China's Revaluation: Baby Step or Great Leap?

Global Finance, Sep 2005 by Platt, Gordon

China's modest revaluation of slightly more than 2% in the value of the yuan against the dollar was either a baby step or a giant leap forward, analysts say.

The adjustment in the pegged value of the yuan to 8.11 from 8.28 to the dollar was accompanied by a move to a managed float against a basket of currencies, but many details of the central bank's new policy went undisclosed.

While a 2% revaluation of China's currency isn't going to eliminate the US trade deficit, analysts say, the possibility of a regime change in the country's foreign exchange policy could introduce the flexibility and additional appreciation of the yuan that will add up to something very significant in the long run.

The People's Bank of China has not published, and will not publish, the components of the currency basket, but analysts surmise it will include the currencies of countries with which China does most of its trade.

"Our best guess is that the currency basket may give the US dollar the highest weighting of 45%, as it includes the trade weights of both the US and Hong Kong and reflects the intention of the authorities to initially maintain relative stability of the yuan against the dollar," says Michael Spencer, chief economist for Deutsche Bank in Asia, who is based in Hong Kong.

"This is deemed necessary to control speculation and to ease domestic opposition to currency reform, especially during a transition period when foreign exchange hedging products are not readily available for most importers and exporters," Spencer says.

The formation of a currency basket should have no immediate impact on the currency composition of China's foreign exchange reserves, Spencer says. But to the extent that the Chinese currency's flexibility has triggered a new downtrend in the dollar, this could affect China's assessment of the profitability of holding dollar reserves and weaken the argument for holding dollar assets, he says.

Deutsche Bank forecasts a 5% appreciation of the yuan in the next 12 months, on top of the initial 2% move.

The governor of the People's Bank of China, Zhou Xiaochuan, said the 2.1% revaluation of the yuan to 8.11 to the dollar on July 21 was an initial step and that the central bank would adopt a gradual approach to reform the country's foreign exchange system.

"China's overall buying power has increased, the currency is stronger and has more value," he said on state television two days after the change was announced. "The positive effects on the economy will be much greater than the negative effects," he said.

China's export companies should probably increase their prices, which would help to correct imbalances in global trade in an orderly way, he suggested, although this was not likely to have a major impact on the US trade deficit.

Globalization and the integration of emerging markets into the global economy have resulted in rapid increases in their share of world trade and their importance in determining the real trade-weighted value of the major currencies, says Bankim Chadha, global head of macro foreign exchange research at Deutsche Bank in New York.

The share of emerging markets in US trade has doubled from 25% in the early 1970s to almost 50% now. The real values of emerging market currencies, therefore, now determine almost half the real value of the dollar on a broad, trade-weighted basis, which is the most relevant measure of the exchange rate for gauging prospects for US trade flows and the current account, Chadha says.

The extent of the US external imbalance argues for a dollar well below historic averages to affect external adjustment, Chadha says. Thus, even significant appreciation of emerging-market currencies of about 12% against the dollar should be expected to have only a modest impact on the US external balance, he says, since this would only bring these currencies to around their historic averages.

Speculators seem to be pouring money into China, keeping the yuan under upward pressure against the dollar, says Carl B. Weinberg, chief economist at High Frequency Economics, based in Valhalla, New York.

Weinberg says that the Chinese government is not prepared to say how it will set the exchange rate or how often it will adjust the reference rate or even how it will intervene if market trading moves the currency more than 0.3% away from the pegged level.

The reference for the peg can be defined using any of several currencies on a given day, Weinberg says.

While the Chinese central bank says that the market should not expect another revaluation to come quickly, if at all, Weinberg says, "We see no merit to a one-time 2% revaluation. In effect, it is merely an extension of the old currency regime at a different level for the exchange rate."

If the People's Bank of China does change the peg again, it will try to surprise the market, Weinberg says. "However, even one more revaluation will prompt a flood of speculation about the timing of the third, fourth and fifth adjustments of the peg," he says.

Meanwhile, China's foreign exchange reserves jumped another $52 billion in the three months to June, to a new record high of $711 billion. While that's still below Japan's $843 billion, the gap is narrowing fast, say analysts at Brown Brothers Harriman in New York.