Freer and easier

China’s moves to free up the way its currency trades might seem like throwing a bone to the United States, ahead of the two countries’ strategic summit in May. But, it is China itself that gains most from this kind of reform, however gradual. The benefits are likely to include less foreign hot money, happier trade partners and the prospect of more capital account opening in the future.

Letting the yuan rise or fall one per cent a day, versus 0.5 per cent previously, is a step towards a more market-driven exchange rate. That’s what Washington and the International Monetary Fund want, and both agree China has made steps in the right direction. The United States is particularly keen to see China get more hands off with its currency. The trade gap with the United States increased by 28 per cent to $17 billion in March compared with a year earlier.

A freer yuan might not mean a stronger one, though. Last time Beijing widened the trading band in 2007, investors saw it as a sign of future appreciation. After China posted a trade deficit in the first two months of 2012, the mood has become more subdued. Moreover, the central bank still controls the pace of the yuan by setting its trading midpoint every morning. After it guided the yuan lower on April 16, spot yuan touched its weakest point in three weeks in the first hour of trading.

More flexibility will make the central bank’s job easier. The People’s Bank of China would have had to step in numerous times in 2011 as the yuan hit the bottom end of its trading range. A larger trading band should make that kind of intervention less necessary. Moreover, increased volatility should deter investors who previously saw the yuan as a one-way bet.

For China, this is a step in the right direction. A flexible exchange rate is a necessary condition for opening up China’s capital account. A currency that moves more with the market will also have a far better chance of being taken seriously as an internationally-accepted one, as is Beijing’s ambition. More importantly, this small but decisive step shows deeper reform is still on the agenda.