2010-08-04

China to use "effective exchange rate"

Onward for Yuan Reform (Part I)
Caixin: The reform that started in July 2005 focused on setting the yuan exchange rate with reference to a basket of currencies. However, there are many questions about this "basket." How did PBOC choose currencies in the basket, and what are their weights?

Hu: To select a basket of currencies, some countries or agencies have taken into account a single measure. For example, the Bank for International Settlements considers the weight of foreign trade. Because the exchange rate floats mainly on the basis of supply and demand in the real economy, the current account can comprehensively reflect the real economy. While in the current account, foreign trade is the most representative factor. As a result, in the selection of currencies in the basket, trade is among the first priorities.

In our opinion, the effective exchange rate basket should have a variety of currencies to reflect diversification of trade and investment. The weight is to be determined based on the current account situation and the currency structure of capital, and the financial account, and cross-border receipts and payments. Usually, currencies in those countries with active economic relations with us or frequently used in bilateral economic activities will be selected for the basket currencies.

Caixin: But people are still more closely following changes in the exchange rate of the yuan and dollar.

Hu: Yes. The mindset cannot be changed overnight due to behavioral habits and the dominant use of the U.S. dollar in accounting and statistics. This underpins the necessity for China to make more efforts to improve the exchange rate regime based on market supply and demand with reference to a basket of currencies.

In the future, consideration can be given to disclosure of the nominal effective exchange rate information on a regular basis and to gradually shift the public's attention on yuan-U.S. dollar exchange rate to the effective exchange rate of yuan, which is the true reference for its movement.

Caixin: As the measure of the exchange rate, is the nominal effective exchange rate a better choice than the real effective exchange rate?

Hu: Theoretically, the best indicator for measuring the international relative price of tradables is the real effective exchange rate, which reflects the movement of the dollar exchange rate to other major currencies and has been adjusted against cross-country inflation differentials.

In practice, however, the nominal effective exchange rate, which is not inflation-adjusted, is more frequently used. Reasons include the fact that it is hard to settle on a universally accepted, comparable price index. Though commonly used, the consumer price index may not be appropriate, according to academics, as it includes the prices of many non-tradables. Other options such as the producer price index, GDP deflator and the index of per unit labor cost are not widely accepted. Moreover, the calculation of the real effective exchange rate has to deal with time lags and availability of data.
The yuan will continue to be managed for the foreseeable future. It sounds like the role of market forces isn't so much supply and demand (though that will play an increasing role), but a valuation model more reliant on economic factors. This makes sense given the country's reliance on trade and it gives policymakers more tools to head off hot money flows.

I wonder if the Chinese will never actually float against the U.S. dollar, in that there may be an entirely new global financial system by the time they are ready to let the yuan float.

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