China signalled it will allow its currency to appreciate against the U.S. dollar, bowing to international pressure days ahead of a visit from U.S. President Barack Obama.
The move to allow the yuan to rise against the greenback would provide much-needed relief to countries trying to compete against China's mighty export machine and put further downward pressure on an already battered U.S. dollar.
China's latest quarterly monetary policy report said its foreign exchange policy will now consider "capital flows and changes in major currencies," indicating China will carefully expose the yuan's value to fluctuations in global markets.
The statement avoided the government's usual boilerplate language of keeping the yuan "basically stable at a reasonable and balanced level."
China's trading partners have complained the government keeps the yuan at artificially low levels, providing an unfair price advantage for China's goods as they compete for market share around the world. Until now, China has largely ignored calls for greater currency flexibility.
The decision to allow the yuan to climb also points to the maturing of China's rapidly expanding economy, while giving its people and companies more purchasing power for goods and assets produced outside the country.
"China is exporting blood and sweat and importing copper and oil. Is that really good in the long term? You are sacrificing the local people's purchasing power in pursuing export growth," said Na Liu, China analyst at Scotia Capital.
The rise in the yuan is expected to be gradual and is not likely to occur until next year. Still, China is likely to quickly draw increased capital flows into the country as international investors aim to benefit from an eventual rise in the currency and local assets. But that trend brings the risk of potential unsustainable bubbles in its real estate and stock markets.
Other Asian exporting countries such as South Korea, Singapore and Thailand, which should be able to compete better with China as the yuan appreciates, are likely to follow suit and let their currencies appreciate as well.
"A little gradual appreciation in the yuan will not naturally hurt China's exports because other Asian countries will follow," Mr. Liu said.
China's currency has been pegged to the U.S. dollar since July of 2008 in an effort to shield exports from the global recession. But the latest economic data released Wednesday suggest a recovery is well under way in China. Industrial production rose 16.1 per cent in October, the most since March of 2008. Exports declined 13.8 per cent, the smallest drop recorded this year.
"It was inevitable," Benjamin Reitzes, an economist at BMO Nesbitt Burns said of China's hint it will shift its foreign exchange policy.
"The reason they can do it now is because they see external demand from the global economy is improving," he added.
Most G20 nations have been unhappy with China pegging the yuan to the U.S. dollar and many have publicly criticized the policy for exaggerating the trade imbalance between China and the United States. China revalued its currency in 2005, allowing the yuan to appreciate 21 per cent against the U.S. dollar before halting the rise in the middle of last year.
The latest Chinese announcement, coming just days before Mr. Obama is due to make his first visit to Beijing, is as much about politics as economics, experts said.
Charles Freeman, a former assistant U.S. trade representative for China, said the Chinese are willing to let the Americans get something to show the U.S. Congress they're working to defuse trade tensions. But "precipitous growth" in the value of the yuan is unlikely, he added.
"We're going back to the slow march that we had before China started really worrying about their own economic recovery," said Mr. Freeman, who now holds the China chair at the Center for Strategic and International Studies in Washington.
"It's a cautious, go-slow approach. If their exports slow a lot and domestic demand weakens, the Chinese will slow appreciation of the yuan again."
And any impact on Chinese exports or the U.S. trade deficit with China is likely to be small. Mr. Freeman pointed out that, as the yuan appreciated against the U.S. dollar and other currencies after 2005, China's current account surplus kept growing and the U.S. trade deficit continued to swell.
"The currency issue is a popular thing to talk about," Mr. Freeman added. "But as far as the U.S., Canada and the rest of the developed world is concerned, it doesn't matter to us whether the products are assembled in China or Vietnam, we're still going to have a deficit with Asia."
But others see more sinister motives in the Chinese move. By resuming a yuan peg to a basket of international currencies, the biggest winner is likely to be the euro, not the dollar, said Peter Morici, former chief economist at the U.S. International Trade Commission. "That makes it more difficult for the Americans to complain, and the Europeans less likely to help lobby the Chinese," he said.
Nicholas Lardy, a senior fellow at the Peterson Institute for International Economics in Washington, said China is caught in a "dollar trap." It has as much as $1.6-trillion worth of U.S. dollar reserves and there are few options to diversify into other currencies. More worrying to them than a slightly higher yuan, he said, is the prospect of a more precipitous erosion in the value of the dollar, weighed down by U.S. inflation and swelling budget deficits. A falling dollar means China will take hefty losses on those reserves, Mr. Lardy pointed out.