China’s yuan reform: Keep your pants on

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Everyone’s gotten themselves all hot and bothered at the prospect that China’s leadership may actually loosen up policy on their currency, the yuan, and allow it to appreciate against the U.S. dollar. Optimism was sparked by U.S. Treasury Secretary Tim Geithner’s unexpected pit stop in Beijing for a meeting with China’s vice premier. But I wouldn’t get your hopes up. If the Chinese do make a move on the yuan, it’s highly unlikely the change will have any meaningful impact, at least in the short term.

First of all, whatever China chooses to do, it won’t be dramatic. Beijing is deathly afraid of rapid movements in the value of the yuan and the consequences that might have on exports. That means any appreciation will be slow and incremental. Barclays Capital said in a report this week that it expects the yuan to appreciate 5% against a basket of currencies over the next year. That’s a very common view. Economists in general expect China to allow the yuan to appreciate by only a few percentage points in coming months. I can’t see such a small increase in the yuan’s value having anything but a small impact, either on the size of China’s trade surplus with the U.S. or on the competitiveness of its exports vis-à-vis those from other emerging economies.

Secondly, any reform China might institute in regard to how the yuan is valued will also likely be minor. My guess is that the best we can hope for is a return to the system China had in place before it effectively re-pegged the yuan to the dollar in 2008. The Chinese government back then allowed the yuan to float in a narrow range against an undefined basket of currencies. If China goes back to such a regime, it means that the value of the yuan will still be (at least) partially controlled. Any step towards a more market-oriented, flexible exchange rate for the yuan is a positive step, but we’ll probably get only a baby step.

Lastly, the Chinese will likely sell any yuan reform as a major concession, while the Obama administration will trumpet it as a major political victory. In fact, it would be neither. China will only allow the yuan to appreciate because it is good for China. Not only would such a move defuse threats of trade sanctions in Washington, a stronger yuan would help Beijing control rising inflationary pressures, which is becoming a policy priority in China. Economists have been saying for a while that China will need a stronger currency to help it fight inflation. So the main beneficiary of a new yuan policy would likely be – China.

My bottom line on any upcoming yuan reform: China helps its own economy, deflects criticism in Washington and effectively gives up nothing. Beijing is playing its hand in this little currency game much more strategically than Washington.