While the announcement by the People’s Bank of China on revaluation of the yuan came as no surprise to market watchers, it appears to have taken the local media by surprise. There is an eerie similarity between what the Chinese are doing and what the Japanese did back in the '60s and '70s. In many ways the Chinese economic miracle today is just a replay of what Japan did half-a-century ago, only much bigger.
Back in the ’60s and ’70s, the Japanese took a lot of flak from the US in particular for not allowing the yen to appreciate. They deliberately kept their currency weak to allow their cheap exports to infiltrate global markets. Eventually, of course, the Japanese economy matured and the currency stabilised.
In the normal course of events, the Chinese would have wished to have kept the yuan pegged to the US dollar, which would have kept their exports extremely competitive. But China’s increasing inflation rate has conferred a different dynamic to the equation.
Two things tend to influence exchange rate movements: Relative inflation rates and the size of foreign currency reserves. China’s foreign currency reserves, at around $2.5 trillion, are by far the largest in the world and are still growing. And this is important from a currency speculation perspective, as few would want to take on that kind of might. It evokes memories of the famous line by Gordon Gekko in the movie “Wall Street”, “The key is capital reserves – without it you can’t piss in the tall weeds with the big dogs”. China is the ultimate big dog when it comes to capital reserves.
But China’s inflation rate, while still low at around 2.8%, is rising and there are fears it could rise significantly if potential asset bubbles such as the property market are not kept in check. A rising currency will help to reduce inflation, in the same way that the strong rand has kept SA inflation under control.
It looks like there are three main driving forces behind the weekend’s decision by the PBoC to organise what is, in effect, a managed float of the yuan. Firstly, a moderate trend of appreciation in the real effective exchange rate (Reer) appears to be a policy objective of the Chinese authorities. However, considering the significant recent decline in the trade surplus, the pressure for a large appreciation in the Reer is substantially reduced.
Secondly, an increase in the value of the yuan relative to a basket of currencies will introduce greater two-way variations in the yuan/dollar rate. Strange as it may seem, it is even possible to foresee a depreciation of the yuan against the dollar, provided any appreciation of the dollar is large enough against other currencies. In other words, the net effect of these actions may just be that appreciation of the yuan against the US dollar is not as significant as originally perceived.
Lastly, the importance of stability in the yuan/dollar exchange rate as a policy objective will probably decline as a result of these actions. Having said that, the Chinese authorities are unlikely to give up on this objective completely, given the fact that the majority of China’s foreign exchange reserves are denominated in dollars.
Bottom line is that the yuan is likely to appreciate by up to 5% to around 6.5 to the US dollar by mid-2011, provided, of course, that there are no major upsets in dollar cross rates.
While effective exchange rate appreciation will dampen exports, the size of the change is relatively small and the impact will likely come through with a considerable lag. Moreover, such appreciation should improve China’s terms of trade, which in turn supports domestic consumption and investment.
In the longer term, an increase in exchange rate flexibility should help to facilitate a more market-orientated background for monetary policy. In particular, it will allow interest rates to play a greater role in monetary policy transmission than is currently the case.
In the near term, however, short-term capital inflows may rise as a result of increased expectations of exchange rate appreciation. This probably explains the move out of US Treasuries on Monday morning.
By Christopher Gilmour
(Gilmour is an analyst with Absa Asset Management Private Clients)