The Nature of China’s Exchange Rate Regime and the Potential Impact on Its Financial System

Abstract

More than five years have passed since China moved into an exchange rate regime with reference to a basket of some major currencies on 21 July 2005. Since then, the controversies over the costs and benefits of China’s exchange rate policy have intensified. More recently, the rapidly rising US indebtedness and pursuit of its quantitative easing policy, the current Eurozone crisis and China’s role in the global macroeconomic imbalances have reignited the debate about alternative reserve currencies. Since China has emerged as the world’s second largest economy and the biggest exporter, its currency has been severely under-represented in global trade and capital markets. Therefore, in light of the current currency war with a ‘rising dragon and falling eagle’, it seems natural to talk about Renminbi (RMB)¹ internationalization and its potential reserve currency role as a rival to the US dollar (USD) and other major currencies.