China Allows Yuan Greater Exchange Rate Latitude

At the Boao Forum for Asia held earlier this month on the island of Hainan in the South China Sea, the topic of the U.S. Federal Reserve’s monetary policy came up for discussion. More correctly, the topic of how the Federal Reserve monetary policy is harming the Asian economies came up for discussion.

Zhou Xiaochuan, Governor of the People’s Bank of China, used the meeting as an opportunity to criticize the use of quantitative easing in the west and the impact this is having on the emerging economies. By continuing to flood their economies with excess liquidity and ultra-low interest rates, the established economies in the U.S. and Europe persist in maintaining very low interest rates. This has investors on the hunt for higher returns and has resulted in considerable cash finding its way eastwards.

This pent-up demand is adding significantly to the inflationary pressures already threatening the emerging economies. In his comments, Governor Zhou acknowledged that he fully understood that the Federal Reserve’s actions were an attempt to support the U.S. economy, but as the primary global reserve currency, Zhou also said the U.S. should be held to a higher standard.

According to Zhou, the U.S. Federal Reserve therefore must “not only consider the U.S. economy, but also the global economy”.

Foreign Investment Adding to China’s Inflation Problems

Fears of a prolongation of the global financial crisis continues to tempt investors to flee the western economies in favor of the emerging nations. China in particular has struggled with an inflow of “hot” capital and this, combined with increasing wealth within the country, has resulted in high inflation.

Officials in China have introduced several measures to curb speculation in an attempt to keep prices in check and it appears that there has been some success. For this past February, inflation in China declined to a 20-month low of 3.2 percent compared to 4.5 percent for the same month one year ago according to China’s National Bureau of Statistics. The decline is due largely to lower food prices which have been responsible for pushing the cost of living higher in recent years.

To date, China has relied mostly on interest rate changes together with increasing bank reserve minimums as a means to control prices. However, China has also been forced to ease its stance on controlling the yuan exchange rate. This past weekend, the People’s Bank of China widened the intraday trading band from just half a percent to a full percent. While still a far cry from a free-floating exchange rate, the move suggests authorities are willing to allow the yuan greater latitude and could be the first step to allowing the yuan to appreciate.

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