After more than a year of international and heated debate, the People's Bank of China (PBOC) announced on July 21of this year that it would calculate the value of the renminbi (RMB) against a basket of currencies. It also set the value of the RMB to the US dollar at ¥8.11/$1, up 2.1 percent from the previous rate of ¥8.28/$1. China's move to a new currency regime may be a step toward a true market-based exchange rate, but the immediate benefit to China—and to foreign companies—may be an easing of US political pressure. Indeed, the move appears to signal the PRC government's awareness of the political and economic pressures for a currency adjustment. Although some observers have criticized the small revaluation, US government officials and leading international analysts immediately praised the change and its timing.

About the change

Although China's previous currency regime was commonly referred to as a peg to the US dollar, China actually maintained a version of a managed float against the dollar: Since 1994, the RMB was allowed to fluctuate within a narrow band. Under the new regime, the band remains—the RMB may fluctuate 0.3 percent above or below the previous day's closing exchange rate—but the value will be determined by referring to a basket of currencies, not just the dollar. The bulk of currencies in the basket are those of China's biggest trade partners: the United States, the Euro zone, Japan, and South Korea.

The economic rationale for the move is strong. China's rising global trade surplus in 2005 put pressure on its currency. Sterilization measures to prevent inflation were taking their toll. And, as several economists pointed out, the government had put administrative tools in place that would allow it to introduce more exchange rate flexibility.

Implications

Analysts have pointed to a number of other consequences of the move:

Wider foreign exchange reform

The change in the exchange rate determining mechanism appears to have spurred other reforms to China's foreign exchange regime. PBOC in early August issued rules for the interbank foreign exchange market, which took effect immediately. And the State Administration of Foreign Exchange (SAFE) again raised the amount of foreign currency Chinese companies may keep for current account transactions. PBOC also broadened the use of currency forward contracts and swaps to a wider range of institutions and clients and for a greater number of purposes.

Winners and losers

Deutsche Bank predicted that PRC airlines, autos, and utilities, along with the Hong Kong tourism sector, would benefit from the move, in part because imported oil and imports of components denominated in foreign currency will cost less. The bank also predicted that the move will help multinational corporations (MNCs) that export to China or produce in China for the local market, since exports to China are now slightly less expensive. On the other hand, the change may negatively affect PRC exporters including export-oriented MNCs especially of textiles and electronics, which operate on thin margins. But if future appreciation is gradual, and if other (particularly Asian) currencies start to recalibrate to the new RMB/dollar rate, the negative effects could be minimal.

An easing of US political pressure—but for how long?

In Washington, it is unclear whether pressures in Congress to act on China's currency practices will ease as a result of these latest moves. If the RMB fails to appreciate, even if in small increments, over the next few months, Congress may give greater consideration to China trade legislation and again press the US Treasury to designate China as a currency manipulator in Treasury's October currency report.

Source: This is an excerpt from an article originally published in the Sept-Oct, 2005 .issue of the China Business Review