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Ahead of President Obama’s visit to Asia, earlier this week, the Chinese central bank issued a report signalling its intention to perhaps consider allowing a more flexible exchange rate regime come into force.

In one way or another, various entities from the U.S to the IMF have criticised the Chinese’ managed exchange rate, which they had relaxed in 2005, but have since reverted to in 2008.

The argument is that the yuan is kept significantly below its true value via strong intervention in the currency markets by the Chinese central bank. (China claims it manages the yuan against a basket of currencies, but if such a basket exists, the dollar is the heaviest component). Since an undervalued exchange rate improves the relative price competitiveness of Chinese goods, this then promotes Chinese exports and discourages American exports. This causes a significant trade deficit and, as the critics argue, is a primary cause of the global trade imbalances that exist today.

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The point is made here in the Guardian that:
“With respect to the Chinese holdings of dollar-denominated assets, China is holding a lot of longer-term US government bonds, such as US 10-year Treasuries. If the Chinese government were to sell off a lot of these, it would drive up long-term interest rates in the US. Since our mortgage rates and other long-term lending rates tend to move with long-term Treasuries, this could obviously have a negative impact on the US economy.”
But this article also highlights why this may not be a big problem.

If interest rates were allowed to rise:
“This will have some negative impact on growth, but there will also be a very positive side from China’s decision to stop buying dollars. The dollar would fall in value against China’s currency. This would make Chinese goods more expensive in the United States, leading US consumers to purchases fewer imports from China and more domestically produced goods. A lower-valued dollar would also make our exports cheaper in China. That would allow us to export more to China. The net effect would be an improvement in our trade balance, bringing back some of the 5.5 million jobs that we’ve lost in manufacturing over the last decade.”

I imagine a lot of bets are being placed in the markets this week on what will be the outcome of the Obama trip and whether China will indeed revalue the RMB in some way. Watch this space!

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