Introduction

As the world ushers in an era of profound changes unseen in decades，the challenges and policy choices China is facing have become increasingly complicated. In recent years，tensions between China and the US have gradually escalated to a trade and technology war and，subsequently，a limited financial war，all of which have significantly reshaped the external landscape of China.

The higher tariffs, technology blockade, and financial sanctions that the US imposed on China have exacerbated China's trade and investment environment. Not only China can no longer rely on a persistent current account surplus or the sustained accumulation of foreign reserves to support external investment，but it also has to be able to adjust to all sorts of external shocks quickly and effectively.

In light of several recently formed regional trade agreements that have excluded China，the global market for China has become increasingly exclusive and segmented across major trade blocs. To make matters worse, the outbreak of the COVID-19 pandemic expedited the adjustments of the global supply chains and put many of China's key trading partners in economic and debt constraints，further obstructing China's efforts to expand its global market and assimilate into the global system of resource allocation and specialization. Without proactively rising to these challenges，China risks being forced onto an inward-and backward-looking path with closed-door policies，which leads nowhere but to a dead end. The formation of the Regional Comprehensive Economic Partnership（RCEP）and the signing of the Sino-EU investment agreement were major development against all these challenges. The two agreements have strengthened the basis for regional and interregional trade and investment integration. But they have only alleviated rather than eliminated the daunting challenges.

As the Chinese economy becomes increasingly integrated with the global economy，it will need to open up its financial market and capital account further and develop its own global financial center，a network of global financial institutions，and a cross-border payment system. China's long dependence on an international financial system dominated by a reserve currency has made it particularly susceptible to international financial sanctions，including risks of being excluded from the global payment system and being cut off from cross-border trade and financial transactions. The current monetary and financial system in China still lacks the capacity to guarantee full support for cross-border trade and investment in the face of external risks，exposing a weakness that urgently needs to be addressed.

It is also worth noting that China's balance of payment has evolved into a relatively balanced state in recent years. As China's savings rate continues to decline and its capital market continues to open up，its current account and capital accounts will likely evolve into a pattern of dynamic balance with deficits and surpluses alternating randomly. It will be a challenge to alter the old approach of maintaining current account surpluses and restricting capital account transactions.

To address these challenges, China needs to tap into its enormous domestic market base and further expand its global market share by enhancing its monetary and production capacity. The Chinese government has recently put in motion a new “dual circulation”strategy that emphasizes “internal circulation”as the core with complementary support from “external circulation.”

As China strengthens its internal circulation and proactively expands the space for global economic partnership，it also needs to remain on guard against external risks that may result from economic，financial，and geopolitical conflicts. Market reactions and adjustments to external shocks will be collectively reflected in the exchange rate. In designing its exchange rate policy，should China push ahead with its foreign exchange market reform and support the integration of internal and external circulations with RMB as the intermediate currency？Or should China intensify its intervention in the foreign exchange market while backing off from its reform efforts and delaying the internationalization of the RMB out of “fear of floating，”“fear of exchange rate overshooting，”and“fear of capital flight”？

This book emphasizes that a floating exchange rate regime，further development of the foreign exchange derivatives market，and the concurrent internationalization of the RMB are the only ways to navigate severe external challenges and successfully achieve the“dual circulation.”Only a floating exchange rate can respond to external shocks and balance-of-payments imbalances in a timely manner and，therefore，function as a shock absorber. Only with a floating exchange rate can China avoid unsustainable intervention with reserve currencies issued by other countries as well as capital controls that would severely impair trade and capital transactions. Only with the further relaxation of foreign exchange controls can China fully develop its onshore international financial centers to facilitate the use of the RMB for both the current and capital accounts and make the RMB a widely accepted currency by global partners. Moreover，only with the internationalization of RMB can China form an independent global supply chain and use its own currency to support cross-border trade and investment.

The first chapter of this book analyzes the macroeconomic impact of foreign exchange intervention based on empirical studies that cover 26 economies. It argues why a floating exchange rate regime could be a favorable choice for most countries under the existing international monetary system. Sustained large-scale intervention in the foreign exchange market would not only incur direct costs, but would also have unintended macroeconomic consequences on domestic prices，real interest rates，and asset prices. Foreign exchange intervention would not only have little effect in curbing capital outflow, but would also impede the development of risk management market and the internationalization of the RMB.The experiences from three major exchange rate policy adjustments in China that took place in 1994，2005，and 2015，respectively，also suggest that equilibrium exchange rates must be determined by market forces rather than subjective judgments.

The second chapter discusses the macroeconomic and microeconomic conditions that would facilitate a successful transition to a floating exchange rate. It evaluates China's macroeconomic soundness systematically using two sets of indicators： the macroeconomic vulnerability assessment and the systematic risk assessment. The term “free-floating” may be falsely associated with a loose and unregulated policy environment，but in fact any country with a successful floating exchange rate regime must adhere to a rulesbasedand highly self-disciplined macroeconomic management. The key to successful macroeconomic management includes disciplined money supply，sustainable public debt，and well-managed external debt. In the absence of major micro-or macroeconomic imbalances，a country should strive to overcome the “fear of floating”and make its exchange rate float.

The third chapter discusses the importance of further developing the foreign exchange （FX）derivatives market in China. Although China has made some progress in developing its FX derivatives market in recent years，with only an underdeveloped over-the-counter （OTC）market and no futures market at all，the FX derivatives market remains a weakness that is hindering the transition toward a free-floating exchange regime. Compared with the OTC market，the FX futures markets can better meet the hedging needs of small and medium-sized enterprises due to its standardized products，greater transparency，stronger supervision，lower cost and credit risk. Our empirical analysis on emerging countries also shows that FX futures can serve as a “stabilizer” and an important complement to the spot and OTC market. Prudential regulation is essential to ensuring the stability of the FX derivatives market. Near-term priorities include gradually phasing out the current requirement of underlying exposures and allowing for a more marketbased approach to risk management.

The fourth chapter explores the paths toward further opening up of the capital market and further internationalization of the RMB under a floating exchange rate. Considering the sheer size of the Chinese economy，the internationalization of the RMB and the openness of China's capital market are lagging behind its economic development. Therefore，it is crucial for China to expedite the creation of the conditions necessary to adopt a floating exchange rate regime so that the internationalization of the RMB can keep up with the growth and opening up of the Chinese economy. With a floating exchange rate，a well-developed FX derivatives market，and wellmanaged money supply and external debt，China would be in a position to further open up its capital market with support from additional policy measures，such as further development of its bond and stock futures market.

In sum，this book demonstrates that，although foreign exchange intervention may appear to be “stability-enhancing，”it does so at the expense of distortions to domestic macroeconomic variables. We argue that，with greater external pressures，the advantages of a flexible exchange rate will also become more prominent. In the face of an especially complicated international environment，the choice of an exchange rate regime is no longer a “good or bad”issue，but rather has become a “life-or-death”issue. Moving toward a floating exchange rate is a logical choice for China and can lay the foundation for the further internationalization of the RMB.Such internationalization is not a peripheral issue that can be sacrificed，but a central issue that would determine whether the Chinese economy can stay resilient against external shocks without having to resort to closed-door policies.

This book reflects the authors'long observation and thinking over exchange rate policy issues and the RMB's internationalization over the past few decades of work experiences. Many ideas presented herein are drawn from practical working experiences and real case scenarios，both in China and abroad，and are further examined through systematic analyses and empirical tests. The authors are grateful for the numerous discussions with experts in China and abroad who have contributed greatly to the writing of the book. We hope that the book will present readers with some new perspectives on China's exchange rate policy issues and the RMB's internationalization while also serving to motivate further research. Finally，the views presented in this book are solely those of the authors'and do not represent the views of their associated institutions.