China's move to introduce flexibility in the exchange rate policy of its currency, the yuan, is good news for the world economy. While financial markets around the world moved up sharply on hopes of a more competitive trade, it would be premature to read too much into the unexpected announcement by the People's Bank of China that it would push for a reform of the renminbi exchange rate mechanism at a time when the world economy is recovering and the Chinese economy is on a sound footing. Neither a sharp one-time revaluation of the yuan nor a shift to a free floating exchange rate system is on the cards. China will continue to manage the exchange rate through the central bank. What is certain, however, is that the Chinese currency will move up in a regime of greater flexibility but the appreciation will not be sharp or immediate. The announcement by China, which came days ahead of the G20 Toronto summit, is significant in that it converts a contentious bilateral China-U.S matter into a multilateral one. It is almost certain that the G20 countries will shift their attention to the lingering global imbalances, where many countries blame the U.S. more than any other country. At the same time, China's effort at rebalancing the global economy through its new exchange rate policy will not go unnoticed.
China's new policy is guided by certain significant domestic factors as well. Its competitiveness is getting eroded, with domestic wages and prices rising faster than in partner countries. Also, in the context of its currency's peg to the dollar, the steep decline in the euro has caused a sharp rise in the renminbi on a trade-weighted basis. Currency appreciation can dampen domestic inflation as it makes foreign goods cheaper to buy. China's flexibility will help India in at least two ways: Exporters will get some relief in the battle with Chinese producers to win global business, and when they do, the Reserve Bank of India will have more leeway in dealing with inflationary pressures without worrying about the consequences of monetary tightening and rising interest rates. Way back in 2005, China abandoned its dollar peg and floated the yuan against a basket of currencies that included the euro and the yen. The yuan appreciated by 21 per cent in the almost three years that the system operated. However, the past need not be a guide to what is going to happen now especially because the global economy has changed so comprehensively. China's new approach to its exchange rate may not be the kind of reform some were hoping for, but the fact that even an announcement from Beijing can have such an impact all-round clearly underlines China's rise.