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China's Calculated Move on Yuan

Interviewee: Steven Dunaway, Adjunct Senior Fellow for International Economics, Council on Foreign Relations
June 22, 2010

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The People's Bank of China pledged to make its currency more flexible, ending the yuan's peg to the U.S. dollar since August 2008. Its June 19 announcement is expected to deflect criticism on its currency policy from the United States and other Western countries at the upcoming G20 meeting in Toronto. But any diffused tensions will not last long, says CFR's Steven Dunaway, since the United States and Europe want a "faster pace of appreciation in the yuan than China is likely to deliver." Although China will try to sell the announcement as a concession to G20 countries, the move is more motivated by the country's self interests, says Dunaway. China wants to avoid foreign hits to its export market in the short term and needs to restructure its economy to sustain domestic growth in the medium term. Depending on the pace of yuan appreciation, the move will reduce the value of China's U.S. foreign exchange reserves, says Dunaway, and should also slow the accumulation of more additional reserves.

What does the statement by the People's Bank of China on the yuan actually mean?

After a brief respite, China's exchange rate policy will become again a source of friction.

What the People's Bank of China actually decided to do was "to proceed further with reform of the renminbi exchange rate regime and to enhance the renminbi exchange rate flexibility." This decision means that the Chinese authorities have ended the peg of the yuan to the dollar, which they have maintained since August 2008. The yuan is expected to begin appreciating against the U.S. dollar and other currencies. However, it will be difficult for a while to figure out just how fast the yuan is appreciating. This underlying rate of appreciation will be obscured for some time because from day to day, the yuan will move up and down in value. The People's Bank of China will use such unpredictable up and down movements in the exchange rate to create two-way risk (meaning at any given moment it would be difficult to predict whether the exchange rate could go up or down in value) in order to limit speculative capital flows.

The underlying pace of exchange rate appreciation also will be determined by consideration of economic conditions in China and conditions in the rest of the world. Having the exchange rate increasingly reflect market supply and demand (as the United States has stressed) is mentioned as a factor, but appears likely to continue to be a secondary consideration in determining how the yuan will be valued.

Why now?

The explanation offered by the Chinese authorities is that growth in China's economy has become more solid and stable. Exchange rate reform is seen as promoting the needed restructuring of China's economy and improving the quality and efficiency of growth. Increased flexibility in the exchange rate will also enhance the effectiveness of China's macroeconomic policies in controlling excesses in the domestic economy and dealing with external shocks.

These are all good reasons, but the real reason is that the timing is fortuitous to diffuse growing pressure on China to move its exchange rate and to diminish the risk that the United States and other countries might retaliate against China's exports if the peg of the yuan to the U.S. dollar persisted.

How significant will the change be, relative to what the U.S. wants to see?

It remains to be seen. Treasury Secretary Timothy Geithner was cautious in his comments on the Chinese announcement. While he welcomed China's decision to increase the flexibility of its exchange rate, Geithner stressed that vigorous implementation of the decision was needed to make a positive contribution to strong and balanced global growth. In the end, the expectation in the United States, Europe, and some of the developing countries is probably for a faster pace of appreciation in the yuan than China is likely to deliver. So, after a brief respite, China's exchange rate policy will become again a source of friction.

What does China want from the G20 and the United States in making this concession?

China will probably try to sell the rest of the world on the idea that it is making some kind of concession. But the reality is that it is not. It is taking this action on the exchange rate because it is in its own self interest in the short term to avoid actions being taken against the country's exports and in the medium term because increased exchange rate flexibility and appreciation of the rate is needed to aid in rebalancing China's economy.

China will probably try to sell the rest of the world on the idea that it is making some kind of concession. But the reality is that it is not.

What impact will currency revaluation have on China's U.S. currency reserves? What impact on the U.S. economy?

It depends on how large a change in the exchange rate takes place and how rapidly China moves to permit its exchange rate to be market-determined. Currency appreciation will affect China's foreign exchange reserves in two ways. It will reduce the value of these reserves, but at the same time, yuan appreciation should diminish the build-up of additional reserves.

For the United States and the rest of the world, appreciation of China's currency will improve the competitiveness of these countries, increasing their exports and helping to deal with global imbalances in saving and investment.

How will the move shift the dialogue among countries at the G20?

China will get its wish and its exchange rate policy will not be on this G20 meeting's agenda.

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