By Rich Miller
When China unexpectedly announced last week that it was scrapping its decade-old currency peg with the dollar, the bond market took fright. Prices plunged and yields soared on fears that Beijing's move would lead to reduced Chinese buying of Treasury securities and increased U.S. inflation (see BW Online, 7/26/05, "The Yuan and You").
Bond investors should stop hyperventilating and calm down. Yes, China's move could turn out to be significant from a historical perspective, especially if it leads to a free float of the country's currency, the renminbi (see BW Online, 7/21/05, "The Yuan: A Baby -- but Key -- Step").
But that's years away. In the time frame most relevant to the bond market -- say the next six months to a year -- the economic and financial impact of China's action is likely to be far smaller. Indeed, there's even reason to think that Beijing's move could end up pushing bond yields lower, instead of higher.
China has primarily affected the bond market through its management of its foreign currency reserves. In order to keep its currency stable in the face of a rising trade surplus and increased hot money flowing into the country, Beijing has had to step up its purchases of dollars and now holds $711 billion worth of foreign currencies in its reserves. Much of that is invested in the U.S., particularly in Treasuries.
Under the new currency system it launched last week, not all that much is likely to change. Why? Because of the cautious way China approached currency reform. In launching its new regime, China also sanctioned a 2.1% revaluation of the renminbi against the dollar. That's miniscule and will do little to narrow China's growing trade surplus, says Morris Goldstein of the Institute of International Economics think tank in Washington. "Size matters," adds Goldstein, who reckons the renminbi is undervalued by some 20% to 25% against the dollar.
The small revaluation is also unlikely to deter speculators from pumping money into the country. Indeed, it could even whet their appetites, now that China has shown that it's willing to countenance a rise in the value of its currency. "It just makes it a one-way bet for speculators," says Desmond Lachman of the conservative American Enterprise Institute, another Washington-based think tank.
The bottom line: China is likely to continue to add significantly to its foreign currency reserves. Of course, it could cut back on the proportion of those reserves that it invests in dollars, especially now that Beijing has said it will manage the renminbi's value against a basket of currencies, not just the greenback.
But there's no doubt the dollar will still be the most important currency for Beijing. "If China's reserves grow by $275 [billion] to $300 billion this year, its total amount of Treasury purchases could still go up [from last year,] even if it invests a slightly smaller fraction in dollars," says Brad Setser, senior economist at research firm Roubini Global Economics.
What's more, China's move could lead to stepped-up buying of dollars -- and stepped-up investment in U.S. Treasuries -- by other Asian countries, including Japan. In the wake of China's announcement, investors bid up the value of the Japanese yen, South Korean won, and other Asian currencies.
While those countries are likely to countenance some appreciation of their currencies now that China has moved, they have already signaled that they're prepared to resist any significant rise by buying up dollars.
Won't China's revaluation boost the price of its exports and increase inflation in the U.S., the main buyer of its goods? Perhaps, but not by a heck of a lot. If all of the 2.1% appreciation of China's currency were passed on to U.S. customers in the form of higher prices, it would increase inflation here by a mere 0.04%, according to calculations by Wall Street broker Bear, Stearns & Co. Even if China allows its currency to rise modestly further over the coming year -- as many experts expect -- the impact on inflation in the U.S. is likely to be limited.
Given China's growing financial and economic clout, it's not surprising that bond investors bailed out of the market last week. But for the moment, at least, their worst fears for what it means for the market seem unfounded.
Miller is a senior correspondent for BusinessWeek in the Washington bureau