de facto dollar peg may now have outlived its usefulness for China.(i) Although foreign exchange reserves are a useful shield against currency crises, by nowChina’s current level is fully adequate, and US treasury securities do not pay a high return.(ii) It may become increasingly difficult to sterilize the inflow over time. (iii) Althoughexternal balance could be achieved by expenditure reduction, e.g. by raising interest rates,the existence of two policy goals (external balance and internal balance) in generalrequires the use of two independent policy instruments (e.g. the real exchange rate andthe interest rate). (iv) A large economy like China can achieve adjustment in the realexchange rate via flexibility in the nominal exchange rate more easily than via priceflexibility. (v) The experience of other emerging markets points toward exiting from a pegwhen times are good and the currency is strong, rather than waiting until times are bad andthe currency is under attack. (vi) From a longer-run perspective, prices of goods andservices in China are low—not just low relative to the US (0.23), but also low by thestandards of a Balassa–Samuelson relationship estimated across countries (whichpredicts 0.36). In this specific sense, the yuan was undervalued by 35 percent in2000, and is by at least as much as it is today. The study finds that, typically acrosscountries, such gaps are corrected halfway, on average, over the subsequent decade.These six arguments for increased exchange rate flexibility need not imply a free float.China is a good counter-example to the popular ‘‘corners hypothesis’’ prohibition onintermediate exchange rate regimes. However, the specific changes announced by the* Jeffrey Frankel is a Harpel Professor for Capital Formation and Growth, KennedySchool of Government, Harvard University, MA, USA, e-mail: [email protected] earlier version of this article, ‘‘On the Renminbi: The Choice Between AdjustmentUnder a Fixed Exchange Rate and Adjustment under a Flexible Rate,’’ was originallydrafted for a seminar held in Dalian, China, 26–27 May 2004, and appeared as NBERworking paper no. 11274. A more informal and condensed version was published as ‘‘Onthe Renminbi,’’ in CESifo Forum, vol. 6., no. 3, Autumn 2005, Ifo Institute for EconomicResearch, Munich, pp. 16–21. It is anticipated that the present revised and updatedversion of the article will be published in Understanding the Chinese Economy, edited byGerhard Illing (CESifo Economic Studies, Munich).The author would like to thank Maral Shamloo for efficient research assistance, theKuwait Fund at Harvard University for support and Yong Zhang; and to thank the tworeferees and participants at conferences in Dalian the American Enterprise Institute, theEuropean Central Bank and the Allied Social Science Association meetings for theircomments.ß The Author 2006. Published by Oxford University Presson behalf of Ifo Institute for Economic Research, Munich. All rights reserved.For permissions please e-mail: [email protected] 1 of 30CESifo Economic Studies, 2006, doi:10.1093/cesifo/ifl004[A3B2 Ver: 8.07r/W] First Proofs CESIFO ifj004 Page: 1–30[28/4/06] {OUP_FPP}cesifo/ifj004.3d [OUP]Chinese authorities in July 2005 have not yet resulted in a de facto abandonment of thedollar peg (JEL classification: F41).On the Renminbi‘‘I have listened to both sides of this debate. Here is what I think.I think those who call for a fixed exchange rate are right in the shortrun. And those who call for a floating exchange rate are right inthe long run. How long is the short run, you ask? You mustunderstand. China is 8000 years old. So when I say, short run, itcould be 100 years.’’–Li Ruogu, Deputy Governor, People’s Bank of China, Dalian,May 2004, as paraphrased by the author.‘‘Certainly we don’t want ... the US situation of having a trade deficitof 6 percent of GDP’’– Li Ruogu, Deputy Governor, People’s Bank of China, as reported bythe Financial Times, p.1, 12/23/04, under the headline, ‘‘China Tells USto Put its House in Order.’’An exchange rate that is de facto fixed has served China well over thelast 8 years. Nevertheless, the recommendation of this article is that thetime has probably come to allow the yuan to appreciate. This judgement isreached for four major reasons. First, calculations based on the Balassa–Samuelson relationship suggest that the real value of the renminbi is(and has for some time been) low—not just low compared to the US dollaror of other rich countries, but substantially below even the equilibriumvalue for a country at China’s stage of development. Second, althoughhistory shows that foreign exchange reserves are a useful shield againstcurrency crises, China’s level of balance of payments surplus and reserveacquisition has by now been very high for several years, so that thecountry is currently giving up a lot when it buys (low-return) US treasurysecurities with the proceeds it raises from (high-return) inward invest-ments. Third, while the authorities have been remarkably successful atsterilizing the inflow since 2002, and the threat of overheating that existedin 2004 seems to have disappeared by 2006, it is doubtful that they cankeep up sterilization on this scale indefinitely. A strategy that continuesto exclude appreciation from the policy response mix will becomeincreasingly difficult. Fourth, the experience of other emerging marketssuggests that it is better to exit from a peg when times are good and thecurrency is strong, than to wait until times are bad and the currency isunder attack. A country as large as China probably requires an exchangepage 2 of 30CESifo Economic Studies, 2006J. Frankel[A3B2 Ver: 8.07r/W] First Proofs CESIFO ifj004 Page: 1–30[28/4/06] {OUP_FPP}cesifo/ifj004.3d [OUP]rate regime with some flexibility, and this is a good time to begin movingin that direction.This need not mean a move to pure floating. An intermediate regimesuch as a target zone is probably more