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UPDATED: August 2, 2010 NO. 31 AUGUST 5, 2010
Monetary Policy Proving Effective
Top banker argues for greater exchange rate flexibility

In response to domestic and international economic and financial conditions, as well as changes in foreign exchange reserves, the central bank focuses on managing inter-bank liquidity, making use of hedging instruments, such as open market operations and the reserve requirement ratio, in an effort to hedge against the rising foreign exchange reserves and absorb excess liquidity in the banking system. But those measures cannot root out the pressure of excess liquidity. Judging by the structure of basic currency sources, the proportion of loans given by the central bank to financial institutions has been decreasing, while renminbi counterparts of foreign exchange reserves have become a major channel for basic money supply in the market. As a result, the independence of the monetary policy is affected. In recent years, China's CPI has maintained a relatively low level, but the general levels such as PPI, and asset prices in areas such as real estate, have been increasing to a large extent. In addition, with increasing liquidity in the banking system, large-scale issuance of central bank bills and the frequent adjustment of the reserve requirement ratio have also had an impact on the operations of commercial banks and the efficiency of the financial system. Therefore, the central bank's hedging cost is on the rise.

Exchange rate's role

Traditional financial theory stated that in an open economic system, a free flow of capital, an independent monetary policy and a stable exchange rate cannot all be achieved at the same time. Generally speaking, only two can be realized simultaneously. Small open-market economies can give up domestic monetary policy in order to achieve exchange rate objectives. For instance, the Hong Kong Special Administrative Region adopted a currency board system in which the Hong Kong dollar is strictly pegged to the U.S. dollar. Hong Kong's interest rate adjustment follows the U.S. Federal Reserve movement. Singapore uses the exchange rate as an intermediary to achieve the goal of monetary policy adjustment. It manages macroeconomic control by using exchange rate instruments rather than adjusting interest rates. As China is a populous country of 1.3 billion people, it should not give up its own monetary policy objectives. China should adopt a more flexible exchange rate regime, stabilize the inflationary level and change the economic growth model.

Currently, a more flexible exchange rate system would help to control inflation and asset bubbles. For instance, when domestic inflationary pressure is high, a proper appreciation of domestic currency can make imported goods less expensive. As a country with a severe shortage of resources, China must import many primary products. Exchange rate adjustment will help relieve "imported" inflationary pressure.

Restructuring the economy and changing its growth model is not only an urgent strategic task, but also a prolonged, arduous endeavor. During the process, China's foreign trade should be more balanced. It is helpful to use managing price measures, such as the exchange rate, to readjust trade imbalances and imbalances in international payments and to relieve pressure stemming from the influx of foreign currencies and mounting foreign exchange reserves. This will also help ensure steady and sustained economic development and a steady money supply.

International practices show a flexible exchange rate regime can help mitigate external economic turbulence, reinforce a nation's ability to withstand external crashes and stabilize the macroeconomy. The series of financial crises that have taken place since 1990 have demonstrated that a rigid exchange rate regime is most vulnerable to speculative forces and can trigger monetary crisis.

A flexible exchange rate regime could also help improve the transmission mechanism of the monetary policy. The exchange rate regime reform started in 2005 prompted Chinese enterprises and commercial banks to voluntarily adapt to exchange rate fluctuations, and greatly enhanced their ability to adapt to market changes. Money and foreign exchange markets have been further developed. Financial institutions have strengthened their risk management, improved services and sped up product innovation. This has laid a micro-basis and market basis for monetary policy transmission. The improvement of the monetary policy transmission mechanism will play a positive role in strengthening the effectiveness of the monetary policy.

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