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New forex management rule a big step forward

By Yi Xianrong (China Daily)
Updated: 2008-08-14 15:45

The revised version of the rule on foreign exchange management was released on August 6 and became effective immediately.

The new rule is a significant progress in China's scheme of managing foreign exchange because it has laid a foundation for free exchange of renminbi in the future. Although the new stipulation does not mean liberating the capital account, it has taken effective measures to facilitate the scheme of forming the exchange rate as well as the cross-border capital flows.

The rule on foreign exchange management was launched on January 29, 1996 and revised on January 14, 1997 for the first time. It played an important role in balancing China's international payment and controlling the country's financial risks.

However, many unprecedented issues surface along with the Chinese economic boom and the intensification of economic globalization, posing challenges to foreign exchange authorities. Thus, the rule must be adapted to the new situations in and out of the country.

One of the most urgent issues to be addressed in the new rule came up after the authorities loosened renminbi's pegging to the US dollars in July 2005.

In our traditional method of foreign exchange management, currency inflows were encouraged while the outflows were not. Such logic was nurtured against the background of a planned economy when the foreign exchanges were rare.

After the renminbi exchange rate reform in 2005, this logic remained valid, which directly led to a double surplus under the regular account and the capital account for China. The foreign exchange reserve kept rising dramatically.

The huge pool of foreign exchange reserve is costly and risky to hold. Worse, the compulsory settlement system of foreign currencies increases liquidity in the economy and stimulates the bank credit growth, pushing up the asset prices.

Meanwhile, speculative money swarmed into China for higher-than-average returns because of the defects in the management system of foreign exchange.

All these happenings posed direct shocks to China's economic soundness and threatened its financial market as well as sustained development of the manufacturing industry.

When the new foreign exchange rule was staged against such a background, it achieved four goals of reform.

The first aspect was that the new rule stresses a balance between capital inflow and outflow. The compulsory settlement of foreign exchange is dropped. As long as the capital inflow and outflow under the regular accounts are based upon true and legal transactions, individuals and businesses could keep their income in foreign currencies in or out of the country according to their own choices.

Foreign exchange flowing in under the capital account should be used exactly in the authorized means. Illegal inflow of foreign currencies or settlement would incur heavy punishment.

The foreign exchange supervisors have the right to watch and review the capital flows and their destinations. Thus, speculative money would be checked.

The second aspect is that the businesses involving foreign exchanges in financial institutions were more strictly watched.

In the new rule, it was stipulated that the renminbi follows a managed floating exchange rate in line with the market demand and supply. All financial institutions engaged in currency settlement and exchange should carry out their foreign currency businesses on the intro-bank market according to relative rules. And the authorities also keep an eye upon the financial institutions on their foreign currency positions.

The third aspect is to establish an emergency contingency mechanism for international payments. Besides seeking an international payment balance, the foreign exchange management authorities put more emphasis upon financial risk control.

It not only collects the daily information about cross-border capital flows through reading the daily sheets, but also watches the situation in real time.

When an emergency occurs, either in the international payments or in the national economy, the State could initiate the contingency plan.

The foreign exchange managers are hence getting a legal approval to "intervene in the foreign currency market and secure the State financial security" in case of a crisis, which was not there in the original rules.

The fourth aspect is the new rules have a specific statement about the means and measures that could be adopted by the foreign exchange managing authorities.

To sum up, the new rules of foreign exchange management have been comprehensively revised and adjusted to increase the market players' freedom, boost the market's fairness and enhance supervision of the market.

It not only helps establish an effective system for forming the renminbi exchange rate, but also assists in curbing international speculative money. In this aspect, it is not an overstatement to say that the new rule is a historical progress in reforming the foreign exchange management scheme.

The author Yi Xianrong is a researcher with the Institute of Finance and Banking under Chinese Academy of Social Sciences.