China has maintained a nearly fixed exchange rate of 8.26 renminbi (RMB) to the U.S. dollar since 1994, in spite of the near total collapse of practically every other fixed exchange rate regime over the last decade.
Hong Kong, a special administrative region of China, happens to have the world's other so-far durable fixed exchange rate regime. That is a coincidence, geographically speaking. In Hong Kong's case the stability of its exchange rate derives from the currency board apparatus that was installed before the 1997 reversion to China. The Hong Kong currency board model may be appropriate for smaller developing economies. Large economies are better candidates for floating exchange rates.
If China is going to fulfill the objective of competing on the level of Japan, Europe, or the United States, it would make sense to move to an RMB floating regime (see, e.g., Dorn 2003). This advice coincides with recent pronouncements from the International Monetary Fund, encouraging China to drop or modify the peg.
How did China's fixed exchange rate survive when over the last 15 years fixed exchange rate regimes have self-destructed in such far-flung places as Russia, Mexico, Thailand, the Philippines, Turkey, and Argentina, to name a few?
Pegged Exchange Bates and Capital Controls
The superficial answer is that China is different because it does not allow full capital account convertibility. This means money can flow into China but it cannot subsequently leave without permission. China allows convertibility for current account transactions but not for capital account items.
Yet economists know capital controls are never absolute and, as Milton Friedman is fond of saying, there is no such thing as a legislative proscription. Circumstantial evidence suggests China's controls are porous. And indeed the controls are leaking. One investment bank estimates that $70 billion of "hot money" (betting on a revaluation of the RBM) flowed into the PRC in 2003 only to flow back out in May and June 2004 when a change to foreign exchange regime looked less likely. Hot money was defined as the change in foreign exchange reserves less total of the trade surplus and foreign direct investment flows.
What then is the significance of capital controls? Consider Malaysia's much touted experience with capital controls in the late 1990s which was much misunderstood. Malaysia installed capital controls in September 1998, a full 14 months after the onset of the Southeast Asian currency crisis (usually marked from July 1997, the date when Thailand released the baht from its peg). Despite misleading claims, Malaysia did not find a "kinder, gentler way" to deal with its currency crisis by the rather public freezing of foreign exchange...