China ends dollar peg
The People’s Bank of China has announced its intention to revalue the renminbi. Consequently, the renminbi will no longer be pegged to the US dollar, which it has been since 1994. Instead, the renminbi will now track a number of foreign currencies: the US dollar, euro, Japanese yen and South Korean won.
This is an important step towards a free floating Chinese currency. However, the renminbi will not be fully convertible until at least 2010, as China has decided to stagger the introduction of its more flexible exchange rate regime.
So, what are the wider implications of the renminbi revaluation? Malaysia announced the end of its dollar peg – which it adopted in 1998 – within hours of China’s announcement. Malaysia will also value its currency on a basket of foreign currencies.
We suspect this will be the start of a general appreciation in Asian currencies. In the past, many of the smaller Asian economies have been hesitant to allow their currencies to strengthen, for fear of damaging their export competitiveness with China. With the rise – albeit modest at this stage – of China’s renminbi, other Asian currencies can also increase. In fact, the Singapore dollar, Thai baht, Indonesian rupiah, the South Korean won, the Taiwan new dollar and the Indian rupee all strengthened slightly when the RMB revaluation was announced.
Another consequence could be to foreign investment in China. The economic stability afforded by the dollar peg has attracted large foreign investment in China over the past ten years. However, while foreign investment in China is huge (in 2004, China enjoyed five times the amount of foreign investment that the Southeast Asia region did as a whole), it fell slightly at the start of 2005 (by 3.2% to $28.6 billion). This reduction has been blamed on a combination of falling prices and rising costs. Significantly, the revaluation of the renminbi could well cause investment to fall further, as it will invariably push up costs.
In addition, by removing the dollar peg, China will no longer need to purchase large quantities of US Treasury bonds. As trade has increased, China has had to purchase large quantities of dollars in order to maintain the dollar peg. With the renminbi now floating against a range of currencies, it is likely the Chinese reserves will change to reflect this. Correspondingly, other Asian countries may also feel less obliged to purchase dollars. It will be interesting to see how the US responds to the shortfall. However, given that the American economy has picked up in recent months – with the strengthening dollar – and there is the prospect of $600 billion being repatriated in foreign earnings (see pages 13-16 to read our article on the Homeland Investment Act) the United States may have its focus elsewhere.