[Anonymous]

The Yuan Grows Up

Untethered from the dollar, it could become a major world currency

Call it one small step for China, one very big step
for the world. While it’s always hard to see the long-term consequences from a
single event, financial historians may mark July 21 as the real start of China’s
development as a global monetary power. That was the day China offered up a
modest revaluation of its currency, the yuan, and said it would begin to adjust
the money’s value based on a basket of currencies, ending the fixed peg that had
been in place since 1994. In itself that’s no big deal. Plenty of economies peg
their money to a basket of currencies. It’s often described as an interim way
for a developing country to manage exchange rates with key trading partners —
until it feels comfortable enough to let its currency float freely. In practice,
because floating means losing a big chunk of control over the price of money,
few countries make it to that last step.

So why is China any different?
It’s still carefully managing yuan exchange rate movements. Its ultratight
capital controls mean money can’t move freely into the country — or out. And
it’s certainly not interested in making its exports expensive enough to slow
down a rip-roaring economy that needs to absorb 10 million new workers a year.
So very little in practical terms changed between July 20 and July 22. The
reason the move to revalue has attracted so much attention is simple. It
involves China, a $1.6 trillion economy that punches way above its weight when
it comes to trade, global commodity consumption, and capital
flows.

There’s more revaluing to come. China has some $700 billion in
currency reserves, mostly dollars, in its treasury, the second-biggest stash
behind Japan’s. That gives it a lot of heft in global foreign exchange markets.
Unlike tiny Singapore, which also uses a currency basket, when China decides to
tinker with the value of its currency vis-à-vis others, it will be felt around
the world. Beijing’s decision to allow the yuan to rise about 2% against the
dollar in July may be only the opening salvo of a carefully managed,
multi-tiered appreciation over the next couple of years, although Governor Zhou
Xiaochuan of the People’s Bank of China (PBOC) denies that. David Malpass, Bear,
Stearns & Co. chief economist in New York, expects a 6% gain by the end of
2006 while Nouriel Roubini, an associate economics professor with New York
University’s Stern School of Business, sees a 10% appreciation of the yuan vs.
the dollar in just the next 12 months.

China Talks, Asia
Listens
Here’s why China’s move is a step toward the yuan becoming a
major world currency. First, People’s Bank now can act like a central bank, not
just a foreign outpost of the U.S. Federal Reserve. Until now, PBOC had to
stabilize the yuan by buying huge amounts of dollars from exporters in exchange
for the Chinese currency every time the dollar weakened — often in response to
Fed moves. It then had to mop up all those excess yuan in the Chinese financial
system by selling short-term notes and bonds to banks, or run the risk of a
runaway money supply and inflation. Also, China has been powerless to stop its
currency from moving in lockstep with the dollar against other major currencies
such as the euro and yen. But with a basket system that includes, say, the
dollar, yen, euro, and key Asian currencies, it can juggle the weightings to
keep its trade competitiveness more broadly in control. The yuan might
strengthen against the dollar but fall against the yen and euro. This makes
sense, since China trades everywhere — not just with the U.S. Its biggest
trading partner as of mid-2005 was the euro zone, followed by the U.S., Japan,
and Southeast Asia.

Second, China now has an arsenal to use against
speculators. By not disclosing the contents of its basket, it leaves markets
uncertain about the timing of future yuan revaluations. True, in the short term
this may open the door to more currency speculation among those expecting a
further pop in the yuan-dollar rate. But for the longer term, speculators used
to making big and destabilizing one-way bets on the currency based only on
dollar movements will need to think twice. After all, Beijing still sets the
foreign exchange rate — not the open market. Big multinationals and Chinese
companies with international operations will also need to adjust for more
currency risk in the post-peg era. The offshore market for nondeliverable
forward currency derivatives used by foreign investors to bet on the yuan’s
future value has mushroomed in recent years and will surely grow
bigger.

Thousands of businesses are sifting through the implications of
the Chinese move. So are the nation’s Asian neighbors, which already seem to be
resetting their clocks to the Chinese sundial. It is no coincidence that
Malaysia dropped its seven-year peg to the dollar moments after the People’s
Bank made its announcement. The Bank Negara Malaysia will now manage the ringgit
against a basket of key currencies that include the yuan, dollar, euro, Japanese
yen, and the Singaporean, Australian, and Canadian dollars.

“Radical
Move”
Following the move by China to bolster the yuan, the Monetary
Authority of Singapore reaffirmed its commitment to maintaining its own
currency’s strength. What’s more, the Thai baht, Indonesian rupiah, Korean won,
and Taiwan dollar have all registered gains since the yuan-dollar decoupling.
UBS Securities estimates Japan, Taiwan, Malaysia, Singapore, and Korea have kept
their currencies undervalued against the dollar by 10% to 15% over the last
year. Now that China has allowed the yuan to appreciate, it gives them breathing
room to follow suit without worrying about losing price competitiveness. “It was
a radical move if you look at the impact on Asian currencies,” says NYU’s
Roubini.

Will all this turn the yuan into a super-currency soon? No, but
to be a true global player you need economic power, global ambitions, and the
willingness to trade your currency freely. China has the first two requirements
in spades. Slowly, it is working on the third. With so much intra-Asian trade
being driven by China, its notes have begun to emerge as a key proxy currency
for regional central banks. China’s growing trade clout may also mean mainland
companies will no longer be willing to pay for 80% of its trade in dollars.
Instead, they may insist on being paid in yuan — and let the other party worry
about exchange risk. Longer term, the yuan may catch on as a viable dollar
alternative among Asian central banks in a way Japan’s yen never did. “Within a
year or two, many Korean and Chinese companies will use the yuan and the won to
settle trade between them,” says Hwang Yoon Jin, senior researcher at the
state-funded Korea Institute for Industrial Economics & Trade.

But to
really get yuan circulating internationally — and hence qualify as a big league
currency — Beijing will need to lift its ban on investment by private Chinese
citizens in overseas stocks, bonds, and real estate. Until then, the yuan shift
by Beijing will look like a very modest development. Yet in the fullness of
time, the death of the yuan-dollar peg may well be remembered as a defining
moment in China’s economic ascendancy. The age of the yuan may come sooner than
anyone thinks.

[Author]

August 10, 2005 at 11:11 AM