China Hints at Further Appreciation of Yuan

With the U.S. pressuring and inflation a concern, China could allow the yuan's value to rise further vs. the dollar. But Beijing won't be rushed

by David Cohen

The May 18 actions by the People's Bank of China (PBoC)—hiking interest rates, raising bank reserve requirements, and widening the daily trading band for the dollar-yuan—appeared timed to attract attention ahead of the May 22-24 summit between U.S. Treasury Secretary Henry Paulson and a Chinese delegation led by Vice-Premier Wu Yi.

In addition to an apparent effort by the Chinese central bank to prevent overheating in the economy, Beijing was sensitive enough to Washington's political pressure to at least make a gesture of reassurance regarding its intention to move toward letting markets set the value of its currency. It remains to be seen whether that will actually translate into acceleration in the pace of the yuan's appreciation, though.

The PBoC hiked its benchmark one-year lending rate by 18 basis points, to 6.57%, and one-year deposit rate by 27 basis points, to 3.06%. This was the first rate hike since March, and the fourth hike since April, 2006, in the face of recent renewed momentum in the Chinese economy. The PBoC raised the bank reserve requirement by 0.5 percentage points to 11.5%, the eighth increase in 11 months, in a continued effort to absorb the explosion in liquidity resulting from daily intervention in foreign-exchange markets.

Dander Rising

The Chinese central bank also widened the U.S. dollar-yuan trading band to rise or fall by 0.5 percentage points daily, from 0.3 percentage points previously. As the prior daily trading band was rarely confining for the dollar-yuan relationship, which has been effectively constrained by daily foreign-exchange intervention, the move could be viewed as a signal that Beijing is prepared to tolerate faster appreciation in its currency.

Cumulative yuan appreciation vs. the greenback now stands at 5.8%, on top of initial 2.1% revaluation upon unpegging the Chinese currency from the dollar in July, 2005. The yuan is widely viewed as undervalued, as reflected in a substantial current-account surplus, and together with the deficit in the U.S., it constitutes one of the two most significant "global imbalances" in the world today.

In the U.S., the temperature has been heating up ahead of the May summit as a House of Representatives committee this month opened hearings on Chinese currency practices, and last week lawmakers formally asked the Bush Administration to investigate whether China practices "currency manipulation." (In its twice-yearly report to Congress on the forex practices of key U.S. trade partners, the Treasury Dept. in December declined to name China a currency manipulator, welcoming steps Beijing has taken to let the yuan rise in value but urging faster movement.)

Gentle Persuasion

But the risk of protectionist sentiment sparking a disruptive trade war remains. Paulson, after returning home from his trip to Beijing last September, was able to persuade U.S. Senators Charles Schumer (D-N.Y.) and Lindsey Graham (R-S.C.), co-sponsors of a threatened 27.5% tariff on Chinese goods, to delay further vote on their bill. They recognize that it would be counterproductive to lean too hard on Beijing, which has made it clear that it will continue to pursue exchange-rate liberalization at its own pace. Though the U.S. filed a formal complaint on Chinese export subsidies and discrimination against imports, beginning a formal process under World Trade Organization rules, this might be viewed as another bargaining chip to encourage China to permit a more rapid appreciation of the yuan.

Paulson recently said that he would keep trying to persuade China to let markets set the value of its currency, although he added that this wouldn't eliminate the U.S. trade deficit with China. There's still the possibility that under U.S. pressure Beijing might allow faster yuan appreciation, though China so far has resisted. The yuan has risen 3.6% in the eight months since Paulson's September visit, exceeding cumulative appreciation during the previous 15 months.

The yuan's relatively modest appreciation vs. the dollar has had limited impact upon the robust Chinese trade performance, which showed a surplus of $63.