OK, Renminbi exchange rate system. This is the party line, you know on the website.

It said that this is an exchange rate system or exchange rate is determined on the foundation of market supply and demand, but the PBOC is part of the market you know, and making adjustment by reference to a basket of currency is not fixing to a basket of currency, by reference to a basket of currency and a managed floating exchange rate system, all right? But while this is the exchange rate policy, when there were financial crises, two financial crises they fixed the exchange rate against the US dollar because the sea is pretty rough out there and so you know try and maintain a bit of stability in the exchange rate So that's the history, all right? They introduced a managed floating exchange rate system at the beginning of 1994. It's been appreciating, banking the Asian financial crisis, they fixed it for a long period and then in the middle of 2005 they reintroduced flexibility to the exchange rate and then came the Global Financial Crisis in 2008. They fixed it again and then by the middle of 2010, they reintroduced flexibility. So that is the history. Now you may be interested in what the basket is. It's an non-published basket. There is no information on the basket other than those that I have summarized here. I think, my guess is that there are over 20 currencies in that basket. They mainly consider trade relationship with these other countries, although Governor Zhou also said that he considers external debt, foreign direct investments, and unrequired transfers in the current account. So it's basically I think a trade-weighted basket with over 20 currencies, OK? That's the behavior. Now if you use a trade-weighted exchange rate index of the Renminbi as the proxy of the basket, you have the black line, which is a little embarrassing in the sense that you know on the basket basis they haven't actually been appreciating the exchange rate that much

so that's why they continue to be under political pressure for further appreciation. Now but obviously I mean quite a lot of people actually focus on the huge balance of payments that they have and very simplistically come to the conclusion that since you are running a large balance of payments surplus, you should be allowing your exchange rate to appreciate. But let me draw your attention to this chart. When over that period from 1995 to 2004, when the balance of trade is more or less in balance, if there is more surplus anyway, the exchange rate had been very stable. A stable exchange rate, stable balance of payments. As soon as they allow the exchange rate to appreciate since the middle of 2005, you know that downward trend is an appreciation of the exchange rate, the balance of payments surplus or the balance of trade surplus surged. This is counter-intuitive. Right? And furthermore, from the period of 2008 to 2010 when the exchange rate were held stable, balance of trade surplus actually fell. So whoever is making use of the argument that because you are running a balance of payments surplus you should allow your exchange rate to appreciate does not really have the empirical foundation although the theoretical foundation is also not existing. Those of us who study economics of course remember what the Marshall-Lerner Condition is. It is only when the Marshall-Lerner Condition is satisfied that your balance of payment would change in the correct direction as a result of changes in the exchange rate. But if the Marshall-Lerner Condition is not satisfied, then you may have a different result, a counter-intuitive result which is this one so far. But in this particular year though, when the balance of trade surplus has actually shrunk, taking place at the same time as an appreciation of the exchange rate, it's more in line with traditional economic thinking.

But this chart just shows you that the exchange rate is not a panacea. The exchange rate may not be the answer to correcting the external imbalance because it could go the other way. The Marshall-Lerner Condition actually comprises quite a number of things but the most important elements are the elasticities of demand and supply for imports and exports. Let's say Hong Kong, we import rice, we import sand, we import water. Even if the exchange rate is very weak, we still have to import so much because we have to eat them, OK? So the elasticity of supply and demand actually is very important to looking at the balance of trade position. Now what I think the exchange rate policy should be the theoretical thinking behind the exchange rate policy should be like this: now as you are aware, China is embracing globalization. It's undergoing a process of reform and liberalization, trading with the rest of the world. But China has a price level that is here, and the rest of the world particularly the trading partners have a price level that is up there. The US for example, Europe for example, price level is a lot higher than in China. And if you are opening up, embracing globalization and trading more and more with the rest of the world, those two price levels should converge. Right? OK? Now in economic terms a convergence of that price level requires an appreciation of what we called the Real Effective Exchange Rate. In other words how your money exchange with the rest of the world in real terms, in effective terms. Now just forget about what "real effective" exactly means but you need such an appreciation of the Real Effective Exchange Rate. Now here I pointed out quite clearly that this can only be manifested in either high inflation rate or appreciating nominal exchange rate. When you want these two to converge, if your inflation rate is very high it will converge quickly, right? Or if your nominal exchange rate is to appreciate,

then it will also converge. You know one US dollar to eight Renminbi and now it's six point something. It is converging somewhat. And if it in the end it becomes one to four, it may converge a little more, OK? So there are two ways of achieving that convergence. If you were given the choice, the policy choice of which route to take, you would take the latter rather than the former, because the high inflation rate is of course very destabilizing. So in simple terms, I think this is how China should be looking at the exchange rate. If your inflation rate is high because you are embracing the rest of the world, then try and appreciate your exchange rate a little bit more, and don't listen to the Americans when they put pressure on your exchange rate. OK? You look at your own situation, because there is a need for convergence of the Real Effective Exchange Rate and you have a choice to allow the nominal exchange rate to appreciate, or allow inflation rate to go higher, then you have a choice. OK? The choice obviously is to allow the nominal exchange rate to appreciate rather than having rampant or rapid inflation. But this thing is highly politicized. Ok? This is a demonstration of a relationship, if any, between the exchange rate and the inflation. And I suspect that you know, given the fairly high inflation rate at this point of time, although part of the inflation rate is the result of base effects or in other words, rapid increases of prices last year, I think China could probably allow the exchange rate to appreciate a little more. So far you've seen a round of 6% or 7% per annum appreciation of the exchange rate. I mean I've been talking to my friends in Hong Kong saying that Hong Kong dollar you have no interest at all. But this really is no-brainer, because there is no other way, you know, the nominal exchange rate of the Renminbi must appreciate. You know I see no other alternative. How can you accept a high inflation rate? I mean you just can't, OK? So for my friends I will say because we in Hong Kong are allowed actually to purchase 20,000 Renminbi a day per person and many of our friends

are doing that including myself. Listen, it's really a no-brainer, this one. And you are actually earning what? You know if you move that money onto the Mainland, you can actually get 3.5% a year and here in Hong Kong 0%, all right? And we are linked to the US dollar. That's not the subject of discussion for today.