China ends dollar peg, renminbi back to pre-crisis regime

China's currency policy has returned to the framework employed before the global financial crisis, but the new environment may not be so hospitable, warn analysts.

The People's Bank of China announced on Saturday evening that the renminbi was to exit the peg to the US dollar. China will now determine its exchange rate with reference to a basket of currencies, with the trading band for USD/CNY the same as the one that existed before the global financial crisis.

On Sunday, the PBOC announced any revaluation of the renminbi versus the dollar will be modest and gradual; this announcement was made only in Chinese and seems to be a defensive move against domestic critics.

Many analysts have expected such a move in the run-up to the next G20 meeting, to be held in Toronto on June 26-27. The eurozone crisis this spring led to doubts this would happen, as it caused the RMB to rapidly appreciation against the euro, to the consternation of China's exporters.

However, last week saw the US and China both notch up rhetoric about the renminbi, and this move will defuse the issue in Toronto.

"The best way to characterise this policy move is 'switch to the pre-crisis regime'," says Qing Wang, an analyst at Morgan Stanley. "Anything that has happened under the previous regime can happen now."

China allowed a managed floating exchange rate for three years, 2005-08. From the PBoC's perspective, the resumption of the dollar peg helped mitigate the impact of the global financial crisis on China, helping China and Asia lead the world towards an economic recovery.

Qing says the yuan is likely to appreciate by 2-3% over the next several weeks as a result of the exit from the peg (reaching USD/CNY 6.60 by the end of 2010, from 6.83 today), will contain inflationary pressures, and help rebalance the Chinese economy. Qing also says the likelihood of China raising interest rates this year has faded.

Not everyone agrees with this rosy prognosis, however.

Diana Choyleva, economist at Lombard Street Research, says the move was meant to assuage US concerns and avert a trade war, but is too little, too late.

"The yuan at most is going to be allowed to appreciate 5-6% in 12 months," she says. "It is 2005 all over again. But this time the world is demand deficient, and the same policy will not work."

She predicts protectionism will continue to build in America and Europe, leading the US Congress to introduce import restrictions unless the RMB is allowed to appreciate significantly. Moreover, a slight appreciation won't address China's internal problems of overheating.

There's also the question of assuming that China's resumption of benchmarking against a portfolio of currencies will automatically lead to an appreciation against the US dollar.

Last month, Jim Walker of Asianomics told delegates at AsianInvestor's institutional investor conference in Hong Kong that the euro is sure to play a sizeable role in the currency basket. If the euro continues to depreciate against the dollar, the basket as a whole loses value, and thus the RMB will cheapen against the dollar.

However, the PBoC can be expected to be very hands-on in how it manages the currency basket, and may adjust it to prevent the RMB from losing value for long, lest the move stoke political debate, not only with the United States, but with other emerging markets that would see a cheaper yuan as a competitive threat.

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