Long wait follows China's small step
Financial liberalisation depends on how fast banks and companies learn to handle the exchange risk, writes Tom Holland
With a tiny step forward, China has begun the long process of overhauling its currency policy.
By itself, Thursday's 2.1 per cent upward revaluation of the yuan against the US dollar will have a minimal direct impact on the world's economy. It will not appreciably undermine the competitiveness of China's exporters, nor will it noticeably slow China's rapid pace of economic growth.
It certainly will not reduce America's massive trade deficit.
Yet the long-term implications of China's policy change for businesses, market traders and policy-makers are enormous. Thursday's adoption of a managed float against a basket of currencies gives Beijing the leeway it will need to adjust the value of the yuan in response to changing economic conditions. In time, that flexibility will help pave the way towards a freely floating exchange rate, a fully convertible currency and deregulated domestic interest rates.
But the day when the value of the yuan is determined solely by the market is still a long way off. Following Thursday's modest revaluation, casual observers are unlikely to detect any difference in China's day-to-day management of its exchange rate for many months to come.
'What China has done is lay down a framework that works in the long term, even though in practice it will look very similar to the old regime,' says Stephen Green, an economist at Standard Chartered.
In theory, Beijing will no longer keep the Chinese currency rock steady against the US dollar. Instead it will aim for broader exchange rate stability by managing the yuan against a range of currencies.
Do not expect any wild swings in the bilateral dollar-yuan exchange rate just yet, however, and certainly do not look for a big yuan appreciation against the US currency. Along with other China-watchers, Mr Green believes that having taken its initial step, the People's Bank of China (PBOC) will keep the currency trading close to the revalued exchange rate of 8.11 yuan to the dollar for the next few months, while it tries out its new system.
Under the new mechanism, the yuan could theoretically appreciate against the dollar by 0.3 per cent each day. That does not sound like much, but cumulatively it would add up to a rise in value of 75 per cent over a trading year. There is no way Beijing is going to permit that.
Although China's exports are growing at a 33 per cent annual rate, over-capacity has eroded exporters' profit margins to wafer-thin levels. Any sizeable rise in the yuan would squeeze them even more, damaging companies' ability to pay back their bank loans and further weakening China's already shaky financial system.
So, US politicians and lobbyists hoping Thursday's move is the precursor to a steady 25 per cent rise in the yuan are likely to be disappointed. 'It's not in China's interest to let the yuan appreciate too much,' says Tse Kwok-leung, a senior economist at the Bank of China.
China is also likely to keep the US dollar-yuan exchange rate stable near the current level, to discourage speculation on a big rise in the yuan over the coming months.
'In the near term, there will be a whole lot of speculation that the yuan will rise and that Asian currencies will appreciate,' says Ray Farris, a foreign exchange and fixed income analyst at Credit Suisse First Boston.
'I think China will work pretty hard to convince the markets that will not happen.'
But over time, China's decision to manage its exchange rate against a basket of currencies instead of just one will allow for bigger exchange-rate fluctuations. As the different constituents of the basket move against each other, the PBOC will intervene in the markets to maintain the yuan's overall stability, potentially leading to some unexpected moves in the dollar-yuan rate. The PBOC is not disclosing exactly which currencies it has chosen for its basket, or how much weight it is giving to the different components, but it is possible to take an educated guess.
The most likely model is a simple trade-weighted basket, made up of the currencies of China's biggest trading partners in proportion to their importance. The exact composition would vary depending on whether the Hong Kong dollar was included.
However, stripping out Hong Kong, on the grounds that much of China's trade with the territory is merely passing through, gives a basket composed of the US dollar, the yen, the euro and the South Korean won.
The US dollar would make up about 33 per cent of the basket, followed by the yen at 29 per cent, the euro at 27 per cent and the won at 11 per cent.
There could be extra refinements. The weightings could be adjusted for inflation, or the basket could include the currencies of smaller trading partners like Australia, or even of potential competitors like India. Even so, the broad shape of the basket would be much the same.
Each day the PBOC will asses the yuan's moves against the basket's currencies. To maintain overall stability against the basket, the central bank will then announce an exchange rate for the yuan against the US dollar to be the reference rate for the following day's trading. The market rate will be permitted to move 0.3 per cent either side of this reference, but not beyond.
Until now, the People's Bank of China has used only the bilateral exchange rate against the dollar to determine its daily reference rate. By using a basket of different currencies, in theory it can allow a much greater degree of fluctuation in the dollar-yuan exchange rate while increasing the yuan's overall stability, which benefits China's importers and exporters.
That sounds counter-intuitive, but in practice it is simple enough. Suppose the dollar-yuan exchange rate is 8.11 yuan to the dollar and the PBOC uses the aforementioned basket. If the yen were to rise by 5 per cent against the US dollar, the PBOC would intervene to push the yuan 1.45 per cent higher against the American currency to maintain its level against the overall basket. As a result the dollar-yuan exchange rate would ease to 7.99 yuan to the dollar.
That is a bigger move than the PBOC is prepared to allow in a single day. But as Chinese banks and companies get used to managing a greater degree of exchange rate risk under the new system, most economists expect the central bank to widen the yuan's permitted daily trading band against the dollar.
Over time, China is likely to move towards a model like Singapore's, in which the currency is allowed to swing by 5 per cent against the US dollar this year, while it maintains stability against its own trade-weighted basket.
It will be some time yet before China permits such big moves, but Thursday's policy change brings it an important step closer.