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Reminbi Revaluation Lends to Stability

Two weeks after the country decided to scrape its currency peg to the US dollar, and to allow it to float within a narrow range, the main question around the world seems to be: What next?

In its report on monetary policy for the second quarter of 2005, released on August 4, the People's Bank of China (PBOC), the country's central bank said that it will manage the exchange rate of its renminbi currency, also know as the yuan, on the basis of market supply and demand and with reference to a basket of currencies in accordance to domestic and international economic and financial circumstances.

The Xinhua News Agency quoted the central bank as saying that the policy will maintain the yuan's basic stability at a reasonable equilibrium, with a basic balance in international payments and that it will safeguard the stability of the macroeconomy and financial markets.

China's central bank re-valued the yuan to make the Chinese currency effectively 2.1 percent stronger against the US dollar for the first time since it was pegged to the dollar in 1994. The yuan will now be tied to a "basket of currencies" that the yuan will move up and down against. The decision, announced to the country's media over the central bank's Web site, re-valued the yuan at 8.11 to the dollar against 8.28 before the announcement.

On its Web site, the central bank said: "Starting from July 21, 2005, China will reform the exchange rate regime by moving to a managed, floating exchange-rate regime based on market supply and demand with reference to a basket of currencies." The yuan "will no longer be pegged to the US dollar." (For a full text of the People's Bank of China's statement, please log on to www.btmbeijing.com.)

Under the floating exchange rate regime, the yuan can fluctuate within a narrow band by 0.3 percent against a basket of currencies in the inter-bank foreign exchange market. The central bank did not offer any details of the components or weighting of the basket.

In the immediate aftermath of China's announcement, the dollar fell sharply against the Japanese yen, Singapore dollar, Indian rupee, Korean won and Thai baht and rose slightly against the euro. The dollar, however, bounced back against the yen the next day. US 10-year Treasury-bond yields jumped to 4.276 percent, a two-month high, from 4.167 percent on expectations that China, which holds the yuan down by purchasing dollars, will now have fewer dollars to invest in treasury notes or bills, reported The Wall Street Journal.

The central bank of Malaysia immediately followed China's lead by abandoning the ringgit's peg to the US dollar in favour of a managed float against a basket of currencies. The peg had been in place for seven years.

On the domestic front, news of the yuan's appreciation by 2.1 percent has triggered mix reaction. Several industries benefited from the stronger yuan. Chinese airlines breathed a collective sigh of relief as the industry as a whole will have lower financing costs after the yuan's appreciation, since a large chunk of their borrowing is in foreign currencies.

Xu Junmin, secretary of the board of Shanghai Airlines, was quoted by China Daily as saying: "The yuan appreciation is definitely good news for us. If the yuan strengthens by 1 percent, our earnings per share for the year will go up by 0.03 yuan."

Another noticeable beneficiary is China's steel industry. The 2 percent appreciation will cut the costs of imported materials by 3 billion yuan (US$369.9 million) this year, according to Qi Xiangdong of the China Iron and Steel Association.

On the flip side, exports are will lose. But Huo Jianguo, deputy head of the foreign trade department at the Commerce Ministry was quoted as saying "an appreciation of 5 percent or less is affordable for export growth under the current foreign trade situation, according to our calculations." He told the South China Morning Post, "The government must take trade growth into consideration when deciding the appreciation margin this year."

Huo's concern may be well-placed as there have been numerous media speculations that China's central bank will continue to adjust the yuan's value upwards. In a statement issued on its official Web site a few days after the revaluation move, the People's Bank of China sought to quell widespread rumours.

The statement said that certain foreign media has misled the public and even wrongly speculated that the revaluation of renminbi by 2 percent was only the first step in a series of adjustments, which could "lead to expectations for further renminbi revaluation by the People's Bank of China in the not-too-distant future."

In what the bank termed a "solemn statement," it said, "A revaluation of the renminbi by 2 percent, effective at the beginning of exchange rate regime reform, does not in the least imply an initial move which warrants further actions in the future."

 "The reform of the renminbi exchange rate regime must proceed in a gradual way. 'Gradualism' is the principle applied in the reform of the renminbi exchange rate regime, rather than in the adjustment of the renminbi exchange rate. The reform is focused not on the quantitative adjustment of the renminbi exchange rate but on the improvement of the renminbi exchange rate regime," the central bank continued.

However small the currency move is, the revaluation is an important step for China, Asia and the world.

Any small move by China can now be regarded as having huge implications for currency traders, who have all seen, following China's announcement, many Asian countries change their currency valuations, whether in the market or in a more managed way. The renminbi's exchange rate value is no longer a Chinese domestic issue alone, but a concern of Asia and the world.

Maintaining the stability of the renminbi and preventing wild swings in its value is in the best interest of all Asian entrepreneurs and businesses-as many learned, harshly, during the so-called 1997-98 Asian financial crisis, when a stable yuan kept the crisis from being worse than it was.

Outside Asia, China's currency move will have similar implications. Having already produced a regional effect, the 2 percent adjustment in the renminbi rate may help ease the deficit pressure of the US with many economies. Critics of China's monetary policies must realize how dangerous and irresponsible it would be to set an arbitrary target for it. Few, if any, analysts claim to be able to predict how global business would be affected by such a move or how it might affect people's daily lives both in the East or West?

The yuan's rate will be managed, even though it will float, reflecting the market situation. What the Chinese buy and what they don't buy, and what they think affordable and what they think too expensive will no longer be just Chinese questions. The yuan will become important for setting the prices of many things.

With China widely considered a "factory of the world," and with India experiencing a similar rapid expansion of its economic and consumer power, very soon, most likely within a decade, what Asians think and do, buy or don't buy will to a great extent determine the functioning of the global supply chain.

As one can see in the views of many economists, the recent debate about the yuan moves us one step closer to a new age. The world is no longer one where a single currency is the most important. Nor will it be one sustained by the natural working of a diverse number of forces, as with uncertain, free-floating currency regimes.

But there is one agonizing fact that China must contend with. The country simply does not have much experience in managing a modern financial industry. Much remains to be done in rebuilding its own banks into banks that can do business and succeed in a more competitive, even cut-throat environment, as was suggested by central bank Governor Zhao Xiaochuan during a July 23 interview with China Central Television (CCTV). On both government and corporate levels, whenever the phrase "financial management" is mentioned, people tend to see more dark spots than shining examples.

But there are larger questions afoot in the world today as China and India step forward in the world economy. Can the existing global financial system and financial service sector easily absorb these new heavyweight players on the global scene? What can be done to ease the inevitable strains stemming from real or imagined problems, whether related to currencies, energy supplies or global market penetrations, arising from this unprecedented growth in Asia?

It is clear that this cannot be allowed to "find its own level." More government-level cooperation will be needed to help maintain world stability, and China should play a major role in this arrangement.

If, as some overseas observers say, China is like a "bicycle economy," where balance can be maintained only if the bicycle maintains its momentum, the bicycle has to run even faster in learning and in being creative in dealing with foreign politicians, in working together with neighbouring economies, in playing a constructive role in the global financial system.

 "I welcome China's announcement today that it is adopting a more flexible exchange-rate regime. Reform of China's currency regime is important for China and the international financial system. [The United States will] monitor China's managed float as their exchange rate moves to alignment with underlying market conditions. China's full implementation of its new currency regime will be a significant contribution toward global financial stability."
--US Treasury Secretary John Snow speaking at a press conference

"China's move will likely have both positive and negative effects on Japan's economy. But the move is welcome as it shows China is moving towards international currency rules."

--Japanese Trade and Industry Minister Shoichi Nakagawa

"Chinese revaluation of the yuan is consistent with positive views on growth.  This long-awaited policy move comes at a time that US economic growth has stabilized at a solid pace, and the Chinese economy appears to be reaccelerating. Impact on the US Treasury market from the revaluation alone is likely to be modest, as the Chinese Government had already moved to a basket approach to foreign exchange holdings and new net purchases of US treasuries had already slowed. A rise in the yuan could lead to upward pressure on US import prices…but much of what is imported from China comes from ventures owned at least in part by US companies and this could be a mitigating factor."
-- Abby Joseph Cohen and Michael Moran of Goldman Sachs in a research note.