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Sunday, June 20, 2010

Amid Pressure, China Eases Currency Peg

The Wall Street Journal

China moved unexpectedly over the weekend to make its exchange rate more flexible, but quickly damped the idea that the move would trigger a dramatic revaluation of the yuan by saying it would make the adjustment "gradually."

The decision by the world's third-largest economy follows heavy pressure by the U.S. and other members of the Group of 20 major economies. It could eventually boost the spending power of China's own consumers, easing the strains with other nations caused by its long reliance on cheap exports. That would be an important milestone on the path to a rebalancing of the global economy, which in the last few years has strained under a massive trade and capital imbalance between the U.S. and its major trading partners.

The decision to drop the two-year-old informal peg to the U.S. dollar was cheered by the U.S. and other trading partners. But with its insistence on gradual change, the Chinese government signaled it wasn't ready to go as far as many in the West want, and analysts say only a modest appreciation of the yuan is likely at first. The test will be the rate of currency appreciation China allows, which was left unclear.

Coming in advance of a G-20 meeting, the decision was as much a political call as an economic one. The leadership had to overcome fierce resistance from a domestic export lobby as well as its own nervousness that letting the yuan rise, and thus tinkering with a driver of China's export-led growth, is all the riskier at a time of deep economic problems in Europe and elsewhere.

But with pressure to revalue building in both the U.S. Congress and the G-20 economies, the decision showed a desire to set China's economic diplomacy on a more sustainable footing. And it should take the heat off China: The G-20 is holding a summit in Toronto this weekend, where China was expected to face pressure to do more to aid the global recovery.

China's decision, announced Saturday evening Beijing time by the central bank, is to return to what it calls a "managed floating exchange rate." When China last followed that regime, from mid-2005 to mid-2008, it resulted in an eventual 21% gain against the dollar.

China returned to a fixed currency amid the financial crisis, and defended that policy as providing stability amid the global turmoil. Beijing effectively repegged the currency, at about 6.83 yuan to a dollar.

But by preventing its currency from rising against the dollar, in spite of its trade surplus with the U.S., China was favoring its exporters at the expense of those who would like to buy more goods from abroad. And export-driven growth was looking increasingly unsustainable, with U.S. consumers paying down their debt and U.S. politicians angry over the trade gap.

Now, "China is taking a cooperative stance. They want to show that China is contributing to the rebalancing globally," said Wang Tao, an economist for UBS AG in Beijing. "China may not act as speedily as many people want, but they are moving in the right direction."

That direction is toward an economy driven less by selling goods to the rest of the world and more by its own consumers' spending. The Americans argue that the yuan is undervalued, giving Chinese exporters an unfair pricing advantage and making China too reliant on U.S. consumers for growth.

Both China's trading partners and the country's own leaders say a shift would be good for all: It would make China less vulnerable to external troubles, while reducing the politically troublesome trade surplus and providing more opportunities for international companies in the Chinese market.

"China is now speeding up the restructuring of the economy and transforming its growth model, a task that has been made even more important and urgent by the international financial crisis," the central bank said, arguing that a flexible currency will help that effort.

The move was hailed abroad. President Barack Obama said, "China's decision to increase the flexibility of its exchange rate is a constructive step that can help safeguard the recovery and contribute to a more balanced global economy." Leaders from Japan, Russia and Europe also expressed approval.

Investors are likely to welcome the move because it lowers the risk of a trade conflict that could hamper global growth. China cited the recovery in its own economy as allowing its move, a judgment that could strengthen investor confidence, which has been shaken by the debt problems in Europe and a slowdown in Chinese housing sales.

A stronger yuan, also called the renminbi, gives local consumers more international purchasing power and puts pressure on exporters to lift their game. That was a change the International Monetary Fund and others saw as important in bringing about what all major countries say they want: an economic order that allows the world to grow steadily without artificial government stimulus.

Although just one part of a complex economic picture, a stronger Chinese currency matters over time, said IMF Managing Director Dominique Strauss-Kahn, because it "will help increase Chinese household income and provide the incentives necessary to reorient investment toward industries that serve the Chinese consumer."

Beijing's announcement caps months of intense diplomatic maneuvering by the Obama administration. In April, Treasury Secretary Timothy Geithner delayed publication of a twice-yearly report on international currency practices. The move was blasted by Congress, but it created a "quiet period" when China wouldn't be subject to much pressure on currency. U.S. officials say the idea was to make it easier politically for China's leaders to move, as they could do so without appearing to yield to outside pressure.

But China didn't give a public commitment on timing, and more weeks passed without any news. Criticism in Congress started to heat up again. Sander Levin (D., Mich.), chairman of the House Ways and Means Committee, said Congress would act if the G-20 summit passed without China changing course.

The Chinese continued to issue harshly worded rebuffs to questions about its currency policy as late as Friday. That delay allowed Beijing to achieve nearly ideal timing in both political and economic terms.

At the beginning of the year, currency-derivative markets had been pricing in a rise in the yuan against the dollar of more than 3% over 12 months. By the beginning of June, expectations had shrunk to less than 1%.

Thus, China can argue its move wasn't pressured by financial markets. In addition, data released this month showed China's consumer price inflation going over 3%, boosting the argument for using a stronger currency to tame prices. A strong yuan would make imported goods cheaper in China.

Mr. Geithner said the Chinese announcement is "an important step," but added, "The test will be how far and how fast they let the currency appreciate."

For Beijing, the move carries risks. Policy makers are haunted by the example of Japan, which at the 1985 Plaza Accord agreed to a major appreciation of the yen against the dollar. Although there is debate about the causes, a Japanese real-estate bubble ensued, followed by a long economic slump. The lesson many in China have taken, rightly or wrongly, is that rapid swings in the exchange rate can be very destabilizing.

China's central bank addressed those fears, saying the exchange rate will be changed gradually, so local companies have time to adjust and maintain competitiveness.

The preference for gradual change is unlikely to please longtime U.S. critics of China's currency policy. "There is a huge gap between what people in the U.S. Congress expect and what the Chinese authorities are really doing," said Xiao Geng, director of the Brookings-Tsinghua Center for Public Policy in Beijing.

Yet the insistence on gradualism shouldn't obscure the significance of the change in thinking that has taken place, Mr. Xiao added. "The people in charge of this issue," he said, "including the top policy makers, are now quite clear about the necessity of allowing real appreciation in the medium and long term."

The flexibility move shows China's leaders recognize that a strict peg to the dollar is hard to square with a large and rapidly growing economy. Incomes in China are rising, which over the longer term tends to push up prices of goods and services as well as the value of the currency.

If the government tried to resist that process by holding down the currency, economists say the result would be much higher inflation, which could lead to serious social and economic problems. By managing the process with a flexible exchange rate, China may be able to secure a better economic future.

Said Li Daokui, an academic economist who sits on the central bank's monetary-policy committee: "This marks the beginning of a new era."