Set the yuan freer

Premier Wen Jiabao has said China will make the yuan more flexible “in either direction”. That may sound strange; up to now, talk of enhancing the yuan’s flexibility has always meant a one way journey — upwards. But, the case for devaluation is getting stronger. So, is the case for setting the yuan freer.

In nominal terms, the Chinese currency has appreciated 3.7 per cent against the dollar in 2011. That rate is politically sensitive, but what matters for the economy is the real effective exchange rate, measured on a trade-weighted basis and adjusted for relative consumer prices. The yuan’s real value is up by 5.3 per cent in 2011, according to the Bank for International Settlements. That’s more than any other currency except Venezuela’s.

In effect, domestic cost pressure has forced Chinese export prices up, despite weakening external demand. The result is predictable: The country’s trade surplus was less than two per cent of GDP in the first half of 2011, the lowest level since 2003, according to RBS. On an absolute basis, the dollar value of China’s trade surplus was 45 per cent below its peak in 2008. At the least, the case for a higher yuan is weakening. If the trend continues, a devaluation could well be justified.

Foreign investors seem to think the yuan has lost some of its luster. The average yield of a basket of yuan-denominated dim sum bonds tracked by HSBC has risen to 3.8 per cent from 2.4 per cent in the past month. And, in the Hong Kong offshore market, which is subject to less control from the People’s Bank of China, the yuan is slightly weaker than in the closely controlled onshore market.

China should allow the exchange rate to reflect changing economics. Better still, the government should trust the market, especially now, when a freer yuan would help Chinese exporters. In 2008, China re-pegged the yuan to the dollar for the sake of stability. That was a step backwards on the road to greater yuan flexibility. This is a good time to move forward.