Market Update — June 21 — Chinese Currency

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Background: China to Be More “Flexible”

The Chinese central bank (the People’s Bank of China) said that they would be more flexible with their currency (known as either the renminbi or the yuan).   For the past two years, the currency had been pegged to the dollar (in other words, the exchange rate had been fixed).  They said that the recovery and upturn of the Chinese economy has become more solid with the enhanced economic stability.  They will not make a one-time adjustment.  Rather, they simply said that they will “increase the renminbi exchange-rate flexibility.”


China had previously stopped pegging their currency to the dollar in July 2005.  They managed a float against a group of currencies and the renminbi appreciated 21% in three years.  Then, they went back to the peg against the dollar.  (You could argue that they did this in 2007 because they expected the dollar to weaken during the recession and they thought that this would help their export driven economy.)


Last summer, the IMF (in an internal report) identified the Chinese currency as at least 20% undervalued.  Now that their trade is more in balance, it’s hard to know how undervalued it is.


Some Key Facts About Their Plan

1. We have no idea how much “flexibility” is planned.  Personally, I don’t expect anything significant.
2. China said that they would have continued emphasis “reflecting market supply and demand with reference to a basket of currencies.”  In other words, they will no longer be solely tied to the dollar.  The bottom line is that China doesn’t like the strengthening of the dollar (the EU is their largest trading partner) and they will allow their currency to appreciate if the euro appreciates.

Why Did They Do This?

1. They did this a week before the G-20 meeting in order to avoid getting beaten up over this issue. China is now saying that discussing the currency is off limits at the G-20.
2. There was tremendous pressure from the US. This will help Geithner to avoid having to label China a “currency manipulator.”  He has postponed putting out his report on this issue.
3. China just reported 3.1% inflation and a more valuable currency will help to curb this inflation.
4. The WSJ immediately published a piece arguing that this reflects the strength of the Chinese economy and this is great for risk assets.  I believe that this is the exact knee-jerk reaction.  But, over time, we might also decide that China is growing too fast and has rising inflation and that this is an attempt to slow their economy.
5. This may be the start of China’s effort to increase consumer demand (at home), so that they can lessen their dependence on exports.

What Will Happen Next?  (Not Much)

1. On Monday at 9 AM (EST), the Chinese government will set the initial benchmark for renminbi trading in the Shanghai currency market.
2. In recent months, China’s trade deficit has been $19.5 billion (May), $1.68 billion (April) and a deficit of $7.24 billion (March).  This has been a decrease and means that China will not allow their currency to appreciate much.
3. After China’s announcement, they later reassured the Chinese people that any rise would be gradual.  Of course, US politicians will not rest.
4. The renminbi has already appreciated 15% this year (because the dollar has strengthened versus the euro), so China is not about to allow their currency to appreciate much more.
5. If the euro continues to decline, the renminbi will actually decline relative to the dollar.  It makes no sense for the Chinese currency to be pegged just to the dollar.  They trade with many other nations.
6. Now, Geithner is going to be pressuring China for “vigorous implementation,” which we will not see.

What Will the Long-Term Effects Be?

1. Commentators are saying that this will hurt exports and drive China to be a more “consumer driven” economy, rather than an export driven economy.  (The exchange rate is being mentioned along with the fact that that Chinese wages are rising and this will lead to more consumer spending.)  But, don’t forget that exports rose 48% last month!
2. It may become even tougher for us to lecture China on their currency.  They can (and will) lecture us on our debt problem.  China owns $900 billion of Treasuries and is our largest creditor.
3. The funny thing is that this probably will have little impact on the US, other than the unintended consequence – that it will have a small inflationary impact here.

Once again, China is calling the shots.  They’re doing this partly for political reasons and partly to slow their own economy.  But, there is domestic pressure on the government and the changes will be minimal.  They are finding themselves handcuffed by the fact that their currency has already appreciated due to their peg to the dollar.

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