Thursday, July 21, 2005


The Chinese yuan, long pegged to the U.S. dollar at RMB8.28=$1, was revalued by 2.1% and will now be allowed to move withing a 0.3% trading band. The U.S. Treasury secretary, John Snow, seems quite pleased:

I welcome China's announcement today that it is adopting a more flexible exchange rate regime.

As we have said, reform of China's currency regime is important for China and the international financial system.

I particularly noted China's objective of allowing the market to fully play its role in resource allocation as well as "to put in place and further strengthen the managed floating exchange regime based on market supply and demand."

We will monitor China's managed float as their exchange rate moves to alignment with underlying market conditions.
But as many writers are noting, such as Nouriel Roubini, this is a very small move, and the tightness of the trading band means that all we've gotten is a small decrease in the rate of growth of Chinese exports. Bond prices slumped this morning, but I don't see much else in the way of impact on the U.S. There needs to be another, larger move before we feel anything here.
The impact on China is quite large, however. David Altig, blogging with Roubini above -- you'd do well to read back to their conversation throughout the day, as I've been -- links to William Polley's finding that the Chinese decided a few days ago to loosen up capital controls. Polley notes that it should have been the tip that the exchange rate move from the Chinese was coming, because free trade, free capital flows and fixed exchange rates are not supposed to exist side by side. This "unholy trinity" (named by Benjamin Cohen in 1993, I believe) is often cited as a reason for floating exchange rates. But work done with Tom Willett and others (to which I've made some very minor contributions) suggest that there are intermediate regimes that can in fact work. The question is whether China (and later in the day, Malaysia) has in fact found one that will work. Like Tom, I think optimal currency area approaches to this question work best, and on that basis the current strategy at least isn't harmful.

My guess is that in the short run, if the exchange rate is going to be allowed to appreciate further, China will first allow the trading band to widen from the 0.3%, and less frequently chane the mix of currencies in the new basket against which the exchange rate of the yuan will be set.

It's worth noting that so far the credit rating agencies aren't downgrading Chinese debt. That may well be because of the small size of the appreciation. A larger exchange rate move along with freer capital markets in China could have caused a downgrade.