China cuts currency ties with dollar

China has broken the link between the renminbi and the dollar after pegging the two currencies for 11 years. The break, which followed concerted American pressure, severs one of the main pillars for global economic stability in recent years.

Although such a move was anticipated at some point it was not expected so soon. The Chinese announcement was quickly followed by a similar move from Malaysia – leaving the Hong Kong dollar the only Asian currency pegged to the greenback.

Last week’s statement by the People’s Bank of China outlined the new “managed floating exchange rate regime”, while leaving out important details. The exchange rate for the renminbi against the dollar was immediately lowered 2% to 8.11 from 8.28. In future the renminbi will be allowed to float against a basket of currencies – although the composition of the basket was not revealed. The maximum that the renminbi is allowed to move in one day will be plus or minus 0.3%.

However, the central bank left open the possibility of further changes to the system in the future. According to the statement: “The People’s Bank of China will make adjustment of the RMB exchange rate band when necessary according to market development as well as the economic and financial situation.”

The move is likely to create several winners and losers. Beneficiaries are expected to include nations that compete with China, such as Turkey (textiles) and Mexico (manufacturing), as well as the euro and Asian currencies. Losers could include the dollar, US treasuries and commodity prices.

Richard Batley, an economist at Schroders, downplays the shift’s significance. “From a long-term perspective nothing has changed,” he says. He does not see it as having a large impact on China’s trade balance, as it remains “a very competitive producer”. China is also likely to continue substantial purchases of American treasury bonds.

However, others see China’s move as the start of an important trend. Yianos Kontopoulos, global foreign exchange strategist at Merrill Lynch, says: “This is likely the first of many chapters of Chinese FX regime adjustment.” (Merrill Lynch “Cause & FX”, July 21, 2005).

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