Yuan exchange rate loosened

Given more latitude, China’s currency could rival the U.S. dollar. But it still has a very long way to go.

(Photo: Xie zhengyi/Image Forum)

Deciphering changes in China’s economic policies is often akin to reading tea leaves. The country’s recent decision to loosen some of the constraints on its currency, the yuan, is no exception, leaving observers to wonder whether China is bowing to trading partners’ demands for economic reform. Or is it merely paying lip service to the whole idea?

On April 14, the People’s Bank of China announced it would widen the trading band for the yuan to 1% on either side of the reference point it sets daily. Previously, the yuan traded within a 0.5% range. The change appears significant because it paves the way for the yuan to eventually float freely, and potentially supplant the U.S. dollar as the world’s reserve currency. It could also ease tensions between China and its trading partners. For years, the country has been accused of keeping its currency artificially low, which gives Chinese exporters an unfair cost advantage over competitors from other nations and leads to huge trade imbalances. The International Monetary Fund has written that the yuan is “substantially under valued.” Some U.S. politicians have been more aggressive, branding China as a currency manipulator. Last year, U.S. Sen. Charles Schumer called China’s currency intervention “a boot to the throat of our economic recovery.”

Allowing a wider trading band for the yuan could theoretically bring it closer to its market value. But many observers are skeptical. “We believe the move is nothing more than window dressing to defuse pressure on China,” wrote Carl Weinberg, chief economist at High Frequency Economics in New York, in a note to clients. The timing of the announcement is certainly suspect. It came just one week before IMF meetings in Washington, where representatives from other countries usually chastise China about its currency policy. This time China preempted such criticism.

The move also allows the country’s leaders to show the world they are still capable of major policy decisions at a time of internal turmoil, Weinberg adds. China’s ruling Politburo is undergoing a leadership change this year, and one star politician, Bo Xilai, has been mysteriously punted from the Communist Party. Police are also investigating his wife regarding the suspected murder of a British citizen.

The immediate economic effects of the bank’s actions are limited, however. There are separate classes of yuan that can be held domestically and offshore, and neither offers a truly flexible exchange rate. Even if the market pushes the yuan to the limit of its 1% band, the central bank can simply reset the value the next day. Mark Williams, chief Asia economist at Capital Economics, believes the central bank may actually intervene more in the future, writing in a recent note there is “little sign in its recent actions that the PBC is relaxing its hold.” Indeed, China’s foreign currency reserves rose another 3.9% during the first quarter.

For now, the rest of the world will have to contend with the slow pace of China’s reforms. “Widening the band is a traditional party approach to change,” says Wendy Dobson, co-director of the Rotman Institute for International Business. “Small, incremental and above all controlled.”