China's Currency: Gradual, Flexible and Sensible (page 1 of 2)

Even though China's decision is not a surprise, this in no way should reduce the importance of what has been announced. China's decision is based primarily on domestic grounds but has also taken into account global factors.

Good for China, Asia and the World

China's decision fits in with what we, as a Bank, had expected for some time. We had predicted a 2-3% appreciation followed by a move to a managed float. Effectively we have got both today. And we had anticipated that the announcement would be made before this September's bilateral US-China meeting in Washington. The Chinese have announced in effect a 2.1% appreciation against the USD and the introduction of a managed float exchange rate system. This makes complete sense for China. Gradualism is key. The Chinese economy continues to grow strongly and as we saw last autumn when interest rates were increased for the first time in 9 years, the market mechanism is now playing a more important role in helping stabilise the economy. A stronger currency, plus the higher interest rates that were also announced today, are important factors in ensuring continued strong non-inflationary growth. The authorities, in their announcement, used the word flexibility. This makes sense, as it is what China needs.

Undoubtedly there may be some people who would argue that China should have appreciated the currency by more. After all, China's exports are still very competitive. However we have disagreed before on this view and we disagree now. It is important that China's currency policy is set in the best interest of its domestic economy and it is possible that too big an appreciation could have damaged Chinese domestic growth. Asia, and the world economy, still need a strong domestic Chinese economy. Hence the importance of gradualism in their currency policy. If the economy remains strong then the currency can appreciate further in the future.

Global impact

The global impact should be neither underestimated nor exaggerated. Clearly the US-China trade imbalance will remain sizeable and Chinese exports will still be very competitive. Global deflationary pressures will continue to remain intense - but that would have been the case whatever the Chinese had announced today. Supply chain optimisation is becoming more evident across Asia - keeping goods prices down. Also, as we have seen in recent months in many countries, despite high oil prices, much of the impact has been seen on corporate profit margins, as consumers around the globe remain price resistant.

In addition to gradualism, China's introduction of greater flexibility into its currency suggests that we should expect to see further future appreciation of the CNY. But not immediately. And, as was indicated in the official announcement from China, this greater future flexibility will be seen against a basket of currencies.

Lessons for speculators

There is also a very telling lesson for speculators. China has shown quite clearly that its currency policy is not going to be set by currency speculators. We never thought it would. As we have pointed out before, there is a big difference between the markets trying to sell a fundamentally weak currency - in which case the market usually wins, and between trying to force up a fundamentally strong currency such as the CNY. As the PboC has demonstrated, central banks are able to resist and win out over speculators in that scenario. The big issue for the Chinese however has been how to sterilise such inflows.