Chinese puzzles

The yuan

Aug 11th 2005
From The Economist print edition

China's new currency basket is broader than most economists had expected

ON AUGUST 10th, three weeks after China abandoned its decade-old peg to the dollar and moved to a managed float of the yuan against a basket of currencies, Zhou Xiaochuan, the governor of the People's Bank of China, revealed which currencies the basket contains. This came as a surprise. Singapore, which has operated a similar system since the 1980s, has never taken such a step. However, China's openness has limits: it is keeping to itself the weights attached to each currency.

Mr Zhou said that the dollar, the yen, the euro and the South Korean won have the biggest weights, but the basket also includes the currencies of Singapore, Britain, Malaysia, Russia, Australia, Thailand and Canada. The Hong Kong and Taiwanese dollars are conspicuously absent. Even so, the basket is much broader than expected. Most analysts had bet on only the dollar, the yen and the euro.

The choice of currencies (and hence presumably the weights), said Mr Zhou, depended not only on the pattern of China's trade but also on the sources of its foreign direct investment (FDI) and the currency composition of its debt. Stephen Jen, an economist at Morgan Stanley, has had a stab at estimating the weights. Using a weighted average of China's trade and FDI, he guesses that the dollar has a weight of 43%, the yen 18% and the euro 14%. This incorporates a higher dollar weight to reflect the importance of Hong Kong and Taiwan. The Hong Kong dollar is pegged to the greenback and all transactions between China and Taiwan are in dollars.

It is still unclear how the system will actually operate. In theory, if the dollar falls against the other currencies, the People's Bank of China should let the yuan rise against the dollar in order to hold the overall value of the basket steady. But this is at the discretion of the central bank. However, if this regime had been introduced in January, then as the dollar rose against the other currencies the yuan would have fallen against the dollar—which would hardly have pleased America's Congress.

China also announced this week a further liberalisation of foreign-exchange trading, allowing non-banks to trade in the spot market and more banks to conduct forward trading. Currency swaps will also be introduced into the onshore market.

The reforms are aimed at making the domestic foreign-exchange market more liquid. That would allow banks and firms to hedge risks and so help them to handle uncertainty following the scrapping of the yuan's dollar peg. The central bank claims the measures will give the market a bigger role in setting the exchange rate. However, thanks to strict capital controls, the bank will retain its tight grip on the yuan.

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