Decision on exchange rate is a highly complicated process, which involves two aspects: exchange rate level and exchange rate formation mechanism. Which one should we pay more attention to, exchange rate level or its formation mechanism? My answer to the question is definitely the latter one.

There are several theories about exchange rate, but several decades of experience on exchange rate shows there's not a single exchange rate theory that can successfully explain existing exchange rate. Therefore, we should respect practice more than theory, and we should respect market more than theoretical model.

Exchange rate is an open system. As for theoretical model, a closed system is better. But exchange rate is a very open system that all kinds of factors, including financial factor, economic factor, political factor and even psychological factor, can affect. That's why not a single exchange rate theory can effectively explain the actual activities of exchange rate.

We should focus more on the formation mechanism of exchange rate, and make efforts to create a mechanism that doesn’t distort exchange rate formation factors and fully demonstrate these factors. It's meaningless to pay too much attention on exchange rate level, because exchange rate is not calculated. We should learn from the market to establish a market mechanism that enables RMB to fully demonstrate its purchasing power, and enable it to form an exchange rate system with other countries' currencies, and further make the exchange rate system lead us to effectively distribute resources globally.

Therefore, as to the RMB exchange rate issue, the key point in the next stage is to deepen RMB exchange rate formation mechanism reform. The big environment for the reform is to deepen economic system reform, and the middle environment for the reform is to deepen financial system reform. With the promotion of all these surrounding reforms, we should pay great attention on establishing effective micro market structure of RMB exchange rate formation. And there are many policies and regulations that are needed to make in terms of market player, tools, trading mechanism, trading market and risk management mechanism. Exchange rate formation mechanism should be given top priority in exchange rate reform.

Exchange rate issue is closely connected with foreign exchange reserve issue. An unavoidable question in the policymaking process of exchange rate is that we should protect foreign exchange reserve or maintain exchange rate when we face exchange rate shock. Different countries give different answers at different times. In my opinion, for China it is more important to safeguard foreign exchange reserve than maintain exchange rate under current circumstances.

Asian financial crisis taught us a big lesson. During the crisis the Thai baht depreciated rapidly, and Thailand government took measures to maintain exchange rate. Within two weeks Thailand lost more than $40 billion foreign exchange reserve, but Thai baht's exchange rate continuously declined.

As to exchange rate issue such as RMB to US dollar exchange rate, although the US government and its policy are important factors that affect exchange rate, in fact international private capital plays a more important role on this issue, as they always want to make profits from it just like what they have done during Asian financial crisis. Since the end of 1980s, the major driving force of the new round globalization is international private speculation capital that doesn't belong to a certain country. Their wealth is even more than the wealth of some countries, which can easily distort a country's economy.

International private capital follows the market rules, while countries are more likely to follow the political rules. As to exchange rate issue, we should focus more on international speculation capital by impairing their hostile assault. More importantly, we should improve our own market to prevent huge arbitrage opportunity, in order to stabilize exchange rate.

In a nutshell, exchange rate is an indispensable part of the entire economic system. And the development of exchange rate mechanism should be in accordance with the development of domestic market economic system.

The author is the head of National Institution for Finance and Development, and the article is an excerpt from his speech on RMB exchange rate reform theory and practice in four decades of reform and opening-up at the CASS.