China's surprise pledge to allow its currency to begin appreciating marks a significant shift in policy that will eventually help rebalance global trade and accelerate an economic shift within China towards growth driven by its own consumers.
Although any rise in the value of the Chinese yuan is likely to happen gradually, the country's central bank signalled over the weekend that it will abandon its policy of keeping its currency closely tied to the U.S. dollar, which it has done since the financial crisis of 2008.
By allowing the artificially weak yuan (also known as the renminbi, or RMB) to rise in value against the greenback, policy makers risk hurting China's key export sector by makings its goods more expensive to foreign buyers. But a stronger currency will boost the purchasing power of China's consumers and businesses - and bring the country closer to achieving its goal of establishing a more self-sufficient economy, driven by domestic demand.
The move will also help control inflationary pressures that have recently emerged in the world's third-largest economy and may allow China to avoid implementing further tightening measures, such as a rise in interest rates.
"China's leaders have increasingly come to recognize that, despite short-term pain for exporters, a more flexible exchange rate and a stronger RMB also bring many benefits to China over the long term, and put its economy on sounder footing," said Patrick Chovanec, a business professor at Beijing's Tsinghua University.
The unexpected announcement comes ahead of this week's Group of 20 summit in Toronto and will serve to relieve political pressure on China's government from foreign leaders who argue that the undervalued yuan gives its exporters an unfair advantage. That pressure has been building ever since new data showed that exports from China surged 48.5 per cent in May from a year earlier, sending China's trade surplus rocketing higher to $19.5-billion (U.S.) from $1.7-billion in April.
How far a stronger currency will go toward bringing down that surplus depends on how far the government allows the yuan to rise. When China permitted the yuan to float against the U.S. dollar between 2005 and 2008, its value increased by more than 21 per cent.
However, no one is expecting that kind of increase in the immediate future. RBC Dominion Securities is forecasting China will permit a 1.9 per cent increase in the yuan against the greenback by the end of the second quarter and a 5 per cent increase by the end of 2010.
Sebastien Galy, currency strategist at BNP Paribas in New York, was more cautious, saying there is the potential for 3 per cent increase by year-end. "It is more than likely the [Chinese]authorities themselves are unsure as it will depend on the strength of the global economy," Mr. Galy said.
In explaining its decision, the People's Bank of China (PBOC) said on Saturday: "The global economy is gradually recovering. The recovery and upturn of the Chinese economy has become more solid with the enhanced economic stability. It is desirable to proceed further with reform of the RMB exchange rate regime and increase the RMB exchange rate flexibility."
However, on Sunday, the PBOC moved to temper its announcement, saying in a separate statement that major changes in the exchange rate were "not in China's interest," and that the Chinese currency would remain "basically stable."
For much of the year, market analysts and currency strategists have expected China to allow the currency to rise from the 6.83 yuan per U.S. dollar peg it has implemented since July of 2008 in response to the global economic downturn. However, the sovereign debt crisis in Europe and concerns about a drop in demand for exports prompted China to hold off on any moves, despite calls from foreign governments including Canada to remove what they deemed an unfair advantage for Chinese manufacturers.
"Concerns about the weak euro and euro area have clearly played a role in delaying a move," RBC analyst Brian Jackson said in a report.
"But we have remained confident that such a move would occur based on our view that it would be in China's own best interests - a stronger yuan would not only help prevent trade tensions from developing later this year but, more importantly, would help keep China's recovery on a sustainable path and to rebalance its economy," Mr. Jackson added.
China has kept its currency pegged to the U.S. dollar by using the yuan to buy U.S. Treasuries and keeping the exchange rate essentially fixed. The yuan has, however, already surged 14 per cent against a skidding euro so far this year, increasing costs for Chinese manufacturers exporting goods to China's largest export market.