China's revaluation is a bid to hit the brakes

By Ross Gittins
July 23, 2005

Working out the implications of China's decision to change its exchange rate is a lot trickier than you may think.

It's undoubtedly a step in the right direction, as everyone's saying, but it's not clear whether its medium-term effect will be good or bad and, over the next few months, its effect will probably be minor.

For openers, we can say that the move to revalue the yuan by 2 per cent against the US dollar isn't nearly as significant as the associated decision — to shift from keeping the yuan's value fixed to the US dollar to now fix it against a basket of the currencies of China's major trading partners.

Indeed, if the 2 per cent revaluation were all there was to it, we could dismiss the move as of no noticeable consequence. The Americans and others who've long been pressing China to revalue have been thinking in terms of 10 to 20 per cent.

So, it's only if the move to a new regime for China's exchange rate leads eventually to an appreciation of a lot more than 2 per cent that there's anything much to talk about.

And, in principle, the new regime does make a bigger appreciation possible. The Chinese authorities are moving to a "crawling peg" regime similar to the one we had between November 1976 and our decision to float the Aussie in December 1983.

So it seems the Chinese are doing what we did: using a crawling peg regime as the transitional step from a fixed exchange rate to a floating exchange rate.

The question then becomes, how long are the Chinese likely to persist with the crawling peg and how quickly are they likely to crawl it up to an appreciation of a lot more than 2 per cent?

My bet is that, if left to their own devices (which they may not be), they'd stick to this regime for some years and move the peg only very slowly. It would be surprising to see it rise by as much as 10 per cent in the space of a year.

But for the sake of keeping the analysis going, let's assume I'm wrong and it doesn't take too long before we've got a decent-sized appreciation. What are the implications?

In an ordinary developed economy, an appreciation of the exchange rate would lead to cheaper imports and to exports that were less competitive on world markets. In consequence, you'd expect the balance of trade to deteriorate and the economy to slow a bit.

For the US, China's major trading partner, you'd expect the opposite. A higher yuan would mean a lower US dollar. Dearer imports would mean fewer imports (and more market share for domestic import-competing industries) and more competitive exports would mean more sales to China.

So the Yanks would enjoy a slightly improved trade deficit and slightly faster economic growth. This is the effect they've been seeking but, even if the appreciation were large, it would fall far short of a magic solution to their problems.

But China is not an ordinary developed economy.

It's a developing economy that still has a lot of government controls, and it isn't part of a democracy. So I doubt if it would work in simple textbook fashion.

It's more likely that, while they couldn't do much to stop imports getting cheaper, the Chinese authorities would act to hold the US-dollar prices of their exports unchanged.

This would make exports less profitable to Chinese producers (their US-dollar earnings would now buy fewer yuan), though that might not do much to deter the manufacturers from continuing to churn them out.

So, even if the appreciation grows in size, it's not clear it would make a huge difference to trade flows — including Australia's trade flows.

It's important to understand that, apart from the much-publicised political pressures, China's main reason for changing its exchange rate regime is to make its monetary policy more effective and give itself greater ability to slow its runaway economy.

With its fixed exchange rate and huge inflows of foreign capital, China has been unable to keep monetary conditions tight. With a floating currency, the inflow of funds would be cut off and converted into just a higher exchange rate. The crawling peg is intended to deliver roughly similar benefits.

But as we discovered years ago, a crawling peg regime is ultimately unsustainable. It's too easy for the markets to anticipate the destination you're crawling to.

They pile in with their funds, hoping to make a killing when you get where you're going — but in doing so, speed up the whole process. Eventually you give up the struggle and go to a proper float.

So while this week's move is a step in the right direction, in the coming months it could make things worse rather than better for China's macro managers.

It's not at all clear how or when things will be sorted out. And, until they are, the effect on the rest of the world — including us — isn't likely to be great.
