China further frees the yuan

dfbb

China further frees the yuan
Greater flexibility for an undervalued currency may help further rebalance global terms of trade.

Barry Sergeant
18 May 2007
The People’s Bank of China announced on Friday that the floating band of the yuan’s trading prices against the dollar would be enlarged from 0.3% to 0.5%, with immediate effect. This marks a further freeing of China’s currency, if only marginally, an event first witnessed on July 21 2005, when the yuan’s peg to the dollar was dropped.

The yuan unit, had been pegged at 8.277 to the dollar for a decade. China today remains under enormous pressure to reform its currency system, in the face of accusations that an undervalued yuan has allowed its exports to become hyper-competitive, especially after a protracted dollar bear market set in late in 2001. The dollar was trading at 7.666 yuan on Friday.

Among examples of the scorn heaped on China, on May 18 2005, the US Treasury, in a bi-annual report to Congress, required by law, lashed out at China, stating that “current Chinese policies are highly distortionary and pose a risk to China’s economy, its trading partners, and global economic growth.”

The value of the dollar and the yuan are critical to global terms of trade. After a spectacular bull market that kicked in during the final days of 1994, the dollar has experienced a protracted bear market since late in 2001. The latter period has been characterised by robust world growth, led by the low-inflation boom in China and the rest of Asia.

The dollar’s bear market seemed inevitable, given the widening of the US current-account deficit as US consumer spending increasingly bulged imports above exports. US consumer spending was given further impetus as China’s export boom started to take off in 1996.

Chinese exports really started to boom, on the back of a “weak” yuan, riding in the dollar’s saddle. Dollar commodity and metal prices, which move in the opposite direction to the dollar, boomed on the back of a bear dollar, and moved higher into spectacular territory on added impetus from massive raw materials demand from the developing world, led by China.

But something had to give and in more recent times, desynchronisation has hit the global economy as a key macro theme, led by a considerable slowing in the US economy, led in turn by the combined impact of higher policy rates and housing woes.

But the rest of the world continues to show strength. The net effect is translating into a less volatile global business cycle, which should help prolong the equity bull market, now on the doorsteps of its fifth consecutive year. In emerging markets, currencies have maintained remarkable strength, pushing down domestic inflation and interest rates.

Indeed, the argument has been advanced that existing economic and financial dynamics in the emerging world resemble those seen in the US in the second half of the 1990s, when the dollar was strong and US consumer demand for imports was restricted. Similar to the US during this period, as the Bank Credit Analyst puts it, emerging markets are now the main source of global growth with “very vibrant and dynamic economies”.

In the conventional wisdom, the bearish case for the dollar remains intact: the US is the weak link in an otherwise solid global economy and divergences in expected monetary policy and return on investment will act as a drag on the currency, helping to redistribute growth back to the US. A weak dollar increasingly erodes the competitiveness of imports, restoring some balance to the burgeoning US current-account deficit.

The problem, if indeed there is one, is that the marketplace is rapidly capitulating to a weak dollar. The situation is compounded by carry trades, which refer to the return or yield relative to 5