CESifo Economic Studies Advance Access originally published online on May 10, 2006
CESifo Economic Studies 2006 52(2):246-275; doi:10.1093/cesifo/ifl004
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On the Yuan: The Choice between Adjustment under a Fixed Exchange Rate and Adjustment under a Flexible Rate
Fixed and flexible exchange rates each have advantages, and a country has the right to choose the regime suited to its circumstances. Nevertheless, several arguments support the view that the de facto dollar peg may now have outlived its usefulness for China. (i) Although foreign exchange reserves are a useful shield against currency crises, by now China's current level is fully adequate, and US treasury securities do not pay a high return. (ii) It may become increasingly difficult to sterilize the inflow over time. (iii) Although external balance could be achieved by expenditure reduction, e.g. by raising interest rates, the existence of two policy goals (external balance and internal balance) in general requires the use of two independent policy instruments (e.g. the real exchange rate and the interest rate). (iv) A large economy like China can achieve adjustment in the real exchange rate via flexibility in the nominal exchange rate more easily than via price flexibility. (v) The experience of other emerging markets points toward exiting from a peg when times are good and the currency is strong, rather than waiting until times are bad and the currency is under attack. (vi) From a longer-run perspective, prices of goods and services in China are low—not just low relative to the US (0.23), but also low by the standards of a Balassa–Samuelson relationship estimated across countries (which predicts 0.36). In this specific sense, the yuan was undervalued by 
35 percent in 2000, and is by at least as much as that today. The study finds that, typically across countries, such gaps are corrected halfway, on average, over the subsequent decade. These six arguments for increased exchange rate flexibility need not imply a free float. China is a good counter-example to the popular "corners hypothesis" prohibition on intermediate exchange rate regimes. However, the specific changes announced by the Chinese authorities in July 2005 have not yet resulted in a de facto abandonment of the dollar peg (JEL classification: F41).
* Jeffrey Frankel is Harpel Professor for Capital Formation and Growth, Kennedy School of Government, Harvard University, MA, USA, e-mail: Jeffrey_Frankel{at}harvard.edu
An earlier version of this article, "On the Renminbi: The Choice Between Adjustment Under a Fixed Exchange Rate and Adjustment under a Flexible Rate," was originally drafted for a seminar held in Dalian, China, 26–27 May 2004, and appeared as NBER working paper no. 11274. A more informal and condensed version was published as "On the Renminbi," in CESifo Forum, vol. 6., no. 3, Autumn 2005, Ifo Institute for Economic Research, Munich, pp. 16–21.
The author would like to thank Maral Shamloo for efficient research assistance, the Kuwait Fund at Harvard University for support; and to thank Yong Zhang, the two referees and participants at conferences in Dalian, the American Enterprise Institute, the European Central Bank and the Allied Social Science Association meetings for their comments.