Ignore the guff; a little yuan weakness may not be so bad

An awful lot of guff gets talked about China's exchange rate policy, much of it by people who really ought to know better. Just a few months ago the big concern among analysts was that huge inflows of short-term capital from corporations and investors anticipating yuan appreciation would flood the financial system with liquidity and fuel runaway inflation.

This week, after President Hu Jintao complained about China's declining competitiveness and the central bank nudged the yuan a smidgen lower against the US dollar, analysts are fretting about the exact opposite.

Now they are worried that Beijing will devalue the yuan. That, they fear, will ignite a round of beggar-thy-neighbour copy-cat devaluations around Asia, trigger uncontrollable capital outflows from the mainland, damage consumer demand within China and exacerbate global financial imbalances, worsening the current economic downturn.

Let's deal with these fears one by one.

First, it is absurd to argue that the fall in the yuan this week will set off a wave of competitive devaluations around Asia. As the first of the two charts below shows, over the 12 months to the end of last week, the yuan had appreciated 8.3 per cent against the dollar. On Monday it dropped by 0.8 per cent, before strengthening a touch to end yesterday's trading 0.3 per cent below last Friday's close. That's the small downward blip you can see at the far right of the first chart; a fall against the US dollar for sure, but hardly a massive devaluation.

A drop of such small magnitude, even if it is repeated over many weeks to come, will not beggar any of China's Asian neighbours. That is because the rest of East Asia's currencies (with the exception of the Japanese yen, which marches to a different drummer) have already fallen heavily against the US dollar over recent months.

That means the yuan has appreciated dramatically against other regional currencies. As the second chart below shows, between mid-July and late November, the yuan rose by a massive 48 per cent against the Korean won. Its subsequent 2 per cent fall is not going to turn any Koreans into beggars by undermining their international competitiveness.