China currently maintains an exchange rate fixed against the US dollar and a (relatively) closed capital account, while exercising an independent, controlled interest rate environment. Domestic and international pressures have been mounting for the Chinese government to re-adjust the currency peg or allow more flexibility in the exchange rate and to free up the capital account to foster greater integration with global markets. Given the need for developing a more mature financial system to meet the needs of a growing market economy and with unrestricted foreign bank entry in 2007, there is also a need for less regulated and more market driven interest rates. To the extent that authorities seek to maintain exchange rate stability while easing capital controls, they must forsake monetary independence. This is the so-called macroeconomic policy "trilemma" constraining macroeconomic policy makers generally. The need for continuing reform of China's currently fragile domestic banking system further influences the nature and timing of policy options. This paper reviews recent macroeconomic management performance in China and assesses the options facing policy makers for reform of the financial system given the current environment and subject to the constraint of existing institutional arrangements.
