The yuan/dollar exchange rate has changed course. And this is among the most crucial trends to look for as major economies fight the financial crisis. For a long time, China was on an exchange rate regime featuring very low flexibility against the dollar, and a slow and steady pace of appreciation. This sounds like a nice thing for those who do not like currency volatility. But it was one of the worst possible exchange rate regimes in that it gave a one way bet on the exchange rate to capital inflows. For people bringing money into China, they had a near-certainty that the exchange rate would appreciate, with a very low risk (i.e. currency volatility). In recent weeks, this appreciation first stalled, and then turned around. From 6.88 on June 18, the appreciation proceeded to 6.78 on September 12, and has returned to 6.88 on 4 December. This was not a particularly clever exchange rate regime in this period, for while the dollar was strongly appreciating against all other currencies, the Chinese hung on to the dollar peg. In the process, the Chinese got a strong appreciation against other currencies, which has hurt their exports at a time of a global downturn. This is a lesson for all champions of strongly managed exchange rate regimes.
When the exchange rate environment changes from one of a tightly managed appreciation to a tightly managed depreciation, capital flows could well reverse. So, the Chinese could see significant sales of domestic assets such as shares or real estate. Exchange rate inflexibility converts problems in the currency market into problems on all domestic asset markets. Another lesson for exchange rate managers. Any long-term solution to the global downturn has got to involve fundamental change on the part of the Chinese govenrment on the subject of market manipulation of the exchange rate. China has got to see that large responsible countries do not engage in such unhealthy behaviour. The problems of the world economy are now the problems of the Chinese economy also. The responsible thing for China to do is to move towards a floating exchange rate, as all well managed countries have done. As the above examples illustrate, this is both about being a responsible citizen of the globe, as well as sheer self interest.