China's July 21 move away from its dollar peg won't transform matters immediately
- From: "Chim" <ChimS1@xxxxxxx>
- Date: 24 Jul 2005 13:53:22 -0700
JULY 21, 2005
NEWS ANALYSIS
By Brian Bremner
The Yuan: A Baby
-- but Key -- Step
China's July 21 move away from its dollar peg won't transform matters
immediately. Longer-term, though, it's likely to be a watershed event
SPECIAL REPORTCHINA'S YUAN REVALUATION
· The Yuan: A Baby -- but Key -- Step
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.
UNSETTLED DAYS. 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.
SMART BETS. 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.
"STERILIZATION." 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.
CREDIBLE START. 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.
.
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