London, 22 June 2010

China's unexpected decision to allow more flexibility in the yuan is too small to have an impact on commodity prices. It makes dollar-priced commodities marginally cheaper for Chinese customers, and could theoretically lift consumption. But in practice the rise in the exchange rate is too small to make much difference and the government's priority is to rein in demand to prevent the domestic economy overheating.

The timing caught the markets off-guard (which is almost certainly what China's monetary authorities intended). But the direction of change came as no surprise to anyone. Investors have been anticipating a stronger yuan for more than a year.

In fact, the real surprise was how small the adjustment was when it was finally announced. Unlike the last yuan revaluation in July 2005, when the central parity was revalued 2 percent and then allowed to crawl higher on a daily basis, this time there was no one-revaluation, let alone the maxi-revaluation some overseas commentators and economists have been calling for.

Proponents of revaluation have suggested the yuan is undervalued by as much as 25-50 percent against the dollar. But the People's Bank of China (PBC) has explicitly ruled out a one-off adjustment. It repeated at the weekend there was no basis for any big appreciation and that the currency's value was not far off its fair level.

This was a token gesture, designed to take the subject off the table at the G8-G20 summits later this month. It promises more flexibility in future but does not commit China to any particular exchange rate in future.

Revaluationists focus on the prospect of more substantial movements over coming months and years. The last period of yuan flexibility saw the currency crawl 16 percent higher against the dollar over three years (from July 2005 to July 2008). But the PBC has not committed itself to any particular rate of revaluation or even a long-term target.

The impact on commodities should be small, at least in the short to medium term:

(1) Markets have been anticipating a stronger yuan in the medium term, so it should already have been largely priced in. If anything the small-scale of the weekend adjustment will disappoint policymakers and investors hoping for a bolder move. It could arguably therefore be bearish for commodity prices. It is certainly not especially bullish.

(2) China's exports have already become significantly less competitive in Europe as the dollar-linked yuan has risen against the euro. Exporters are also starting to lose competitiveness from rising wage rates (at least in the coastal provinces). Given thin profit margins and the relatively low level of value-added for many of the country's exports, the authorities are unlikely to want to see a major appreciation against the dollar and further erosion of the country's competitiveness.

(3) Some commentators have focused on revaluation as a precondition for "rebalancing" China's demand away from exports towards domestic consumption. In practice, however, the economy shows signs of overheating. Inflation is above the government's target and wages are rising. There have been big hikes in the minimum wage rate in the export-oriented manufacturing centres of Guangdong, Fujian, Zhejiang, Jiangsu and Shanghai. The all-China consumer price index hit a 19-month high of 3.1 percent in May, above the government's 3.0 ceiling.

Producer prices were up a staggering 7.1 percent compared with the same period a year earlier. There is no room to stimulate domestic consumption further. The main priority is how to slow the pace of growth and curb inflation without provoking a slump or a rise in unemployment.

(4) On balance, policy is likely to become more restrictive during the next 12-18 months in a bid to cool growth and avoid a further build up in inflationary pressures. Despite a couple of increases in bank reserve requirements this year, monetary policy is still very simulative. Most of the interest rate reductions and cuts in required reserves implemented in 2008 and 2009 to sustain growth in the midst of the global banking crisis have still to be reversed.

Overall demand for imported commodities will continue to rise. But the small exchange rate shift signalled by PBC at the weekend is unlikely to prompt a big increase in demand for imported items or put significant upward pressure on international commodity markets traded in dollars in the near term.

Ends --

By John Kemp, Reuters Columnist - for Commodities Now