How often does a 350-word statement make headlines around the world? Not too often unless there's a sex scandal involved, but The People's Bank of China accomplished the feat just this past week when it announced plans to "further reform the RMB exchange rate regime and enhance the RMB exchange rate flexibility" (and nobody had to sleep with anybody).
What the heck does this mean, why is it important, and what's China's reasoning for changing its course on the issue? I'm glad you asked.
What the heck it means
As I wrote back in April when I told you and Paul Krugman to chill out about China's currency, China has fixed the value of its currency, the RMB, relative to other world currencies at an artificially low value in order to subsidize its export manufacturing sector. The reason the government pursues this path is because export manufacturing has been an engine for economic growth and job creation in China for the past 25 years. The strategy has largely worked, with China putting up better than 10% annual GDP growth for the past 30 years.
By announcing plans to reform this fixed-rate regime, enhance exchange rate flexibility, and "enable the market to play a fundamental role in resource allocation," China is finally signaling a willingness to allow supply and demand to determine the value of its money. Given China's trade surplus and all of the investment dollars that are flowing into China, the consensus is that China's currency should appreciate quite a bit -- with some economists suggesting that a natural exchange rate is closer to 4 or 5 RMB to the dollar rather than the 6.8 RMB to the dollar rate that exists today.
Why it's important
Although it's unlikely that we will see a rapid 50% rise in the value in the RMB (for reasons I'll talk about below), this move does matter for both China and for the world. First, it signals a willingness in China to finally start weaning the economy off of the economic heroin that is the export manufacturing sector. While challenging for companies such as Nam Tai Electronics (NYSE: NTE ) that have feasted on low-cost labor, it's better for the economy overall. Further, it suggests that China is confident that domestic consumption can pick up some of the slack that a slowdown in export manufacturing might produce and that China is serious about its plans to become the world's largest, most important economy -- both positive developments for anyone who has been investing in China.
Further, it means that Chinese consumers, enriched by a newly stronger currency, will be able to purchase more and more expensive goods from the U.S. and Europe. This could mean more jobs for U.S. workers as well as a new potential catalyst to help along the global economic recovery. Potential beneficiaries include luxury brands that are growing increasingly popular in China such as Luxottica (NYSE: LUX ) and Coach (NYSE: COH ) .
And finally, it means Paul Krugman has one less topic to whine about on The New York Times editorial page.
The question, of course, is why is China, a notoriously self-interested nation, now willing to set a new course on currency policy? Before I get to that, it should be noted that, despite mainstream media reports to the contrary, the RMB is not going to rise against the dollar overnight. In fact, The People's Bank went so far as to claim in its statement that "the basis for a large-scale appreciation of the RMB exchange rate does not exist." While I disagree with this outlook, the fact is that China, and The People's Bank said as much, will continue to manage the bands within which the value of the currency will float. As a result, any appreciation in the value of the RMB will happen slowly over time.
There are two reasons for this. First, the manufacturing sector employs more than 10% of the Chinese workforce and Chinese workers, many of whom have migrated to cities to find jobs, are notoriously cranky when they're left unemployed. A rapid revaluation of the RMB would cause many of these factories to become suddenly uncompetitive and shut down, resulting in unemployment that the Chinese government simply isn't willing to deal with.
Second, it's worth remembering that The People's Bank, the very body behind China's exchange rate policy, is currently long more than $2 trillion thanks to China's trade surplus. Should the yuan appreciate, it would do so at the expense of the dollar -- thereby devaluing China's reserves. As a result, one should expect RMB appreciation to proceed at roughly the same rate The People's Bank is able to unwind its position in the dollar.
My China conspiracy theories
With that as background, there are two self-interested reasons why China would proceed with this change. First, it's well-known that China has come under heat from the international community about its currency given the economic struggles and high unemployment in the U.S. and Europe. President Obama has made several fiery speeches on the topic and the U.S. has come very close to labeling China a "currency manipulator." By announcing this change to its currency policy now, China inspires some international goodwill ahead of the upcoming G-20 summit.
Second, China's artificially weak currency has given rise to inflationary fears. In fact, China's National Bureau of Statistics reported earlier this month that inflation in May was 3.1% -- ahead of the government's 3% target. As food and oil prices continue to rise in dollars, Chinese households would get squeezed if the RMB continued to be pegged to the dollar. By unpegging the RMB and allowing it to appreciate against the dollar, those imported goods become more affordable for Chinese citizens. This, in turn, makes them happier, wealthier, and more likely to remain supportive of the government.
All told, the Chinese government has made a savvy move here that buys it time with international critics while also giving it flexibility to pursue a more measured exchange rate policy. It's not quite the groundbreaking development that many in the media made it out to be, but it is a milestone and good news for investors like me and our members at Motley Fool Global Gains who have been increasing exposure to the Middle Kingdom.