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Asia-PacificJuly 31 2005

China’s new currency regime raises questions

China’s decision on July 21 to replace its currency peg to the US dollar with a managed floating exchange rate regime has been welcomed by those clamouring for currency reform. But the relatively small 2.1% revaluation of the renminbi leaves many questions unanswered.
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Although China was under considerable pressure – notably from the US in recent months – to revalue its currency, the decision surprised financial markets. The full implications for trade and regional currencies in the months ahead are not yet clear.

Under the new regime, which will be based on a basket of currencies rather than the US dollar alone, the renminbi has been revalued by 2.1% from 8.28 to 8.11 to the dollar. The currency would be allowed to float but on a limited basis of plus or minus 0.3% daily.

The People’s Bank of China (PBoC), the country’s central bank, said: “The target is to establish a managed floating exchange system based on market supply and demand, and to maintain renminbi stability on a reasonable and balanced basis.”

But it remains to be seen how much the currency could appreciate. Some analysts believe it is 15%-25% overvalued. While the initial revaluation is small and the float is limited to 0.3% on a daily basis, a significant appreciation of the currency could take place in the coming weeks and months.

However, the PBoC responded: “A big fluctuation in renminbi exchange rates is negative for China’s economic growth and won’t happen after the reform.”

China believes that using a basket of weighted currencies, based on market supply and demand as a reference, will restrain large swings because “the fluctuations between major currencies in the international market will, in effect, limit the renminbi’s fluctuations”.

The PBoC did not give any details of the weightings of the reference currency basket, however.

“The principle for China to reform the exchange system is to be independent, manageable and progressive,” it said.

The US Treasury secretary, John Snow, welcomed “the commitment to using market forces”.

Most financial commentators consider the unpegging of the link to the dollar to be a significant event and this first revaluation represents a modest start.

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Read more about:  Analysis & opinion , Asia-Pacific , China