Removing Regulatory Barriers in China: Changing the Foreign Exchange Regime

YC Richard Wong and ML Sonia Wong
The University of Hong Kong

I. Introduction

This paper examines the way in which China has transformed itself from a highly centralized foreign exchange regime towards current account convertibility. The focus of the paper is on the endogenous aspect of the process. We describe the way in which the open door policy and other reforms in China have expanded the foreign exchange rate's role in the Chinese economy and have compelled the government to remove regulatory barriers on foreign exchange transactions. We also describe the way in which reform in the foreign exchange regime fueled itself and created pressures for further reforms, especially in banking. Consistent with China's approach to economic reform, relaxation of exchange controls in the country has proceeded incrementally, experimentally, and pragmatically. It has also strived for a minimal number of conflicts with vested interests.

The paper is structured as follows. In section 1, the introduction, we provide some historical background in order to put the reform which China's economy has undergone in recent years into perspective. In section 2, we examine the way in which the highly centralized foreign exchange system became the two-tier system when China attempted to promote exports. In section 3, we investigate the way in which China unified the exchange rates and established a unified inter-bank foreign exchange market in 1994 and the way it moved towards current account convertibility in 1996. In section 4, the effects of foreign exchange reform on export performance are examined. Some final remarks are offered in the concluding section.

I.I Background Information

Before China's economy opened up, all foreign trade in the country was conducted strictly according to mandatory plans. These consisted of import and export plans upon which the central planning authority decided. In determining these plans, the authority sought to achieve a balance in foreign exchange requirements. The heavy reliance on mandatory plans implied that the foreign exchange rate had very little influence on the level and the pattern of foreign trade. Rather, it was essentially an accounting device used in the formulation of foreign trade plans. In China's pre-reform period, the exchange rate played no direct role as a price signal in either foreign trade or in the allocation of resources in China.

The role of the exchange rate began to change in 1978, after China decentralized foreign trade authority to localities and enterprises. When foreign trade corporations (FTCs) were given a certain degree of freedom to conduct foreign trade, the exchange rate began to act as a signal to motivate importing and exporting decisions. Because the domestic currency was overvalued, FTCs had little incentive to expand exports. To counteract the disincentive effects of exports due to exchange rate overvaluation, China began to modify its foreign exchange policy shortly after the decentralization of foreign trade took place. The modifications that occurred were as follows.

First, the official exchange rates were steadily devalued so as to compensate for the rising costs of exports. Second, the foreign exchange retention scheme, whereby exporting enterprises and local governments were allowed to retain a certain portion of their foreign exchange earnings to finance their own imports, was introduced. Third, foreign exchange swap markets, which allowed exporters to convert their retained foreign exchange earnings at more favorable exchange rates, were established in 1988. Although the retention scheme and the swap markets were designed to provide incentives to exporters, they also helped to increase the convertibility of China's domestic currency.

From 1988 to 1993 China had a two-tier foreign exchange system. It consisted of (1) the administrative allocation system through foreign exchange plans, and (2) the buying and selling of the retained foreign exchange earnings through swap markets. As compared with the highly centralized foreign exchange allocation system of the pre-reform period, the two-tier foreign exchange system allowed markets to play a role in the allocation of foreign exchange. It was reasonably effective at stimulating the growth of exports and at improving the efficiency of the Chinese foreign trade. The system, however, had problems. It introduced distortions in price signals, which could in turn exert a pervasive influence on the allocation of resources as the Chinese economy became increasingly open and price responsive.

On January 1, 1994, China unified its official and swap market exchange rates and established a unified inter-bank foreign exchange market. The 1994 reform was a major step towards current account convertibility. Afterwards, exports, tourism, and foreign direct investment grew briskly, at rates of 31.9 percent, 56.4 percent, and 22.7 percent, respectively, in 1994 (see table 1). Foreign exchange reserve increased by 114.5 percent in 1994 and 42.6 percent in 1995. By the end of 1996 the foreign exchange reserve of China had reached US$105 billion. It was able to meet the IMF requirements for current account convertibility on December 1, 1996, without causing major fluctuation in the foreign exchange market.

Table 1: China's Foreign Trade, Investment, and Exchange Reserve, 1983-1996
(Billions of US$)

Source: Data for 1989 to 1995 was obtained from the Statistical Yearbook of China. Data for 1996 came from China's most recent economic statistics and from China Economic News

II. From Plans To a Two-tier System

When foreign trade was decentralized in 1978, China recognized that the practice of requiring FTCs to surrender all their foreign exchange earnings to the government at an overvalued exchange rate would depress the returns received from exports and hence reduce FTCs' export incentives. Starting in 1978 China modified the foreign exchange management so as to promote exports. Measures adopted included the devaluation of the renminbi, the introduction of the foreign exchange retention scheme, and the establishment of foreign exchange swap markets. These measures not only helped to promote exports, they also created a more liberalized two-tier foreign exchange system and paved the way for current account convertibility.

II.I. Devaluation

Before the decentralization of foreign trade took place, the effect of the exchange rate on exports and imports was not the main issue at stake for exchange rate determination in China, because trade flows were determined largely by plans. The exchange rate was set with an eye towards its influence on a few non-trade items such as remittances from overseas Chinese and earnings from tourism. As a result, the exchange rate was fixed mainly on the basis of the relative prices of a basket of consumer goods in China and in other major cities in the world. Because many consumer goods in China were under-priced, this led to a substantial overvaluation of the renminbi (Wang 1991, Lardy 1992).

To alleviate the disincentive effects of the overvaluation on exports, the government began steadily devaluing the renminbi after 1980. The first round of devaluation began on January 1, 1981, with the introduction of an internal settlement rate of 2.8 yuan per U.S. dollar in trade transactions. [1] The internal settlement was determined on the basis of the average cost of generating one U.S. dollar of foreign exchange earnings plus a 10 percent margin (Wang 1991, 67). That devaluation marked a turning point for China's foreign exchange rate policy. From 1981 to 1993 exchange rates in China were determined largely on the basis of the costs of generating foreign exchange earnings (Lardy 1992). In line with the rising average costs of generating foreign exchange earnings, the exchange rates were being adjusted downward gradually so as to make exports profitable. The major devaluations before the unification of exchange rates in 1994 are shown in table 2.

Table 2: Major Devaluation Episodes in China: 1980-1993

* refers to the devaluation from the official exchange rate to the internal settlement rate. The internal settlement rate was abolished at the end of 1984.

>From 1981 to 1993 there were six devaluations in China. The amount of devaluation ranged from 9.6 percent to 44.9 percent. The devaluations that took place in 1981, 1986, 1989, and 1990 were major ones in which the exchange rate was adjusted in one shot. The devaluations that took place in 1985 and 1993 were minor ones in which the exchange rate was continuously adjusted downward by small amounts.

The changes to China's exchange rate before 1994 had an important feature. Although the exchange rate was set to make exports profitable, the official exchange rates were usually lower than were the costs of generating foreign exchange earnings, as is revealed in table 3. This suggests that devaluation in this period was employed to passively compensate for the rising costs of exports rather than to actively promote export. As devaluation implied a gain for exporters and a loss for importers, it was politically easier for the government to introduce it when the average costs of generating foreign exchange earnings had already exceeded the official exchange rate.

Table 3: Average Costs of Generating Foreign Exchange
Earnings and the Official Exchange Rates: 1979-1996

Source : For average costs of generating foreign exchange earnings, data for 1979-1988 and 1990 was obtained from Zhang 1993, 86; data for 1989 was obtained from Sung 1994, 126; and data for 1991-1992 came from Lin 1992, 224. Data for 1995 came from Xiao 1996. It was obtained by the author during a trip to the Shanghai area in June 1995. Official exchange rates were obtained from the Statistical Yearbook of China.

The fact that the official exchange rate moved in accordance with the average costs of generating foreign exchange earnings also implied that devaluation in this period might have been driven by the domestic price reform, the enterprise reform, and the exchange rate policy itself. Before the introduction of the price reform and the enterprise reform, the government had relatively good control over export costs, because domestic enterprises had to deliver fixed quantities of domestic goods to FTCs at fixed prices according to plans. As price reform and enterprise reform in China continued, domestic enterprises could set the prices and the quantities of goods that they supplied to FTCs. The relative shortage of goods in the domestic market meant that FTCs had to compete for the exportables and bid up the costs of exports. The government was forced to devalue the currency. The devaluation itself fueled further rises in prices and once again exerted pressure on the exchange rate.

II.II. Foreign Exchange Retention

Except for a very few years during which the internal settlement rate was used, the average costs of generating foreign exchange earnings in China have generally been higher than the official exchange rate. Why did exporting enterprises have an incentive to export when the costs of generating foreign exchange earnings were higher than the official exchange rates? In China, the differential between the average cost of generating foreign exchange earnings and the official exchanges rate does not reflect the true profitability of FTCs, because of the foreign exchange retention system. The foreign exchange retention scheme was introduced in 1978 to enhance exporting enterprises' incentives to export. [2] After exporting enterprises had sold all their foreign exchange earnings to the government at the official rate, the government allowed exporting enterprises and local governments to reserve a certain amount of foreign exchange. If they wanted to use the retained foreign exchange, they could use renminbi to buy it back from the government according to the prevailing exchange rate, as long as the use of the foreign exchange fell within the confines of regulation. As the official exchange rates were overvalued, the right to buy back foreign exchange at the official rates in effect further devalued the domestic currency. Foreign trade corporations thus had an incentive to expand their exports until the average costs of generating foreign exchange earnings were higher than the official exchange rates (Zhang 1993).

The permitted rates of foreign exchange retention in China have changed considerably since 1978. In 1979 the retention rate for exports handled by ministerial trading enterprises was 20 percent of earnings above the level of exports achieved in 1978. The retention rate for exports of local government was 40 percent of earnings above the 1978 level. [3] In 1982 the government-fixed retention rates for each region were equal to the share of total export revenues retained in the previous year. The provincial rates ranged from as low as 3 percent to as high as 25 percent. In 1985 the government raised the retention rate to a minimum of 25 percent for all regions. [4] In addition to the basic retention rate, all provinces could also retain 70 percent of the above-plan foreign exchange earnings. In 1987 the government granted a preferential retention rate of 70 percent for foreign trade enterprises in light industry, arts and crafts, and garments. In 1988 the contract responsibility system was implemented in the foreign trade system. Under the new system, the amount of foreign exchange earnings submitted to the central government was fixed by contract and, above that, foreign exchange earnings would be shared by the local and central governments at a ratio of eight to two. According to the estimate of the World Bank (1994), the effective retention rate from 1987 to 1990 was about 44 percent of all foreign exchange earnings. In 1991 the government increased the retention rate further when export subsidies were abolished. For most commodities, 80 percent of total foreign exchange earnings could be retained. The government, however, reserved the right to purchase at the swap rate 30 percent of foreign exchange earned from commodity exports.

Although the foreign exchange scheme was designed to provide incentives to exporters, it broke the monopoly the government had during the pre-reform regime on the access to and the use of foreign exchange. Now the government had to share foreign exchange earnings with exporters. Although there were various restrictions on the use of retained exchange, the holders of foreign exchange quotas usually had a considerable degree of discretion when it came to the use of foreign exchange earnings, especially after 1988. [5] The continuous increase in the permitted retention rates represented a continuous diminution of the government's monopoly power over the access to and the use of foreign exchange. The Chinese transition to currency convertibility was gradual. It started in 1979 with the introduction of the foreign exchange retention scheme.

Foreign exchange reform in many developing countries has failed due to opposition from vested interests. China was fortunate in that the volume of imports in the pre-reform period was low, and hence vested interest in the old regime was not great. The rapid and continuous expansion of exports allowed the central government to maintain its desired volume of imports when the permitted foreign exchange retention rates were raised for enterprises and local governments. In 1993 the permitted retention rate had reached 80 percent, but exports also increased to US$91.74 billion. The government meanwhile could still obtain more than US$18 billion to finance its imports, an amount nearly double its volume of imports in 1978.

II.III. Foreign Exchange Swapping

Shortly after the foreign exchange retention system was introduced, exporting enterprises and local governments received permission to sell foreign exchange quotas to units which sought access to foreign exchange to purchase imports. The possibility of swapping foreign exchange further enhanced export incentives, because it gave holders of foreign exchange quotas another opportunity to capture the value of retained earnings. In addition to purchasing imports, they could convert retained earnings at rates that were more favorable than were the official rates. [6] Similar to the foreign exchange retention system, foreign exchange swapping, in effect, permitted further devaluation of the domestic currency. The exchange rates in swap centers and the transaction volumes from 1980 to 1993 are shown in table 4.

The first foreign exchange swapping service was established by the Guangdong Branch of the Bank of China in 1980, and it was soon extended to twelve major cities (Wang 1991). The price of early transactions was 3.08 yuan per U.S. dollar (Wang 1991). As the swapping price was only 10 percent more than the internal settlement rate and the rate of foreign exchange retention was not high in the early 1980s, the transaction volume in the early years was modest. Nevertheless, the early transactions represented a breakthrough in China's foreign exchange allocation system. They marked the beginning of an era in which the price mechanism would be used to allocate foreign exchange in China.

The first foreign exchange swap market opened in 1985 in Shenzhen. Markets then opened in Shanghai and Beijing in 1986 and in Tianjing in 1987. From 1985 to 1987, the foreign exchange swap markets provided swapping services to joint ventures only. Domestic enterprises were not allowed to participate. The annual transaction volume in foreign exchange swap markets in this period was low, at US$ 1.89 billion in 1986 and US$ 4.2 billion in 1987 (Lin 1993, .195).

In 1987 domestic enterprises in light industry, arts and crafts, and garments were allowed to sell their retained foreign exchange in the foreign exchange swap markets. In April 1988 all domestic enterprises were allowed to sell their retained earnings in foreign exchange swap markets. The relaxation of exchange controls gave further impetus to the expansion of the number of swap markets as well as to the transaction volume. It also provided additional incentives to exporters. By the end of December 1992 there were over 100 swap markets, and the transaction volume had reached US$25 billion (World Bank 1994).

Table 4: Swap Market Prices and Transaction Volume: 1980-1993

Sources: For swap rates, data for 1980-1986 was obtained from Wang 1991, 81-2; data for 1997-1992 comes from World Bank 1994, 35. The transaction volumes were obtained from Lin 1993, 195 and 224. 1993 figures come from the Almanac of China's Finance and BankingBanking.

The foreign exchange swap markets were not entirely free markets. Initially, the government attempted to control swap rates by imposing ceiling rates. In February 1986 a price cap of 4.2 yuan per U.S. dollar was imposed (Wang 1991, 82). In 1988-1989 there was a price cap of 5.7 yuan per U.S. dollar (Lin 1993, 224). Since 1989, swap market prices have been liberalized gradually. To achieve this gradual liberalization, the government has pegged the prices by intervening in swap markets rather than by setting prices directly. [7]

Secondly, the government imposed controls on the sources and the use of foreign exchange. In the late 1980s sellers had to provide documents to show that foreign exchange had been acquired legally. In most cases, buyers had to obtain import licenses (or other relevant documents) from the Ministry of Foreign Economic Relation and Trade (MOFERT) and administrative approval for their transactions from the State Administration of Exchange Control (SAEC). Beginning in December 1991, when all domestic residents were allowed to sell their foreign exchange in the swap markets without being required to show proof of their sources of foreign exchange income, selling foreign exchange at the swap markets was virtually unrestricted. In contrast, buying foreign exchange from the swap markets was still subject to the administrative approval of MOFERT and SAEC. SAEC's authorization was based on a priority list that reflected the industrial policy of the state. [8]

Finally, transactions across swap markets were restricted. There were significant differentials in exchange rates across markets in different parts of the country. Exchange rates in the eastern and western regions were generally higher than the average rates, and the southern region's swap rates were usually the lowest in the country (Huang and Wong 1995). The market segmentation implied that there were barriers to direct arbitrage between markets.

Although transactions in the swap markets were subject to various restrictions, the establishment of the swap markets was a major step towards current account convertibility. With the increase in transaction volume in the swap markets, the price mechanism began to play a more and more important role in the allocation of foreign exchange in China.

III. From A Two-tier System Towards Current Account Convertibility

In 1994 China moved to unify the exchange rates and establish a unified inter-bank foreign exchange market. The demise of the two-tier foreign exchange system was caused, in part, by its own success. The system had helped China to expand its foreign trade and foreign investment. China's increased openness, however, strengthened the link between the external sector and the internal sector. It increased the distorting effects of the multiple exchange rates (the official rate, the swap market rates, and the black market rates) on the allocation of resources in China. There were increasing pressures on the government to correct the exchange rate. On the other hand, expansion in exports and foreign investments also resulted in a substantial foreign exchange reserve, which made the strict exchange controls less of a policy imperative.

On January 1, 1994, China unified the two-tier exchange rates at the prevailing swap rate of 8.7 yuan per U.S. dollar. Foreign exchange swap markets were replaced by a national inter-bank foreign exchange market with its headquarter in Shanghai. [9] The foreign exchange retention scheme and the foreign exchange plans were abolished, and a foreign exchange selling and buying system was introduced. All foreign exchange income derived from all sources by all Chinese enterprises and institutions had to be sold to designated banks. In exchange for the compulsory selling of foreign exchange, enterprises were granted more freedom to buy back foreign exchange from banks. For general imports, enterprises could buy foreign exchange at authorized banks by presenting import contracts and payment notices issued by financial institutions abroad. For imports under quota, license, and registration management, enterprises could buy foreign exchange by presenting the corresponding contracts and other “valid certificates” issued by MOFERT. Although the purchase of foreign exchange was still restricted, the 1994 reform was a major step towards the convertibility of the renminbi for current account transactions.

The new exchange rate system introduced in 1994 is a managed floating system. At the beginning of each trading day, the People's Bank of China (PBoC) publishes the renminbi exchange rate, based mainly on the dealing rates at the foreign exchange market on the previous day. The designated foreign exchange banks quote their own rates within a floating range set by the PBoC. The establishment of the national inter-bank foreign exchange market has improved the efficiency of foreign exchange allocation, since foreign exchange is traded at a unified rate in a unified national market.

As part of the 1994 reform, foreign-funded enterprises were allowed to continue to keep their foreign exchange in designated accounts instead of selling it to an authorized bank, as domestic enterprises were required to do. They were, however, denied access to the inter-bank market. They continued to buy and sell foreign exchange through swap markets, generally under case-by-case review and with the approval of the SAEC. Starting in the first half of 1996, foreign-funded enterprises in certain trial areas are permitted to buy and sell foreign exchange from authorized domestic banks without the SAEC's approval for most current account transactions. Their access to the inter-bank exchange market was extended nationwide beginning on July 1, 1996. They are allowed to maintain a foreign exchange settlement bank account within pre-approved limits. Also following a trial period, foreign bank branches in China are allowed to provide foreign exchange settlement and exchange business for foreign-funded enterprises. On November 27, 1996, Dai Xianglong, governor of the People's Bank of China, announced that China would meet the IMF requirements for current account convertibility beginning on December 1, 1996.

China's move from a two-tier system towards current account convertibility has been gradual. The 1994 reform was an incremental change rather than an abrupt plunge into an entirely new foreign exchange regime. Most of the practices in the new system had already existed before the introduction of the reform. Starting on December 1, 1991, Chinese residents and permanent foreign residents were already allowed to sell and buy foreign exchange from swap markets. In March 1993 residents and travelers were allowed to carry a maximum of 6000 yuan in and out of China. In June 1993 a pilot scheme launched in Guangzhou allowed foreign travelers to change foreign exchange directly into renminbi. At the end of 1993 swap market rates already covered 80 percent of China's current account transactions (World Bank 1994). What the unification of exchange rates achieved was essentially an expansion in the coverage of the swap market rates to all international payments and capital flows.

In 1996, after the inter-bank foreign exchange market had been operating quite smoothly for almost three years, foreign-funded enterprises were permitted to join in as well. On the other hand, restrictions prevailing before the reform on the convertibility of renminbi were retained. Buyers of foreign exchange still had to present a “valid certificate” to authorized banks. Foreign-funded enterprises still had to comply with their foreign exchange balancing requirement by means of an annual foreign exchange review and foreign registration procedures.

Perhaps the most fundamental change to take place after 1993 was the abolition of the swap markets and the establishment of a unified inter-bank foreign exchange market for domestic enterprises. Under the new system, exchange rate stability and current account balance have to be maintained through monetary policies of the PBoC and administrative controls of MOFERT rather than through foreign exchange controls on the current account transactions. Consequently, exchange rate determination is no longer simply a trade or current account issue. Broader economic concerns relating to macroeconomic stability and monetary and fiscal policy were brought into the picture, as were different political and economic constituencies. Exchange rate determination had an effect beyond imports and exports, but with wide sectors of the economy through the inter-linkages of various markets and bureaucracies. These changes make it increasingly urgent for China to speed up banking reform and to develop a set of market-based policy instruments. They also make it increasingly important for China to speed up enterprise reform. It will be difficult for the central bank to stabilize the exchange rate as long as authorized domestic banks have not been completely commercialized; interest rates are not market determined, and enterprises have not yet been subject to hard budget constraints.

The establishment of the unified foreign exchange market in an increasing open and market-oriented economy also means that the PBoC's exchange rate policy has direct implications for the macroeconomic stability of the economy. In 1994 there was a surge in the foreign exchange supply due to the rapid expansion of exports and foreign direct investment (see table 1). In order to maintain a stable foreign exchange rate, the PBoC bought a large amount of foreign exchange on the foreign exchange market. The intervention of the PBoC increased the money supply and was one of the important factors behind the high rate of domestic inflation, which reached about 25 percent at that time.

Such interrelations between the internal and external sectors of the Chinese economy imply that exchange rates in China cannot be set with an eye simply towards promoting exports. In fact, following the 1994 reform, exchange rates in China could no longer be determined on the basis of the costs of generating foreign exchange earnings. From 1994 to 1996 the general price level in China rose more than 40 percent, and there was a substantial increase in the costs of generating foreign exchange earnings. The renminbi, however, appreciated slightly due to an increase in the foreign exchange supply, as was evidenced by the rising foreign exchange reserve. The currency appreciation and rising export costs reduced the profitability of exports. Exports grew at a rate of only 1.5 percent in 1996. Despite the strong voice from the exporting sector to devalue the renminbi so as to promote exports, the PBoC maintained a stable renminbi due to its concern over controlling domestic inflation. The strengthened link between the internal and external sectors of the Chinese economy has expanded the constituents of the exchange rate policy beyond the foreign trade sector. China now has less latitude in which to employ the foreign exchange policy to promote exports.

IV. Foreign Exchange Reform and Export Performance: 1981-1996

When China began implementing the open door policy, it had inherited from the old regime a foreign exchange control system that was extremely unfavorable for export expansion. From very early on, the government began to adjust the exchange rates and to relax the foreign exchange controls so as to increase export incentives. The liberalization measures created a two-tier foreign exchange system that played an important role in stimulating and sustaining export growth. In 1994 China unified the exchange rates and established a unified inter-bank foreign exchange. The reform shifted the focus of the foreign exchange policy from promoting exports to maintaining macroeconomic stability. The effects of foreign exchange reform on export performance from 1981 to 1996 are shown in figure 1.

Figure 1 shows that export growth from 1981 to 1993 was quite closely related to the differential between the effective exchange rates and the average costs of generating foreign exchange earnings (ACOGFEE), expressed as the percentage of the ACOGFEE (see appendix 1 for data explanation). As we have argued, the differential between the official exchange rates and the average costs of generating foreign exchange earnings is not a good indicator of the profitability for exports. The effective exchange rate faced by exporters in China is the weighted average of the official and swap market rates, with the weights being determined by the foreign exchange retention ratio. Figure 1 suggests that devaluation, the foreign exchange retention scheme, and the swap markets were effective in raising the profitability of exports. The exporting enterprises in China were responsive to these reform measures, and hence foreign exchange reform was one of the important causes of China's export growth. It should be noted that from 1988 to 1993, when the swap markets were in operation, export growth was less closely related to the differential between the effective exchange rates and the average costs of generating foreign exchange earnings. The major reason for this was that the swap markets had provided exporters with the opportunity to hoard retained foreign exchange quotas for speculative purposes. With the abolition of the swap markets and the introduction of the foreign exchange buying and selling system in 1994, the export performance is once again corresponding closely to the differential between the effective exchange rate and the average costs of generating foreign exchange earnings. China, however, has less freedom to use the foreign exchange rate policy to promote exports.

V. Concluding Remarks

A central economic planning system is essentially a set of complex and intertwined regulations imposed by central planners to straitjacket market forces. The objective of central planners is to achieve a pattern of resource allocation that is different from the pattern dictated by the market forces. Removing regulatory barriers in a centrally planned economy is path-dependent. Removing certain regulations in a particular sector releases the market forces and affects the functioning of other regulations in that sector. Pressures are created for the removal of some of the remaining regulations in that sector. Further liberalization of a sector releases market forces, which affect the functioning of other sectors. Removing regulatory barriers in different sectors then becomes interrelated. The removal of regulations in one sector creates pressures to remove regulations in other sectors. The removal of regulations in other sectors provides a new impetus to remove the remaining regulations in the original sector. It is possible for a liberalization process in a particular sector to trigger a gradual liberalization process that eventually transforms the very nature of the original economic system.

China's reform of its foreign exchange regime during the past two decades has been a gradual, evolutionary process. China's transition towards current account convertibility was not governed by a grand blueprint designed to construct a well-functioning foreign exchange market. The coherence that emerged was certainly not envisaged by the Chinese reformers when the internal settlement rate and the foreign exchange retention scheme were introduced. At the outset of the reform, relaxation of foreign exchange controls was driven by the decentralization of foreign trade. It expanded the role that the exchange rate played in the Chinese economy and compelled the government to remove the regulatory barriers to foreign exchange transactions. The relaxation of exchange controls stimulated foreign trade and strengthened the link between the external and internal sectors of the economy. Pressure arose to implement further reforms of the foreign exchange regime. With the establishment of a unified inter-bank foreign exchange market in 1994, there was an urgent need for China to speed up the banking and enterprise reform.

After the 1996 reform, current account convertibility in China remained restricted. The restrictions can be justified by the fact that the foreign exchange reform took place prior to reforms in other sectors of the economy. The immediate removal of all controls in an environment in which state-owned enterprises were still not subject to hard budget constraints and in which the banking sector had not been completely commercialized could have caused massive devaluation and created severe macroeconomic instability. Restrictions have to be phased out eventually so as to improve the efficiency of the inter-bank foreign exchange market. At this point, China's basic challenge is that of speeding up its banking and enterprise reform so as to coordinate its further reform in foreign exchange regime.

Reference

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Appendix 1

Export Performance and Differential between Effective Foreign Exchange Rates
and Average Costs of Generating Foreign Exchange Earnings In China 1981-1996

Note: The effective exchange rates are calculated as a weighted average of the official rates and the swap rates. For 1981, the retention rate is 9 % (Lardy, 1992). The retention rates for 1982-1986,1987-1990 and 1991-1993 are obtained from World Bank (1994). They are 25%, 44% and 80% respectively. The average costs of generating foreign exchange earnings for 1993-1996 are estimated by inflating the average cost of generating foreign exchange earnings in 1992 by the retail price index.

Removing Regulatory Barriers in China:

Changing the Foreign Exchange Regime
Paper Prepared for the Conference of

China as a Global Economic Power:
Market Reforms in the New Millennium

Shanghai, June 15-18, 1997

By YC Richard Wong and ML Sonia Wong
The University of Hong Kong
E-mail address: rycwong@econ.hku.hk
mlswong@hkusua.hku.hk

Footnotes

[1] When the dual exchange rate system was created, China began to devalue the official exchange rate, which was 1.55 yuan per U.S. dollar in January 1981. By the end of 1984 the official exchange rate had reached 2.8 yuan per U.S. dollar, and the internal settlement rate had been abolished.

[2] In 1979 the government approved the expansion of the system to the non-trade sector.

[3] There were also separated retention rates applying to certain new types of trade. For example, the retention rate for fees from processing and assembly of foreign components was 30 percent of all earnings.

[4] The rate for Guangdong and Fuijian was raised to 30 percent, and the rates for Inner Mongolia, Xianjiang, Guangxi, Yunnan, Guizhou, and Qinghai were raised to 50 percent.

[5] In 1985, after a sharp fall in the foreign exchange reserves, the government imposed very restrictive controls on the use of retained foreign exchange and froze a large share of the retained earnings. The controls were removed in 1988.

[6] As noted by Lardy (1992), some exporters failed to utilize all their retained foreign exchange because they were unable to obtain licenses for the imports they desired.

[7] In February 1993 the government again imposed a price cap of 8 yuan per U.S. dollar on swap centers in an attempt to stem the year-long fall in the yuan. That price ceiling was removed in May 1993.

[8] For details of the priority list, please refer to World Bank (1994).

[9] From January 1994 to July 1996 foreign-funded enterprises continued to buy and sell foreign exchange through the swap markets.

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