China Drops Yuan's Dollar Peg. Implications?

One of the biggest shoes of 2005 has just dropped in the financial markets with today’s announcement that China has ended the yuan’s peg to the dollar and will now measure its currency against a basket of monies. Allowing the currency to strengthen may assist the country’s government in controlling inflation and gives the People’s Bank of China more room to raise interest rates to restrain the economy. Thoughts?

Market update: S&P 500 futures up 5.50 at 1242. The dollar fell against the yen and is at 110.84 yen and $1.2217 per euro. Gold up $2.84 at $424.69. U.S. 10-year note futures down 12/32 at 111 16/32.

The short-term losses were expected (and gold is always a hedge against inflation). In the long run, this will help improve US exports, however. Expect the Yuan to rise over the next few years.

From here:

U.S. Treasury Secretary John Snow applauded the shift as a significant contribution to global financial stability, while a senator who has been a leading critic of Beijing’s currency policies called it a welcome “first baby step.”

Very small baby step. Also, the three tenths of one percent band in which the yuan will fluctuate against the dollar is laughably small. Basically, all their doing is giving the US a teeny concession while making the peg easier to manage by diversifying the currencies they use to manage the peg. Very smart. Makes the life of their central bankers easier, makes some splashy headlines, and means exactly nothing.
Unless this brings more speculators in pressuring the yuan up because they interpret this as only the first crack in the wall, with more to come. We shall see.

Has the yuan been artificially over-valued up to now? Or artificially under-valued? What’s the general consensus?



As pantom said, baby step. A change thus small could disappear under such other factors as changes in demand. You can speculate as to the effect, even with hindsight, but you won’t know. Presumably the demand for Chinese goods would be reduced ever so slightly, ceteris paribus.

As for BG’s questions, the yuan is pretty much thought by everyone to be undervalued. China buys boatloads of US treasury bills, sending those dollars back to the US Gov instead of using them to consume US goods. This keeps dollars out of circulation and the dollar higher. Japan does the same thing. This keeps the yuan (and yen) lower, which makes Chinese (and Japanese) goods cheaper. It props up exports, brings more dollars into the country, with which the country buys more US government securites. It is a mercantilist approach to national finance.

One wonders how they’ll feel after some time has elapsed. At the very least, it seems to me that today’s decision implies 1) some degree of diversification of China’s (quite large) foreign-currency reserves away from dollars and 2) less official demand from China for dollars and so for assets in which to invest those dollars, which is to say U.S. Treasury debt. I’m not sure what exactly that may amount to at the margin, as China isn’t the only buyer out there, but China is a buyer and a sizable one.

Significantly undervalued.

How would it improve U.S. exports? What do we export to China (other than U.S. Treasury bills)? What would we export if the yuan were worth more relative to the dollar?

One might imagine that the rise in the yuan would make Chinese goods more expensive for thrid countries to buy, and they might therefore switch to buying American goods.

Well, if you read INTC’s latest earnings report, 80% of their revenue is now from overseas, with China being one of the fastest growing market segments. I would suspect MSFT sells a wee bit of software, too. You can probably take it from there to figure out the rest, although I do believe we also export food, especially wheat.

It should be noted, as John Mace’s cites point out, that China is far more open than Japan to foreign companies. For GM, it’s become a very important market, for instance.
IF this actually makes the Chinese buy other currency’s securities, it will raise interest rates here and kill the real estate bubble, unless of course Japan and the other Asian countries pick up the slack. That would certainly be a meaningful effect. We’ll have to wait and see if something like this happens.

It’s designed to calm down the anti-China feeling in Congress, though you can call it a first step towards full convertibility of the Renminbi if you like. A 2% revaluation translates into no serious difference in terms of export price competitiveness.

For a slightly tongue-in-cheek illustration see the Friday entry in my blog.

The details of the basket of currencies the RMB will be pegged to haven’t been released yet, but the RMB’s trading range is going to be very narrow. So, no big deal.