Currencies hit the Headlines

Two currency movements are in the news today. Firstly the pound has fallen to an eleven year low against the Euro with one Euro now worth eighty pence. The second currency hitting the headlines is the Chinese renminbi which has appreciated beyond Rmb7 to the US dollar for the first time since 1994.

Sterling and the Euro

Sterling has depreciated by more than seventeen per cent over the last year, that is a bigger fall in the value of the currency than happened when the pound was devalued on the 16th September 1992 (Black Wednesday). A cheaper currency is naturally decent enws for our export sector and should provide some support to the economy as other components of aggregate demand weaken (notably consumer spending). But a falling currency also risks creating further inflationary pressures because the prices of imported goods and services from Euro Zone countries increase.

The Renminbi and the US dollar

In July 2005 the Chinese authorities released the renminbi from a fixed exchange rate peg against the dollar and they have let it is rise very slowly under a managed exchange rate system. Yesterday, the People’s Bank of China, the central bank, fixed the renminbi’s daily mid-point at Rmb6.9920 per dollar before currency traders edged it yet higher in the FX market. The renminbi has now appreciated in value by 4 per cent against the US dollar since the start of 2008.

Why is China seemingly prepared to countenance a steeper appreciation in the value of its currency? Several forces are at play.

(1) Inflation is at an 11-year high and real GDP growth continues to expand by more than 11 per cent a year. A rising currency should help to keep the lid on imported inflation and also soften the growth of aggregate demand - China is giving greater importance to sustainable growth and the currency is a useful instrument of macroeconomic policy in achieving this

(2) Trade tensions: The enormous trade surpluses that China runs with many advanced nations has been and remains a major source of contention. Many politicians in United States say the renminbi is undervalued, giving Chinese exporters unfair advantages. and there is an underlying pressure within the United States to introduce protectionist measures unless the Chinese allow a faster and larger appreciation of the currency to bring about a re-balancing of trade.

Of these two factors, overwhelmingly the biggest fear for the Chinese is the surge in consumer price inflation especially because of the social and political problems that an acceleration of prices is having notably in rural areas and in its effects on the urban poor.

And whilst the renminbi has been rising against the US dollar, it has been falling against other currencies - including the Japanese Yen. So the overall effect of currency movements for the Chinese economy is not as large as it might seem. That said, the Chinese authorities are now belated realising that the condition of their domestic economy makes an appreciation of the currency the right macroeconomic tool to employ as a means of managing demand and price pressures.