A Yuan-Revaluation Surprise

China ended the currency's direct peg to the U.S. dollar sooner than expected. The move impacts bonds, regional currencies, and oil prices

It's no surprise that China would move to revalue its currency against other major ones. The big shock for financial markets is that it happened well ahead of expectations.

In a historic move, Beijing announced on July 21 it will no longer peg the yuan to the U.S. dollar, an arrangement that had been in place since 1994. China will tie the yuan to a basket of currencies instead.


  Within the new basket, the yuan has been revalued upward against the dollar by 2.1%, well short of calls by the U.S. for at least 10%, but a significant first step nonetheless. This brings the value of the yuan to 8.11 per dollar from 8.28.

The size of the move is pretty much in line with what many observers were anticipating -- though the timing certainly caught markets off guard. The impact of the announcement is now rippling through world financial markets.

The Japanese yen and other floating currencies have jumped higher, while government bond yields have risen around the world. The U.S. dollar was hit by selling in a knee-jerk response to the decision, though it soon erased most of its losses.


  Meanwhile, other countries that peg their currency to the greenback appear ready to respond in kind. Malaysia has already said it is changing the peg of its currency, the ringgit, to a "managed float." Singapore, which already uses a managed float vs. a basket of currencies, will automatically appreciate against the U.S. dollar in sympathy with the yuan and the yen.

China's move will be watched for the extent to which it triggers a broader adjustment in currencies across the region. After the announcement, the yen rose 2% vs. the dollar. Bank of Japan officials were quoted in wire-service stories as saying they welcome the decision, adding that it will help make Chinese growth more balanced and sustainable.

Another effect of the revaluation might be seen in the energy markets. Sources contacted by Action Economics indicate the removal of the yuan-dollar peg could lift crude oil prices significantly, as it will give China an instant discount on dollar-denominated oil imports.


  How did Washington receive the news? Treasury Secretary John Snow, who has led the U.S. push to make Beijing free up its currency, welcomed it. Snow said the Treasury "will monitor China's managed float as their exchange rate moves to alignment with underlying market conditions."

But China's decision is unlikely to satisfy calls for currency adjustment from the U.S. Congress. Indeed, the 2.1% appreciation vs. the dollar by itself will hardly make a dent in the U.S. current account deficit. It's a good bet that calls for additional moves by Beijing will likely intensify with the approach of the September visit to Washington by China's President Hu Jintao.

From Action Economics staff analysts

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