How Beijing May Loosen Up

China's leaders are still hedging, but a wider trading band for the yuan is likely

The rumors have transfixed currency traders worldwide: China, it is said, will soon bend to international pressure and loosen its fixed currency regime. The Chinese yuan is considered grossly undervalued by the U.S., Japan, and the Europeans -- all groaning under the weight of cheap Chinese exports. On Feb. 7, the Group of Seven Finance Ministers telegraphed to Beijing in thinly veiled terms their desire for a widening of the trading band on the yuan, now pegged at 8.27 to the U.S. dollar. Here is a walk-through of the major issues.

Are the whispers that China is weighing a revaluation true?

What has the markets whipped up are media reports out of Beijing suggesting China will let its currency appreciate 5% perhaps as early as March, and another 5% in 2005. Yet on Feb. 10, Chinese Premier Wen Jiabao signaled he's in no great hurry. China needs a cheap yuan to fuel its high-speed growth and keep employment expanding. Also, clobbering the profits of exporters could be doubly damaging, since many are indebted to the country's already ailing Big Four state-owned banks.

So, Beijing is going to thumb its nose at major trading partners?

Well, no. But don't expect anything more than baby steps on currency reform. The futures market is pricing 12-month forward contracts on the yuan at approximately 7.8 to the dollar, suggesting a modest 5% appreciation by February of 2005. The betting is that Beijing will do just enough to quell its critics abroad -- but not enough to jeopardize its growth prospects. "Beijing doesn't want the yuan to go up sharply, but there is a lot of pressure right now from the outside world," notes Henry Yang, chief of the Taipei-based Multiwin Asset Management Co.

How will China's financial mandarins manage revaluation, however modest?

The government could simply change the peg. Or it could widen the trading band -- now a constricted 0.03% -- so that the yuan will naturally rise 5%, to about 7.8 to the dollar. Another approach is to create a basket of currencies consisting of the dollar, yen, euro, and regional currencies such as the Korean won, all of which are important to China trade. Each component of the basket would trade or, in market jargon, "crawl," vs. the yuan. The yuan might appreciate against the dollar, but depreciate vs. other currencies, so that Chinese products remain price competitive in other markets.

If the dollar weakens against the yuan, will China lose its voracious appetite for U.S. Treasury bonds?

It's true that to maintain the currency's peg to the dollar, the Chinese have recycled their massive export earnings and capital inflows into U.S. Treasuries. Some 70% of Beijing's $400 billion in foreign currency reserves are in dollars. If China opts for a basket, it may rebalance its reserves by investing in more yen and euro bonds. But scare stories about a Chinese exodus that triggers a U.S. bond crash are nonsense. "At the margin, the Chinese might purchase less U.S. debt," says Michael Kurtz, a currency strategist with Bear Stearns Asia Ltd. in Hong Kong. But it won't be enough to roil the markets: The U.S. still boasts the most liquid and safest bond market in the world.

How high would the yuan need to go to cut into the U.S. trade deficit with China?

A heck of a lot more than the 5% jump now priced into the futures market. Analysts differ, but most think the yuan is undervalued anywhere from 20% to 40%. So expect the U.S. trade deficit with China to remain huge. Final numbers aren't in yet, but the U.S. trade deficit with China for 2003 is expected to top $125 billion -- a 20% jump over 2002 levels. China will surely get a pummeling from U.S. pols this election year, but don't expect Beijing to cave.

But hasn't China committed itself to serious financial reform?

Sure, but on its own time. Beijing understands that a more flexible currency regime is critical to its transition to a more market-oriented economy. But right now it needs to recapitalize its banks, clean up its equity markets, and somehow keep the economy firing on all cylinders to absorb a massive army of job seekers. Addressing global problems caused by the undervalued yuan simply isn't a high priority.

By Brian Bremner in Tokyo, with Dexter Roberts in Beijing

— With assistance by Dexter Roberts

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