China Extends Olive Branch

The revaluation of the yuan calms fears of a trade war.
Author:
Publish date:

It used to be said about China that changes in its society were measured in cycles of thousands of years. Nowadays, China is moving at a much faster pace.

The Beijing government Thursday took a first step toward un-pegging its currency from the U.S. dollar. The move comes only 10 years after the peg, which has kept the value of the currency at 8.27 against one dollar, was put in place.

Despite the relative haste, the move remains minuscule in scope. The People's Bank of China said the immediate result of Thursday's action would be a 2% revaluation of the yuan to 8.11 against the dollar.

"This is an utterly cosmetic, unbelievably small and inconsequential move that China took before

president Hu Jintao comes to the U.S.

in September," says Dennis Gartman, who writes daily on global investments in the

Gartman Letter

.

Amid mounting trade tensions between the U.S. and China over the yuan peg, which has kept Chinese exports cheap and made U.S. goods less competitive, this is simply "a gesture of goodwill," Gartman says.

The announcement, however, took most people by surprise, creating big moves especially in the foreign exchange and bond markets. "Markets were expecting a 3% to 5% move, and not until the end of the year," says Ashraf Laidi, currency strategist at MG Financial Group.

The dollar and U.S. Treasuries fell on the news, as traders assumed China would increase its purchase of nondollar currencies and assets to manage the new currency regime.

The yen was the biggest gainer, rising over 2% against the dollar, while the euro added 0.2% vs. the dollar, after rising close to 1% earlier in the session. The benchmark 10-year U.S. Treasury bond fell sharply, losing 25/32 while its yield rose to 4.26%.

Another short-term impact of the revaluation is an easing of concern that escalating tensions between China and the U.S. over the yuan could spark a trade war and seriously damage the global economy. "This is a definite plus in that it will help wet down the fires of protectionism and the threats of punitive tariffs," says Don Straszheim, chairman of Straszheim Global Advisors, a financial research group specializing on China.

The other implications of this first symbolic move remain mired in short-term uncertainties. First off, early headlines on the subject implied that the yuan would now start from a peg of 8.11 against the dollar and be allowed to float either up or down by 0.3% on a daily basis.

But upon closer reading of the PBOC's announcement, the yuan will be pegged to the closing price of

"a"

foreign currency, selected from a basket of currencies on a daily basis, notes Carl Weinberg, chief economist at High Frequency Economics.

"For today, the lucky currency is the U.S. dollar and the par rate is 8.11, but it seems that it could be any currency and any rate tomorrow at the PBOC's pleasure," Weinberg wrote. "Around this central parity rate

du jour

, a 0.3% variance will be tolerated."

Against other currencies, aside from the pegged one, the yuan would be allowed to move within a certain range that has yet to be announced.

"There are still many questions about this and there's still a lot that we don't know," says SGA's Straszheim.

"What's for sure is that they'll retain the right and the flexibility to revalue the yuan at whatever pace they want, and there's absolutely no guarantee that

against the dollar and others it will really be allowed to move by 0.3% every day. It'd bet my hat on that," he says.

"But the key is that this is a first step toward embracing market influence. We believe there will be a sequence of further steps. We just don't know how quickly they'll go."

Straszheim believes China is working with a three-year time horizon. In 2008, China will host the Olympic Games and wants to be considered a full member of the international community, with a floating -- or close to floating -- currency by then.

Whereas the small scope of the move may have some doubting any real impact on currency markets (and ultimately all other markets), the door has been left open for massive speculation, writes Yianos Kontopoulos, global forex strategist with Merrill Lynch.

"Whether deemed insufficient or not, final or not, the Chinese move will reverberate over the rest of the forex markets and beyond. We believe it will be a mistake to dismiss it under any circumstances," he says.

Proceeding at a very slow pace, the revaluation would eventually allow an adjustment of trade imbalances between China and the U.S. and with other major economies. The undervalued currency has kept Chinese exports cheap, hurting the exports of U.S. and other major economies, arguably throughout Asia.

"This is the beginning of the end of the cycle of dollar weakness," Kontopoulos believes, although he concedes the adjustment could take many years.

Until then, if the yuan does indeed continue to appreciate at a slow pace, Chinese exporters paying less for dollar-denominated raw materials will have no incentive "to trade-off

this margin boost for market share by cutting prices," writes Bank of America strategist Tom McManus.

"We anticipate scant declines in China's export volumes given its huge competitive advantage at exchange rates near the old peg," he says.

It would take a 15% to 25% appreciation of the yuan against the dollar for U.S. importers -- such as retailers -- to cut back on Chinese imports, McManus says. By then, importers would likely "find it difficult to pass along price increases to low-end U.S. consumers who are already paying more for energy and short-term money."

The negatives of such a yuan appreciation would also be felt by the many U.S. companies, such as

Wal-Mart

(WMT) - Get Report

, and non-U.S. companies that rely on low-cost production -- mainly cheap labor -- in China and throughout Asia. Repatriating profits in the home currencies, however, could partly offset higher costs.

In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He appreciates your feedback;

click here

to send him an email.