China finally makes its move on RMB. But is this the real deal?

After months of intransigence, Beijing has finally announced a move to end the yuan's 23-month old peg at 6.83 against the USD. The announcement was made by the People's Bank of China at 7 p.m. on Saturday, 19-June-2010.

So is this the real deal the financial community has been eagerly waiting for?

For sure, those clamouring or hoping for an outright revaluation of the renminbi against the greenback were disappointed. Some even accused Beijing of posturing ahead of the coming G20 meeting in Toronto this weekend. They were hoping to prevail with a clear and transparent exchange rate policy from China.

But for us, this is the real deal. It is an unequivocal abandoning of the fixed rate regime for a managed float. Yes, we agree that they could have offered more in terms of details rather than a few statements couched in broad terms referencing "flexibility" in the exchange rate and ruling out "large scale" adjustments.

But what do you expect from China? Transparency is not exactly a hallmark at this stage of their development. And besides, in a managed float regime against a basket of currencies similar to Singapore's, the idea is not to give away the mechanics and the whole kitchen sink. In other words, don't expect predictability from them but you can be sure they'll strive for stability in their exchange rate with orderly movements. China simply doesn't want a volatile exhange rate that exist now amongst the G3 currencies.

The implications for this move is enormous. For one, this flexibility in the exchange rate frees up its monetary policy which theoretically had to be subsumed under the US Federal Reserve because of the peg. A stronger currency will also cap inflationary pressures in the country.

The longer term impact of a stronger RMB bodes well for domestic consumption as overall purchasing power increases. This will surely help China rebalance its economy towards a consumption orientation from the current investment and export driven model. Of course, this is no magic bullet. China still needs to look into helping its citizen reduce precautionary savings for education, health care and old age to boost disposable income for consumption.

We reckon that the central bank will probably move very cautiously and slowly in the initial months. With the RMB having appreciated substantially by 16% against the EUR since the start of the year, its current account surpluses shrinking and its terms of trade expected to deteriorate over wage hikes in the coming months, there is limited room to move against the USD from current levels.

Still, we think it is reasonable to expect a rate of 6.60 and below per USD within the next 12 months. The current spot rate is 6.8167.