Beijing's currency gesture fails to defuse threat of US protectionism

Who, if anyone, blinked? China's decision to alter its currency regime last week could be the momentous change of heart that the Americans have persistently demanded, a possible route towards the removal of external imbalances. Or it could be no more than a bit of economic titillation, designed to placate foreign opinion while changing little of significance as far as China itself is concerned.

From the early 1990s up until last week, China's currency, the renminbi, had been held at RMB8.28 against the dollar. Then, on Thursday, in the words of Joseph Heller, Something Happened. The Chinese announced four main revisions to their currency regime.

First, the renminbi was to be revalued to RMB8.11 against the dollar, a rise in value on the day of 2 per cent.

Second, the renminbi would now be targeted against a currency basket rather than the dollar alone, although the details of this basket have not yet been specified.

Third, the renminbi would be allowed to fluctuate against the new basket by a daily maximum of 0.3 per cent on either side of the previous day's closing price (this doesn't amount to very much because the previous regime also theoretically allowed for this margin of adjustment against the dollar: in practice, though, fluctuations were a lot smaller).

Fourth, the renminbi would be allowed to adjust in value against the basket according to market conditions: the decision over the scale of adjustment, though, would be taken by the People's Bank of China and, hence, there would be no free float.

Relative to what the Americans would like to see, this is, so far, small fry. When the US Administration was thinking earlier this year of labelling China a "currency manipulator", it held off in the hope that the Chinese would deliver an immediate and substantial currency revaluation: the Americans indicated at the time that "substantial" was to be taken as a gain of no less than 10 per cent. Last week's move falls a long way short.

Of course, if the new currency basket trades within a 0.3 per cent band on either side of the previous day's closing price, it might be possible to have a rise in the currency of 0.3 per cent per day. After 10 trading days, on a compound basis, the renminbi could be up a further 3 per cent. And after a year's worth of trading days, the renminbi could be up by around 80 per cent. Impressive numbers, but better, I suspect, at demonstrating the theoretical joys of compound interest than of providing a clue of where, exactly, the renminbi will end up over the next few months.

In fact, Friday's first full day of trading left the renminbi a little weaker against the dollar, suggesting that there is no automatic "crawling peg" that will allow the currency to rise on a steady and predictable basis.

All of this is rather good news for the Chinese authorities. The last thing they would have wanted was either a large appreciation - which would have looked like a capitulation in the face of American pressure - or a one-way bet that might have led to massive capital inflows, thereby pushing the renminbi ever higher. Instead, the Chinese authorities appear to have created a system which allows for currency adjustment only on their terms.

Consider what we don't know. We don't know how frequently the People's Bank of China will countenance currency adjustments. We don't know which currencies are contained within the new currency basket. We don't know the relative weights of currencies within the new basket, nor do we know the basis for those weights (relative trade flows, size of capital flows?). We don't know which market conditions would persuade the Chinese authorities that a further adjustment might be necessary.

In other words, despite the adjustment, and despite the US Administration's decision to welcome China's move with open arms (John Snow, the US Treasury Secretary said in the aftermath of the announcement: "I greatly welcome their commitment to using market forces, to relying on market forces to bring the currency into alignment with underlying demand and supply forces."), the reality is that most of the currency cards are still being held in China's hands. The commitment to "market forces" is still unclear and, as a result, it's difficult to be sure precisely what it is that John Snow is welcoming.

The good news is that both the Chinese and the Americans can present the adjustment as some kind of victory. For the Chinese, the move is small enough to have little effect on underlying economic conditions and, as a result, safeguards China's requirement for "sovereignty" on economic policy decisions. For the Americans, the revaluation and the dangling carrot of further adjustments to come can be described as a success for sustained diplomatic pressure thereby stymieing, for the time being, the rise in protectionist pressures. This, after all, was the biggest fear: if China did nothing, and the US insisted on a huge exchange rate adjustment, the danger was that US Congress would eventually slap large tariffs on Chinese imports into the US, thereby raising the risk of a global trade war.

With any luck, this nightmare scenario will be avoided. Congressmen Charles Schumer and Lindsey Graham had already postponed a vote on their bill to impose a 27.5 per cent tariff on Chinese imports, based on signs that China would, indeed, make reforms. With some reforms having now come through, hopefully the bill will shrivel and die. Are, though, the reforms enough?

The biggest uncertainty at this stage, at least from an American point of view, is the degree to which the renminbi appreciates further in coming months. The US authorities assume that the renminbi is significantly undervalued but studies have produced a wide range of estimates of where "fair value" for the renminbi lies.

What happens if market forces don't push the renminbi significantly higher? What happens if the renminbi is prevented from rising rapidly because of intervention from the People's Bank of China? What happens if the dollar is unusually strong? In these circumstances, and depending on the weights within the currency basket, the renminbi might have to fall in value against the US currency to preserve its stability against the currency basket as a whole.

These are, for the most part, operational issues. The broader issues are what, economically, will change as a result of China's currency reform. The renminbi might end up stronger over time. But China will remain super-competitive: its workers are willing to work for wages a lot lower than we, in the rich - and spoilt? - West are prepared to accept. The US might be able to forestall protectionist pressures for a while. But it's unlikely that China's reform, on its own, will make any difference to the persistently large US current account deficit: eventually, therefore, protectionist pressures may well return.

All in all, then, last week's changes may have been good for the politicians but, economically, it's not obvious that a lot has changed. The debate on China's role in the world economy and, more specifically, the role of its currency, has not ended: it's merely moved on to the next stage.

* Stephen King is managing director of economics at HSBC.

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