Structural Changes in the Renminbi Exchange Rate Mechanism

• Published date: 01 March 2021
• Author: Guanyu Su,Junhui Qian
• Date: 01 March 2021
• DOI: http://doi.org/10.1111/cwe.12368

©2021 Institute of World Economics and Politics, Chinese Academy of Social Sciences

China & World Economy / 1–23, Vol. 29, No. 2, 2021 1

Structural Changes in the Renminbi

Exchange Rate Mechanism

Guanyu Su, Junhui Qian*

Abstract

This paper examines structural changes in China’s exchange rate mechanism. For this

purpose, we propose a predictive model incorporating three factors that infl uence the

central parity rate: a smoothing factor, a market factor, and a basket factor. We first

apply the model to analyze the effects of 12 exchange rate reforms since 2005, treating

these reforms as predetermined structural breaks. Among other results, we find that

the main impact of introducing a “counter-cyclical factor” is to weaken the role of the

basket factor. We estimate structural breaks in data, assuming that the number and dates

of breaks are unknown, and we find that, although the majority of estimated breaks

occur within the neighborhood of exchange rate reforms, there are breaks due to other

external shocks such as the escalation of the China–US trade confl ict in May 2019. It is

suggested that our model may be used to guide future currency reforms in China.

Key words: central parity rate, exchange rate reform, RMB, structural change

JEL codes: F30, F31, F41

I. Introduction

The reform of the renminbi (RMB) exchange rate mechanism has come a long way

since 21 July 2005. Table 1 lists important milestones in the past 15 years. On 21

July 2005, the People’s Bank of China (PBC) announced the change to “a managed

fl oating exchange rate regime based on market demand and supply with reference to

a basket of currencies” (PBC, 2005) from a regime of hard pegging to the US dollar

(USD). In the new regime, the central parity rate (CPR) of the RMB against the USD

is announced around 9:15 a.m. each day, before the onshore exchange rate market

opens. Then the exchange rate of the RMB against the USD (USDCNY) is allowed

to fl uctuate within a range of ±0.3 percent around the CPR during the trading hours.

*Guanyu Su, PhD Candidate, Antai College of Economics and Management, Shanghai Jiao Tong University,

China. Email: suguanyu@sjtu.edu.cn; Junhui Qian (corresponding author), Professor, Antai College of

Economics and Management, Shanghai Jiao Tong University, China. Email: jhqian@sjtu.edu.cn. The authors

are grateful for fi nancial support from the Natural Science Foundation of China (No. 71673183).

Guanyu Su, Junhui Qian / 1–23, Vol. 29, No. 2, 2021

©2021 Institute of World Economics and Politics, Chinese Academy of Social Sciences

2

The fluctuation band was widened to [–0.5%, 0.5%] on 21 May 2007, [–1%, 1%]

on 21 April 2012, and [–2%, 2%] on 17 March 2014. On 11 August 2015, another

historical reform was introduced: the setting of CPR “should refer to the closing rate

of the inter-bank foreign-exchange market on the previous business day” (PBC, 2015).

In February 2016, the PBC introduced the mechanism of “the previous closing rate

plus changes in the currency basket” (PBC, 2016) for setting the CPR. Responding to

depreciation pressure in the fi rst half of 2017, a “counter-cyclical factor” was added

into the mechanism in May 2017. The CPR mechanism fi nally became “closing rate +

exchange-rate movements against a basket of currencies + the counter-cyclical factor”

(PBC, 2017). For a more detailed account of the evolution of the RMB exchange rate

mechanism, we refer to Yu (2018).

Table 1. Milestones in the reform of the RMB exchange rate

Milestones Date Main changes

“7.21” reform 21 July 2005 The managed-fl oating mechanism was introduced, with a [–0.3%, 0.3%]

fl uctuation band around the central parity rate.

4 January 2006 Market makers were introduced and a new mechanism for setting the

central parity rate.

21 May 2007 The fl uctuation band was widened to [–0.5%, 0.5%].

1 August 2008 Volatility restricted with the onset of the global fi nancial crisis.

19 June 2010 End of crisis mode.

“4.21” reform 16 April 2012 The fl uctuation band was widened to [–1%, 1%]. Banks’ foreign

exchange dealings were deregulated.

“3.17” reform 17 March 2014 The fl uctuation band was widened to [–2%, 2%]. Banks’ foreign

exchange dealings were deregulated.

“8.11” reform 11 August 2015 The central parity rate was allowed to refl ect market demand and

supply (previous closing rate).

15 February 2016 The mechanism of “closing rate plus exchange-rate movements of a

basket of currencies” was introduced for setting the central parity.

20 February 2017 The time window for calculating the movements of a basket of

currencies was modifi ed from 24 hours to 15 hours (4:30 p.m. previous

day to 7:30 a.m. current day).

26 May 2017 A “counter-cyclical factor” was introduced into the central parity

pricing mechanism.

9 January 2018 The counter-cyclical factor was set to neutrality.

1 August 2018 The counter-cyclical factor was restarted.

An extensive literature on the RMB exchange rate mechanism shows that the RMB

remains closely tied to the USD even after the “7.21” reform of 2005. Using the method

described by Frankel and Wei (1994), Ogawa and Sakane (2006) found no evidence

that the PBC targeted a currency basket after the “7.21” reform. Frankel and Wei (2007)

estimated the weights of an RMB currency basket and found that, from the “7.21”

reform in 2005 to January 2007, the estimated basket placed virtually all the weight on