June 19th, 2010
11:40 PM GMT
Hong Kong, China (CNN) – China’s surprise announcement that it will continue floating its currency after a nearly two-year hiatus is catching the financial world by surprise.
After Chinese leaders denied for months they would cave to international pressure, the Saturday announcement by China’s central bank is widely seen as a way to defuse the issue from being raised at next week’s G-20 summit in Toronto, especially since China’s May exports shot up nearly 50 percent year-on-year. But is that the whole story?
China is notorious for playing its cards close to its chest. In an interview with state-run news agency Xinhua in December, Chinese Premier Wen Jiabao said China would “absolutely not yield” to international pressure to raise the trading value of the yuan, which the Peterson Institute for International Economics had claimed was 40 percent under its market value against the dollar at the time. Wen echoed his refusal to budge at the March Chinese parliamentary meeting.
But now, China clearly sees an advantage to floating the yuan. Why?
The World Bank released a report on Friday that again urged China to strengthen its currency as a way to encourage domestic consumption and reduce inflation. A stronger yuan also would cut import costs for resource-hungry China.
Still many expected the euro's recent dramatic decline would forestall China’s move to end its peg to the U.S. dollar. Collectively, the eurozone is China’s largest trading partner and its weaker currency keeps Chinese goods competitive.
But now a different story line is emerging – we may actually see China’s yuan drop in value once it is allowed to float.
The Peterson Institute last week revised its estimates on the yuan to say it believes the yuan is now 24 percent overvalued against the dollar. Over the weekend, economist Nouriel Roubini told Reuters that if the euro continues its slide the yuan “would have to be allowed to depreciate relative to the dollar, a paradoxical outcome."
So will this help defuse economic tensions between the U.S. and China? So far, Western leaders are giving very broad applause to the move. If the yuan, however, begins to move down, that applause is sure to be short-lived.
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