Will they or won't they? There is confusion at the moment about whether the mainland will allow its currency to float on the market, with some senior officials saying it will happen soon and others denying it.
Make no mistake about this, however. Floating a previously fixed currency is a big move and involves more than just the currency. It entails removing restraints on capital flows and opening markets much further. It is what any country must face when it joins the World Trade Organisation.
It also brings an immediate uncertainty. Will investment money suddenly flow out of the mainland when this window is opened and the currency collapse or will money rather come in and the currency strengthen? There is no definite answer to this but let's look at it from two perspectives. The first is a simple (very simple) way of assessing whether the present exchange rate against the US dollar overvalues or undervalues the yuan.
We shall assume here that prices for similar goods were the same in the US and the mainland in January 1986 (the earliest date for which your correspondent can find reasonable inflation figures for the mainland).
The question then becomes whether the mainland's higher inflation rate was reflected over time in a weaker currency so that prices stayed roughly similar after adjusting for currency movements.
And your answer (may I have the envelope please?) is that the yuan on this basis looks undervalued. As the first chart shows, its actual exchange rate has fallen from 3.21 to 8.28 against the US dollar over the period.
However, if inflation differences with the US were all that governed its movement that exchange rate would now be much stronger at 5.5.
