By Brian Bremner
It was a long time in coming, a modest first act, and nowhere bold enough to assuage the most vocal Chinese critics in the West. But none of that should detract from the significance of the July 21 decision by the People's Bank of China -- and no doubt by the highest echelons of Chinese President Hu Jintao's government -- to abandon the yuan's decade-old peg to the dollar. Instead, the PBOC will shift to a managed floating exchange rate regime based on a basket of currencies. As part of the shift, the yuan will be allowed to appreciate slightly, about 2%, against the greenback.
First let's state the obvious: This will have little impact on China's surging trade dynamics or on the skeptics who believe Beijing is engaging in a shadow play to get the international community off its back, while it continues to use a cheap yuan to stoke its export machine.
China's politically sensitive trade deficit with the U.S. could easily top $200 billion by yearend, vs. about $160 billion last year. And it looks like its global trade surplus -- which in recent years has been a modest $30 billion or so -- could jump fourfold, to more than $120 billion in 2005. That isn't too far from what Japan delivers year in and year out -- and China's economy is about one-third the size. So the move on the yuan was far too modest to make much of a dent in China's export juggernaut.
Yet this is an important first step in a gradual liberalization of China's fixed currency regime and toward an eventual capital-flow liberalization. From a global perspective, what the rest of the world will be most concerned about is whether the move will have a huge negative impact on the dollar or dry up the Chinese appetite for U.S. Treasury bonds. The markets could be unsettled for a few days, as they digest this news. Indeed, Treasuries took a big dip following the announcement, recovering later in the day. Still, the move by China likely won't trigger great upheavals.
Though nobody knows for sure what's in the PBOC's basket of currencies, it likely includes the dollar, euro, yen, and possibly a broader set that would include the money of China's dozen or so top trading partners. Those currencies will now fluctuate in value against the yuan, but as one appreciates, others might fall, balancing out the overall effect on Chinese trade.
Since this is a "managed float" Chinese authorities will probably keep exchange values -- especially the dollar/yuan rate -- from experiencing really big shifts in either direction.
COOLING THE CRITICISM.
Such a scheme would not -- as some fear -- change the makeup of China's $700 billion in foreign currency reserves, 70% of which are in dollar assets like U.S. Treasuries. Although some say China might sell off some of those reserves and buy yen and euros, Beijing would still need lots of greenbacks -- the world's most liquid currency. It's also unlikely that China would orchestrate a destabilizing sell-off of its U.S. Treasury holdings, which could harm its biggest export market.
So why did China bother? First, a shift to a basket tied to a modest revaluation of the yuan should quiet U.S. criticism of Beijing's monetary policy, at least for awhile. U.S. Treasury Secretary John W. Snow immediately welcomed the move, calling it "good news for China and good news for the global economy." Added a senior Treasury official: "It's the beginning of a broader process of adjustment."
Second, the basket will likely allow China to keep the yuan in a tight range against the dollar, while giving the illusion of a market-based system. Third, although China's top trade partner is the U.S., it exports almost everywhere. A basket should ensure steadier prices for customers worldwide, not just Americans.
Another plus for China is that it may not have to disclose the basket's composition -- which means it could still play with the exchange rate by changing the mix, giving dollars more or less weight as needed to keep rates from shifting too dramatically.
A currency basket and a more flexible yuan should have another payoff: It will likely ease the flood of speculative cash into Chinese money markets and real estate that has been a real headache for monetary authorities. This crowd has been betting -- correctly it turns out -- that China would eventually have to let the yuan rise.
Overseas investors have been snapping up condos in Shanghai, hoping that on top of big property-value gains they would also see their returns sweetened by currency gains. Chinese CFOs also have been borrowing heavily in foreign currencies, figuring that they could pay back those loans with a stronger yuan. That's probably why outstanding foreign-denominated debt (mostly dollars) borrowed in China grew 18%, to $228 billion, in 2004 year-over-year.
That flow of money, plus export hard-currency earnings that need to be recycled back into yuan, had placed huge strains on the PBOC. To defend the fixed currency peg between the yuan and dollar, the central bank buys (or sells) foreign currency in exchange for yuan. When too much yuan is circulating around the money system, the PBOC withdraws that extra cash through what money traders call "sterilization" -- issuing notes and bonds.
If that fails to soak up the extra cash, the money supply can expand dramatically, igniting inflation and encouraging banks to lend recklessly given they have more yuan than they know what to do with.
That could be less of a problem now if Chinese financial authorities handle their new managed float system in a savvy way. True, nobody expects dramatic appreciation of the yuan right away, and short-term speculators could continue to be a force. And investors will continue to be long on China for a variety of good reasons.
But once the PBOC's new system gains credibility and the yuan has greater freedom to rise and fall more quickly, speculators can no longer assume there's only one direction for the currency to go. More important, a more flexible yuan should help China smooth out the boom-and-bust cycles that can be devastating to a developing economy like the Middle Kingdom's.
Bold action that Western policymakers had hoped for? Not really. But it is a credible start. If China follows through, the shift will be remembered as an important turning point in the development of its financial markets and its growing economic maturity.
With Rich Miller in Washington, D.C
Bremner is Asian bureau manager for BusinessWeek, based in Hong Kong
Edited by Douglas Harbrecht