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Section: Daily Dispatches

What Flexibility? Yuan is Still Pegged to the Dollar

By Andy Mukherjee
Bloomberg News Service
Tuesday, November 29, 2005

There's a good chance that 2005 will be remembered in the financial
markets as the year in which China blinked and made the yuan more
flexible. The misconception should be snuffed out before journalists
start compiling their "Things-That-Shook-The-World-This-Year" lists.

What flexibility? All that happened on July 21 was that the yuan
moved from one peg to another, says a new study.

Although China no longer targets a fixed rate of about 8.3 to the
dollar, it continues to hug the U.S. currency almost as firmly as

"The evidence suggests," say economists Ajay Shah and Ila Patnaik
and statistician Achim Zeileis, "that the new Chinese currency
regime is a peg to the U.S. dollar."

China's official position is that the yuan began its long march to
flexibility after it was pegged to a basket of currencies. Apart
from the dollar, the basket includes the euro, the Japanese yen, the
South Korean won, the Singapore dollar, the British pound, and the
Malaysian ringgit, among others.

In August, Stephen Jen, Morgan Stanley's global head of currency
research, computed the implied weight of the dollar in China's
currency basket at 85 percent.

"It's possible," he speculated, "that the People's Bank of China is
only gradually allowing the basket index to be revealed so USD/CNY
remains stable in the initial period."

What if a much simpler explanation for the stability is that the
basket just doesn't exist?

What if the pundits who claim to have unearthed signs of correlated
movements between the yuan and the yen have it all wrong?

If Shah and his co-researchers are right, expectations that Asian
currencies would rise in 2006 on the back of a more flexible -- and
stronger -- yuan may come to naught, just as they did this year.

Ten of 15 currencies in the Asia-Pacific region that are tracked by
Bloomberg have declined this year. The yen has fallen the most
against the dollar (14 percent), the won the least (0.3 percent).
The yuan has risen about 2.4 percent -- or an additional 0.3 percent
since the July 21 revaluation.

To arrive at their conclusion that the yuan is still pegged, the
researchers have computed the daily changes in the Chinese
currency's value against the Swiss franc, a clean floater.

If the People's Bank of China has indeed begun managing the yuan
against a basket, then fluctuations in the yen or the euro against
the Swiss franc would have a bearing on the yuan-franc.

If, on the other hand, the yuan still is pegged to the dollar, they
would both move in lockstep against the Swiss franc.

The first hypothesis is squarely rejected by a regression analysis;
the second is shown to be overwhelmingly true.

If one plots the dollar against the Swiss currency starting July 22,
the graph looks like a mirror image of the yuan-franc.

Thus far in their analysis, the researchers have used statistical
techniques that have existed since 1981. Using a newer approach,
known as econometrics of structural change, Shah and his team have
ruled out the possibility that China's currency regime is becoming
more flexible with time.

The authors have set up a weekly monitoring mechanism on this Web

Until Nov. 21, the latest date for which Shah has done the
math, "there's no evidence that the currency regime has changed
compared to that prevailing" in the 68 days to Oct. 31, he says.

Shah is a consultant to India's finance ministry. His study,
however, has nothing to do with the Indian government. He also has
shown that the Indian rupee and the Russian ruble are severely

It isn't a predictive study. It doesn't say that the yuan will
remain pegged to the dollar forever or even tomorrow. When -- and
if -- China embarks on the road to a flexible currency, the
researchers expect to discern the signs on their radar.

Those signs, or a lack of them, may have a crucial significance next

If the U.S. Federal Reserve stops raising interest rates next year
and Japan, coming out of deflation, starts increasing them, then
there may be a case for the dollar to weaken against Asian
currencies in 2006.

The authorities in Beijing, some analysts say, will embrace a
stronger yuan either under pressure from the United States or after
the domestic Chinese economy overheats so much that it becomes
imperative to shift the export engine into a lower gear.

"China may decide to move its currency by about 10 percent or more
in the next 12 months, thus leading not only to a weakening of the
dollar relative to the renminbi but also to an appreciation of a
wide range of Asian currencies, including the yen," says New York
University economist Nouriel Roubini.

Looking at how determined China is to hold on to a de-facto dollar
peg close to the original level, it's not at all clear if it will
allow a 10 percent revaluation in 2006.

A flexible yuan may still make the list of the world's momentous
financial events -- though not this year, nor perhaps the next.


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