China

Evolution of China’s
Exchange Rate Regime
in the Reform Era

1

Reforms of China’s exchange rate regime have been a key factor underlying
the country’s growing participation in global trade since economic reform
began in 1978. From 1949 until the late 1970s, the state fixed China’s
exchange rate at a highly overvalued level as part of the country’s importsubstitution industrializationstrategy. Through its system of economic
planning, the state adopted policies to accelerate industrial development
in order to reduce China’s dependence on imported manufactured
goods. These policies included direct controls on imports and exports,
an overvalued exchange rate, and tight controls over foreign exchange.
The overvaluation of the currency allowed the government to provide
importedmachinery and equipment to priority industries at a relatively
lower domestic currency cost than otherwise would have been possible.
But the overvalued exchange rate led to excess demand for foreign
exchange and turned the terms of trade against producers of China’s exports, which in the 1950s were predominantly agricultural and processed
food products. As early as 1950 the Chinese authoritiesintroduced extensive exchange controls that, among other things, required the deposit of
all sources of foreign exchange, including export earnings, in the Bank of
China, the sole institution authorized to deal in foreign exchange.1 This
surrender requirement was facilitated by the establishment of a small
number of state-controlled trading companies that specialized in trade
in well-defined,nonoverlapping product lines. By the mid-1950s, the few

1. Beginning in 1985 the state began to gradually allow other banks to conduct foreign
exchange transactions. The Bank of China is a commercial bank while the People’s Bank of
China is China’s central bank.

3
Peterson Institute for International Economics | www.piie.com

remaining nonstate companies engaged in international tradewere nationalized, ensuring direct state control of virtually all sources of foreign
exchange. The Bank of China, in turn, allocated the limited supply of foreign exchange to priority uses identified by the state through its economic
planning process.
The overvaluation of the currency naturally depressed the domestic
prices of traditional export goods and undermined the incentive to
producethem. The state sought to overcome this problem by requiring
producers to achieve specified levels of output and product sales to state
trading companies for sale in the international market.
Several types of evidence support the view that the Chinese currency
was systematically overvalued for the three decades before reform began in the late 1970s. First, the currency was inconvertible andsubject to
extensive exchange controls, summarized above. Second, the domestic
currency cost of earning one dollar in export sales substantially exceeded
the exchange rate throughout the 1950s–70s (Lardy 1992, 24–27), so foreign trade companies, on average, lost money on their export sales. For
example, in 1975 products that cost RMB3 on the domestic market could be
sold internationally for $1;but since the exchange rate was only RMB1.86
per dollar, a trading company would incur a loss of RMB1.14 for every
dollar’s worth of international sales. These losses on exports were covered by the profits these firms earned from the domestic sales of imported
goods whose prices were based on a markup over the cost of similar domestic goods (Lardy 1992, 26). Finally, as we explain below, when thecurrency reached what was arguably close to an equilibrium level in 1994–95,
this level represented a substantial depreciation from that which prevailed
in the years before reform.

Transition to an Equilibrium Exchange Rate
China’s transition by the mid-1990s to a system in which the value of its
currency was determined by supply and demand in a foreign exchange
market was a gradual...