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

when the balance of trade is more or less in balance.so that's why they continue to be under political pressure for further appreciation. 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. 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. But let me draw your attention to this chart. you know that downward trend is an appreciation of the exchange rate. stable balance of payments. a counter-intuitive result which is this one so far. balance of trade surplus actually fell. it's more in line with traditional economic thinking. if there is more surplus anyway. A stable exchange rate. Those of us who study economics of course remember what the Marshall-Lerner Condition is. taking place at the same time as an appreciation of the exchange rate. then you may have a different result. But if the Marshall-Lerner Condition is not satisfied. But in this particular year though. the balance of payments surplus or the balance of trade surplus surged. you should be allowing your exchange rate to appreciate. When over that period from 1995 to 2004. . Right? And furthermore. 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. when the balance of trade surplus has actually shrunk. As soon as they allow the exchange rate to appreciate since the middle of 2005. This is counter-intuitive. the exchange rate had been very stable. from the period of 2008 to 2010 when the exchange rate were held stable.

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

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

Listen. all right? And we are linked to the US dollar. . That's not the subject of discussion for today.5% a year and here in Hong Kong 0%. this one.are doing that including myself. And you are actually earning what? You know if you move that money onto the Mainland. it's really a no-brainer. you can actually get 3.