From the FT:
China has kick-started a major plan to internationalise the renminbi and the process is likely to be faster than many expect, according to HSBC.This is clearly a great effort on the part of China and something they desperately need. But there is one small problem. The renminbi exchange rate is pegged to the dollar and is highly controlled. A currency can not take a center stage in the global markets if it's not free floating.
If successful, this could lead to nearly $2,000bn in annual trade flows, or as much as 50 per cent of China’s total, being settled in renminbi each year by 2012, compared with less than 10 per cent today.
Back in 05 under the US pressure, China allowed a controlled appreciation of the renminbi against the dollar, claiming it was a "float". Over the 3 years that followed, they allowed a roughly 6% appreciation a year - just enough to make Washington happy. As the global slowdown became apparent, China stopped the appreciation and fixed the exchange rate at about 6.8 CNY per USD.
When governments artificially control markets, unintended and often unwanted consequences arise. China now has a problem. Keeping currency artificially low causes foreign capital to flow in to purchase artificially low-priced assets. China has accumulated $2 trillion of foreign reserves and rising. China's choices have become limited: let the currency appreciate more to slow down foreign capital inflows or impose foreign capital controls (another artificial measure). Neither is appealing to the communist regime.
The renminbi is now a boiling pot, ready to explode. If the peg is lifted, the currency could easily appreciate 30%. And what would happen then? China's competitive edge with respect to exports would rapidly diminish. It would have to actually compete instead of using artificially low prices due to a fixed exchange rate. And that China is not prepared to do.
To see how a floating currency exporter competes, take a look at Japan. The yen not only floats but is quite volatile and can swing 20 plus percent a year. Japan has to compete on quality of product and spread it's manufacturing internationally to manage currency fluctuations.
For example Japanese firms who sell autos in the US, manufacture them mostly in the US as well. Japan does not rely on cheap currency and is able to compete head to head with US manufacturers mostly in dollars. But just like it is for the US, it's tough for Japan to compete globally without the cheap currency (and therefore cheap labor) advantage. That's why Japan's growth has stalled and will remain weak for some time to come.
But it's an ugly reality that China refuses to accept. They need growth of over 8% to keep the masses content and keep the communist regime in power (see post called Frustrated, China's regime is showing it's teeth). Weak currency is their main tool to maintain growth.
China will use the foreign reserves to acquire assets abroad and secure energy and raw materials sources. But artificially weak currency is not a sustainable long-term policy as it brings with it some serous domestic problems. These problems may include price inflation in goods and particularly labor, ultimately causing more domestic unrest.
Before renminbi becomes a major global currency like the yen, China will need to take some harsh medicine dished out by the free markets. And until there is a political change in Beijing, it's hard to imagine China moving away from the "cheap currency" policy to compete internationally.