China’s floating yuan? Be careful what you wish for

China has announced this week end that it will slowly allow the yuan to move within a range, i.e. quit (but not too fast…) the peg to the dollar. Many see that China finally caved in to the demand of the US to let its yuan floats and let it appreciate in order to help “rebalance” trade. In the context of the global financial crisis and the G20 meeting, I think the announcement and the move per se are more show than substance but it also points to something more fundamental: monetary systems built on fiat currencies are fragile things and the only thing worst is a fixed exchange rate on fiat money and international coordination.

After a while (here 2 years of 100% yuan peg to the dollar) it is hard to maintain a peg that is not in harmony with market forces. At some point, China wants to stop acquiring dollars at the fixed rate – the yuan is too cheap at that rate and their money supply is booming (Chinese are recycling their dollars in yuan). We notice lately that China was trying to cool off a speculative boom in the Shanghai real estate market. There are also others consequences that many miss when they only look at the appreciation of the yuan in rebalancing trade:1- it means less demand for US Treasuries because now China does not need to buy loads of them to keep their yuan 100% fixed to the dollar. It will be pegged to a basket of currencies (which China has not disclosed yet) where the dollar’s role will be less. 2- If the yuan is allowed to float within a range it also means it could go lower against the dollar (the opposite of what Washington wants) because for example, recently, the yuan has risen against the euro and if the latter continues to depreciate, the yuan would be allowed to depreciate against the dollar (in a basket of currencies). 3- The appreciation of the yuan will not bring back manufacturing in the US because what brought the US job market to its knees is the collapse in the housing market. Be careful what you wish for…