With the renminbi depreciating for six straight days starting last Wednesday, debate about its value has been renewed. Markets are fixated on whether Beijing will allow or even encourage the renminbi to depreciate further although diplomatic pressures remain strong for continued appreciation.
Although the global economy has deteriorated, paradoxically, conditions are better than a year ago for moving to a more flexible exchange rate system. A prolonged slowdown in global economic activity from the eurozone crisis, coupled with a sluggish US recovery, is now likely. With China’s key export markets under stress, its trade surplus will decline to about 1.5 per cent of gross domestic product this year from around five or six per cent several years ago. Coupled with the efforts to liberalise imports, China’s trade surplus may soon evaporate.
In recent months other east Asian currencies have become more volatile and on balance have depreciated significantly. Given the strong interlinkages in regional currency movements due to their shared production network, China will also be pulled into greater flexibility. And since inflation in China will remain relatively higher than its key western trading partners, its real exchange rate may appreciate marginally even if nominal rates decline. All this will create a conducive environment for China to develop a more flexible exchange rate system where the prospect of a decline is the same as of an increase – as it should be. Continue reading »