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    Greater China
     Jul 23, 2005
Beijing's 'Thursday surprise'
By David M Lenard

HUA HIN, Thailand - At 8:00 local time on Thursday, July 21, the People's Bank of China (PBoC), China's central bank, released the text reprinted here. The most important parts of the
Announcement of the People's Bank of China on Reforming the RMB Exchange Rate Regime

July 21, 2005

With a view to establish and improve the socialist market economic system in China, enable the market to fully play its role in resource allocation as well as to put in place and further strengthen the managed floating exchange rate regime based on market supply and demand, the People's Bank of China, with authorization of the State Council, is hereby making the following announcements regarding reforming the RMB exchange rate regime:

1. Starting from July 21, 2005, China will reform the exchange rate regime by moving into a managed floating exchange rate regime based on market supply and demand with reference to a basket of currencies. RMB will no longer be pegged to the US dollar and the RMB exchange rate regime will be improved with greater flexibility.

2. The People's Bank of China will announce the closing price of a foreign currency such as the US dollar traded against the RMB in the inter-bank foreign exchange market after the closing of the market on each working day, and will make it the central parity for the trading against the RMB on the following working day.

3. The exchange rate of the US dollar against the RMB will be adjusted to 8.11 yuan per US dollar at the time of 19:00 hours of July 21, 2005. The foreign exchange designated banks may since adjust quotations of foreign currencies to their customers.

4. The daily trading price of the US dollar against the RMB in the inter-bank foreign exchange market will continue to be allowed to float within a band of +/- 0.3% around the central parity published by the People's Bank of China, while the trading prices of the non-US dollar currencies against the RMB will be allowed to move within a certain band announced by the People's Bank of China.

The People's Bank of China will make adjustment of the RMB exchange rate band when necessary according to market development as well as the economic and financial situation. The RMB exchange rate will be more flexible based on market condition with reference to a basket of currencies. The People's Bank of China is responsible for maintaining the RMB exchange rate basically stable at an adaptive and equilibrium level, so as to promote the basic equilibrium of the balance of payments and safeguard macroeconomic and financial stability.
statement were items 1 and 3, which said: "starting from July 21, [the] RMB [aka yuan] will no longer be pegged to the US dollar", and "The exchange rate of the US dollar against the [yuan] will be adjusted to 8.11 yuan per US dollar at the time of 19:00 hours of July 21, 2005."

Despite the deliberately bland and enigmatic wording (the PBoC has certainly graduated from the Alan Greenspan school of baffling, Solomonic pronouncements), the announcement sent shock waves through global financial and currency markets and was expected to cause significant readjustments in the global economy.

China's abandonment of the US dollar peg not only changed almost 11 years of currency policy but directly reversed government statements from only days before. China's soaring trade surpluses and foreign currency reserves had prompted foreign pressure to allow the yuan to appreciate, and speculation that a move was imminent reached fever pitch in mid-May. But the PBoC successfully damped down such talk over the last several weeks, only to catch currency markets flat-footed with Thursday's move. Thus, even if the revaluation itself had been expected, its timing was not.

Beijing's 'Thursday surprise' essentially consisted of two policy changes, each significant by itself. First, where previously 8.28 yuan had bought 1 US dollar, as of July 22, it only takes 8.11 yuan to buy a dollar; ie, the yuan was allowed to appreciate 2.1% against the dollar. Second, whereas the yuan had been officially valued in terms of dollars and backed only by dollars, China's currency is now valued in terms of an adjustable "basket of currencies".

Interestingly, the composition of the basket was not defined (note the ambiguous language in point 1, "a basket of currencies"), although observers generally expected it to include, at the very least, euros and Japanese yen. This appeared to make China's currency policy similar to that of Singapore, which also values its currency in terms of a basket whose composition may be changed by government fiat. It is also noteworthy that the two steps were taken at the same time; most observers had expected a revaluation against the dollar first and a shift to a basket-defined currency later.

Collectively, these measures allowed the government to cautiously edge the yuan away from the dollar, certainly a logical move given the dollar depreciation of recent months. This was accomplished not only by the basket measure, which gives the PBoC latitude to strengthen the yuan simply by redefining the basket as opposed to buying US treasury bonds as it had in the past, but also by the careful "such as the US dollar" language in point 2, which, read literally, would allow the bank to define the yuan in terms of any currency it likes, while still implying that the yuan would remain de facto predominantly dollar-backed.

Will continuous appreciation be allowed?
Point 2, which states that the market close for the yuan value on one trade day will become the "central parity" for the following working day, coupled with point 4, which establishes a +/- 0.3% range in which the yuan's value will be allowed to float, appears to open up the possibility of a steady stepwise rise in the yuan over the next several weeks. This is because the yuan is widely believed to be undervalued by at least 20% in pure market terms, and would therefore instantly appreciate by at least that amount if freely traded; but since only 0.3% daily changes are allowed, any large appreciation would have to occur in 0.3% daily increments.

But the government lost no time in preventing the steady-rise scenario. First, the PBoC statement itself says that "The PBoC is responsible for maintaining the RMB exchange rate basically stable at an adaptive and equilibrium level, so as to promote the basic equilibrium of the balance of payments and safeguard macroeconomic and financial stability." "Basically stable" cannot possibly mean that a large-magnitude rise will be allowed anytime soon. Strengthening this notion, the yuan barely budged early Friday from its opening rate of 8.11. Currency traders said the central bank had been buying dollars to prevent the yuan from immediately zooming to the top of its band. China's official media also poured cold water on any expectations of further appreciation; a China Daily editorial said pointedly Friday: "Expectation for a bigger appreciation of the yuan's value was, and will be, unrealistic." And few currency market observers expected further rises in the short term. Maxine Koster, economist at CSFB, was typical: "I think that's probably it for this year. We should see maybe some more small steps next year. But nobody's going to [pressure] the Chinese into doing it - they'll do it when they're ready, which is shown by this move which came out of the blue."

Fluctuation band for other currencies set at 3%
Point 4 of the Thursday announcement left unclear ("a certain band") what the trading band for non-dollar currencies would be in the new basket arrangement, but this was later clarified by the PBoC; other currencies will be allowed to fluctuate within a band of +/- 1.5%, ie, a 3% band, according to AFX. This was expected to give the central bank more flexibility, noted Morgan Stanley economist Andy Xie, who said that China could allow more flexibility in the yuan's movements against these currencies given that they will make up a much smaller share of the basket than the US dollar.

Why now, why only 2.1%?
Thursday's announcement was a careful compromise by a government that prizes stability. Revaluation per se was expected; Chinese financial officials have said many times in the past several months that the country would eventually shift to a more flexible, market-driven exchange rate regime, so the question was actually "when", not "if".

There are several possible reasons for the surprising timing of the policy shift. First, the government did not want to reward speculators or give the impression that it was giving in to speculative pressure. Although there has in fact been large-scale buying recently of yuan and yuan-denominated assets (such as domestic real estate) in anticipation of revaluation, the level of such activities had clearly flattened in the last several weeks after a peak in May. So the timing allowed the government to claim that it had outsmarted the speculators. Second, recent economic figures, which showed 9.5% growth in the first half of 2005 even after macroeconomic cooling measures, have weakened one of the government's key arguments against revaluation, namely that the Chinese economy was still too fragile to easily adjust. Third, China's financial reform measures have been making reasonable progress (eg, with the recent investments in the China Construction Bank by the Bank of America and Temasek Holdings), and this has helped to cool fears that the plans of state banks to list on overseas stock markets could be threatened by additional insolvencies created by a large-scale revaluation. Fourth, revaluing now will smooth the way for President Hu Jintao's planned visit to Washington in two months. Fifth, CNOOC's attempt to take over Unocal is at a critical phase, and a revaluation could strengthen the bid in two ways: financially, by increasing the value of CNOOC's yuan holdings in dollar terms, which could allow it to increase its bid; and politically, by allowing China to claim that it is accommodating US wishes over the yuan-dollar exchange rate.

The small, 2.1% magnitude of the revaluation, although unexpected, is readily explicable in several ways. First, it will allow the government to assess the ability of domestic institutions to adjust to the new rate, potentially easing similar adjustments in the future. Second, the modest revaluation allowed China to avoid the appearance that it was capitulating to outside pressure from the US or EU. Although past US critics of China's currency policy, such as Senator Charles Schumer (Democrat-New York), generally welcomed the move, its magnitude was certainly far less than most of them had asked for (most had called for a revaluation of between 10 and 40%, and the 27.5% tariffs on all Chinese exports to the US called for by the Schumer-Graham bill was a figure which specifically reflected the extent to which the yuan was felt to be undervalued by the US Congress). Third, a 2.1% adjustment was not felt to be large enough to seriously threaten many Chinese export firms, many of which operate with minimal profit margins due to overinvestment in sectors like textiles. Such companies, whose products are now 2.1% more costly to their US customers, can respond by increasing prices or by cutting costs; some combination of both is likely, but given the vast cost advantage Chinese firms possess over their developed-country competitors, it is unlikely that major changes in trade patterns will materialize as a result of the change.

The case against 'baby steps'
Until Thursday, the conventional wisdom was that any revaluation would be at least 5%. The main reason for this belief was that a small revaluation would only increase speculative pressure on the yuan by creating a self-fulfilling perception that further revaluation moves are only a matter of time. It was argued, in effect, that pulling off the Band-Aid all at once would be less painful than removing it slowly. Early Friday, reports indicated continued strong demand for the yuan and yuan-denominated assets, suggesting that the fear of speculation was somewhat justified. But the government's vigor in defending the new rate showed that Beijing intends to do what it takes to keep the lid on for the time being. With the battle lines thus drawn, it will be interesting to see how the exchange rate develops over the next several weeks. If indeed the yuan appreciates further, given the wording of the PBoC announcement, Beijing can always claim that it actually intended to allow additional appreciation, "according to market development as well as the economic and financial situation" (point 4).

The international reaction
As expected, important US figures welcomed the move. Treasury Secretary John Snow said: "I welcome China's announcement," and Federal Reserve Chairman Alan Greenspan (whose recent statement that revaluation would not significantly alter the US employment picture was widely noted) called it "a good first step", while adding that further adjustments would be necessary. Senator Schumer opined that "it is smaller than we had hoped, but to paraphrase the Chinese philosophers, a trip of a thousand miles can well begin with the first baby step," adding, "we expect more." His Republican colleague Lindsey Graham also promised to keep up the pressure, saying: "What paid off most was persistence, the unwillingness to let the issue die." At the White House, press secretary Scott McClellan said the administration was "encouraged by China's announcement,'' but President Bush himself, despite giving a speech on trade in Washington Friday, did not comment specifically on the revaluation. Overall, while it appeared very unlikely that Thursday's move by itself would quell pressure for further revaluation, it certainly weakened the position of those in the US who have argued for stronger action.

Outside the US, reaction was generally positive. Malaysia broke its peg to the US dollar almost immediately after the announcement, suggesting a government contingency plan had been in place for a yuan revaluation. Hong Kong, however, maintained its dollar peg for the time being. The monetary authority of Singapore (MAS) said that the change would not have a major impact on the Singapore dollar or the country's exchange rate regime. In Australia, observers considered the move likely to boost Australian exports to China; JP Morgan China economist Stephen Walters noted, "Australian exports should get a boost as China's purchasing power increases," although he cautioned that "so too will all other countries exporting to China." Acting Prime Minister Mark Vaile also lauded the effect on exports, "especially on resources and agriculture products". In Thailand, the Bank of Thailand (BOT) welcomed China's decision, saying in a statement that it fully supported the policy change, and that the increased flexibility comes at an opportune time and it believes that the move will be of great benefit to both China and the global economy.

In South Korea, most analysts expected the move to have little immediate impact, although economist Koh Yu-seon at Korea Investment & Securities commented that the yuan revaluation might help ease inflationary pressure in China, improve purchasing power there, which would in turn help south Korean exporters. Japan's Chief Cabinet Secretary Hiroyuki Hosoda said cautiously, "[the revaluation] must be the conclusion of the Chinese government having considered various things. We pay our respects to that ... I think it is the first step toward [China's] economic globalization." In the EU, French Finance Minister Thierry Breton said that he was "delighted" by the revaluation decision and welcomed the move as "positive", saying: "It's a positive adjustment for the Chinese economy but also for the euro zone ... this development, which responds to the wishes of the countries of the G7, is liable to strengthen the financial stability of the world economy."

Near-term effects
Most Asian currencies strengthened against the US dollar Friday in tandem with the yuan. Chinese stock markets rose due to a perception that the more flexible currency regime will make Chinese assets more attractive to buyers, even though it simultaneously made those assets more expensive in foreign currency terms. Within the Chinese market in early trading Friday, airline stocks rose while textile stocks fell; Chinese airlines will benefit from the country's increased buying power for dollar-denominated aviation fuel, while textile makers will suffer from increased prices for their products overseas. In the US markets, bond yields were expected to rise because the anticipated reduced buying from China, a major purchaser of US bonds, will force bond issuers to raise yields to maintain the same level of sales. In the currency markets, commodity-dependent currencies like the Australian dollar, the Canadian dollar, and the Norwegian kroner were predicted to rise due to China's heightened purchasing power for these countries' commodity products. In addition, many observers expected improved results for multinational firms operating in China, because the revaluation made their China-based profits worth more in terms of their "home" currencies.

David M Lenard is a correspondent for Asia Times Online in Thailand.

(Copyright 2005 Asia Times Online Ltd. All rights reserved. Please contact us for information on sales, syndication and republishing.)

Revaluation: a dangerous distraction? (May 21, '05)

Time not ripe for revaluation (May 14, '05)

Revaluation not imminent: vice finance minister (May 11, '05)

It's not the yuan, silly (Apr 14, '05)

The case for China to pull the peg (Nov 20, '04)

To re or not to re? (Jun 19, '04)


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