Free Floating Yuan: The Real Story

The biggest news in the world today didn’t actually happen. Conspiracy!

“China Eases Currency Peg,” The Wall Street Journal announced yesterday. The Journal, along with every paper in the world, has something to say about China’s groundbreaking move Sunday. At long last, we’re told, China has agreed to end its currency manipulation agenda and allow the yuan to float freely.

Or did they?

“The People’s Bank of China has decided to proceed further with reform of the RMB exchange rate,” read the country’s actual statement. The Chinese government noted that it was now “desirable” to stop fudging the yuan, but didn’t actually announce a plan to do so. In fact, the brief statement made it quite clear that “the exchange rate floating bands will remain the same.”

In other words, keep cool. All we really know is that China has “decided to proceed” with reform and will – eventually – “enhance the RMB exchange rate flexibility.” As Treasury Secretary Geithner noted, “The test will be how far and how fast they let the currency appreciate.”

If China insists on acting so… Chinese… We expect the change to occur in painfully slow motion and in a limited range.

After all, China has a massive export economy to protect. In fact, China will be the biggest manufacturing economy in the world by 2011. At latest count, according to a new IHS Global Insight study, the US accounted for 19.9% of the global production. China is good for 18.6%. Sometime over the next year, the firm says, the inevitable will occur, and China’s 1.2 billion citizens will start producing more than ours.

Unless, of course, they let the yuan get too strong.

Nevertheless, the yuan is back in en vogue today. Traders bought the currency up 0.42% overnight – its biggest move since its 2005 revaluation.

Free Floating Yuan

Still, at 14 cents, there’s a long way to go before the yuan is even close to a level playing field with the US. If history is any guide… buy the dips.

In the long run, a stronger yuan is just another – very powerful – argument for China’s booming middle class. The Chinese have proven their appetite, for a lack of a better phrase, for “Western living.” Recent labor strikes and labor disputes have demonstrated that the young Chinese poor are ready to give up their role as the world’s cheapest labor. And now a stronger yuan… to boost their purchasing power?

“A stronger local currency might mean China is changing gears in its economic growth plan,” Dan Denning affirms our suspicion. “That is, rather than relying on export-driven GDP growth, it will shift toward more domestic demand (people spending money). According to The Financial Times, consumption as a percentage of GDP in China has actually fallen from 45% to 35%. In other words, Chinese economic growth has become even more export reliant.

“Is that changing now? Hmm. We’ll see. For Australia, there’s an argument to be made that a stronger Chinese currency is bullish for commodities. China can use its stronger currency to buy more tangible assets and fewer US Treasury bonds. And maybe the unleashing of Chinese domestic demand will boost demand for certain Australian resources that are used in the production of finished consumer goods and not capital goods.

“The other take on the China move is that it’s a race to the Keynesian bottom globally now…it could be that the mantle of leadership for engineering global inflation has shifted East over the weekend.”

Ian Mathias
for The Daily Reckoning