Sinking Chance of Floating Yuan

MAY 9, 2011   THE WALL STREET JOURNAL

By TOM ORLIK

Another meeting of the U.S.-China Strategic & Economic Dialogue, another brief surge for the yuan.

The annualized month-on-month pace of appreciation for the Chinese currency against the dollar hit 10.6% in April, from 3.4% in March. In addition to any usual attempt to take some heat out of talks about the yuan/dollar exchange rate, surging inflation has given Beijing a reason to let the currency move higher.

But it will be cold comfort for most of China's trade partners and rivals. The slumping dollar means that even as the yuan has strengthened against the greenback, it has continued to weaken against other currencies.

Meanwhile, rumors that have circulated suggesting a one-off appreciation of the yuan against the dollar, or a move from a crawling peg to a managed float, have little chance of gaining traction with China's conservative decision makers. 

The summit of senior U.S. and Chinese officials, which kicks off in Washington D.C. Monday, might raise the temperature on the yuan. But slow progress, not sudden change, remains the most likely outcome.

The slow appreciation of an undervalued yuan has reduced the People's Bank of China to the role of economic plumber, trying to find ways to soak up the tens of billions of dollars that flood into the economy every month through the trade surplus and a porous capital account. Traditional monetary-policy tools—such as the interest rate—are harder to use because of the risk of attracting even more capital inflows. 

A one-off appreciation of, say, 10%, followed by a return to a dollar peg would reduce the incentive to bring speculative capital into the country. A managed float that allowed the yuan to appreciate to a level set by the market would be an even more radical solution, again helping to choke off inflows from currency speculators, as well as controlling the trade surplus, once an equilibrium level were reached.

For the central bank, either move would increase the room for maneuver in monetary policy. But for Premier Wen Jiabao and the decision makers on the State Council, that is a second-order concern.

The first priority remains securing growth and employment.  An undervalued yuan is a crucial prop to the competitiveness of the export sector, which is the main driver of demand and engine of job creation in the Chinese economy. 

In theory, the benefits of a floating yuan outweigh the costs. In practice, China's pragmatic leaders are unlikely to give up the familiar benefits of export-driven growth for the uncertain payback of a step into the unknown. Inflation might mean a faster pace of appreciation in the months ahead, but investors betting on a one-off move are riding for a fall.

Write to Tom Orlik at tom.orlik@wsj.com