Markets across the world staged a smart rallyon Monday, reacting to the Chinese government’s signal that it was going to be more flexible on the yuan. There are several reasons why China’s decision to allow its currency to appreciate is good for the markets. One, it reduces trade tensions between the US and China. Two, the hope is that a stronger yuan will increase commodity demand, because the Chinese will consume more as a result of their higher purchasing power. But this conclusion sits uncomfortably with another one that China’s competitors, such as India, will gain as the yuan’s appreciation takes some of the edge away from Chinese exports. To the extent that commodity imports are used for exports, the yuan’s appreciation may not be such a good thing. A Deutsche Bank AG research note by Jun Ma and Wenjie Lu draws attention to this effect.
They point out that “although the substitution effect on the RMB (renminbi, or Chinese yuan) appreciation is positive for China’s demand for imported commodities (as they become cheaper in RMB terms), the currency appreciation itself serves as a tool for policy tightening that reduces overall demand for commodities. The net impact is likely to be very small.”
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Jun and Wenjie predict that any knee-jerk gains in commodities and in commodity-related currencies such as the Australian dollar will be reversed soon. Nevertheless, China’s move will certainly impact some sectors. The Deutsche Bank paper says: “A 10% RMB appreciation...will cut volume exports of apparel by 3.7%, electric machinery by 2.2% and electronic components by 1.4%…will boost imports of sugar by 6.7%, coal by 2.7%, but nearly zero impact on crude oil, iron ore and non-ferrous metals.”
Third, and this is also important from India’s point of view, it will diminish some of the concerns that the central bank has about the impact of currency appreciation. In other words, the flexible yuan will provide some comfort to central banks of countries that compete with Chinese exports, allowing their currencies, too, to appreciate, thereby, making them less concerned about inflows of funds and also acting as a dampener to inflation.
Madan Sabnavis, chief economist at CARE Ratings, says that “for the three-year period between June 2005 and June 2008, the coefficient of correlation (between the movement of the two currencies) was 0.69 (and significant), meaning thereby that further appreciation of the yuan would be associated with the rupee also strengthening under ceteris paribus conditions.” The yuan was allowed to gradually appreciate against the US dollar between 2005 and 2008.
Fourth, a stronger yuan should boost consumption in China, while reducing its dependence on exports, thus helping the process of “global rebalancing”.
Although this is likely to be a slow process, it does signal a move in the right direction. Almost all analysts urge caution, though, pointing out that any moves in the yuan are likely to be slow and controlled.
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