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About the Chinese currency reform


Tags Monetary Theory


So yesterday it finally happened:-the yuan was revalued , after years of pressure from particularly the U.S. government but also the EU and Japan. However the move was much smaller than expected, a mere 2.1%. This will hardly satisfy Senators Smoot Schumer and Hawley Graham (as Larry Kudlow likes to call them). Contrary to what some people seem to think, this currency reform will not mean that the yuan will float. China will continue to peg its currency, only now to a basket of currencies whose composition will be kept a secret, rather than to the dollar alone. This is the system Singapore has had for years and Malaysia also announced yesterday that they will switch their peg from the dollar alone to a basket of currencies.

Surprisingly Hong Kong, the third Asian country whose currency were formally linked to the dollar [through a currency board], announced that they will keep the link to the dollar even though this will in effect mean that they will [albeit only to a lesser extent as the yuans movements against the dollar is likely to be small]sever the indirect link to the yuan. Normally fixed exchange rates are with the currency of the largest trading partner, and China are a much bigger trading partner than the U.S. for Hong Kong. Ironically, this new system could mean that the yuan could again weaken against the dollar, if the recent rally of the dollar versus the euro and the yen continues and the yuan could perhaps fall below the old 8.28 exchange rate. What will then the effects of this reform be?

A larger increase in the value of the yuan would have resulted in a higher U.S. consumer price inflation both because of the rise in prices of Chinese import goods and because of the rising commodity prices that a stronger yuan would have resulted in ( A stronger yuan means that dollar-denominated commodities will be cheaper for the Chinese, increasing their demand).

Moreover, the likely reduction in the U.S. trade deficit would have translated into a lower capital inflow into America which in turn would have pushed up interest rates. These effects would have been reinforced by the likely rise in the value of other Asian currencies that would have likely followed as many other Asian central bankers would have felt more relaxed about letting their currencies appreciate if the yuan rises in value too. But a 2.1% exchange rate rise will have virtually no effect on the trade deficit and bond yields and consumer price inflation will hardly be affected at all either. And because the yuan is pegged to a basket of currencies, exchange rate movements against the dollar will likely be small.

And while this move has in the short-term mildened criticism of China from western politicians, if it turns out that the final effect is a mere 2% appreciation or less, the Schumer-Graham tariff bill will likely be revived again. So unless this move is followed up by another revaluation of a larger magnitude, this move will for all practical purposes only be a symbolic move, probably intended to postpone western protectionist measures.

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