Slow float from China

Hopes are riding high that China will soon announce a change in its fixed exchange rate policy in the wake of yesterday's surprise meeting between US Treasury Secretary Timothy Geithner and Chinese Vice-Premier, Wang Qishan.

Any move by China to allow the yuan to appreciate and to widen the daily trading band within which the yuan is allowed to fluctuate against the US dollar will be hailed as a political victory for the Obama administration, which for months has faced intense pressure from Congress to insist Beijing change its currency policy (Full coverage: China's economic policy).

Recently, however, the Obama administration has been scrupulously avoiding any suggestion that it is pressuring China over its currency.

Last weekend, Geithner delayed the release of a US Treasury report, which might have labelled China a 'currency manipulator'. Such a move would undoubtedly inflame already tense relations between Beijing and Washington. And several days ago, Geithner told Indian television that it was "China's choice" whether to revalue its currency, although he believed Beijing would see that it was in its interests to have a more flexible currency.

And of course Geithner is right. If China decides to let the yuan appreciate, it is far more likely to reflect Chinese concerns over surging commodity prices than a desire to placate US politicians.

The huge pressure on iron ore prices has seen big producers – such as the giant Brazilian mining company, Vale, and Australia's BHP Billiton – drop the 40-year system of annual price negotiations and move to short-term contracts. As a result, Chinese steel mills now have to pay close to double the price for iron ore than they were previously paying.

And it's a similar story for other major commodity imports. As a result, Chinese companies are facing steep increases in their input costs, which they are passing on in the form of higher prices. Letting the yuan appreciate against the US dollar would mitigate the effect of these big jumps in the prices of their commodity imports, which are priced in US dollars. For the Chinese, a stronger yuan would have the important benefit of taking some of the inflationary pressures out of the Chinese economy.

There's little doubt that a stronger yuan will hurt low-margin export industries such as textiles and shoes, that are already grappling with the problem that Chinese labour costs are higher than countries such as Vietnam and Bangladesh. Against this, the Chinese government will be weighing the inflationary pressures building up in the entire economy from the sharp increases in the prices of commodity imports.

When China finally lets its currency rise against the US dollar, you can be sure that it has much more to do with trying to counteract the effect of surging import prices, than with trying to whittle down its massive trade surplus with the United States.

Remember, it was only last month that Chinese Premier Wen Jiabao was declaring the yuan was not undervalued, and was warning the US to desist from trying to force China to let its exchange rate move with the market. He also launched a thinly veiled attack on the US, saying "What I don't understand is depreciating one's own currency, and attempting to pressure others to appreciate, for the purpose of increasing exports. In my view that is trade protectionism.”

Now, the carefully scripted line from Chinese officials is that the Chinese move to peg its currency to the US dollar in July 2008 was only a temporary policy measure that was adopted in response to the financial crisis.