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China Loosens Grip on Yuan

If there is one thing that has been as reliable as the sun rising daily over the course of the last couple of decades, its the fact that China manipulates its currency and that the US follows by deeming China a currency manipulator. Interestingly enough though, this “broken record” type situation may soon be coming to a close.

As China has faced massive problems with liquidity in its deregulated shadow banking sector as well as a credit crunch that has plagued the country recently, concerns about growth and credit stability have taken center stage. (WSJ) Chinese financial leaders seem to now be realizing that steps need to be taken in order to improve their own global financial position and that means taking a look at their currency.

The Chinese have what is referred to as a “pegged currency” — they control or peg their exchange rate to another currency (ie: the USD) in an attempt to make trade easier for all parties involved and keep expectations constant. One of the side effects of a mechanism like this is the weakening of the pegged currency and the loss of the ability control interest rates and money supply — because you constantly have to be able to absorb any increases in supply as well as satisfy any excess demand as well. China does this in order to make their exports cheaper in foreign currency terms. As we have talked about in class, a weaker Yuan leads to more demand for the currency due to cheaper exports, which leads to a higher GDP.

The sustainability of a mechanism like this has always been scrutinized but has never seemed to bother China (and why would it with 10% y/o/y GDP growth) but that seems to be changing before our own eyes. In China’s pegging scheme, the central bank controls the range in which the Yuan/USD is allowed to fluctuate (See the image below)



This range has been about 1% movement in either direction historically but the central bank is rumored to be preparing to let it broaden to 2 or 3% in either direction. (WSJ) Now while that may not seem like much, it may signify the fact that China is realizing that its economy is changing and is ready to adapt (the call being for a free floating currency eventually). The WSJ article also points out that another motivation for the movement to a free floating currency may be that China’s real goal is to overtake the dollar as the world reserve currency eventually. This seems like something of a pipe dream, but enough people use the Yuan that it might not be out of the question. All in all the loosening of the currency grip will be a good thing for the dollar and the US because it may force outflows to China to stay in state and boost GDP here.