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September 28, 2006
Currency sleight of hand
Probably one of the more frequent comments from the Chinese on the yuan is that they do not have a timetable for revaluation. Yet the gradual appreciation of the currency continues--too gradual for some tastes, but appreciation nonetheless.
What if they did have a timetable? Well it would be a little like the Fed telling us what short term interest rates will be in January. If it is credible, it would anchor expectations and force the rebalancing of millions of dollars in various portfolios. Having no timetable means that the uncertainty remains and keeps a lid on speculation.
It is that last part that is particularly important to the Chinese. What we see as currency manipulation is their attempt to discourage speculation. Hence, now that the yuan appears to be revaluing a little faster in recent days, it may be the beginning of a new phase of their transition to a more flexible currency. The next phase may get interesting, so says Bloomberg:
Sept. 28 (Bloomberg) -- The yuan's gain may slow, after the biggest monthly advance since a link to the dollar ended last year, on speculation China's central bank will engineer two-way moves in the currency, Royal Bank of Scotland Plc said.
China may have allowed the strengthening to undermine the case for U.S. tariffs on Chinese goods as two senators mull a vote on sanctions, said Hong Kong-based strategist Ben Simpfendorfer. Wider swings create greater potential losses for traders speculating on a higher yuan. A central bank spokesman declined to comment on whether it will buy or sell the currency.
``The central bank is hesitant to allow one-way movement'' in the yuan, Simpfendorfer said in an interview. ``The central bank wants to create more two-way risk to prevent speculation on appreciation building up. That's not what we're getting.''
Checking the archives, I first did a post on this aspect of the question back in March of 2005. It still seems relevant.
When I teach international macro, I spend a day on exchange rate forecasting and explain why it is better to be consistently on the right side of the forward rate with your forecast than it is to have a smaller absolute error on the wrong side of the forward rate. This is because the forecast relative to the forward rate determines whether you will go long or short on the dollar. Pick the wrong direction and you lose.
So I can intuitively follow what the the Bank of Scotland's analysts are thinking China might do. The may want to add some uncertainty even about the direction that the yuan might go in the short term (weeks) even though the long term trend (years) will certainly continue in the direction of appreciation. If they play it well, it could stem the tide of speculation be making it riskier to play off of short term forecasts of the spot rate.
Now that is a bit more manipulative than the current scheme.
While it certainly is possible that is what they are doing, I'm not convinced yet. I think it bears very close watching to see if they reverse course in a month. Certainly the current (i.e. last few days) of appreciation will not continue much longer, I wouldn't bet that they would necessarily reverse.
And that is exactly what they want, isn't it?
Now before you go thinking that this is the kind of manipulation that we need to retaliate against, think again. When (and I do mean when) the yuan is finally floating at something approximating a free market value, the volatility of the yuan will have to approach that of the dollar, euro, and yen. Betting on appreciation cannot remain a sure thing forever. So if you are on the path to reform but you don't want to be led around by the financial markets, doesn't it make sense to try not to be too predictable? They need to be able to pull a rabbit out of a hat every once in a while--hence the title of this post, "currency sleight of hand". Watch what they do as well as what they say, because the two may not always agree.
It's unfortunate that it has to be this way (assuming the Bloomberg article turns out to contain a good prediction) because it does smack of manipulation. However it is not all that dissimilar to the communication dilemma faced by our own Federal Reserve. If you lay a timetable in front of the markets it does tie your hands. But although there is some similarity in the dilemma, the implications are different. While a clear communication strategy might lead the Fed towards a policy rule (which some would regard as a good thing), strict adherence to a policy rule is probably not in the best interest of a developing country which must balance so many policy goals. As we have seen so often, the stakes are rather high for developing countries.
It is going to be extremely interesting to see how this plays out. I'll be watching it closely. It certainly does seem reasonable for China to start widening the band. American's need to be aware that this means more volatility and more of an appearance of manipulation. So when the complaints start coming, just remember you heard it here first. Looking at the long view, this could turn out to be a very positive step. And while the politicians may spin the recent trend in yuan appreciation as a result of our tough talk by certain senators, I think that would be arrogant and naïve. The discussions between Secretary Paulson and the Chinese leaders are likely to have been a lot more nuanced--getting to the nuts and bolts of how to pull off the biggest feat of prestidigitation in currency history. That is, getting to the question of how to proceed with a substantial revaluation of the yuan without letting anyone see how you're doing it. At least I hope that is the case.
Postscript: The Bloomberg article concludes:
The yuan's 12-month forwards rose to the highest since at least 1998, suggesting traders are raising their bets on the currency's appreciation. One-year contracts show traders are betting the yuan will strengthen to 7.6445 in a year, compared with 7.6545 yesterday. That would mean the currency would rise 3.2 percent in that period.
Put that in the file to be revisited later.
UPDATE: See also Felix Salmon's post at Economonitor. There are a couple of nice items on the RGE main page about China as well.
Posted by William Polley at September 28, 2006 03:47 PM
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