The Translucent Box: China's RMB "Managed Peg" & Singapore Dollar's "Managed Float"

There are two articles about China's new currency system in the papers, both on the new 'managed float' similar to Singapore's. We see the wide gap in the reporting qualities among the journalists, even though both are from the top media establishment in the world. WSJ, despite its far right editorials, still boast the best in its staff. See for yourself excerpt of WSJ's coverage a thte end of this post, and compare with NYT's in this link (registration needed).
Edited to add: But NYT also has Paul Krugman's excellent article!

The changes comes in with two shifts. 1) the change in the methodology of peg. 2) the revaluation (2.1%). I think it is more important to study the former, while the latter is just a small adjustment conveniently inserted to test the water. It is not even large enough to appease the protectionist in Capitol Hill.

First, let me highlight the key differences and similarities between the RMB and SGD systems (a more thorough discussion by MAS here), a detailed discussion on new RMB basket peg mechanism here
  • Both link to a basket of major currencies, presumable trade related for the respective economy
  • Both have a central parity (determined by the basket) and moving band
  • Both have the basket (hence central parity) concealed from the public -- and adjusted without notification to the public
  • There is no capital control in Singapore, therefore no need to publish the official central parity. Tha band for Singapore is announced semi-annually. Singapore's Monetary Authority will intervene at their own discretion, to maintain the central parity and the band -- In 1997/98 Singapore had to widen its band and it announced to the world, before the semi-annual announcement is due.
  • China chose to publish the "central parity" every evening (needed because they have capital control and RMB is not freely tradable). (Edited to add: in fact, it is not the true central parity that they published. It is the "closing price", which they allowed to veer into based on the results of the basket peg calculation)
  • As a result, China also chose to publish the gap, and make it very narrow (0.3%) (edited to add: Fang Xinghai said on July 27 WSJ that the gap for euro and yen could be more than 0.3%)
  • Singapore cedes control of its interest rate to the market but China is still dictating interest rate (including domestic rate for foreign currencies!), made possible due to its capital control (but perhaps the target of the next step in reform?)
  • A static basket is different from a "crawl". My personal understanding is there is no crawl in a real (static) basket peg, where up of one currency is compensated by down of another. However, since the basket is concealed, the composition may change, hence resulting in an "effective crawl". (of course, 'crawl' also happens when one secretly adjust the peg)
  • PBC said "2. The People's Bank of China will announce the closing price of a foreign currency such as the US dollar traded against the RMB..." Businessweek interprets this statement as "China says each day it will choose one currency from the basket to be the reference currency -- but it apparently won't say which one". (Note in the Chinese announcement it seems to imply the XR for all currencies would be published, literally it means "the closing price the USD and other foreign currencies"). If the English version and Businessweek's interpretation are true. This would result in a crawl as well.
  • China's announcement adds another uncertainty (or arbitrariness) to the mystery, it said it will only "reference" the basket, and may adjust (i.e. over-ride the basket recalculation result) based on demand/supply reality (i.e. market force, including speculative force!). It seems fairly arbitrary and earns China the fame of "black box". The extra flexibility will be rarely exercised and should require high level approval. We can view the change in a basket as another revaluation done quietly.

I think Brasher (NYT) raised a good point about the new system being opaque. I agree an opaque system leaves too much room for the PBC bureaucrats to pull arbitrary strings. My problem with NYT's coverage is that it did not try to really understand the system, nor did it really studied Singapore's or compare the two. Worst still Bradsher probably mis-understood how the new RMB central parity works and has confused the daily gap of 0.3% with the daily recalculation.

I still believe China's new system, although labeled "opaque" by some, is better described as "translucent". Because it is essential still a basket, and one can approximately guess what the basket contains by simple mathematic tools such as multi-variable linear regression. A simple Excel spreadsheet would do the job. The fact that the basket content is concealed is just a way to ward off speculators. Speculators profit from tiny sub-percentage changes through immense leveraging (LTCM's leverage during the Russian crisis is above 1000x, i.e. 0.1% can yield a profit and loss of 100%). The purpose of a "translucent box" is to create an error zone (if one use linear regression) at the sub-percentage point range so that it becomes essentially useless to speculators, while still translucent enough for disciplined management of the float.

So here you are, a translucent box, you know what is going on inside, roughly, but you cannot measure with high precision. This is not uncommon, even in science. In physics, we have Heisenberg's Uncertainty Principles, where your act of measurement interacts with the subject and can potentially influence the results. Here speculators move itself can change the demand/supply and lead to China's over-riding the basket peg temporarily, or not.

Yes, it would be nice if it could be more transparent. But for China's needs, 1) basket to decouple from USD, 2)protection against speculators (hence unpredictability), 3) risk averseness: so needs a proven model, 4) the fact that China still has capital control. I am not sure if there is a better alternative.

The essence of this new change is a fundamental shift in methodology by the Chinese, by decoupling from USD. They will have more room to guide their economy, with less interference from having to maintain a close distance to US interest rates/etc. 2.1% is a gesture. It is not enough to please anybody outside, though still welcomed by even the hardliners in US. The small revaluation (2.1%) serves China as an experiment, to see how much impact on its export, employment and GDP growth. Any impact on Capitol Hill is just a bonus.

What happens in the longer run? Brad Sester said, "Big changes usually happen through a series of smaller steps, and big decisions are taken only after intermediate steps are tried and found wanting. "

below is an excerpt of the excellent coverage by WSJ. For detail see www.wsj.com (subscription),
Currency Decision Marks Small Shift Toward Flexibility;
Move Follows Broader Embrace Of 'Floating Rate' Systems By Developing Countries;
Using Singapore As A Model

Jon E. Hilsenrath and Mary Kissel. Wall Street Journal.
Jul 22, 2005. pg. A.1

China took only a small step away from a rigidly fixed currency system yesterday. But its actions still marked a big step in the 30- year evolution of the global financial system toward more market- driven, flexible exchange rates.

Countries generally choose either a "flexible" policy for their currencies, allowing them to trade freely in often ruthless global financial markets, or a "fixed" approach, keeping the currency stable but losing control of other economic levers like interest rates.

China, mindful that painful tradeoffs come with either approach, is trying to chart a middle path. Using tiny Singapore as its model, it aims to allow some market flexibility while maintaining many government controls. In addition to moving the yuan up a bit, it said it would end the yuan's link to the dollar and instead let it trade in a narrow range tied to a "basket" of currencies -- with details of the currencies and their mix kept secret.

It also promised "greater flexibility," a suggestion that the target the government sets for the currency will be determined, at least in part, "based on market supply and demand."

The move ultimately could set China on a course traveled by many developing countries in recent years. Some 139 countries, most of them small, moved from fixed to flexible exchange rates between 1990 and 2002, according to the International Monetary Fund.


The choice between a fixed-rate system and a flexible-rate system can be unappetizing, since both carry risks. Defending a fixed exchange rate -- under which a currency is set at a predetermined rate -- can force policy makers to push up interest rates to preserve their currency's value and possibly wreck their economies. A flexible exchange rate -- under which a currency's value "floats" against other currencies -- can absorb shocks, but also exposes a country's financial system to speculative attacks and sudden devaluations that can hurt an economy.

Some economists say a middle ground could carry even greater risks, because it opens a country's currency to market forces but leaves officials without all the tools to defend it. China, however, clearly is betting that it is in a position of strength in charting its own course, because of its huge financial resources and, importantly, because of government controls on the movement of capital in and out of the country.


The global currency system has evolved significantly since a system of fixed-exchange rates among major economies was negotiated after World War II. The original goal of the victorious powers was to create a new world economic order that, they hoped, would avoid the chaos that followed the collapse of the gold standard in World War I and exchange-rate turmoil that contributed to the Great Depression. The system, known as Bretton Woods for the New Hampshire resort where it was negotiated, called for the U.S. and Europe to maintain fixed exchange rates, with some flexibility to make adjustments in times of economic crisis, under the watchful eye of the International Monetary Fund.

The Bretton Woods system ran into trouble in the 1960s, in part because U.S. trade deficits mounted and the nation lacked financial reserves to support the currency. It finally came unmoored in 1973, and most major currencies began floating against their counterparts. A number of Europe's major economies surrendered the ability to adjust their currencies against each other with the creation of the transnational euro in 1999. But the euro moves freely in financial markets against the dollar.

Developing countries were slower to make the move. Still, bound to the developed world by trade but often too small to navigate the global financial system safely, many have chosen or been forced to do so. In 1975, 87% of developing countries had some type of pegged exchange rate, according to the IMF. By 1996, the figure was below 50%, and it has continued to fall. Chile, Israel and Poland moved to flexible regimes gradually, while Turkey and Brazil made such moves more abruptly. Hong Kong stands out as an exception: Despite China's move, the Hong Kong dollar remains fixed to the greenback.

"Exchange-rate flexibility is extremely important as the economy keeps opening up," says Ramkishen Rajan, a visiting economics professor at the Lee Kuan Yew School of Public Policy in Singapore. A country with a fixed exchange rate essentially must buy its currency when foreign investors try to sell large amounts, in order to sustain its value. That can drain its foreign-currency reserves -- and push interest rates higher.

China's exchange rate has stayed stable, despite the gobs of capital pouring into the country, only because its central bank has bought billions of U.S. dollar assets, such as U.S. Treasury debt. Chinese technocrats and economic officials around the world saw its approach as unsustainable, in part because buying dollars for yuan made it difficult for China's central bank to manage the supply of credit internally.

China also has avoided another common problem for countries with fixed exchange rates. They usually run into trouble when economic and market conditions argue for a lower value and they can't do what's needed to prop up the currency.

China is in the opposite situation, with a currency that appears undervalued. That's a more comfortable problem to tolerate, but comes with its own share of possible pitfalls, inflation being one of them. China's controls on capital have been important in limiting, though not eliminating, the ability of citizens and speculators to put pressure on its currency, making it easier for the government to manage the currency than it is for countries where capital flows more freely.

Singapore adopted its basket approach in 1981, when memories of oil shortages, stagflation, and exchange rate volatility of the late 1970s remained fresh. It was seen as a halfway house between fixed and flexible currencies.

The advantage of a basket is that a currency isn't pulled way out of whack by sudden market moves, for instance when the dollar moves sharply against the euro, as has been the case recently.

It is known as a "managed float," meaning that the government doesn't let the markets set its value without limit, but doesn't try to maintain a fixed peg either. Especially in a smaller economy, a fixed peg can be broken when speculators bet billions against it, as several Asian countries learned in 1997. China has technically operated a managed float since 1994, but is now expected to allow more flexibility.

Singapore's approach, closely studied by the Chinese in recent months, has been an economic success: Per capita income has risen substantially, inflation has been contained and interest rates have stayed low, encouraging consumers to spend. Despite essentially open borders for goods and capital, authorities have managed to keep the Singapore dollar relatively stable, tolerating a slowly rising trend.

Singapore doesn't reveal exactly how its basket of currencies is constructed, an approach China appears to be emulating. Because they don't know which currencies are in the basket, market participants are kept off-guard, and are reticent to make big bets against the central bank. Slowly, the central bank can edge the exchange rate up or down -- a technique called a "crawl" -- rather than do it in one, big jolt.

While the model has worked well for Singapore, it's less clear that it can work for an economy as large as China's. Singapore's gross domestic product is only half as much as Wal-Mart's annual revenue.

Moreover, because of its smaller size and the government's firm grip on power, Singapore's central bankers have a number of ways besides interest-rate moves to steer the economy that a larger country like China may not. For example, by tinkering with rules on how Singaporeans can use funds in their mandatory pensions accounts, the Monetary Authority of Singapore has in the past influenced prices in the housing market.