Amid some confusion over just how it will work, economists are scurrying to decode the implications of China’s decision to revamp its currency regime today, abandoning the peg to the U.S. dollar in favour of a managed floating regime based on a basket of currencies.

The new currency basket remains unspecified at this point, and China has allowed an initial 2% revaluation against the dollar. The trading band for the new currency basket will also be very tight, limited to just 0.3%.

“Details are still very hard to come by and there is a good deal of confusion regarding the mechanism of the peg and the basket; even so, this will be seen as the first step in a series of revaluations,” comments BMO Nesbitt Burns. “Such a small revaluation can have little real effect on global trade flows or economic activity. But the psychological and expectational effects are meaningful, and will no doubt mitigate some of the trade tensions between the U.S. and China.”

The move to cool those tensions is being heralded by politicians. Jean-Claude Trichet, president of the European Central Bank, issued a statement indicating that he approves of China’s move. “The international community had considered such a move towards greater flexibility desirable for a better functioning of the global economy,” he said. “I welcome this decision and expect the handling of the new managed floating exchange rate regime to contribute to global financial stability.”

Canada’s Minister of Finance Ralph Goodale also applauded the move, saying, “Canada and the rest of the G7 have been saying for some time that increased flexibility in the Chinese exchange rate would benefit the Chinese economy and would contribute to greater stability in the global economy. Today’s announcement makes it clear that the Chinese authorities agree.”

“It remains to be seen exactly how the new system will work and how much flexibility it will provide. But this is an encouraging first step,” he added.

“A change in the exchange rate regime was generally expected at some point,” notes Bank of Montreal. “The changes announced involve a somewhat smaller initial revaluation than many expected, but this is consistent with China’s cautious approach to policy changes.”

BMO notes that some implications of the Chinese currency move became immediately apparent. The yen appreciated about 2% versus the dollar, Malaysia abandoned its currency peg against the US dollar, and Singapore is also due to make some changes in its currency regime. “In general, Asian currencies can be expected to appreciate in sympathy with the yuan to maintain relative competitiveness with China. This may help the US contain its expanding trade and current account deficits, but the size of the currency movements is too small to solve their external deficit problem,” it says. “However, the revaluation may help defuse some of the protectionist fervour building in the US Congress, in particular the threatened 27% tariff on Chinese imports.”

RBC Capital Markets notes that the yuan revaluation has implications across a host of currencies and will affect U.S. interest rates, which means that most developed markets will see some follow-on effect on yields. But it sees bigger implications too. “First, this will likely be perceived as a first step of many. So, rather than addressing concerns about its undervalued currency, this move will only prompt more speculation that further adjustments are on the way. Speculative currency inflows into China will accelerate, increasing the pressure caused by excess money growth in China’s domestic economy,” it predicts.

However, CIBC World Markets suggests, “While today’s announcement implies that further adjustments are coming over time, China isn’t going to risk upheaval by taking a great leap forward in foreign exchange policy. We could see another 5% rise against the US$ over the next year, particularly if the dollar weakens against other currencies. But it’s hard to see Beijing doing anything bolder as it tests the waters in terms of the economic consequences.”

Assuming that China will revalue further, BMO Nesbitt says this is good for most stocks and bad for bonds. “It is good for the Canadian economy as it marginally reduces the cost of commodities for Chinese consumers and, thus, might increase demand,” it adds. “A mitigating factor, however, is the weakening effect of revaluation on the Chinese economy.”

“A stronger Chinese currency also has implications for Canada’s resource producers. Its appreciation effectively lowers the prices for these commodities in China, and thereby increases demand at any given US$ price. But as for the other implications for Canada, the baby-step approach to currency revaluation will leave such impacts hard to see amidst the general volatility in commodities markets,” offers CIBC.

@page_break@China’s revaluation will have some other indirect effects on Canada, RBC notes. “The net effect is likely to be less pressure on the Canadian dollar to appreciate. However, there will also be some pressure on Canadian long-term yields to follow U.S. yields upward, with a minor impact on Canada’s housing market,” it says.

“More importantly, even this small revaluation means that China will be collecting fewer U.S. dollars due to its trade surplus and will, therefore, be recycling fewer dollars into U.S. Treasury purchases,” RBC adds. “China’s move could provide the trigger for an upward move in long yields. The impact of higher yields will be felt most keenly in the booming U.S. housing market and will reduce demand for other interest-sensitive consumer spending, taking some wind out of the U.S. economy. This upward influence on yields will be felt across developed markets with similar effects on housing in other countries.”

“Politically, this was an astute move by the Chinese,” BMO Nesbitt declares. “It markedly reduces the probability of the Treasury declaring China a ‘currency manipulator’ and it will cool the rhetoric of trade restriction and retaliation in the U.S. Congress. Certainly, the politicians will still talk tough against China, but it is unlikely now to manifest in actual legislation, especially in advance of the August 1 recess and the September visit of President Hu Jintao.”