The politics behind China’s surprise

By Nicholas Consonery

On Saturday June 19, Beijing shook Washington and global markets with a landmark announcement that its currency, the renminbi (RMB), would become more flexible. The move caught many by surprise, including yours truly. I thought — and argued earlier on this blog — that Beijing’s concerns about the fiscal crisis in Europe (which still seems to be getting worse) would likely delay action on the RMB. I was wrong.

At the onset, I’ll say that my fundamental understanding of the Chinese government’s economic priorities has not changed. Beijing still has tremendous incentive to protect its export-focused industries in the short-term, and the leadership has already made clear that it is very concerned about the potential spillover of a financial or even sovereign debt implosion into the European real economy. This could threaten the strength of Chinese exports to the continent and risk slower growth in China. So even though the RMB has become a bit more flexible, I expect we will only see very slow, crawling-upward appreciation against the dollar this year for these very reasons.

But if Beijing is so concerned about the strength of its exports, why pursue even slow upward movement in the RMB — which would make Chinese-made goods more expensive? Especially when the currency is already appreciating on a trade-weighted basis; up by 3.37 percent according to the Bank of International Settlements?

The short answer is that Beijing is not impervious to foreign pressure, and became convinced that the potential downside costs of doing nothing outweighed the risks behind a small move.

This leads me to the current discussion over whether Beijing was more motivated by political or economic factors in moving on the currency. I think it’s a false paradigm, because both factors were at play, and in China, everything economic is political. To my mind, the decision was economic, but the timing was political.

Let me explain my thinking:

First, Beijing’s move on the RMB might actually have done more to protect Chinese exports than if they had done nothing. In moving on the RMB, Beijing is seeking to avoid foreign policy turmoil that could disrupt its economic goals. In other words, it became clear to Beijing over the past few months that if they did nothing on currency, the Obama administration might not be able to hold back congressional pressure to impose concrete punitive measures against imports from China. Beijing’s move on the RMB made it far less likely that these punitive steps are taken, and thus the outlook for China’s ability to continue (mostly) unhindered exports to the United States remains strong.

Beijing must have sensed — more than I gave them credit for — the growing likelihood of a punitive response from the United States on currency, and they were aware that the more visible and direct the critics in D.C. became, the harder it would become for them to sell a move domestically (which goes back to the point of risking a much more confrontational trade relationship with the United States). So they timed the move to accrue maximum political benefit — perfectly coordinated to coincide with the G20 summit in Toronto this week. And they gamed us all ahead of time by greatly lowering everyone’s expectations — making even a very small move that much more gratifying. In doing so, they have all but silenced the international criticism and (momentarily?) eroded any broader support for the more punitive moves called for by leading China skeptics in Washington.

But another important point is that I don’t believe Beijing would have made any change in their currency policy unless at least some contingent in the bureaucracy was arguing that it was in China’s best economic interest to do so. And this is exactly the argument that’s been waged within the Chinese bureaucracy for the past six months, where we’ve observed a consistent back-and-forth between policymakers at the Chinese central bank (PBoC) and the Ministry of Commerce (MOFCOM) on whether and when to proceed with exchange rate reform.

PBoC officials have been arguing consistently that RMB reform must move forward, both because of its immediate function in combating inflation, and because of its longer-term role in promoting the economic restructuring discussed above. But MOFCOM officials have been generally opposed, citing the potential downside risks of appreciation for export-focused industry. At the end of the day, it looks like May’s positive economic data — which showed a nearly 50 percent increase in Chinese exports year-on-year and a slight uptick in consumer price inflation — convinced the top leadership that the PBoC was right, and that the domestic economy could still benefit from a very gradual appreciation of the currency despite the ongoing fallout in Europe.

The final point is that China’s economic priorities are not simply limited to protecting exports. It has been clear, especially for the past year, that Beijing is becoming more serious about taking steps to reduce the economy’s reliance on export and investment-intensive growth. The crawling appreciation I’m expecting for this year won’t help much in this regard, but in a longer-term sense, Beijing clearly needs a stronger, more flexible currency to accomplish many of its economic goals, from promoting domestic consumer spending to strengthening the ability of Chinese firms to purchase inputs abroad (like natural resources), and fostering the domestic financial industry. The rising generation of Chinese leaders is clearly focused on pursuing these adjustments. In late May, Vice Premier Li Keqiang (who will likely become the next Premier in 2012) promoted this kind of economic restructuring in a consequential speech published in the leading Chinese Communist Party journal Qiushi. In his speech, Li specifically discussed the role that the RMB reform could play in rebalancing the domestic economy. Next time I’ll take his words (a bit) more seriously.

Nicholas Consonery is a China analyst at Eurasia Group.