Will China abandon its currency peg to the dollar?

The issue of whether the Chinese Renminbi (RMB) should be revalued has vexed the US authorities for several months and tensions have become heightened ahead of President Hu's visit to the US on April 12th.

The impasse over the RMB has arisen because the US believes the Chinese are keeping the currency artificially low by pegging it to the dollar, allowing China to sell more exports and adding to an already a massive trade surplus.  The situation is complicated by the fact that much of China's foreign exchange reserves are invested into US Treasuries that the Obama administration is desperate to sell to finance the large US fiscal deficit.

Ted Scott, Director, UK Strategy at F&C, acknowledges that relations between China and America have not always been so strained, but rather mutually beneficial and symbiotic, prior to the credit crunch.

Scott commented: "In the years before the recession, the US consumer embarked on a huge spending binge, much of which was spent on cheap Chinese exports which boosted China's economy via its export sector and underpinned the boom in the US economy. At the same time, China's purchase of US Treasury bonds helped finance the growing twin trade and budget deficits. However, once the recession took hold, the US consumer retrenched and unemployment quickly climbed towards 10%, remaining at 9.7% despite some evidence of economic recovery. The US regards the Chinese policy of intervening in the foreign exchange market with hostility as they consider it impedes the US economic recovery and effectively prevents job creation."

A war of words has followed in recent weeks but, in the last few days, the Chinese have alluded to a change of heart. The deputy director-general of the Chinese Financial Research institute stated that the RMB's trading range could be allowed to widen, so letting it appreciate against the dollar. Also, the Governor of the People's Bank of China hinted that an exit from the dollar peg could be soon by saying the policy was being used to weather the financial crisis.

These statements, in Scott's view, were couched in tentative language and it would be wrong to read too much into them, but it should be remembered that the RMB was allowed to gently rise against the dollar by about 20% in the years before the recession. Once the Chinese export sector was hit hard by the global downturn, the authorities re-pegged the RMB to the dollar.

Scott anticipates one problem the Chinese authorities face is that the RMB being fixed against the dollar has attracted a lot of speculative money from buyers expecting the RMB to be revalued at a later date. This expands the money supply and increases the risk of inflation, which has started to show signs of becoming a problem as the economy has recovered faster than expected. Scott believes this is the catalyst that may have prompted China to rethink its foreign exchange policy, rather than the constant criticism by the Americans, which is likely to render the Chinese administration, if anything, more intransigent.

"To discourage the speculators, China may not decide to have a one-off revaluation or even allow the RMB to gently appreciate against the dollar as before. It may allow the RMB to float (i.e. down as well as up) as the Chinese official suggested in his statement. This will make it more difficult for the speculators to have a one-way bet against the currency and, at the same time, provide some comfort to the US if and when the peg is removed," Scott concluded.