July 22, 2005,
Yesterday, China adopted a managed float of its currency, the yuan, ending the dollar-peg system that has lasted since the early 1990s. (Malaysia followed suit.) China will now use an undisclosed basket of currencies to set the value of the yuan, and will announce the resulting dollar/yuan exchange rate on a daily basis. For July 21, this was 8.11 yuan per dollar, about 2 percent stronger than the 10-year 8.27 yuan per dollar peg. China will also limit intraday moves in the dollar/yuan exchange rate to plus or minus 0.3 percent.
China’s basket, I believe, is primarily made up of dollars, and also may include euros, yen, and several other currencies in relation to their trade with China. To maintain a basket, China would not in any way be required to change the makeup of its (now largely dollar-based) international reserves, but it may gradually match its reserves with the currency weights in the trading basket. Note, however, that some 90 to 95 percent of all China’s foreign trade is denominated in dollars, minimizing the “need” for the country to significantly alter its reserve composition.
In its announcement, China stressed phrases that the U.S. and G7 had encouraged: “Moving into a managed floating exchange rate regime based on market supply and demand. … RMB [yuan] will no longer be pegged to the U.S. dollar and the RMB exchange rate regime will be improved with greater flexibility.”
The U.S. had made noises in recent weeks that a move was expected, and Malaysia’s immediate parallel move indicates that China’s move was in fact coordinated.
If the U.S. maintains its initially positive reaction, China’s announcement will be a constructive development in that it will have relieved protectionist tension and, at least for a while, the threat of the Bush administration allowing current tariff legislation to make progress. It also reduces the risk that the U.S. Treasury would name China a “currency manipulator.”
I don’t, however, think this will have a major impact on world financial markets or trade flows. The impact would only be significant if the new regime were managed in such a way as to allow for larger yuan-dollar changes over a relevant time horizon.
In this respect, I do not assume that China’s move is necessarily the “first in a series of moves,” or that it automatically translates into an effective “crawling peg” by which China’s currency would begin a long upward march against the dollar. Rather, China may use this move to satisfy U.S. and EU demands for greater flexibility and I stress here that China sees strong domestic and economic reasons to oppose large-scale currency appreciation.
This managed float also does not materially change the fundamental value of the dollar (established by U.S. monetary policy), commodity prices expressed in dollar terms, or bond yields (which are more heavily influenced by the value of the dollar, inflation expectations, and U.S. monetary policy).
On the margin, China’s move should be viewed as mildly favorable for equities, commodities, Asian currencies, and the Mexican peso, and a mild negative for dollar-denominated bonds.
By having taken maxi-revaluation scenarios off the table, the move is likely to reduce speculative “hot money” flows into China. These flows were the largest single contributor to China’s FX reserve accumulation over the past twelve months. As such, China’s FX reserve accumulation would be likely to slow in the months ahead.
How will the U.S. react? I assume positively. Where will China peg the dollar today? I assume at roughly 8.11 yuan per dollar in order to make clear the stability of the new system. What additional announcements will China make in the near-term regarding capital account flexibility? I expect it to liberalize capital outflows, perhaps in the near future.
David Malpass is the chief economist for Bear, Stearns.