Renminbi (RMB) showed renewed tendency of weakening against the US dollar and other currencies recently and reached a new low in August 2023. This prompted important questions about China’s exchange rate policy: Which factors contributed to the recent weakening of RMB? Will the authorities tolerate increased exchange rate volatility? What would the central bank do if it were to intervene? These same questions emerged from time to time over the past two decades，although the fundamentals and policies of the foreign exchange market have evolved significantly during that period. The purpose of this article is to provide a framework for thinking about these questions and to provide some tentative answers.

In a nutshell，the exchange rate is the relative price of a currency. Therefore，the level of exchange rate，like the prices of meat and vegetables，is determined by demand and supply. What is unique about asset prices like currency value is the expectation of appreciation or depreciation，which could easily amplify movements in demand and supply. The current exchange rate regime for the RMB is called a “managed float”，which by definition is a product of both market and policy. The exchange rate can fluctuate freely，to a certain extent. But exchange rate stability is still important. Unfortunately，the central bank did not clearly define the threshold at which it began to intervene. This is probably the main source of policy uncertainty in the Chinese foreign exchange market. The central bank could intervene in the RMB exchange rate by setting the central parity of the exchange rate，buying and selling foreign exchanges，and restricting cross-border capital flows.

Determinants of Exchange Rate

There are three broad sets of factors influencing exchange rate，i.e. transactions directly related to current account activities，capital movements related to investment returns and longer term expectations about economy，finance and the currency. Since the exchange rate is the price of a currency relative to another currency or a group of other currencies，the level of the RMB exchange rate is determined by the demand for and supply of RMB in the foreign exchange market.

For most countries with closed capital accounts，current account balances essentially determine the directions of changes in exchange rates. For instance，exports generate revenue in hard currency，creating demand for domestic currency，while imports require payment in hard currency yielding domestic currency supply. Therefore，other things being equal，current account surplus implies pressure for domestic currency appreciation. During their boom years，export-oriented East Asian economies all enjoyed large current account surpluses. Around the mid-1990s，many East Asian economies experienced current account deficits. For countries with inflexible exchange rate regimes such as Thailand，escalating depreciation pressure eventually led to the collapse of the Thai Baht in July 1997.

As capital accounts were gradually liberalized，investment returns became increasingly more important factors influencing cross-border capital flows and exchange rate movements. International financial flows associated with Federal Reserve Bank’s (Fed) monetary policy adjustments offered one good example. In 2020，in the wake of the COVID-19 pandemic，the Fed aggressively cut the policy rate to zero and injected large volumes of liquidity into the market. This led to lower US market interest rates and more capital outflows. As a result，the US dollar depreciated somewhat，and some emerging market economies experienced capital inflows and currency appreciations. Again in 2022，as the Fed rapidly tightened monetary policy in response to high inflation，some emerging market economies experienced capital outflows and currency depreciations.

The final set of factors concerns investor expectations. If investors are positive about an economy，they would be more willing to hold its currency. This could contribute to currency appreciation. After China joined the WTO at the end of 2001，the economy quickly boomed and market participants became very optimistic about China’s economic outlook. Many foreign-invested enterprises kept their profits in the country，instead of repatriating profits out of China as planned. Although the RMB did not appreciate until July 2005，when the exchange rate became flexible，the pressure for currency appreciation mounted very quickly before that.

The above three-tiered framework is useful for understanding exchange rate movements，as different factors play different roles at different times. For instance，in the early 2000s，appreciation pressures on the RMB were dominated by large current account surpluses and accumulation of foreign exchange reserves.

Main Policy Considerations

As the RMB’s bilateral exchange rate against the USD moved above 7 in mid-May，2023，investors’ anxiety about the central bank’s tolerance and likely policy action escalated rapidly. In order to shed light on these important issues，it is useful to take a step back and understand the policy framework.

The current exchange rate regime is called a “managed float”，which is neither a free float nor a fixed rate. The essence of RMB’s current “managed float” mechanism includes the following two elements. First，at the beginning of the trading day，the People’s Bank of China (PBOC) sets the central parity of the exchange rate based on the closing rate of the previous trading day，overnight movements in exchange rates and other policy considerations such as a counter-cyclical factor. Secondly，the daily trading band is set at plus or minus 2%.

This design is consistent with the PBOC’s official language about the exchange rate policy: increasing flexibility of the exchange rate; letting market forces playing greater roles in determining exchange rate; maintaining stability of the exchange rate at the equilibrium level. Clearly，the policy objective is to eventually introduce a market-based exchange rate system with limited short-term volatility. The People’s Bank of China Law stipulates that the objective of monetary policy is to maintain stable currency value and support economic growth. Therefore，exchange rate stability，but not fixed exchange rates，is a very important macroeconomic policy objective.

Exchange rate affects economic activities through at least two channels – the trade channel and the financial channel. A weaker currency enhances export competitiveness and promotes economic growth. This explains why most export-oriented economies have policy biases in favor of weaker currencies. However，the financial channel may work in the opposite direction. A weaker currency triggers capital outflows and inhibits economic growth.

Perhaps the most important effect of exchange rate movements is on financial stability. The weakening of the currency not only triggers capital outflows，but also leads to rapid worsening of expectations. In the worst case scenario，this could result in a financial crisis as investors rush to the door. The worst case scenario could be significantly reduced if the domestic financial market is well developed and the financial regulatory regime is mature. In 2015 and 2016，Fed's aggressive tightening of monetary policy triggered massive capital outflows and financial crises in South Africa，Turkey and Russia.

The Chinese policymakers’ tolerance toward exchange rate volatility is also driven by concerns about economic and financial stability. However，the threshold is not clearly and accurately defined. In fact，the threshold is probably also an endogenous variable given dynamic economic and financial conditions. It is therefore almost impossible to predict an exact level of the exchange rate that would trigger policy intervention.

Policy Options

So what can the PBOC do if it decides to intervene in the foreign exchange market? There are at least three policy tools.

The first is the daily “central parity” setting. Although the policy reform introduced on August 11，2015，significantly increased the role of market factors，the existence of “policy consideration” and especially “counter-cyclical factor” allows policymakers to “manage” the exchange rate. For instance，if the central bank wishes to reduce currency depreciation，it could always set the “central parity” at a level stronger than the closing rate of the previous trading day. This could limit the extent of currency depreciation over time.

The second is to buy and sell foreign exchange reserves in foreign exchange markets. In the early 2000s，when the PBOC resisted pressure from RMB appreciation，it purchased a large amount of USD. Again，in the second half of 2015 and 2016，when the PBOC resisted pressure from the depreciation of the RMB，it sold a large amount of USD，leading to a significant contraction of foreign exchange reserves.

And the third is to adjust the capital account control measures. If the RMB is under pressure to depreciate，the central bank can encourage capital inflows and limit capital outflows. In 2015-2016，the central bank did not change the policy framework，but stepped up efforts to implement control measures. Such measures could be “effective” in reducing depreciation pressure but could cause lasting effects on investor confidence.

International investors often also speculate that the PBOC intervene in exchange rate indirectly by window-guiding financial institutions’ trading activities in foreign exchange markets. Such channels，even if they still exist in some ways，are probably not common phenomena anymore.

The overall takeaways are that China’s exchange rate regime already evolved from the fixed system to “managed float”. Market forces are increasingly important in determining exchange rate. The medium-term goal is to achieve “managed free float”，meaning that management becomes very infrequent and unusual. But the current “managed float” regime means that the central bank reserves the right to intervene when the exchange rate becomes too volatile. And the central bank’s main concerns are about macroeconomic and financial stability.

The author is the Vice President of National School of Development，Peking University