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Is China a Currency Play?

Is China a Currency Play?

Since the beginning of this decade, China's booming economy, fueled by large inflows of foreign direct investment (FDI) and rapid export growth, has emerged as a significant force in the global economy. In 2003, China surpassed the United States as the world's largest recipient of FDI, and its foreign exchange reserves surged to nearly UD$820 billion by the end of last year, second only to Japan.

Both inward investment and export growth continues to create strong demand for China's currency, the Yuan (also referred to as, Renminbi). All things being equal, such demand pressures should cause the Yuan to appreciate relative to the U.S. dollar and cause China's external position to return to balance. But all things are not equal.

From 1994 through mid-2005, China's Yuan, stood at the de-facto peg of 8.28 to the dollar while its economy roared ahead. On July 21, 2005, the People's Bank of China (PBOC), the country's central bank, began a new policy of calculating the Renminbi's value against the US dollar using a weighted average of the prices, given by major banks. The prices are pegged to a basket of currencies representing their biggest trading partners. The list is comprised of: the US Dollar, the Euro, the Japanese Yen, South Korean Won, the UK Pound, the Thai Baht and the Russian Ruble. The highest and lowest offers are excluded from the calculation.

If the ramifications of the prior paragraph aren't clear, let me explain: the market effects of supply and demand remain very controlled at present. In fact, several US politicians are arguing that the Yuan is artificially low, giving Chinese exporters an unfair advantage, contributing to US trade deficits and hurting US labor markets. Nevertheless, the Chinese government is not anxious to let their currency float freely anytime soon.

From my research, the consensus suggests that the stance of China's Communist Party-led government will not change, despite the broadening of its global trade surplus and its buildup of foreign exchange. It is expected that Beijing will continue to allow only gradual moves from its prior Yuan peg against the dollar and is loath to increase the Yuan enough to dampen growth in its coastal factories. Exports are a key source of jobs in a country that must find employment for tens of millions of the poor farmers and workers laid off by bankrupt state factories in the continued transition from communism to capitalism.

To appease its major trading partner, last July, China bumped up the value of the Yuan by 2% against the US Dollar, somewhat diminishing tensions with the United States. But in the months since, the Yuan has appreciated less than 1% more against UD Dollar. Still, some economists believe that China's reserves are now growing so huge as to compel the central bank to deliver a more significant revaluation. Time will tell?

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