The day has arrived. Call it what you will?astute political strategy, caving in to international pressure or simply protecting its economy from overheating?China has finally given the yuan a carte blanche, after two years of maintaining a fixed peg against the dollar, to float. This ?monumental? decision prompted President Obama to praise China for a determined shift away from garnering further external surpluses and towards domestic consumption, a euphoric response by the markets, inspiring hope for an increase in the competitiveness of other nations? exports. And the timing couldn?t have been better. To take some of the heat off of its ?currency management? policy, China announced the return to a managed float regime, just ahead of the recently concluded G-20 meet in Toronto, in order to allow the members to focus on issues more central to their needs like greater representation of emerging economies in the World Bank and IMF and the opposition of the global levy on banks being proposed by the G-7. China has once again illustrated its astute use of soft power.
Alas, the euphoria was short-lived. While the G-20 members appear to have been pacified?objective achieved!?the markets are not quite as optimistic any more. The Hang Seng, which had gained 3.1% on June 21, slipped by 0.5% and the Nikkei 225 that jumped 2.4% the day after the announcement, shed 1.2% the following day. This was because the announcement raised expectations of a significant shift in policy by the Chinese central bank. But, in fact, this was only China returning to its pre-2008 exchange rate regime; the government?s ?new? trading band was in place before the financial crisis. So while the yuan will once again be allowed to trade, the band within which trading is carried out will be very narrow and closely monitored, permitting no more than a 0.3% appreciation against the dollar per day.
The question then is?is China?s continuing refusal to allow its currency to appreciate significantly necessarily a bad thing? The West, with the loudest and most resilient voice emanating from the shores of New York City, has done everything short of labelling China a ?currency manipulator? (more in the interest of diplomacy than the economy) to put pressure on the Chinese government to revalue. This, they say, is in the interest of decreasing the widening gap in trade imbalances between the West and China?revaluation of the yuan will lower China?s trade surplus, reducing the US? burden. But how is China to blame for the US?s insatiable appetite for debt? After years of consuming the cheap Chinese exports ubiquitous in American markets, the US is now realising its folly of accumulating ever-growing deficits. Thus, leaving no stone unturned in its quest to put pressure on the Chinese government to revalue for ?greater global good?.
But, the US doesn?t appear to have taken into account how the yuan?s appreciation to its projected fair-value?the estimates of undervaluation range from 25-40%?will impact middle-America and global investment. The clothes, furniture and other consumer durables imported from China allow middle-American households to stay afloat. They depend on stores like Walmart, Cosco?s and Target to meet their need for these essential goods, where shelves are lined with products almost exclusively produced in manufacturing units located in China. Should the price of these goods increase by 40% (or even 25%), American households, already struggling with the highest unemployment level seen in seven decades, will be hard pressed to meet even basic requirements.
If analysts and speculators were to believe that the Chinese currency will be permitted to appreciate by a substantial margin, it would require little imagination to predict the direction of global investment flows. The inflow of large sums of ?hot money? into the real estate and money markets is the last thing an economy already showing signs of overheating needs. Not only is this detrimental for China, but it will devastate the dollar, too. Sceptical? Think carry-trade?selling dollars to invest in the yuan.
So yes, China has essentially reverted to its pre-crisis policy of using a basket of currencies (with the largest share still belonging to the dollar) without taking any drastic measures.
And this is probably the best move in the current economic climate. China, continuing on its path of adroit decision making, is policing the yuan?s gradual appreciation. The apt policy at this stage would be for China to gradually decrease the weightage of the dollar in the basket of currencies, allowing the currency to reach a more balanced fair-value.
Strange as it may sound, the yuan saga smells more of an American hypocrisy than Chinese manipulation.