The long march

Written by The Economist | Updated: Jun 30 2010, 06:00am hrs
For months the rich worlds policymakers have quietly pressed China to abandon its exchange-rate peg with the dollar. On June 19th, a week before world leaders from the G20 were due to gather in Toronto, China at last gave ground. The countrys central bank said it would again allow the yuan to move more freely against a basket of currencies, although it ruled out a one-off revaluation as unwarranted. The announcement was greeted cautiously by Tim Geithner, Americas treasury secretary, but in private he may be relieved that a potentially nasty row over the yuan has been averted.

Chinas move is also timely because it assuages fears that it has become less committed to rebalancing its economy. Its huge current-account surplus was cut by more than a third as a share of GDP last year, and had seemed likely to shrink further. But a surge in exports in May raised concerns that China would once again rely on selling to foreign markets for growth now that the rich world has emerged from recession. By allowing a more flexible yuan, China stands a better chance of disarming its critics in Congress who believe that it has been unfairly subsidising its exporters with a cheap currency. It also gives China more tools with which to cool its economy and tame inflation. A stronger yuan would cut the costs of imported goods. Even better, abandoning the fixed tie with the dollar has liberated Chinas interest-rate policy.

The change in direction is welcome but will not work wonders quickly. One problem is that Chinas exchange-rate policy will be judged in parts of Washington by how much ground the yuan makes against the dollar, not against all currencies. If the euro weakens further, that would slow the yuans rise against the dollar and give fresh impetus to China-bashers in Congress in the run-up to mid-term elections in November.

A lot also depends on how quickly the currency is allowed to rise. Some China-watchers expect the yuans ascent to resume at the speed it reached when it was last untethered from the dollar, in the three years after July 2005. That may be too optimistic. Chinas anxiety about the prospects for rich-world economies may mean that the yuans rise is more stately this time. China wants to stem the flow of hot capital into an economy that is prone to sudden jumps in stocks and house prices. To add to the protection afforded by capital controls, it will surely discourage the idea that the yuans appreciation will be steady and speedy. So the currencys 0.4% rise against the dollar on the first days trading after the announcement was partly reversed the following day.

In any case, fixing trade imbalances is not a simple matter of currency adjustment. In principle, a stronger yuan would help by making exports less profitable and by giving consumers more spending power. But workers displaced from Chinas export industries will have to find jobs elsewhere. And a host of distortions and frictions makes that harder than it should be. Until these obstacles are removed, a sharp appreciation of the yuan might result in a surge in Chinese lay-offs, not a boom in Chinese consumption.

Reforms to tackle the root causes of excess saving in China are therefore needed as part of a lasting solution to global imbalances. That means more liberalisation to make it easier for small firms in labour-intensive services to challenge cosseted state-backed firms; it means better corporate governance to help unlock the cash hoarded by state-owned enterprises and spread it around the economy; and it requires a wider social-security net to persuade Chinese householders that they need not insure themselves against every catastrophe. A stronger currency is a handmaiden to these changes. But it cannot do all the work of transforming Chinas economy.

The Economist Newspaper Limited