What does China's revaluation mean for markets?

China is finally to allow its currency to rise against the US dollar. Markets have perked up on the news, hoping the revaluation will play a key part in a sustainable global recovery. But are they right? John Stepek explains.

Marketsacross the globe jumped this morning on news that China plans to allow its currency, the yuan renminbi (RMB), to appreciate against the dollar.

The exact wording of Saturday's statement from China's central bank was vague. The People's Bank of China "has decided to proceed further with reform of the RMB exchange rate regime and to enhance the RMB exchange rate flexibility." But everyone took it to mean that the RMB will be allowed to rise against the dollar.

China first scrapped the RMB-dollar peg in July 2005. It replaced the peg with a managed float against a basket of currencies. In three years, the RMB appreciated by 21% against the US currency. But the peg was reinstated in July 2008 as the credit crunch hammered global trade. Since then, it's given the more xenophobic elements in the US government a great excuse to bash China on behalf of the country's manufacturers.

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So the latest announcement is seen as China's way of taking some of the heat off ahead of the G20 summit this week. China's not keen to discuss the exchange rate at the summit, and by making this announcement, it can probably get away with not doing so.

So why the big bounce in markets? Well, on the face of it, there are lots of reasons for investors to get excited about this. China is presenting this as its contribution to global rebalancing. The ultimate hope of global investors is that China will take over from the US as the consumer power-house of the 21st century. It'll pick up the flag and lead us on a sustainable path out of the global recession.

A stronger currency is one key element of doing this. It should ease inflationary pressures in the Chinese economy. That means markets will stop worrying as much about China pushing up interest rates a stronger currency has pretty much the same effect.

It also increases the purchasing power of the Chinese consumer. It's perhaps no coincidence that this move comes at a time when Chinese workers are visibly striking for pay rises - and being given them. If China's manufacturers can't rely on the global consumer to buy their stuff, well, China will just create its own consumer class (for more on why pay rises for Chinese workers are good news, see my colleague Cris Sholto Heaton's recent MoneyWeek Asia article on the topic: Why Chinese wage rises are good news for investors).

But you can read too much into the move.

Diana Choyleva at Lombard Street says the move is just "aimed at throwing a bone to the US and the rest of the world, and nothing more." Julian Jessop at Capital Economics adds that any appreciation of the RMB against the dollar is "likely to be small, perhaps just a few percent over the remainder of the year," so "trade tensions will soon return."

Apart from anything else, as a result of the dollar peg, the RMB has already risen by around 16% against the euro this year. They're not likely to want the same to happen with the dollar. And "even a much bigger move would do nothing to boost the global economy without additional steps to increase demand within China itself."

In short, this is more about politics than economics.

And more to the point, despite the best hopes of investors around the world, even a serious revaluation would be no panacea for the US economy. As Stephen Roach, chairman of Morgan Stanley Asia, told Bloomberg: "It's just bad economics to pretend we can fix the lives of middle class Americans by getting the Chinese to revalue it's a horrible misconception." The problem is that Americans aren't saving enough, not that Chinese goods are too cheap.

The US has a "multi-lateral" trade deficit in other words, it's not just China. If tariffs are imposed on China, says Roach, then Americans will just buy the same goods from somewhere else. "If we don't boost our national savings rate, with trillion dollar deficits as far as the eye can see, the Chinese piece of our multilateral trade deficit just goes to a higher-cost producer and that taxes the American people."

Of course, China's not blameless in all this. But "US-China trade now represents only 12% of total Chinese trade with the rest of the world. Consequently, it is wrong to fixate on the relative price between these two nations - specifically, the foreign exchange rate between the US dollar and the Chinese renminbi - as the solution for the deeply rooted savings disparities that drive these multilateral imbalances."

That won't stop populist senators in the US for pressing for protectionist measures when it turns out that the Chinese have no desire to let the dollar collapse utterly against the RMB. But it's hard to think what would satisfy them.

John Stepek

John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.