Monday, 21 June 2010

Yuan back to normal

In a statement crafted with traditional Chinese care, it was announced the China's monetary authorities would allow for more flexibility in the movements of the Yuan. This Newspeak caused something of a stir in the markets, which immediately began to brace themselves for a major appreciation of the Chinese currency. Markets are likely to be disappointed in this respect.

There had been rather quiet around the Yuan for a while. USA's China-bashers had for some reason backed down and that created the situation we described in an earlier post: China needs to revalue the Yuan for purely internal purposes, but cannot be seen to bow to pressure from the most populist US lawmakers.

China has an urgent need to control the capital inflows that result from running a huge current account surplus, but has not equipped herself with a modern money market and the necessary instruments. Instead, Chinese monetary policy is run on the basis of quantitative methods reminiscent of the period of central economic planning.

Needless to say, when there is a huge appetite for credit in one segment of the economy (property and construction sectors), and the government tries to cut off this sector's access to otherwise abundant liquidity, you set yourself up for major distortions that provide huge incentives for corruption.

In 2008, the Chinese government was the first to introduce a major package to cushion the impact of the international banking crisis: This package has now been proven efficient, and the Chinese leadership can rightly be proud of the timely action. However, the package did not shift as much growth over to domestic demand as hoped, and recently the Chinese trade surplus has begun to grow again.

Thus the monetary inflows have begun to increase again at a time where the Chinese economic policy authorities have clearly signalled that they want to see slower growth.

Before the outbreak of the international crisis, the Yuan had been allowed to appreciate in a clear but controlled manner against the USD. In July 2008 this policy was reversed and the currency was again locked to the USD. As a defensive initiative it was a brilliant move. Nobody knew if the Dollar would go up or down as a result of the goings-on in the banking sector. Roughly half of the world's economy is running a de facto peg to the USD.

By locking the Yuan to the dollar, China chose to protect their relative position towards the major export markets. Obviously not against Europe, but the Euro proved to be the stronger currency. This solution helped Chinese exports but created some other problems.

Now the exports are back on track, and the Chinese authorities appear poised to resume a policy of a slow and controlled revaluation of the Yuan. The probability of a sudden, major appreciation of the Yuan is close to zero.

The winners will be China's direct competitors as well as companies exporting to China. This has been clear for a while. This week-end's announcement is not revolutionary. It is just a reassurance that China's monetary policy has reverted back to the crawling peg policy from 2005-2008.

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