China move on currency largely misinterpreted

Both the stock markets and news reports have largely overstated, in my opinion, the Chinese central bank’s announcement on June 19 that it would further reform its exchange rate regime and increase the flexibility of the RMB exchange rate.

The knee-jerk interpretation -- rarely correct -- is that China is so confident about the prospects for global growth that it no longer needs the ‘stability’ of the peg to the US dollar, which was reportedly imposed during the financial crisis in 2008 to help Chinese exporters cope with the global recession.

But readers will recall that the US dollar had a tremendous rally at that time against all currencies. A Chinese currency pegged to the dollar during that time meant that the RMB also rallied against those other currencies, hurting China’s exports to those countries.

Prior to that, China had set currency reform into action in July 2005, which resulted in a roughly 21 percent appreciation of the RMB against the US dollar over three years (the RMB was not alone in that respect, as several currencies were appreciating against the US dollar at that time).

It should be noted that China’s exports did not suffer during that period of RMB appreciation, although it is important to remember that the US economy was bubbling towards exhaustion and eventual recession, in the final vestiges of credit-boom induced expansion and largess.

That is hardly the world we live in today.

The positive spin on this latest development saw stock markets record early gains, on expectations the move would benefit the world’s exporters and manufacturers -- the assumption being that Chinese purchasing power would increase by way of an appreciating RMB currency, benefiting the world’s name brands.

I don’t necessarily see it that way, since there very seldom are any guarantees in the markets. More flexibility in my view means that the RMB would be free to move in either direction of the dollar, or the Euro or any other currency.

As we have witnessed in the currency markets of late, the US dollar, so hated only six months ago, has seen a huge rally since that time, with the Euro seeing its fortunes head the other direction.

In other words, what this Chinese move will ensure more than anything else in my opinion, if seen through to full exchange rate flexibility, is that one more currency will enter this highly volatile debt-stricken world.

The Chinese view is that the reform is in line with China's long-term fundamental interests, which include boosting employment especially in the service sector, curbing inflation and asset bubbles and creating a more favorable international environment for the country’s development.

Therein lies the critical point: China is bowing to pressure, particularly from the US, to do something about its peg. But it is doing so on its terms and at an opportune moment in time.

The US dollar has rallied strongly for the last six months, as China and its exporters are very much aware. If the US dollar continues its dramatic rise against all currencies in the months, and perhaps years, ahead, then it makes a lot of sense for China to loosen its peg now.

A country attempting structural reform -- from export oriented to more reliant on internal demand cranking its economic engine, understands that such changes do not occur overnight. In the meantime, its exporters remain the main drivers of economic growth.

Year long inventory builds aside, a currency pegged to an appreciating US dollar does very little for exports to the rest of the world.

China loosening is exchange regime also does very little for a world choking on mountains of debt and struggling with debt service payments, leaving less in the coffers for imports from China.

Against that backdrop, China’s move this past weekend may be more about self-interest and positioning for a hard landing than anything else.

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