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July 22, 2005
China revalues
Out of town and blogging sporadically, I should have known something like this would happen.
By now you've heard that China dedicded to revalue the yuan by about 2 percent. That is enough to get the market's attention, to be sure; but it's not as much as what some politicians wanted. Nor is it sufficient to really affect our economy right away. It won't fix the trade deficit.
In case you, like me, have been away from the news for the last 24 hours, you can catch up here and here, for starters. You can also check out the blogosphere-- macroblog, Economist's View, Max Speak, Dan Drezner, Brad Setser, and a Wall St. Journal Econoblog featuring Dave Altig and Nouriel Roubini just to name a few.
Kash at Angry Bear rightly realizes that this small move could actually prompt more speculation (Setser and Roubini note it as well). Remember various devaluations in history that prompted capital flight because the initial devaluation wasn't big enough? Well, this is the same prinicple working in reverse. One thing that can prevent it is for the Chinese central bank to do a good job of managing expectations. Keep a very close eye on this over the next few months.
King at SCSU Scholars as well as the Altig and Roubini Econoblog mention this post of mine. So let me tell you what was going through my mind when I wrote that.
I did mention the principle of macro/monetary theory that says that you can't have free trade in assets, fixed exchange rates, and independent monetary policy (you can have at most two of the three). I honestly did think about connecting the dots, but decided in the end to leave it to the reader (I have excellent readers who did notice the connection). I really didn't expect it to happen before the end of the week. (Who did?) But like many of the econobloggers out there, I figured something was definitely building. In that respect, the announcement on the lifting of capital controls earlier this week did seem to be almost a necessary step in a sequence of events--as a signal if nothing else. So while I didn't think it would be this week, I can't say I fell out of my chair with surprise. The combination of the relaxaton of capital controls (assuming it's more than just a token gesture) and today's announcement on the exchange rate are important steps in China's macroeconomic development. But it is just one more step--neither the first, nor the last.
Here's what I thought about the timetable to revaluation back in April.
A few years ago, it might have been 2002, I was asked when I thought China would begin to relax their exchange controls in a meaningful way and begin to float. At that time, I answered somewhere between 2008 and 2012, and that it would be gradual, perhaps taking that entire range of years to complete. Funny thing is that today I'm less sure. I don't think I have the confidence to give a range like that now. If pressed, my answer would probably be about the same, but with less confidence. There would be something to be said for beginning before the Olympics, but that's really going out on a limb.
How things change. More recently, I would have probably expected something by the end of the year, or more conservatively in 2006. I was still off by a bit.
I also said this at a moment when the game theory implications made me throw up my hands. So did China choose summer to make the move when Wall St. traders are vacationing in the Hamptons? Just a thought. I think the intention all along was to create an atmosphere where some movement would be expected, but no one would know the day. I'd say it worked.
The bond market took it as well as could be expected. The 10 year lost almost a point, but that's not bad all things considered. The yield curve looks a little more respectable, though I wouldn't take any extra undue joy from that. Besides, there is likely to be some further adjustment over the next few days as the market gets used to the new normal. Let's watch it for a few days. Certainly by the next FOMC meeting we might have some interesting things to say about it.
I agree with the consensus that this will not have a huge effect in and of itself. It is significant that China is no longer exclusively pegging to the dollar. But again, this isn't going to cure our trade deficit or lead to any other massive implications in the short term.
I do believe, however, that this is just one step in a long road. The pace may quicken or it may remain (dare I say) measured. I have said in the past that China will not make any moves until they feel it is time for them. I think that still applies to the endgame. You won't see complete convertibility or a true floating exchange rate for a long time. China has a lot of work to do before then. They also have to continue to build their monetary reputation. If they are able to maintain control over the rate within the band they have set out, it will go a long way towards building that reputation and moving the day of full convertibility closer. If today's move only turns up the speculative heat, then they may have moved too soon.
But for now, I'm optimistic that this very gradual change will be interpreted correctly. China is earning a reputation, and I don't think they will squander it. After one day, I'd say they should be very happy. Now comes day two...
What does this mean for the Fed and policymaking in general? Let's leave that for another day. So far, not much. 2% isn't going to throw a huge crimp in Greenspan's style. As time goes on, if there is further movement, you can be sure that I will have more to say.
And that's where we are. Everyone wants to say something, but what do you say that hasn't been said already? And there are some aspects on which comment is rightly reserved until we see how the market adjusts. We've been expecting it for a long time, but with little or no idea of when it would happen. Now realizing that the immediate impact will be little more than a ripple, we are left to ponder when and how the next move will take place and whether this will quell the speculation or encourage it. Despite the flurry of activity today, this story will play out over weeks and months.
But it sure is exciting, isn't it?
Posted by William Polley at July 22, 2005 1:08 AM
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Comments
My small contribution was to comment on Dean Baker's Maxspeak post - and then take a whack at Darda's NRO "analysis". We came late to the party - and all the punch was gone!
Posted by: pgl at July 22, 2005 4:35 PM