L ike their counterparts in many other emerging market economies, Chinese policymakers are facing a complex set of questions related to the desirability and appropriate mode of implementing exchange rate flexibility and capital account liberalization. The Chinese authorities have stated publicly that both exchange rate flexibility and capital account convertibility are their medium-term objectives, but they have resisted recent calls from the international community for an early move toward more flexibility.The issue has come to the fore in the context of discussions about the appropriateness of maintaining the current exchange rate regimewherein the renminbi is effectively linked to the U.S. dollar-given the rapid pace of China's reserve accumulation. Many observers have interpreted this surge in reserve accumulation over the past two years, which has reflected a rapid expansion of China's exports as well as large inflows

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This Working Paper should not be reported as representing the views of the IMF.

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This Policy Discussion Paper should not be reported as representing the views of the IMF.The views expressed in this Policy Discussion Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Policy Discussion Papers describe research in progress by the author(s) and are published to elicit comments and to further debate. This paper reviews the issues involved in moving towards greater exchange rate flexibility and capital account liberalization in China. A more flexible exchange rate regime would allow China to operate a more independent monetary policy, providing a useful buffer against domestic and external shocks. At the same time, weaknesses in China's financial system suggest that capital account liberalization poses significant risks and should be a lower priority in the short term. This paper concludes that greater exchange rate flexibility is in China's own interest and that, along with a more stable and robust financial system, it should be regarded as a prerequisite for undertaking a substantial liberalization of the capital account.