The yuan floats

The long-awaited revaluation of the yuan has finally happened. Speculation about the revaluation of the Chinese currency had been in the air for years, and had resulted in billions of dollars worth of hot money flowing into China, eager to take advantage of the arbitrage opportunity that people had spotted.

The pressure on the Chinese to revalue had been steadily increased, in particular by the US government, which threatened to impose protectionist trade barriers against Chinese goods should its pleas for yuan revaluation fall on deaf ears.

The final straw that broke the Chinese government's defence of the yuan-dollar peg was the second quarter GDP numbers, which showed year-on-year growth of 9.5 per cent.

That's higher than the 9.4 per cent growth seen in the first quarter, and the same as the GDP growth rate for 2004.

Clearly, despite the measures taken by the government to cool the economy, growth has continued at breakneck pace.

Moreover, much of the growth has come from exports, with shipments from China growing at 31 per cent in the second quarter.

The Chinese government has therefore signalled that it is going to put into effect a more flexible exchange rate policy.

True, speculators are likely to be disappointed with the 2 per cent appreciation of the renminbi, but the Chinese authorities have also announced that they are replacing the yuan's dollar peg with a basket of currencies, and the currency will be allowed to move 0.3 per cent either way from the previous day's close; this leaves the door open for further creeping appreciation.

Given the amount of foreign investment that China attracts, there's a good chance that Thursday's revaluation is the beginning of a long process.

Asian currencies, including the rupee, rallied against the dollar after the yuan revaluation, with the markets being caught by surprise.

The move has been universally welcomed. The problem with the yuan's dollar peg was that, no matter how much the dollar declined in value against other currencies, its value against the yuan remained rock solid.

The upshot was that countries whose exports competed with Chinese exports were at a disadvantage. Now that the peg has been loosened, this constraint will no longer remain.

At the same time, the Chinese authorities have chosen the timing for the revaluation well. The dollar has been appreciating against other currencies in the past few months, so abandoning the peg will not hurt much.

And with GDP growth at red-hot levels, a slight slowdown induced by currency appreciation would be perfectly welcome.

Also desirable, from the Chinese authorities' point of view, would be a deceleration in hot money inflows, which forced the Chinese to add to their bulging foreign exchange reserves.

However, this does not rule out the possibility that speculative flows, betting on further revaluation, will continue.

The revaluation that happened on Thursday is unlikely to have any major impact on China's growth and therefore on commodity prices.

In fact, since Chinese imports will become cheaper, China's voracious appetite for commodities may actually increase. And since 40 per cent of Chinese imports are used for exports, it is doubtful whether Chinese exports too will be affected significantly.

So far as India is concerned, the move will give the Reserve Bank of India some room to allow the rupee to appreciate.

And to the extent that the prices of imports determine inflation, inflationary pressure too may abate, thus reducing the incentive to raise interest rates.