China's Opaque Currency Policy

This is a complicated story from AOL News / New York Times:

An old Chinese saying holds that the longest journey begins with the first step, but in the case of China's currency policy shift yesterday, the destination of the journey has been left completely unclear and the chosen route has many risks

China has abandoned one of the world's clearest currency policies, a tightly managed peg of the yuan to the dollar that had endured since 1997. China has chosen instead to adopt one of the world's most opaque currency policies, with a secret mechanism to reset the yuan's value each night.

For nearly eight years, Beijing's leaders trusted in Alan Greenspan, assuming that where the dollar went, China could safely follow. Now China's rulers are putting their trust in a much less well-known central banker: Zhou Xiaochuan, the governor of the People's Bank of China, who must manage the more discretionary policy put in place yesterday. Starting with the Asian financial crisis in 1997 and continuing through the rapid economic expansion since then, China has allowed the yuan to vary less than one-hundredth of a percent from its peg of 8.277 to the dollar. That impressive stability helped prompt business executives and entrepreneurs from around the world to invest $60 billion a year in new factories and other operations in China. These investors were confident that they knew what those businesses and their exports would be worth in dollars.

The People's Bank of China raised the value of the yuan by 2 percent on yesterday, to 8.11 to the dollar. But more important, the bank said that each evening, it would set a new trading range for the yuan to move within on the next trading day. To add to the uncertainty, each day's new range may not necessarily be expressed in terms of dollars, the bank warned. It did not provide examples, but the euro would be the most likely alternative.

To determine the new peg, the central bank will look at how a basket of foreign currencies moved the day before. But the central bank did not reveal which currencies it will track or their relative weightings within the basket. This policy gives enormous discretion to China's leaders to push the yuan up or down as they choose.

The only limit that the central bank put on its moves was a promise yesterday that the center of each day's trading range would not move more than 0.3 percent in either direction from the center of the previous day's range. But with 20 or so trading days in a month, that means China could in theory push its currency up by 6 percent a month - or push it down by the same amount.

For the past five years, China has been under tremendous pressure by the U.S. to release its currency from its peg to the dollar and revalue it. Because its currency is pegged to an artificial price with the dollar, as the dollar has fallen in the currency markets, so has the yuan. The cheap currency has allowed China to continue to flood the U.S. with inexpensive Chinese goods, sending dollars to China at which the Chinese have been investing in U.S. Treasuries. But have the Chinese been taking in too many dollars? Over the last couple of weeks, there have been a number of reports of Chinese companies buying up U.S. companies--CNOOC tried to buy up Unocal, Levono Group bought up IBM's personal computer business, and Haier Group tried to buy up the American appliance maker Maytag. China's dollars that are invested into U.S. T-Bills are used to finance the U.S. budget deficit, which may cause long-term interest rates to rise, and the dollar's value to drop--along with the yuan. It is a complicated economic dance between the U.S. and China.

So the Chinese are going to try something different. They are certainly not going to release the yuan off its peg to the dollar--that could wipe out the U.S. market for cheap Chinese goods that allow the Chinese factories to hum, and provide for China's sizzling economic growth. But the Chinese central bank is going to look at a basket of currencies, see how these currencies are trading, and then shift the yuan according to the central banker's discretion. And there is the limit that the yuan can move to no more than 0.3 percent in either direction from the previous day's range. The Chinese central bank had probably placed that limit to avert the Asian currency meltdowns of the late 1990s from happening to China. This new policy does provide some political breathing room for China. Because China will be shifting the yuan according to some basket of currencies (though there is no definition as to what the currencies are or their relative weightings), the Chinese can claim they are no longer manipulating their currency as to gain advantage in trade with the U.S., as some in the U.S. government have charged.

It is an interesting development. More to come.