China last Saturday announced that it would gradually make the yuan?s exchange rate flexible to its highest level since July 2005 against dollar, indicating that it was ready to break a 23-month-old dollar peg that had come under intense international criticism.
The development had an immediate supportive impact on the base metals and energy markets, as China is the world largest base metals consumer and one of the largest energy users.
Any flexible in exchange rate means cheaper raw material for Chinese buyers.
Now, the yuan is allowed to rise or fall by 0.5% a day against dollar from an opening mid-point set by the central bank at 9.15 am local time based on quotes collected from market makers.
The yuan?s daily trading band against other major currencies is set at plus or minus 3% from the daily mid-point.
During the three years following an initial 2.1% revaluation of yuan on July 21, 2005, the currency has gained 19%.
China is the world?s second largest oil consumer, using one in every 10 barrels produced. China is also the top consumer of iron ore, copper and aluminum and the world?s largest buyer of soybeans.
The most benefited from China?s yuan move will be global manufacturing and resource companies that supply the world?s third-biggest economy with equipment and commodities it needs to fuel growth.
The biggest losers due to the revaluation will be China?s own exporters and commodity producers. A relatively mild yuan appreciation against the dollar of about 5% would cause loss to these companies.
An analysis of the yuan?s appreciation in 2005-06 shows that Chinese exports will slowdown on account of the appreciation.
After the 2005-06 revaluation, Chinese exports grew more slowly at 26% per annum; and so did oil demand (6% pa), compared to 34% and 11%, respectively, during the three years prior to the revaluation.
Though the news temporarily lured investors back into base metals after the fall of last few days because of the euro zone debt crisis, many believe that in future the yuan will rise slowly, possibly by 3-10% over the year.
If we can analyse China yuan move from another perspective, we can say that this will affect on Chinese growth, especially if Chinese authorities are looking at a slightly more moderate rate growth.
May be the currencies appreciation may mean that they don?t have to take other steps to achieve that. Apart from enhancing China’s overseas purchasing power, the move could reduce trans-Pacific trade frictions, usher in key structural reforms at the micro- and macro levels, and give China additional policy flexibility to deal with any future inflation pickup. The big question now is after flexibility what next for yuan?
Most probably exchange rate reform would be gradual, ruling out both major appreciation and a one-off revaluation.
Other possibility is, the central bank will increase the exchange rate’s flexibility and ensure that it could both rise and fall depending on market conditions. For a long time, China has wanted to introduce more two-way risk into the exchange rate. In conclusion we can say that China?s currency flexibility is welcome but it is too early to say that this rise would be enough to help rebalance world growth.
On the other side the impact of China?s yuan revaluation on commodities should be small in the short-medium term and in the long run prices will follow global economic growth and other fundamentals.