The yuan unpegged

Learning to crawl

China’s new-found flexibility on its currency should ease trade tensions with America, but may turn attention to others

Hong kong

CHEAP goods from China can sour relations with America even when they are sweet. Earlier this month, for example, American officials seized a shipment of honey from China because it violated food-safety standards. It contained an antibiotic used to treat “foulbrood”, a disease that afflicts bee larvae. The bust was lauded by Charles Schumer, a Democratic Senator from New York, who condemned China’s “honey launderers”.

But honey is not the stickiest issue dividing the two countries. Mr Schumer and many other members of Congress also rail against China’s currency, the yuan, which they believe is artificially cheap. They have been urging President Barack Obama to get tough. On June 16th he wrote a letter to the leaders of the G20 underscoring that “market-determined exchange rates are essential to global economic vitality.” Many feared a case of foul mood when the leaders gathered in Toronto on June 26th-27th.

But on June 19th China unveiled a potential remedy. The People’s Bank of China (PBOC), the country’s central bank, said it would increase the flexibility of the yuan, which has been tightly pegged at about 6.83 to the dollar since July 2008. In setting the exchange rate, it would pay heed to a basket of currencies, it said, as well as “market supply and demand”.

In China’s fledgling foreign-exchange market, the central bank sets a central dollar parity for the yuan each morning. For the past two years, it has allowed the currency to move barely a whisker from this rate. Now it seems prepared to let it rise by up to 0.5% on any given day—but not to let it rise by that much day after day. On the Monday after its statement, the PBOC let the currency appreciate by over 0.4%, generating quite a bit of excitement. At that rate the yuan would double in value in just 174 trading days. The next morning the central bank set its parity to reflect the previous day’s close. But as Tuesday wore on, it decided that “market supply and demand” needed a bit of a nudge. Heavy dollar-buying by the country’s big state banks, presumably at the PBOC’s behest, pushed the yuan down against the dollar, allowing the central bank to set a Wednesday-morning parity of 6.81 (see chart 1).

The last time the central bank let the currency crawl, it clambered up by 21% against the dollar over three years. But it may not match that pace this time. China will not want the yuan to get too far ahead of other significant currencies that may be falling against the dollar. As the central bank says, China now has a “long and diversified” list of trading partners. Against a broad basket of their currencies, the yuan has already risen this year; against the euro it has strengthened by 17%.

On any given day the yuan may also slip, as well as climb, against the dollar. The central bank is keen to deter “hot money” that might seep past the country’s capital controls, looking to profit from a stronger currency. Mark Williams of Capital Economics, a research firm, thinks it has already succeeded. The currency forwards market expects the yuan to appreciate by only 2.2% over the next 12 months, a slender return given the hassle of getting money in and out of China.

Even without the central bank’s guidance, the upward pressure on the yuan may be more bearable this time, according to Zhao Qingming, a former economist at the PBOC, and David Li, an adviser to the central bank. In an interview with HSBC, they point out that China’s trade surplus has narrowed significantly (see chart 2). Six months ago William Cline and John Williamson of the Peterson Institute of International Economics in Washington, DC, calculated that the yuan would have to strengthen by 40% against the dollar to restore “equilibrium”, which they defined as a current-account surplus of 3% at full employment. Now they reckon it would have to climb by only 24% against the dollar and 14% against its trading partners overall.

But although China’s trade surplus is not as conspicuous as it was before the crisis, America’s tolerance for such imbalances has also fallen. “China’s currency manipulation would be unacceptable even in good economic times. At a time of 10% unemployment, we simply will not stand for it,” said Mr Schumer in March after introducing a bill to slap duties on any country intervening persistently in the foreign-exchange market. When the world economy is short of demand, argues Paul Krugman, a Nobel prizewinner, countries that persistently spend far less than they earn contribute to global unemployment.

In his letter to G20 leaders Mr Obama criticised the “heavy reliance on exports by some countries with already large external surpluses”. China is not the only country at fault. Germany’s current-account surplus ($135 billion in 2009) is less than half the size of China’s ($297 billion) in dollar terms; it is also smaller relative to the size of its economy. But China’s surplus is dropping faster. According to projections by the Economist Intelligence Unit, a sister company of The Economist, Germany’s surplus will narrow by only $20 billion this year; China’s by $68 billion. That represents an injection of extra demand for the rest of the world’s goods and services this year, relative to last.

Like China for the past two years, Germany has also pegged its exchange rate—to the euro. No one is accusing the European Central Bank of manipulating the currency, but the euro’s slide implies that the zone’s members will be relying on foreign demand, not their own, to restore their fortunes. Goldman Sachs expects the euro area’s current account to show a surplus this year, which will only grow next year. Perhaps Mr Schumer should demand the interdiction of Frankfurter sausages.