In the world of economic diplomacy where gestures often mean much more than concrete action, China’s move to abandon its currency peg against the dollar is significant. It is, therefore, no coincidence that the move comes roughly a week before the G20 summit in Toronto where pressure on China to adopt a more flexible currency regime was expected to intensify. China has clearly pre-empted some of this by agreeing to more exchange flexibility. However, this move is unlikely to mean any dramatic change, at least in the near term. While China has committed to dropping its de facto dollar peg (6.83 yuan to the greenback) that it has maintained since mid-2008, it has not promised either a one-off revaluation against the dollar or a free-floating currency. It will continue to “manage” its currency through heavy intervention by its central bank. Thus, a sharp appreciation in the yuan against the dollar is unlikely. This is incidentally not the first time that China is relaxing its exchange rate regime. It had abandoned its dollar peg in 2005 and moved to a managed float against a basket that included the euro and the yen. In roughly the three years that this mechanism operated, the yuan appreciated by 21 per cent against the dollar. This might be some indication of how much appreciation is likely in the near to medium term.
Gestures are important to financial markets as well, and the implication of China’s move is being analysed threadbare by financial analysts across the world. The immediate response has been to read the move to allow flexibility as proof of the Asian behemoth’s confidence in its own economic recovery. China’s stock market has risen, pulling other markets in the region up along with it. Asian currencies, including the rupee, have moved up. Once this initial euphoria abates, there are a couple of issues that markets are likely to grapple with. China’s growth model has been dependent heavily on exports that, in turn, have fed off an undervalued exchange rate. Greater exchange rate flexibility could dent exports and the country’s ability to sustain its scorching pace of growth is contingent on how much the economy has been able to and can exploit its domestic demand (particularly consumption) base. If growth shows signs of flagging, financial markets (particularly those for commodities where China is seen as the key demand driver) could sell off. It could also resurrect fears of another dip in growth. Besides, China is the principal creditor to the rest of the world, particularly the US and Europe where it deploys its one trillion dollars of foreign exchange reserves in government and quasi-government bonds. This stockpile of reserves is the result of its exchange rate policy. Its central bank has bought dollars and euros relentlessly to cap the yuan’s exchange rate.
A flexible exchange rate regime would reduce the Chinese central bank’s need to intervene in the market and could thus reduce its stock of foreign exchange reserves, or at least slow down the pace of accretion. Its appetite for dollar and euro bonds will wane as a result. For western governments that are likely to see large budget deficits and consequently supply large quantities of bonds in the international markets, this could spell trouble unless the demand from their own households and companies compensates. The risk is that interest rates in the G7 countries will tend to rise sharply. That could keep markets and policy-makers on edge. All in all, the yuan flexibility story has to play itself out fully before markets can rush to judgment. While this weekend’s news may win some comfort for Beijing, next weekend in Toronto the world will wait to see if China puts its money where its mouth is.
