Yuan reform taken off the table, but not for long

But despite the signs that a long-awaited revaluation is off the table, it would be a mistake to go to the other extreme and conclude that the Chinese exchange rate will remain locked in place ad infinitum.

The very caution of U.S. officials at the Strategic and Economic Dialogue this week in Beijing and its potential for sparking a political backlash in Washington suggest that China could move sooner than expected to break the yuan's 22-month-old peg to the dollar.

In toning down its criticism of yuan policy, the Obama administration showed it had bought into China's insistence that foreign pressure would not be conducive to reform.

U.S. Treasury Secretary Timothy Geithner spoke softly, trying to make the case that a more flexible exchange rate was in Beijing's own interest. That approach is not without risk.

"It leaves the U.S. administration wide open to criticism that it is not speaking up for U.S. interests if China does not restart reform soon," Mark Williams with Capital Economics said.

"For this reason, it seems reasonable to conclude that U.S. officials are still fairly confident that exchange rate reform is imminent," he said.

Behind Closed Doors

Geithner let on nothing about what he said behind closed doors in Beijing, but it would be surprising if he did not at least try to explain that simmering U.S. anger about Chinese exchange policy could easily boil over.

"In an ideal world, this is the way to do it. My worry is that it may not be terribly popular politically in the United States," said Michael Pettis, a senior associate at the Carnegie Endowment for International Peace in Beijing.

"There may be more impatience in the United States than there ought to be," he said.

Geithner's main argument -- that a more market-driven yuan would help Beijing contain inflation -- is likely to have little sway at this time. Falling vegetable prices, a key driver of inflation, are likely to blunt broader price pressures in China.

Beijing certainly gave no hint of feeling any urgency.

The most President Hu Jintao offered in public was a reiteration of a long-standing assertion that China is committed to reforming its "exchange rate formation mechanism in a self-initiated, controllable and gradual manner."

U.S. officials said they were encouraged by this statement, but investors read it as a signal of non-action.

The yuan tumbled in offshore forwards on Tuesday to imply a mere 0.6 percent appreciation against the dollar over the next year. The expectation had been closer to 4 percent a month ago.

Part of the fall has been triggered by a rush by speculators globally back into dollars. Forwards on Wednesday actually implied depreciation over a one-month horizon.

To some, the market move was over done.

"At this point, one year premiums pricing in 0.6 percent appreciation is a bit of a joke. In my perspective, there is value here," said Craig Chan, senior foreign exchange strategist at Nomura in Singapore.

Not Just U.S.-China

Just a few weeks ago, there was virtually unanimous agreement in financial markets that China was on the cusp of dropping the dollar peg, put in place to help the country through the global financial crisis.

The key development that has led market players to revise down expectations for yuan appreciation is Europe's debt crisis, not the China-U.S. dialogue.

Standard Charted bank shifted its call for dropping the peg from May to the third quarter, after a G20 meeting of world leaders in Canada in June that many analysts had tipped would be the trigger for a yuan move.

China's commerce ministry has already said that exports to Europe will suffer. And the Chinese trade-weighted exchange rate has risen steadily in the past month, tracking the dollar higher as global financial markets wobble.

The euro slumped to a four-year low against the dollar last week.

"The uncertainty hanging over yuan reform is the reduced confidence in the euro, and nobody knows when market sentiment will recover," said Wang Han, senior economist at research group CEBM in Beijing.

"I think the Chinese government will need at least another three months to figure out the impact of the European debt crisis on its exports and then it can decide on the yuan," he said.

Other analysts say a delay of that length would court trouble for Beijing in a U.S. election year when members of Congress have called for tough action if the yuan remains locked in place.

And with G20 leaders meeting in Toronto next month, China will not relish having the finger pointed again at its exchange rate policy as a fundamental cause of global economic imbalances.

"This is not the time for caution," Pettis said. "This is the time when people need to face the problem head on and aggressively, because if we're all too cautious, trade relations are going to get worse, not better."

[Source: By Simon Rabinovitch and Aileen Wang - Analysis, Reuters, Beijing, 26May10]

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