China's financial system and foreign exchange regime

China’s economy has become increasingly integrated with the world markets. Most international economic transactions conducted between China and other countries involve the foreign exchange market. It is therefore important for everybody concerned with the global economy to understand China’s foreign exchange regime. The objective of this research is to point out interactions between China’s financial system and foreign exchange regime, and the implications for the overall Chinese economy. The underlying hypothesis is that there are significant implications and constraints between the financial system and the foreign exchange regime in China. The methodology employed in this study combines microeconomic and macroeconomic approaches. It includes macroeconomic modeling, research interviews, descriptive analysis, and statistical analysis. The macroeconomic framework of the study is the macroeconomic balance approach model. The findings of the research show that the renminbi is significantly undervalued. The undervaluation plays a leading role in ongoing inflationary pressure on the domestic economy and consequent large scale sterilization. According to a macroeconomic model, proposed in this study, large scale sterilization will lead to deterioration of domestic demand and increasing dependency on external demand. Administrative controls on capital outflows, that aim to protect the internationally uncompetitive financial sector, are one of the main sources of the undervaluation. According to this study, the optimal medium-term foreign exchange regime for China is to stabilize the value of renminbi against an internationally fully convertible currency. However, in the long-term China should attempt to introduce a more convertible renminbi. The prerequisite for such a reform is an improvement of international competitiveness of the domestic financial markets.