China’s yuan reform: back to the future

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After months of debate, denial and conflict, China finally announced a new policy on its controversial currency, the yuan (also known as the renminbi, or RMB). For the past two years, the yuan has (unofficially) been pegged to the U.S. dollar, sparking criticism from politicians in Washington, high-profile economists and China’s fellow developing nations that Beijing was pursuing a “beggar-thy-neighbor” agenda to keep Chinese exports artificially cheap to expand their market presence at the expense of competitors. China had stubbornly resisted the pressure to change its exchange rate policy, insisting that the yuan was valued exactly how it should be.

But over the weekend, in a surprise announcement, the People’s Bank of China signaled the peg would come to an end. Here’s what the central bank said in a statement:

In view of the recent economic situation and financial market developments at home and abroad, and the balance of payments (BOP) situation in China, the People´s Bank of China has decided to proceed further with reform of the RMB exchange rate regime and to enhance the RMB exchange rate flexibility.

What does that mean? Unfortunately, at least in the short run, probably not much.

While announcing the so-called reform, the People’s Bank also made it very clear that any change in the yuan’s value would come gradually at best. Its statement stated plainly that its priorities remained generally unchanged – to “maintain the RMB exchange rate basically stable at an adaptive and equilibrium level, and achieve the macroeconomic and financial stability in China.” The People’s Bank further signaled a return to the currency valuation system that existed before the peg was resumed in 2008 – a managed float in which the yuan traded in a narrow band against an unnamed basket of currencies. That process was put in place in 2005, and though it did result in yuan appreciation – by some 21% versus the dollar over three years – it also allows Chinese policymakers a degree of control over the exchange rate to prevent rapid movements.

In other words, we’re looking at a back-to-the-future scenario, with Beijing returning to an old policy that, though better than its peg, won’t produce the drastic overhaul of China’s currency regime that many critics would like to see. In fact, on Monday morning, the yuan didn’t move at all against the dollar. (UPDATE: The yuan, however, did begin appreciating against the dollar in trading later in the day, reaching its strongest level in modern times.)

Analysts as a result are not predicting a major change in the yuan’s value against the dollar. Here’s what BofA Merrill Lynch predicts:

We do not expect a significant appreciation against the US dollar. In fact, the RMB could even depreciate against the USD if the Euro declines. Gradual moves will be tolerated…Our end-2010 forecast remains unchanged at 6.80/USD, not far from current levels. We expect a more significant appreciation on a trade-weighted basis. Our FX forecasts imply that the nominal effective exchange rate could appreciate some 6% by end-2010, and 12% by end-2011.

An argument can be made that a dramatic revaluation of the yuan isn’t necessary based on economic fundamentals. Beijing’s policymakers made it obvious that that’s exactly how they feel about it. The central bank statement read:

China´s external trade is steadily becoming more balanced. The ratio of current account surplus to GDP, after a notable reduction in 2009, has been declining since the beginning of 2010. With the BOP account moving closer to equilibrium, the basis for large-scale appreciation of the RMB exchange rate does not exist.

That position may not fly back in Washington, however. China most likely chose this moment to make its surprise announcement to deflect criticism of its currency policy at the G20 summit in Toronto, which takes place this weekend. Beijing might succeed. But if the pace of yuan reform remains slow, China will continue to face criticism in world capitals, and the yuan will remain an unfortunate sore point in Beijing’s relations with the rest of the world. We’re unlikely to see enough change in the value of the yuan in the short-to-medium term to have any significant impact on world trade and investment patterns.

However, in my opinion, any change in yuan policy that brings into play any degree of flexibility is a good one – especially for China. A more rationally determined yuan will help China make that difficult but crucial adjustment from an invest-and-export economic model to one based more on domestic demand. It will also give Beijing another tool by which it can moderate inflation. China also clearly wants the yuan to play a bigger role in world trade and finance, and a more market-based valuation system will be an absolute necessity to make that happen. Meanwhile, the downside to China in terms of lost exports is likely to be minimal. Here’s what Qing Wang of Morgan Stanley had to say:

We commend this important policy move by the Chinese authorities. This is desirable and timely and should be welcomed by the market, in our view. This policy move should help contain inflationary pressures in the short run and rebalance the Chinese economy over the medium and long run, in our view. A Renminbi exit from the peg and subsequent gradual appreciation against the USD should be positive for the stock market, even though a stronger Renminbi will likely hurt low margin exporters who do not have pricing power.

So it’s all good. But keep in mind this is a baby step on a long road to a truly market-determined yuan exchange rate. Until China’s allows a free-floating currency, controversy over its value will persist, and the yuan will play a limited role in the global economy.