Patching the basket

Sep 29th 2005 HONG KONG
The Economist
China takes another tiny step towards a flexible currency

SO NEW, and already there's a hole. Two months after abandoning the yuan's peg to the dollar for a link to a basket of several currencies, China has been forced to weave part of the basket again. On September 23rd, the People's Bank of China said that the yuan would be allowed to fluctuate by 3% a day against the euro, yen and other non-dollar currencies, compared with 1.5% previously. Daily movements against the dollar, meanwhile, remain limited to only 0.3%.
The reason for the change seems wholly practical. Under its old exchange-rate system, China controlled the yuan's value against the dollar, but allowed a fair bit of movement against other currencies. When it moved to a basket on July 21st—revaluing the yuan by 2.1% in the process—the corollary was tighter limits on daily fluctuations against currencies other than the dollar. But maintaining these has proved cumbersome.

Suppose that the euro jumps by 2% against the dollar in a day—a big move, but not unheard of. The European currency should then rise against the yuan as well. But it would not be possible to accommodate the full change within the 1.5% and 0.3% trading bands—unless the Chinese central bank could somehow nudge the dollar back up against the euro. Indeed, there have been rumours that over the past few weeks the monetary authorities have been using their copious foreign-exchange reserves to intervene in precisely this fashion.

Allowing non-dollar currencies to fluctuate by 3% gives the Chinese authorities a little more leeway, lessening the need for expensive intervention. It should also cut potential trading losses at designated foreign-exchange banks, because they can now hedge more effectively. It will also reduce currency speculation, if the wider bands are harder to put under pressure.
The timing of the change was also expeditious. Coming just before the meetings of the IMF, the World Bank and the G8 in Washington, DC, it allowed China to deflect charges that it is still frustrating a meaningful appreciation of the yuan. Since the peg was abandoned, the Chinese currency has risen by a mere 0.2% against the dollar (see chart).

True to form, the day the Washington meetings closed, on September 25th, the central bank made a further declaration: that it had no intention of changing the yuan's trading range against the dollar, in which 80% of China's foreign trade is settled. The tweaking of the currency basket so soon after its creation shows that market forces are having some impact on the yuan. Even so, it will be a long time before China has a truly flexible currency.