China announces increased flexibility in its exchange rate

There was some big news over the weekend, with the Bank of China announcing that it was going to allow some flexibility in its exchange rate. The statement from the BoC points to the global economic recovery and domestic growth as the background to pursue further exchange rate flexibility. Markets have reacted positively to the announcement, with corporate bond indices opening up tighter this morning.

This signals the end of a de facto peg to the USD that started in mid-July 2008. From July 2005 to July 2008, the Chinese authorities very gradually allowed the Chinese renminbi (yuan) to appreciate by around 21% against the USD. Any appreciation of the yuan this time around is likely to be similar to the period between 2005-2008 i.e. modest and consistent.  We should highlight that there is still some uncertainty around the timing, nature and potential scope of the new flexibility in the yuan at this early stage.

For us there are a number of main implications of this move worth highlighting.

Firstly, by keeping the yuan pegged to the dollar, Chinese exports are cheaper than they would be if the currency was allowed to float. There are many critics, particularly in the US, that believe China should be penalised for keeping its currency artificially weak. These penalties would likely take the form of trade protectionist measures. By allowing greater flexibility in its currency, the Chinese are reducing the likelihood that other countries start to introduce trade barriers in an effort to protect local industries. On this point, the timing of the announcement is interesting given there is a G-20 meeting this week.

Secondly, any move to see the yuan appreciate in value versus the USD is likely to be bearish for US treasuries at the margin resulting in higher yields. The exact nature of the impact on US treasuries is difficult to analyse. If the yuan appreciates in value then China will have less USD to invest into US treasuries, suggesting a weakening in demand. That said, given the appreciation in the yuan is likely to be measured it is unlikely that this is going to have a huge impact in the demand for US Treasuries in the short-term.

Thirdly, there will be upward pressure on global inflation rates if Chinese goods become more expensive due to the rising currency. Import prices for developed economies are likely to increase, suggesting higher producer and consumer prices. Analysing the allocation of items in the UK CPI basket for instance, we can see that many of the CPI divisions use Chinese goods as an input for the final product. This is similar for the inflation divisions in Europe and the US. Additionally, have a think about how many goods you own are manufactured in China. We can now see how a rise in the yuan can lead to higher costs for inputs which may lead to higher consumer prices. Given inflation is already above target in the UK this is something the Bank of England will have to keep a close eye on.

Fourthly, if the yuan appreciates versus other currencies, the purchasing power of Chinese businesses and households is going to improve. This could provide a boost to growth for countries that export goods to China and something that would be highly positive for global growth.

Ultimately, the announcement by the Chinese authorities is a positive step. A more flexible yuan will allow some correction of the imbalances that have developed in the global economy in recent decades. Given that China is such a large economy it is likely that the appreciation of the yuan will have many more impacts on global trade and finance than those listed above. We believe that any currency move will likely be gradual, thereby avoiding the large disruptions that a one-off revaluation would have on the global economic recovery. Watch this space.