China to revalue its currency

(July 21, 2005) China today announced it would revalue the renminbi, taking market watchers by surprise by removing the U.S. dollar peg entirely, using a basket of currencies instead to set exchange rates going forward.

In addition to revaluing the currency, pushing it up 2.1% against the U.S. dollar, the People’s Bank of China says the U.S. dollar peg will be replaced by a trading band that will allow the currency to fluctuate 0.3% above or below a rate set by an, as yet unnamed, basket of currencies. The changes come into effect on Friday.

China’s growing competitiveness in trade has made the country a target for rhetoric and increasing pressure from the international community regarding its currency policy. The United States in particular has been speaking out more aggressively in recent months. China meanwhile, says the U.S. is using it as a scapegoat for manufacturing declines, and has been very careful to avoid any perception that it is bowing to pressure or being forced into making changes.

Leading up to the announcement, most Asia watchers agreed that the country would revalue at an unexpected time, once the pressure was off. But many expected China to follow the western model, and allow the currency to float.

“Frankly I think what they’ve done is masterful,” says Don Reed, president of Franklin Templeton Investments Canada. “The U.S. should be happy with this, and the Chinese, by using a basket of currencies have made it [the renminbi] stronger because they’re not reliant on any one currency. A lot of issues have been solved by the way they handled it.”

Overall, Reed says a 2% move in the currency is not expected to have major impact on Chinese investments or international portfolios since many Chinese companies that could be affected by increased costs are still owned by the state. “It’s not a big impact for investors, either positively or negatively, but going forward I think if removes some uncertainty,” he says.

Mark Grammer, vice president of investments at Mackenzie Financial, agrees that 2% likely won’t make a huge difference in the long run, but says pegging the currency to the value of a basket of currencies could have negative implications for the U.S. bond market. He says the psychological impact of the move however is positively impacting other Asian currencies.

Since the announcement, the Japanese yen and the Korean won have gained ground against the dollar and the euro.

“Certainly the yen has had a very strong move on the back of this because of expectations of a pickup in Japanese exports to China. In general I would guess that the yen would play a significant role in the new basket for the renminbi. So that’s probably why the yen is moving,” says Grammer. “On the other hand, the yen has been fairly weak of late. This may just be the excuse the yen needed for a rally.”

Filed by Kate McCaffery, Advisor.ca, kate.mccaffery@advisor.rogers.com