Ambassadors to China are only occasionally summoned by the foreign ministry to be told that an announcement of international significance is due. That was the case at 6 P.M. Saturday. Within the hour, China had duly ditched the yuan's 23-month old peg to the dollar that has been a lightning rod for criticism that Beijing has been gaining an unfair trade advantage during the global downturn by artificially holding down its currency. Despite the disruption to their evening plans, the envoys did not go away disappointed. This was big news. But the potential for political and market disappointment in the months to come remains considerable. For the consensus among China-watchers is that the central bank will initially be cautious about taking advantage of the permission it has been granted to revert to the flexibility it enjoyed before the yuan was effectively repegged near 6.83 per dollar in mid-2008 to provide stability during the global crisis. In the three years following an initial 2.1 percent revaluation of the yuan on July 21, 2005, the currency gained a further 19 percent. But in those first remaining months of 2005, the appreciation was just 0.56 percent. A repeat of that snail's pace of climb will infuriate US lawmakers who, while welcoming China's policy shift, want to see words followed by deeds. No one knows what will happen in the days and weeks to come. Predictability and transparency are not hallmarks of China's policy. As Qing Wang, Morgan Stanley's chief China economist, put it in a note: “The best way to characterise this policy move is as a ‘switch to the pre-crisis regime'. Anything that has happened under the previous regime can happen now going forward.” But there are several reasons to assume that gradualism will be the initial watchword: Firstly, the economics. In its statement, the People's Bank of China noted – correctly – that its external surpluses have been falling. As such, it said, “the basis for large-scale appreciation of the RMB exchange rate does not exist.” The debt woes of the euro zone, China's biggest trading partner, will merely reinforce this judgment. Second, the politics. The decision was so important, according to two informed sources, that it was taken by the country's highest decision-making body, the nine-member Standing Committee of the ruling Communist Party's Politburo. A stronger currency is in China's interest because it will add momentum to domestic demand. This dovetails with the Party's strategy to spread wealth, reduce yawning income equalities and reduce reliance on investment-heavy export industries. A firmer yuan will also help cap incipient inflationary pressures. Letting the yuan rise should also cool anti-China sentiment in the US Congress, for now at least, and fend off the risk of China's being declared a currency manipulator by the US Treasury. Those are all important pluses for China. Still, the shift could expose China's leaders to criticism by nationalists that they have acted under external duress, a perceived loss of face that would be compounded if they were then to let the yuan rise at a rapid rate of knots. “The message to the outside world is: don't pressure us,” said Li Daokui, an academic adviser to the monetary policy committee of the People's Bank of China, the central bank. Another economist with direct knowledge of the workings of the central bank's committee agreed. “You've backed us into a corner this time. Don't do it again,” would be the thrust of what President Hu Jintao tells the Group of 20 summit in Toronto at the end of this week, he said. This person, who declined to be identified because of the sensitivity of the issue, said the PBOC had held serious discussions about depegging the yuan as far back as December. The central bank wanted more autonomy in monetary policy, which was partly hostage to the Federal Reserve's stance due to the dollar link, but could not overcome opposition from pro-export lobbies. He said the PBOC was likely to revert to a crawling peg against the dollar – as was the case from July 2005-2008 – because the concept of managing the yuan against a basket of currencies was too complicated to convey to politicians. Finally, he said appreciation was likely to resume eventually at the same pace as prior to mid-2008, in other words about 7 percent a year. “Some years it could be 8 percent, other years it might be 5 percent. But you can forget a 30 percent increase. We haven't forgotten what happened to Japan,” this insider said. China blames the long years of slow growth and deflation suffered by Japan on its acquiescence, under foreign pressure, to a sharp rise in the yen as part of the 1985 Plaza accord. Andy Rothman, a strategist at brokerage CLSA in Shanghai, broadly shared this analysis. He said he expected appreciation of about only 0.2 percent a month until Europe stabilises. “Then look for the appreciation to return to the 5-7 percent pace of the 2005-2007 period,” Rothman said in a note. He, too, said China was likely to focus almost exclusively on the yuan exchange rate against the dollar, despite lip service to managing the exchange rate with reference to a basket of currencies. – Reuters China's shift is an important ingredient in helping to rebalance its economy and hence the global economy. So is the round of big pay increases in southern China. Both increase domestic purchasing power. But the macroeconomic forces that determine savings and investment rates, and hence a country's external balance, are complex and slow-burning. A rising yuan, by itself, will be no more of a game changer for global imbalances today than it was from 2005-2008. The ageing of China's working population from mid-decade, which will erode its savings rate, will be more of a watershed. “For the near term, the rate of appreciation will be slow enough as to have no material impact on Chinese exports,” Rothman wrote. And, as US-China Business Council President John Frisbie said, a change in the yuan may not have much of an impact on China's all-important trade balance with the United States. “On the import side, much of what we import from China is stuff that we imported from elsewhere before; if we didn't import it from China, we'd likely just import it from somewhere else,” he said in a statement. Moreover, the group's members have never cited the yuan's exchange rate as an impediment to exporting to China. “Macroeconomics says an appreciating RMB would likely have some effect on trade flows, but the reality is probably not very much,” Frisbie said.
