Yuan band move makes a virtue out of market necessity
You have to admire Beijing's timing.
On Saturday the People's Bank of China announced it would widen the daily trading band of China's currency. From today, the yuan will be allowed to fluctuate by as much as 1 per cent either side of a central reference rate against the US dollar, double the width of the previous trading range.
By itself, the move is not especially significant. It has long been expected. And although a wider trading range allows for a little extra movement in the yuan's exchange rate, it doesn't necessarily follow that we will see a big increase in the currency's intraday volatility.
After all, the yuan has been allowed to move as much as 0.5 per cent either side of its reference rate for five years now, but as the first accompanying chart shows, the exchange rate has seldom fluctuated by anything like as much.
Certainly a wider trading band does not mean the yuan will be free to float like other major currencies. The central bank will continue to control the yuan's exchange rate by setting its daily reference rate and by intervening in the foreign exchange market to nudge the currency in the direction it desires.
Nevertheless, Saturday's announcement is important because it represents one more incremental step in the gradual liberalisation of China's currency regime.
To a large extent that liberalisation is being imposed on Beijing by market forces. For a long time Beijing has kept the value of its currency artificially low to boost exports.
But in recent years the authorities have found that their manipulation of the currency has carried unintended, and unwelcome, consequences.
What happened during the global financial crisis was a good example. As the US credit crunch began to bite in the summer of 2008, China's central bank halted the crawling appreciation of the yuan against the US dollar in order to help exporters out in the face of weakening demand.
For the next two years the authorities kept the exchange rate rock steady at around 6.83 yuan to the US dollar.
That stability may well have assisted exporters. But the authorities soon found that keeping the yuan down had a price. To mop up the liquidity created by their interventions, they had to issue vast quantities of short-term debt. That meant they had to keep interest rates down, which helped fuel inflation.
As a result, the appreciation pressure on the yuan showed up in higher domestic prices, rather than in a stronger currency. Between June 2008 and June 2010, the yuan's exchange rate against the US dollar didn't budge, but in real effective terms the Chinese currency strengthened by almost 10 per cent, thanks largely to inflation.
Wisely, the central bank decided that a stronger currency was more desirable than inflation, and resumed the yuan's appreciation.
Now, the authorities are finding themselves compelled to ease up on their tight control of China's exchange rate and capital regimes in order to push through vital domestic financial reforms.
If China is to rebalance itself towards consumption-driven growth and avoid the so-called middle income trap, the authorities will have to liberalise domestic interest rates, which will mean allowing higher real rates. That would make continued foreign exchange interventions punitively expensive, which means that Beijing will also have to relax its grip on the yuan.
Progress will be gradual, but although the process is inevitable in the long term, Beijing will look to extract every ounce of political capital that it can out of each incremental reform.
That explains the timing of Saturday's band widening. The central bank could have announced the move at any time over recent months. But with senior officials travelling to Washington this week for the spring meetings of the International Monetary Fund and the World Bank, Saturday's reform will help undercut the arguments propounded by US critics of China's exchange rate policy.
And it will strengthen Beijing's reputation for financial reform, bolstering the position of Chinese officials in multilateral economic talks.
In other words, Beijing has deftly made a virtue out of a necessity. It's a neat piece of timing.