Free Market Yuan? by Joseph Trevisani

When I was in graduate school I wrote a paper on the Chinese Banking system. In those days state banks — there were no others — kept semi-imaginary accounts of debits and credits. Loans were assigned by state planners, repayment was the exception, default was endemic and without penalty, and financial transparency was zero. That was only 20 years ago. When considering Chinese economic and exchange policy it is best to keep China’s extraordinary transformation in mind, not because it is unique, which it is, but because it will accustom the critic to the long view. (Originally September 27, 2006) Update February 4, 2008

When I was in graduate school I wrote a paper on the Chinese Banking system. In those days state banks — there were no others — kept semi-imaginary accounts of debits and credits. Loans were assigned by state planners, repayment was the exception, default was endemic and without penalty, and financial transparency was zero. That was only 20 years ago. When considering Chinese economic and exchange policy it is best to keep China’s extraordinary transformation in mind, not because it is unique, which it is, but because it will accustom the critic to the long view.

On Monday February 4th 2008 the central parity rate for the Yuan was set at 7.1923 against the dollar. That represents an 11.32% appreciation from the 8.11 rate enacted in July 2005 when the dollar peg was abolished. It is 13.35% higher than the 8.30 pegged rate which had existed for the decade prior to July 2005.

11.32% over 30 months is not a large move by currency market standards. Since last August, in only six months or 1/5 the time, the Euro has appreciated 11.03% against the dollar.

In the past two and a half year the yuan has gained an average of 0.38% a month versus the dollar; in the past six months the euro rose an average of 1.84% each month against the US currency. But over the past six months the appreciation of the yuan has accelerated, with not much less than half – 4.79% — of the total move since 2005 coming since July 2007. At an average 0.80% per month this is almost three times faster than the 0.27% monthly rate the government had permitted over the previous two years.

Less than three years ago the yuan was essentially fixed against the dollar. Chinese businesses, consumers and the government itself had little or no practical experience with the impact of exchange rates on their economy. For an country whose currency was pegged at 8.30 (give or take 0.3%) to the dollar for 10 years the past two and a half year have been an enormous and very rapid accommodation of the Chinese economy to world market forces.

The Chinese planners have managed their most astonishing economic renewal by keeping their eye on the generational horizon. There have been many arguments from Western governments, our own included, over the past five years urging yuan revaluation and criticizing the Chinese for deliberately keeping the yuan undervalued for trade and growth. There is truth to those arguments. China’s growth has been export led and capital intensive and both benefit from a cheap yuan. The deciding factor in Chinese economic deliberations has not been external pressure but what is useful for the domestic economy. Chinese goods and Chinese governmental purchase of western debt and securities have given the government great clout in Western capitals. The Chinese have moved the yuan to a controlled appreciation because this will help allay some of the inflationary and expansionary dangers lurking in their economy, not because they are concerned about the American Congress or the complaints of European finance ministers.

The question is often asked will the Yuan ever be freely traded? The Chinese government has given us the answer. ‘Yes’. The revaluation of the yuan is a step along that road. But the yuan will not join the currency markets until a free market yuan is in China’s best interest and that destination, if no longer generational, is still years away.

Joseph Trevisani has 18 years of experience in Forex trading and management and is a senior partner and the Chief Market Analyst at FX Solutions.  Prior to joining the online trading industry Mr. Trevisani worked at Credit Suisse for 12 years in New York and Singapore as an interbank currency trader and trading desk manager.  Returning from Asia he managed the Asian Trading desk and was a proprietary trader for The Bank of Bermuda in Hamilton... More