Will China float its currency?

China’s dollar peg is distorting prices, with potentially disastrous consequences for the world economy. Will China give way and let the yuan float? Simon Wilson reports.

What’s new?

China saw a 46% surge in exports in the year to February, lending fresh weight to complaints that its currency is undervalued. It follows recent predictions by several economists, including ‘Doctor Doom’ Nouriel Roubini and Goldman Sachs’ chief economist Jim O’Neill, that China is set to relax or remove the renminbi’s unofficial dollar peg. This has been in place since July 2008.

Most analysts agree it undervalues the renminbi (or ‘yuan’) by around 25%-40%. Currency traders got excited last weekend when the governor of the People’s Bank of China, Zhou Xiaochuan, hinted that a revaluation – or least appreciation – was on the way. Zhou said the currency peg was a “temporary” policy for dealing with the financial crisis. But his remarks seemed to contradict more non-committal comments from other senior figures, including the commerce minister.

Why is a fixed dollar peg a bad thing?

The most fundamental argument in favour of genuinely free-floating currencies rests on a basic tenet of market economics: that if you distort prices you distort the overall allocation of resources, leading to inefficiency and bigger trouble down the line.

Whether it is consumer goods, assets such as equities or bonds, or national currencies, the ‘price mechanism’ is an essential gauge by which households and firms make spending or investment decisions.

If those decisions are not based on true demand and supply, then bad decisions get made. In this case, the Chinese government is holding its currency at an artificially low price to keep its exports cheap – a distortion that could have dangerous implications for the entire global economy.

Why does it matter so much?

For many years, China’s exchange-rate manipulation didn’t matter much. Indeed, in the aftermath of the Asian crisis of 1997, China won international respect for maintaining its dollar peg (held at 8.27 RMB/dollar until 2005), in effect leaving the renminbi overvalued while neighbouring economies undertook competitive devaluations.

The Chinese currency only became obviously undervalued in the years that followed, as first the technology-led stockmarket bubble and then China’s 2001 entry into the World Trade Organisation fuelled a surge in investment and exports.

Then, as the dollar began falling against other floating currencies in the years before the 2008 banking crisis – and the renminbi with it, despite the largely cosmetic 2005 decision to let it float within a narrow band – the value of the renminbi became even more clearly out of line.

What about more recently?

This perception that the renminbi is undervalued has only grown since it was once again pegged to the dollar in July 2008. China’s economy is now powering ahead with 8% growth rates, and its foreign reserves last year surged 23% to $2.4trn.

This is a problem, as is often argued by President Obama and many US pundits, because an undervalued currency gives China an unfair advantage when it comes to exports and manufacturing and so is a none-too-subtle form of protectionism.

But of course, this is precisely why China is less keen to revalue – its reliance on exports means that any significant rise in the renminbi could hurt economic growth and, more importantly for Beijing, push up unemployment.

 And as Andrew Batson in The Wall Street Journal points out, when Japan let the yen appreciate under US pressure in the mid-1980s, the resulting slowdown in growth “pushed the government to boost spending and lower interest rates. A real-estate bubble and years-long slump followed.”

So why should China let the renminbi rise?

Unemployment is a big concern for the Chinese government. But so is inflation, which is an equally big threat to social stability. Consumer prices rose at an annual rate of 1.5% in January. It might not sound much, but prices are expected to continue rising in the coming months.

China can only keep its currency pegged to the dollar by printing money to buy green­backs, and all those billions of renminbi ultimately feed back into the real economy – chasing assets, creating bubbles and stoking prices.

A stronger currency would help contain inflation on two fronts. It would cushion the impact of rising import prices; and it would give the central bank more flexibility to raise interest rates without attracting ‘hot money’. China also recognises the need to rebalance its economy in favour of domestic consumption: revaluation would help that, but it’s a big risk when its export markets are already threatened by sluggish demand.

Whatever it decides, the timing and extent of any strengthening are likely to be dictated by domestic stresses, rather than mounting calls for new tariffs on Chinese imports by US senators.

What will China do?

A large, one-off revaluation would please economic purists, but seems an unlikely move for China’s cautious leaders. On the other hand, a resumption of the gradual appreciation of the renminbi against the dollar (the trend seen between 2005 and 2008) also presents difficulties.

This would be likely to attract inflows of ‘hot money’ – speculative currency flows in search of a one-way bet – likely to frustrate Beijing’s efforts to control domestic asset- and consumer-price inflation.

Some economists, such as Bank of America-Merrill Lynch’s China specialist Ting Lu, believe China’s best bet would be to benchmark the renminbi against an undisclosed basket of currencies, which is similar to the system used by Singapore.

  • Ben Gee

    No, China will not float the yuan for at least 15-20 years. Floating the yen was what did the Japanese economy in in the 1980’s. China is determined not to follow the foot steps of Japan. The US can cry until the cow come home, but China will only allow the yuan to appreciate at a managible level like during 2005- 2008. However, once the Chinese economy is at par with the US economy, China may float its currency then, but not before.

  • Ian

    I agree with Ben, I think the Chinese are alot smarter than some give them credit for. I am of the opinion that we are looking at buying into the US 100 years ago , except we are now in the 21 Century, and thats looking at a 21 Century life style , for a country 4 x the size of the US in this Century.
    Stand aside at your peril, or jump on board, but I am with Jim Rogers. This will be the biggest thing to have ever happened, it is
    that Whole region, And the rest of the third world, buy BHP a go to sleep for 20 years

  • Anthony, Cape Town

    Its glaringly obvious the Yuan is under-valued – you only have to go into a “pound store” to see how absurdly cheap Chinese products are. If this stuff can be sent around the world and can still be sold for a pound or a dollar the mind boggles at how cheap it must be at the factory door and how little wages the workers must earn. Surely virtually a form of slavery?

    What then would happen if the US (and other countries) were to slap a big tariff on Chinese goods, as I think they should have done long ago. It would help the environment too – anyway much of the stuff made in China is frivolous junk, which is wasting resources.

    I suspect we are afraid to do this because it would make China angry, very angry. So they have us by the shorts dont they?

  • BChung

    What a idiotic and arrogant comment from Anthony.

    Being an auditor based in Hong Kong, I have to visit atleast a dozen factories located in China. The smallest one employs around 1500 workers to the biggest 8000. All these factories have canteens, provided with hot full meals 3 times a day which I enjoyed alot in a few of these factories, they are also provided dormitories where they can stay.

    Workers in these factories are not FORCED to go on overtime, but OT pay is good and sometimes will double or even triple their monthly pay. Since I have to stay there at least a week or 2 every time, talking to workers and management about work and other stuff is part of my job anyway, you will find plenty of these workers are happy to work 14-18 hrs a day for 2 -3 days a week, to earn more.

  • BChung

    By the way Mr. Anthony, did I mention that workers in China are having more BARGAINING POWER this year? Yes I just said Bargaining power, factories are raising their wages, some by 100% or more, building leisure facilities (Soccer pitch, basketball court, one of my client even have a bloody bowling alley), free air conditioning in dormitory and bonuses…..maybe perhaps is just a matter of time inflation will be exported back to the west after all, even without the evaluation of the Yuan. Who knows maybe 2 years from now, we will be hearing DC bashing China for not pegging the Yuan to the USD.

  • Bob

    There is no such thing as a free lunch – the idea that a country can just peg its currency and gain a huge advantage is ridiculous and wrong. China is paying a huge price for maintaining the peg – they lack flexibility in fiscal policy in things such as controlling inflation. That Wall St. Journal reference is wrong – when Japan let its currency float, exports *increased.* If you think that Chinese exports will decrease if the yuan is allowed to float, I got a bridge to sell you. This simplistic scapegoating will do nothing to solve our problems.

  • Ash Arora

    No, I believe China has less to gain and more to lose at this moment to allow yuan to float.

    China holds the largest US debt. If the dollar is allowed to depreciate against the yuan, does this not cause the US debt to depreciate too in value i.e. helping US and not China? So why would China want to do that?!

    Ultimately, consumers win by getting cheap products. Rest of the world has managed to keep a lid on inflation because of these cheap goods. If this stops, there will be political and social consequences for our unprepared governments and public.

  • Steve S

    If the Yuan floats it will go up. This will make things from china more expensive in the US. This would hurt the recovery since everything comes from China. The Chinese would be richer if they let the yuan go up more purchasing power the US would suffer

  • b raaack

    china is a rapidly growing economy with everything to loose seeing asw how so much of there economy is based off manufactureing . to let the yuan float would cause a great loss in exports and therefore an increase in chinese unemployment. the U.S puts pressure on china to do so becasue this would allow for more manufacturing jobs in the us and would also lower there debt to china. But why would china do all this jsut to pleasse the U. S its not there problem the unemployment rate is so high,. ultimately china will take a huge hit its a good thing they have soo much mooney in their national reserves to bail out their country when it happens

  • Boredom Blues

    The Petro dollar is undervalued and so is the Yuan. China is a country that”s 6000 years old. So let’s determine the value of the YUAN.


Claim 12 issues of MoneyWeek (plus much more) for just £12!

Let MoneyWeek show you how to profit, whatever the outcome of the upcoming general election.

Start your no-obligation trial today and get up to speed on:

  • The latest shifts in the economy…
  • The ongoing Brexit negotiations…
  • The new tax rules…
  • Trump’s protectionist policies…

Plus lots more.

We’ll show you what it all means for your money.

Plus, the moment you begin your trial, we’ll rush you over THREE free investment reports:

‘How to escape the most hated tax in Britain’: Inheritance tax hits many unsuspecting families. Our report tells how to pass on up to £2m of your money to your family without the taxman getting a look in.

‘How to profit from a Trump presidency’: The election of Donald Trump was a watershed moment for the US economy. This report details the sectors our analysts think will boom from Trump’s premiership, and gives specific investments you can buy to profit.

‘Best shares to watch in 2017’: Includes the transcript from our roundtable panel of investment professionals – and 12 tips they’re currently tipping. The report also analyses key assets, including property, oil and the countries whose stock markets currently offer the most value.