The first question that should be asked following China’s recent move to loosen its currency peg is what this means for Chinese exporters. Since many Chinese firms have thin margins, it’s often said that a small rise in the renminbi could wipe out their profits. But similar fears were widespread when the renminbi last began climbing in 2005, and despite a 20% gain over three years, Chinese manufacturing certainly wasn’t put out of business.

That’s because while margins in low-end industries like textiles and toys were around 2-4% before appreciation started, they remained the same afterwards, according to Capital Economics. While firms have no pricing power individually, collectively they were able to push up export prices to compensate for the stronger renminbi, while also cutting costs.

It seems likely that the same will happen this time, especially since any gains are likely to be slow. While policymakers who campaigned for the currency peg to be relaxed may have won the first argument, pro-manufacturer factions such as the Ministry of Commerce will be fighting to keep the new crawling peg to as slow a crawl as possible.

The idea that a stronger renminbi will stoke import demand and rebalance the global economy also seems overstated. China has already made a large contribution to this through its stimulus policies over the last year. The trade surplus has come down substantially, to a deficit in March, while the surplus with the world ex-US has disappeared.

Having said that, the surplus with the US – the most controversial part of China’s trade – has fallen little. That’s because China is mainly an importer of raw materials, components for assembly and capital goods for investment. Some US exporters benefit from this, but not as much as other countries such as Korea, where China accounts for 25% of exports. Thus even if the stronger renminbi were to boost import demand further, the US would probably not be a major beneficiary.

So while China’s move will take the political heat off for a while, it seems unlikely to fix the US deficit. And because the idea that this chronic problem is at least partly due to excess demand seems to be anathema to US policymakers, it’s unlikely that the threat of retaliation and protectionism has gone away for good.

Although the impact of a more flexible renminbi on trade may be limited, we might see more of an effect on financial flows. And while the size of China’s economy and surplus means that it attracts the lion’s share of attention, the country’s policies are not unique in Asia.

Almost all of China’s neighbours manage their exchange rates and struggle with the “impossible trinity” – the theory in international economics that holds that a country cannot have independent monetary policy, a fixed exchange rate and free capital movement at the same time. Instead, it must choose any two or accept some trade-offs. Today, Western economies have chosen to have fully floating foreign exchange markets, in which their central banks rarely intervene. This isn’t the case elsewhere, although the policies that Asian countries follow do vary.

At one extreme, there’s Hong Kong. Since 1983, the Hong Kong dollar has been anchored to the US dollar using a currency board whereby the Hong Kong monetary base in circulation is backed by US dollar reserves. At the same time, the currency is fully convertible. As a result, Hong Kong is obliged to import monetary policy from the US.

Meanwhile, the Singapore dollar is closely linked to a basket of other currencies, with some flexibility within a narrow band and a general upward trend. Like Hong Kong, it has an open capital account and is fairly restricted when it comes to monetary policy.

China, on the other hand, pegs the renminbi to the dollar while also trying to implement its own policies; consequently, it’s forced to keep a closed capital account. The Indian rupee is allowed more flexibility but also restricts capital flows. Elsewhere, Korea has the freest currency and a relatively open capital account.

Within this framework, most Asian currencies are viewed as being undervalued, and it’s generally accepted that they should be allowed to rise over the long term. But many export-orientated countries don’t want to let their currencies climb too far ahead of others for fear of undermining their competitiveness.

With the renminbi now on the move again, this gives other Asian currencies the green light to appreciate in line with the Chinese unit. But the prospect of further appreciation creates its own problems: if the currency is seen as likely to rise, this encourages hot money to flow into the economy to take advantage of the trend.

1 | 2 |