The report from the 19th National Congress of the Communist Party of China clearly stated that market-oriented reforms of the renminbi exchange rate need to be deepened. Now is the time to accelerate that effort. What steps will we see in this effort? The following article attempts to address that question and assess the issues that policy makers will be considering.

From the 1980s to the first half of the 1990s，the renminbi was pegged to the US dollar，and over that period，the renminbi's exchange rate was adjusted downwards several times. The value of the Chinese currency was revised from 1.5 to one US dollar at one point to 8.7 to the US unit at its weakest level. At the beginning of 1994，a new exchange rate reform took effect，as China proposed establishing a single rate，replacing a dual rate framework covering different types of transactions. It was described as a managed floating rate system that was based on market supply and demand.

In the ensuing three years，the exchange rate was adjusted to reflect the surplus in the international balance of payments，gradually strengthening from 8.7 renminbi to one US dollar to 8.3 renminbi to the dollar. However，since 1997，in order to cope with the impact of the Asian financial crisis and later to maintain the nation's export competitiveness，authorities basically abandoned the target of exchange rate reform set in 1994 and intervened to stabilize the exchange rate to stop the national currency from appreciating. That kept the exchange rate effectively fixed at 8.3 renminbi to the dollar. China became a country with an exchange rate peg once again.

In July 2005，under the rapid accumulation of trade and capital surpluses，China decided to carry out another reform，announcing that the renminbi's exchange rate would be based on a basket of currencies. It also said that the daily trading range for the renminbi against the US dollar should be confined to 0.3% above or below a mid-rate. By March 2014，the range had been widened to 2% above or below the mid-rate. The 2005 reform set the course for nearly a decade of continuous appreciation of the renminbi.

On August 11，2015，in order to deepen the market-based reform of the renminbi and facilitate the renminbi's smooth inclusion into the International Monetary Fund's Special Drawing Rights system，a basket of reserve currencies，the People’s Bank of China announced an improvement in the mid-rate quotation formula. Market makers would provide price quotations to the China Foreign Exchange Trade System (CFETS) each morning by referring to the previous day's closing exchange rates，taking into account supply and demand on the foreign exchange market and changes in exchange rates of major international currencies overnight. Such a far-reaching reform has brought an end to the opaque and rigid state of the formation mechanism of the renminbi mid-rate and making the renminbi exchange rate more market-oriented.

In February of 2016，the central bank released another rules-based innovation in determining the renminbi mid-rate against the dollar. Under the new framework，the mid-rate would be based on the closing market rate of the previous day，while also taking into consideration the effect of the renminbi exchange rate index (as calculated by CFETS) which would be based on a trade-weighted average of 13 currencies. The basket was later expanded to 24 currencies. Specifically，the renminbi mid-rate would be equal to the average of the change in the relative price of the closing price of the previous day and the change in the mid-rate required to keep the renminbi exchange rate index unchanged over the past 24 hours.

In 2017，the central bank introduced a counter-cyclical adjustment factor to its formula. Under this pricing framework，the mid-rate would be equal to the previous day's closing price plus the exchange rate changes of a basket of currencies and the counter-cyclical adjustment factor. With the counter-cyclical adjustment factor included，the mid-rate could offset pro-cyclical fluctuations and thereby avoid over-reactions by the market.

Since the beginning of 2016，the exchange rate reform has systematically guaranteed relative stability in the renminbi against the US dollar，and this has helped curb irrational market behavior. However，it has actually weakened the market nature of the renminbi exchange rate. As such，we can say that after decades of exploration and reform，the degree of marketization of the renminbi exchange rate system in China has improved somewhat，and the currency's flexibility has increased though to a limited degree.

Reasons for Accelerating Reform

There are several important reasons for accelerating the reform of the renminbi exchange rate system.

This will allow us to better resist external shocks and ensure the independence of our monetary policy. At present，the global economy and financial system are entering a period of relative turmoil. As an important step towards the normalization of monetary policy，the US Federal Reserve announced its balance sheet reduction plan in October 2017. Since then the Trump administration has rolled out the largest tax reduction in the past 30 years. Regulations covering the financial sector，energy and pharmaceuticals have been rolled back and plans are being discussed for a large-scale infrastructure investment package. These could lead to an economic boost reminiscent of the Reagan era of the early 1980s. With higher interest rates and a stronger dollar，we could see a massive inflow of global capital to the US. That could mean financial turmoil in emerging market economies.

China is the second largest economy in the world and its economic and financial cycles are not in sync with those of the biggest economy - the US. China therefore needs to conduct an independent monetary policy. At present and for a substantial period into the future，China's monetary policy needs to remain basically neutral amid continuing downward pressure on the nation's real economy. At the same time，in the face of real estate bubbles，we need to guard against excessive monetary tightening in the near term. Improper tightening would likely pop the real estate bubbles，committing the mistakes made by Japan in the late 1980s.

Facing the impact of US currency and tax policy adjustments，we need to maintain the renminbi's exchange rate at a stable level and raise domestic interest rates. Even if the People's Bank of China does not raise benchmark interest rates，market controls aimed at preventing a depreciation of the renminbi eventually will lead to increases in domestic market interest rates.

Of course，we can deal with this kind of situation by strengthening controls over capital outflows. But if we reintroduce some control measures that had previously been removed，the market may interpret this in a negative way. This would undermine the overall image of the reform and opening up program，and that in turn could create new pressures from capital outflows.

There are many ways to evade foreign exchange regulations. In practice，new management measures will not necessarily work. Therefore，it is advisable to expand the trading range of the renminbi in the effort to make the exchange mechanism more flexible. Allowing appropriate fluctuations in the exchange rate can effectively cushion the domestic economy from unfavorable external pressures.

It would also help to withstand large-scale speculative attacks on the currency. Both theory and practice show that flexible exchange rate arrangements are more conducive to resisting speculation. Because in the face of a large number of cross-border trade and capital flows，the lack of an elastic exchange rate arrangement can easily over-estimate or underestimate the value of the local currency. That can create expectations of currency depreciation or appreciation. Relatively flexible exchange rate arrangements tend to allow timely adjustments of exchange rates and thereby avoid a sustained overestimation or underestimation of value. Because expectations include risk premiums，speculation under a fixed or pegged rate regime can be significant even when nominal interest rates at home and abroad are about equal or when domestic nominal rates are higher than nominal rates abroad. The financial crisis in Thailand in July 1997 was a typical case of a speculative attack on an overvalued Thai baht.

China’s foreign exchange reserves began a prolonged downward trend after reaching an historic high of nearly US$4 trillion in June 2014. Over the fourth quarter of 2015，reserves declined by nearly US$100 billion each month. In 2016，the downward trend slowed but by early 2017 the total of reserves had fallen below US$3 trillion. The drop of US$1 trillion in foreign exchange reserves resulted from a combination of factors，including a shift of foreign exchange from official accounts into the hands of the public as well as currency valuation effects. However，it is undeniable that the main reason was that reserves were used to head off large-scale speculative attacks against the currency.

Despite the heavy cost，ensuring the security of the financial system was worth the effort. Taking into account the added sources of risk，increasing credit defaults，the relative weakness of financial regulation and other conditions in China’s financial system，market regulation now needs fresh adaptations. For long-term stability，an effective mechanism to deal with speculative shocks should be established as soon as possible.

It is also necessary to expand the opening up of the financial system to foreign investors. This is already a long-term strategy for China. Since the beginning of the century，great strides have been made in opening up China's capital account. At the beginning of 2016，about 40% of the types of transactions in China under the 40-item capital account as calculated by the International Monetary Fund (IMF) had achieved "basic convertibility" while 50% were considered "partially convertible" and 10% were "non-convertible." Looking ahead，with the further liberalization of China’s economy，it will be an important goal to achieve basic convertibility of more types of transactions under the capital account. In order to achieve this goal，we need more preparation in the areas of state-owned enterprise reform，financial market reform，financial supervision and reform of the exchange rate system. The so-called "trilemma" theory states that a country cannot achieve the free flow of capital，a fixed exchange rate and an independent monetary policy simultaneously. In order to make a further opening of the capital account possible，the exchange rate system needs to become more flexible.

The conditions for pushing ahead with reforms have become increasingly mature. Through years of economic structural readjustment，China’s economic development has largely shed its former export-oriented model. Exchange rate stability is therefore much less important than it had been in the past. In order to grow domestic demand，however，there is a need for independent monetary policy，and that means that exchange rate flexibility is of considerable significance.

Additionally，after more than a year of market consolidation and policy adjustments，market expectations of renminbi depreciation have largely disappeared. New reform measures are unlikely to produce significant one-way market effects. In addition，foreign exchange reserves of $3 trillion are more than sufficient to meet the needs of ensuring stability. According to the IMF calculations，the nation has more than US$1 trillion more than it needs to cope with market volatility.

The Next Steps in Reform

The reform of the renminbi exchange rate system includes two aspects. One is the marketization of the intermediate exchange rate formation mechanism and the other is the gradual expansion of the permitted daily trading range around the mid-rate -- often called the parity rate -- of the currency against the dollar. In August 2015 and January 2016，we made substantial strides in the marketization of the mid-rate mechanism. The next step in the reform process can focus on expanding daily fluctuations. The author believes that authorities should pay close attention to the feasibility of expanding the fluctuation of the renminbi against the US dollar around the mid-rate and determine proper measures for implementation. Since the mid-rate needs to take into account the movements of a basket of currencies，an increase of the daily trading cap to 5% up or down from the current 2% should not have a great impact.

In order to ensure smooth progress in this reform，it is necessary to make some policy adjustments. For example，it is necessary to maintain the existing management of capital flows and avoid introducing new measures of capital outflow liberalization for the time being.

After the flexibility of the renminbi exchange rate system has been expanded，all transactions that figure in the international balance of payments may have an impact on exchange rate fluctuations. Generally speaking，current account transactions (especially trade) have a relatively modest impact on the exchange rate. This basically reflects changes in the real economy. Capital account transactions，especially securities and other investments often result in wider swings in the exchange rate. They are often associated with speculative arbitrage and not related to the fundamentals of the real economy. According to current market supply and demand，in order to prevent an excessive fall in the renminbi exchange rate -- similar to Japan's experience after an expansion of the currency's trading range - any reform plan should include appropriately strengthened controls over capital outflows. Authorities should also continue to strengthen audits of current account transactions to ensure authenticity. At the same time，the liberalization of capital inflows can continue to be appropriately encouraged. Reviewing the history of the nation's foreign exchange reforms，we can see that one of the successful aspects of the 1994 foreign exchange reforms was that while proclaiming a single，managed float exchange rate system，there was also an emphasis on continuing to strengthen capital account (external debt) management. Such historical experience still serves as a useful guide for our current policies.

It is also necessary to strengthen communication with the public and make use of a wide range of media channels in order to guide and manage exchange rate expectations. Policy statements from central banks and other regulators can have an impact on the exchange rate. Analysts and commentators have argued that the depreciation of the renminbi after the exchange rate reform on August 11，2015 was partly due to the fact that the market failed to fully understand the central bank’s intentions. In order to avoid a recurrence of that kind of reaction in future，we should attach greater importance to communication with the market and strive to gain market understanding and acceptance before formally announcing policy reform measures.

Moreover，it is necessary to intensify the exchange of information and policy communication with the central banks of the developed countries，such as the US，and strive for positive policy coordination in order to create a favorable external environment. The macroeconomic policies and structural reforms of the world's second largest economy have a significant global impact.

A strengthening or weakening renminbi as well as the regulation of the nation's foreign exchange market can have an impact on international financial markets. Therefore，if the People's Bank of China can communicate with the central banks of advanced economies as it drafts plans for reform or even as it is ready to disclose those plans，this will help reduce the impact on the international financial markets. This in turn will help smooth the process of domestic reform.

Finally，it is necessary to accelerate the development of foreign exchange derivatives markets，such as foreign exchange swaps，currency futures and currency options. For a long time，domestic enterprises and financial institutions have lacked sufficient hedging tools to deal with the risks arising from exchange rate fluctuations. This has been one of the main obstacles to the reform of the renminbi exchange rate system. In turn，the lack of progress in the development of hedging products is due to the small fluctuations in the renminbi exchange rate. This kind of vicious cycle must be broken. Otherwise，the reform of the renminbi exchange rate will remain under constraint. Chinese enterprises and financial institutions will be unable to fully adapt to the changes in the international financial market. The development of hedging tools as part of the overall exchange rate reform will help make breakthroughs in these cycles.

The author is a professor at the School of Finance at the Central University of Finance and Economics