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The renminbi has recently been in the spotlight in the international finance arena. Will China succumb to U.S. pressure and realign the exchange rate of the renminbi against the U.S. dollar? If China does so, when will the exchange rate be realigned, and by how much? Even though the Hong Kong (H.K.) dollar is pegged to the U.S. dollar under the current linked exchange-rate system, any significant, especially unanticipated, change in the exchange rate of the renminbi against the U.S. dollar will have spillover effects on the Hong Kong economy given the increasingly close economic integration between China and Hong Kong, not to mention the latest launch of renminbi deposits by local banks. If China catches a cold, Hong Kong sneezes.

The current politico-economic situation confronted by the Chinese government is not unprecedented. During 1986-87 the New Taiwan (N.T.) dollar appreciated sharply against the U.S. dollar partly as a result of U.S. political pressure, although economic fundamentals were the main driving force. China's economic conditions today parallel those of Taiwan in the early 1980s in many respects—phenomenal economic growth, persistent trade surpluses, massive foreign-exchange reserves, exchange control, and a managed exchange rate. Reviewing Taiwan's experiences, especially the experience of one of its former central bankers, in managing the appreciation of its currency may shed some light on the renminbi's future development.¹

The Taiwanese exchange rate system underwent a "big bang" between June 1986 and the end of 1987. Before this transformation, the N.T. dollar had been highly stable for at least three decades, fluctuating narrowly around an exchange rate of 1:40 against the U.S. dollar. This stable trend started to change in the mid-1980s as a result of massive capital inflows and huge trade surpluses.² By the end of June 1986, the Central Bank of Taiwan's holding of foreign-exchange reserves had soared by approximately 30% in one year, rising to U.S. $31 billion. This gave Taiwan the fourth-highest amount of foreign-exchange reserves in the world, just after the United States, France, and Japan.³ In light of its twin deficits, the U.S. government threatened Taiwan with trade retaliation if the latter refused to open its market for U.S. goods and to appreciate the N.T. dollar immediately and considerably. The rest is now history: The N.T. dollar continuously strengthened against the U.S. dollar until it stabilized at an exchange rate of about 1:25 in 1988, appreciating by more than one-third within a couple of years.⁴ In retrospect, some lessons from this episode may be relevant not only to China's current situation in terms of the renminbi but also to central banking policy in general.

1. Don't lean against the wind of the market. Much as some economists and commentators are now saying about the renminbi, in the 1980s many argued that the N.T. dollar should not appreciate against its U.S. counterpart because of the adverse impact this would have on the competitiveness of Taiwan's exports. The crucial issue was, however, not whether the N.T. dollar should appreciate but whether it would appreciate. Those against the move disregarded an important economic fundamental—Taiwan had enjoyed persistent trade surpluses and accumulation of foreign-exchange reserves since the early 1970s. The Central Bank could have intervened to suppress the appreciation of the N.T. dollar, but only at the expense of higher inflation and possibly a halt to economic growth owing to U.S. protectionism. Moreover, a cheap-dollar policy might have failed to sustain Taiwan's international competitiveness in the longer run against other competing countries, such as the Four Tigers, with lower production costs.

2. Economic structure cannot be known precisely. If the pressure on the N.T. dollar to appreciate could not be countervailed, what would the optimal policy of accommodation have been? When U.S.-Taiwan negotiations commenced, the U.S. Treasury demanded that the Taiwanese government immediately appreciate the N.T. dollar once and for all by at least 20% to correct the trade gap. Most Taiwanese businesspeople and government officials, however, contended that the Central Bank should cap the appreciation, as they thought most Taiwanese exporters would go bankrupt if the N.T. dollar strengthened above this limit, initially estimated at 1:35. In hindsight, both sides erred in their predictions or estimations, their subsequent frequent revisions notwithstanding: The N.T. dollar ultimately stabilized at around 1:25, a rate far above their original expectations. As the "equilibrium" exchange rate for the N.T. dollar could not have been known precisely ex ante, it is highly unlikely that a once-and-for-all appreciation policy would have worked out satisfactorily.

3. Gradualism works. The Central Bank opted for a gradual policy instead. Despite criticism from some local academics who supported the once-and-for-all policy, the Central Bank intervened in the foreign-exchange market to limit the rate of the N.T. dollar's appreciation to one cent a day. In a testimony to the Control Yuan Council, the then Governor of the Central Bank admitted that he did not know what a "reasonable" exchange rate for the N.T. dollar should be. The public generally interpreted his statement as an attempt to dodge political pressure from interest groups and the United States, presuming that the Central Bank had a well-thought-out confidential plan about the timing and magnitude of the appreciation.

This interpretation was, however, at best half-correct. As a tactic against the United States' tough stance, the Central Bank agreed only in principle to allow the N.T. dollar to appreciate gradually, without making any promises about the timing and magnitude of the appreciation. Indeed, the Central Bank had no plan about the target exchange rate. The "equilibrium" exchange rate of 1:25 was an outcome of market demand and supply following the elimination of exchange control in July 1987. What the Central Bank's gradual policy tried to accomplish was to prolong the appreciation process as much as possible such that the magnitude of appreciation and its impact could be spread over time. The Central Bank hoped that doing this would allow Taiwanese enterprises sufficient time to adapt to the changing economic environment. Had the Central Bank opted for a once-and-for-all policy, many exporters might have gone under because of the adverse impact of drastic and rapid appreciation of the N.T. dollar. A newspaper poll in December 1986 revealed that over 60% of firms preferred the daily appreciation of the N.T. dollar by a small amount to unscheduled exchange rate adjustments.

4. Currency appreciation is not necessarily harmful. Although, in theory, the appreciation of the N.T. dollar had an unfavorable impact on Taiwanese exporters, the entrepreneurs were more resilient than expected, and there were no waves of bankruptcies. Despite the appreciation, trade surplus continued to widen during the early period of appreciation, whereas export growth in subsequent years was not adversely affected.⁵ In hindsight, a stronger N.T. dollar would probably have contributed to Taiwan's development of high-value-added industries, thus sustaining its international competitiveness in the long run.

5. The Central Bank's objective is not profit maximization. One of the factors that kept Taiwanese enterprises solvent during this difficult time was their arbitrage profits from foreign-exchange dealings with the Central Bank. The Central Bank's gradual policy induced general expectations of appreciation of the N.T. dollar and almost risk-free arbitrage opportunities for the private sector. As long as the expected trend of appreciation was uninterrupted, anyone who brought in a certain amount of U.S. dollars, say, in the form of export revenue or borrowing from abroad, and converted these U.S. dollars into N.T. dollars would be able to buy back the same amount of U.S. dollars with fewer N.T. dollars later. As a result of arbitrage activities, the Central Bank reported a record exchange loss of N.T. $240 billion for the accounting year ending June 1987. Nevertheless, the loss did not undermine the Central Bank's willingness to act as a shock absorber to alleviate the adverse impact of the N.T. dollar's appreciation on the economy. It is not unusual nowadays to find central bankers publicizing the rates of return on their managed reserve funds, as commercial bankers do. The Central Bank of Taiwan, however, correctly adhered to stabilization and promotion of growth as its main objectives, although achieving these goals incurred a substantial exchange loss.

6. Eliminate exchange control at the right time. The Taiwanese experience is also an example of successful policy coordination. In 1986, when upward pressure on the N.T. dollar began to gather momentum, the alert Taiwanese government started to study the possibility of abolishing exchange control to ease potential inflationary pressure resulting from massive capital inflows. In March 1987, the exchange control ordinance was amended, allowing exchange control to be lifted temporarily if the trade surplus was deemed to be huge. Exchange control was discarded entirely in July of the same year. Based on economic conditions alone, the elimination of exchange control was long overdue, as Taiwan's foreign-exchange reserves substantially exceeded the internationally acceptable standard, which stated that foreign-exchange reserves holdings should be sufficient to support imports for three months. Taiwan's foreign-exchange reserves were higher than the international average, because Taiwan could not obtain foreign exchange from the International Monetary Fund (IMF) or the World Bank and could not count on U.S. commercial banks as a reliable source either, as well as because of well-known political factors. Fortunately, the political developments on both sides of the Taiwan Strait at that time, coupled with massive capital inflows, made possible a timely elimination of exchange control.

Returning to the situation with the renminbi, should China follow in Taiwan's footsteps, appreciating the renminbi and eliminating exchange control? Not necessarily. There are similarities between the two cases, but there are also differences. One obvious difference is in their bargaining power. In international economic and political relations, Taiwan was, and still is, relatively isolated. As more than half of Taiwanese manufactured goods were then shipped to the United States, it was difficult, at least in the short run, for Taiwan to find a substitute market. By contrast, being the world factory and a member of many international organizations like the IMF and the World Trade Organization, China should have more bargaining chips with which to oppose U.S. political pressure.

So what does this exercise tell us? I leave that to readers to decide, because the practitioner in political economy is Everyman—the public official and the voter—and not necessarily the economist. But as the late Nobel laureate Friedrich Hayek rightly remarked, "in economics you can never establish a truth once and for all but have always to convince every generation anew" and "knowledge once gained and spread is often, not disproved, but simply lost or forgotten."⁶ By reviewing Taiwan's experience, policymakers, economists, and laypeople can perhaps gain new insights or be reminded of those they have forgotten.

Hayek, Friedrich A. (1944) "On Being an Economist," an address given to economics students at the London School of Economics in 1944, first published in The Trend of Economic Thinking: Essays on Political Economists and Economic History (vol. III of The Collected Works of F. A. Hayek), edited by W. W. Bartley and Stephen Kresge (Chicago: University of Chicago Press, 1991), pp. 35-48.

Wang, Jun (1999) Cai Jing Ju Bo: Yu Guohua Sheng Ya Xing Jiao, Yu Guohua Kuo Shu; Wang Jun Zhi Bi, (The Reminiscences of Mr. Yu Guohua) Taipei: Sunbright Publishing Co.

¹ A formal comparative analysis of China's current situation and Taiwan's experience, though desirable, is not the purpose of this short paper. What follows is drawn from my own limited knowledge of the economics of China and Taiwan and from my reading of the reminiscences of Mr. Guohua Yu, former governor of the Central Bank and also President of Executive Yuan (usually referred to as premier) in Taiwan (Wang 1999). Readers should bear this in mind. I hope this paper will spur interested readers to conduct in-depth formal investigations.

² According to official statistics published by the Central Bank, the balance-of-payments surplus was widening in the early 1980s and jumped notably to U.S. $23 billion in 1986, up from $6 billion a year earlier.

³ The official name of Taiwan's central bank is the Central Bank of China. I call it the Central Bank of Taiwan, or simply the Central Bank, throughout this paper to avoid confusing it with its counterpart in Mainland China.

⁴ The percentage of appreciation depends on how the exchange rate is quoted. No matter how the percentage is calculated, the rate of appreciation was substantial over that period.

⁵ Official statistics published by the Central Bank reveal that Taiwan's total exports of goods and services continued to grow in subsequent years despite a stronger N.T. dollar. However, the stronger dollar also stimulated growth in imports of goods and services. As a result, the total trade surplus narrowed sharply from U.S. $16.4 billion in 1987 to U.S. $8.7

Acknowledgment: This paper was written when I visited the Hong Kong Institute of Economics and Business Strategy at The University of Hong Kong in March 2004.

Chu Kam Hon is Associate Professor at Department of Economics, Memorial University of Newfoundland, St. John's, Newfoundland & Labrador, CANADA A1C 5S7.


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