Finally, the Big Event: China Revalues

Apparently, the rumors were true. China made the big announcement today:

1. Starting from July 21, 2005, China will reform the exchange rate regime by moving into a managed floating exchange rate regime based on market supply and demand with reference to a basket of currencies. RMB will no longer be pegged to the US dollar and the RMB exchange rate regime will be improved with greater flexibility.

2. The People’s Bank of China will announce the closing price of a foreign currency such as the US dollar traded against the RMB in the inter-bank foreign exchange market after the closing of the market on each working day, and will make it the central parity for the trading against the RMB on the following working day.

3. The exchange rate of the US dollar against the RMB will be adjusted to 8.11 yuan per US dollar at the time of 19:00 hours of July 21, 2005. The foreign exchange designated banks may since adjust quotations of foreign currencies to their customers.

4. The daily trading price of the US dollar against the RMB in the inter-bank foreign exchange market will continue to be allowed to float within a band of 0.3 percent around the central parity published by the People’s Bank of China, while the trading prices of the non-US dollar currencies against the RMB will be allowed to move within a certain band announced by the People’s Bank of China.

My first reaction is to keep a close eye on the bond market. Will long-term interest rates be bid up substantially today? (As of 10:00am EDT, 10-yr treasury bond yields had risen from about 4.18% to 4.23%.) They might, if the bond market thinks that China can now reduce its purchases of dollars. This would happen if the currency markets stop putting pressure on the yuan to appreciate, which would happen if this slight change in the exchange rate is enough to make the yuan less attractive to investors than it has been.

However, another possibility is that China could actually face increased capital inflows as a result of this small move, if people speculate that this is just the beginning of a series of small revaluations (or one long, steady revaluation trend) of the yuan. In fact, I think it quite likely that China will face increased demand for yuan now, rather than decreased demand. This might be particularly true if I’m correctly reading item #2 above to suggest that the exchange rate can gradually crawl downward (since the closing price of one day, which could be up to 0.15% lower than that day’s starting price, becomes the starting price the next day).

In short, I can easily imagine that the PBOC may actually have to increase the rate of accumulation of dollar assets as a result of this change in their exchange rate regime, at least for a while. Presumably that was not their goal in making this change, so it will be extremely interesting to see what happens…