As G-20 finance ministers and central bankers meet in Seoul to call a verbal truce at least in the currency wars, Bloomberg has a piece noting that China has taken note of what happened to Japan after the 1985 Plaza Accord led to the rapid appreciation of the yen against the dollar.
A short history lesson for younger readers: Following the accord between what was then the G-5 to depreciate the dollar against the yen and the mark, the dollar fell by 51% against the yen between 1985 to 1987. Japan’s exports shrank, unemployment rose, cracking the system of lifetime employment at the large conglomerates, and the economy slowed dramatically — the endaka fukyo, high-yen recession. The cutting of interest rates to get the economy going again led to the asset bubbles which, after they inevitably went pop, left the country mired in debt, which in turn has left the Japanese economy becalmed in the still waters of recession and deflation ever since.
Now Japan made policy mistakes and had a political and social system designed to absorb external shocks rather than effect change when change was needed, so the analogy only goes so far, but Beijing doesn’t want to go anywhere near there in the first place. Hence its determination to let its own currency appreciate only gradually.
There are two other lessons from Japan’s experience in the 1980s that won’t have escaped the notice of China’s leaders. First, it was Japan’s huge current account surpluses that had given it the global buying power in the 1980’s that made the country “No 1” and raised a scare among developed nations, particularly the U.S., that Japan was taking over the world and would eclipse the U.S as the world’s leading economy. When the current account surpluses disappeared, Japan’s emerging clout on the world stage evaporated with it. Second, what happened to Japan’s economy after the Plaza Accord led eventually to the long-ruling Liberal Democratic Party lose its monopoly grip on power.
First day of China’s newly re-instituted managed exchange rate regime was very much like the last day of the dollar peg it replaces. The People’s Bank of China left the yuan-dollar rate unchanged Monday–though we can’t say we were surprised. Days two through four, ahead of the G20 meeting next weekend, may bring some cosmetic appreciation in the Chinese currency. Thereafter we continue to expect the yuan to rise only slightly if at all against the dollar with the central bank continuing to be unbending in its flexibility.
We have long argued that China would allow its currency to appreciate, as much of the rest of the world is demanding and which in the long-term is in its own economic interest, but that it would do so at a time of its own choosing. That indeed has been Beijing’s public position regardless of the volume of the rhetoric coming out of Washington and Brussels. Today’s unexpected announcement by the People’s Central Bank of China that it will return to its pre-financial crisis managed floating exchange rate regime introduced in 2005 to replace the yuan’s peg to the dollar but suspended in July 2008 following the onset of the global financial crisis, is more style than substance, though there is some substance there.
No one should think, though, that Beijing is letting the currency float freely. The central bank is explicit that there will be no ‘large-scale appreciation of the yuan” and that the previously used narrow bands within which the currency can move will be re-instituted. That means that any appreciation in the exchange rate is likely to be modest and gradual. And while the announcement comes ahead of the G20 summit in Toronto, with the intention, we assume, of taking some of the sting out of the issue there, there is no indication of the timetable by which it will be implemented. We don’t expect the central bank to be in much of a rush. Nor do we think that all China’s economic policymakers are yet convinced of the solidity of global economic recovery that allowing the yuan to appreciate would imply and which the central bank cites as a justification for the policy switch.
There is also an opaque reference in the central bank’s statement that “continued emphasis would be placed to reflecting market supply and demand with reference to a basket of currencies”. While no one has known exactly what the composition of the reference basket was, beyond being overwhelmingly U.S. dollars, given the changing nature of China’s trade over the past couple of years, the new mix could have a material effect on the politically sensitive U.S. dollar-yuan rate that would mean that rate not moving much, and the yuan-euro rate moving more, a combination that wouldn’t appease the increasingly bellicose critics of China in the U.S. Congress. If the euro remains weak, the yuan could conceivably depreciate against the dollar, which would really put the cat among the pigeons.