WSJ on leadup to revaluation

WSJ on the leadup to revaluation. Careful preprations began two years ago, but the Senate tariff threat determined the timing. Treasury officials were on the ball.

Behind Yuan Move, Open Debate and Closed Doors
Two-Year Saga Included Secret and Staged Meetings, Weeks of Quiet Diplomacy
By JAMES T. AREDDY in Shanghai, NEIL KING JR. in Washington, MARY KISSEL in Hong Kong and JASON DEAN in Beijing
July 25, 2005; Page A1

Last Thursday morning, several key foreign banks were asked to send a representative to the headquarters of the People's Bank of China, the central bank. The topic wasn't clear.

The meeting began around the time China's foreign-exchange market was closing for the day at 3:30 p.m. As a central-bank official began to talk, the doors were shut and locked.

"They started talking about something that wasn't very useful and then started to collect mobile phones and BlackBerrys," said a banker who was briefed later. The Chinese then distributed a four-point statement: Beijing was unlinking the yuan from the U.S. dollar effective immediately.

Then another surprise: The bankers were told they would have to cool their heels until an official statement was read nearly three hours later on China's government-controlled 7 p.m. news program.

That last-minute combination of surprise and secrecy was in keeping with the long-running drama over the yuan. It is a saga whose twists and turns included secret trips to Beijing by a U.S. envoy, debates among Chinese ministries about how much to revalue, and a seaside conference in China that featured American economists debating before an audience of high-level Chinese officials whether or not revaluation made sense.

According to U.S. and Chinese officials, China began thinking about allowing the yuan to rise in value against the U.S. dollar in 2003 with the accession to power of a younger, reform-minded generation of Chinese leaders led by President Hu Jintao and Prime Minister Wen Jiabao. Leading the push for change was the newly appointed head of the central bank, the scholarly, English-speaking Zhou Xiaochuan.

Foreign bankers consider Mr. Zhou one of the best of a new breed of senior Chinese officials familiar with the intricacies of global economics and market economies. Before running the central bank, Mr. Zhou spent 20 months as China's top stock-market regulator, but his credibility stemmed from top central-banking positions through the 1990s.

Proponents of a change in the yuan argued that more countries were moving toward flexible exchange-rate systems and that blindly tying the yuan to the value of the dollar kept China's financial system dangerously closed, hobbling the development of needed overhauls like market interest rates.

Opponents feared the impact a change would have on China's booming exports. A stronger yuan would tend to make China's exports more expensive relative to other countries' exports. And some were chafing at what was already becoming a drumbeat of American criticism of China's currency policy.

People were saying, " 'Why should we have to listen to what America says,' " said a Chinese official familiar with the yuan debate. Yet, similar debates about the currency policy were taking place among Chinese leaders, their views emerging through ministry-linked think tanks and reported prominently in the nation's financial media.

In the spring of 2003, the People's Bank stepped up its study of China's peg to the dollar and whether the government should make a change. It held staff seminars on exchange-rate and macroeconomic management, and invited leading U.S. economists to Beijing to present their views. The central bank also sent officials to the Hong Kong Monetary Authority, the city's central bank, and the U.S. Federal Reserve for training.

Aware of the research taking place inside the central bank, economists at investment banks in Hong Kong and China began confidently predicting that China would scrap its peg to the dollar. That accelerated a guessing game in the financial markets about the yuan that would last for the better part of two years.

Meanwhile, in Washington, criticism of China swelled as the U.S. trade deficit with China widened. In 1998, U.S. officials had praised China for sticking with its fixed peg to the dollar during the 1997 Asian financial crisis. But now the U.S. and many European countries charged that the yuan was grossly undervalued and gave China an unfair advantage selling its products overseas.

Hoping to deflate the issue, U.S. Treasury Secretary John Snow flew to Beijing in early September 2003 to meet with Mr. Zhou and Chinese Finance Minister Jin Renjing. The Chinese adopted what became a very familiar line: They might one day move to a more-flexible exchange rate, but never under U.S. pressure.

Three times in 2004 Mr. Snow met with his Chinese counterparts to seek some sign of progress on the currency issue, each time coming away with little to show to increasingly vocal critics back home. China, in the meantime, was quietly stepping up its meetings with officials at the Monetary Authority of Singapore, the city-state's central bank.

Singapore was one of the most successful adherents to a managed floating exchange-rate system, presiding over an expanding economy and keeping inflation in check for several decades. China's central bankers sent midlevel staff for extended visits to Singapore's central bank to learn how it managed its exchange-rate regime.

In May 2004, China hosted a two-day conference in the seaside town of Dalian. Beijing-based officials, including Mr. Zhou and his deputy, listened to presentations on exchange-rate management from top American economists. Stanford University's Ronald McKinnon and Columbia University's Nobel Prize-winning Robert Mundell didn't support a change to China's peg to the dollar. Harvard University's Jeffrey Frankel and Morris Goldstein of the Institute for International Economics in Washington did. One big risk they saw to adjusting the exchange rate was that too small a change could prompt speculators to demand more, a situation China may now face.

At the end of the conference, a senior Chinese bank official stood up and said China planned to follow Mr. Mundell's advice in the short term and Mr. Goldstein's advice in the long term, "only we're not going to tell you how long the short term will be."

In Washington, congressional anger over the yuan came to a boil this spring. On April 6, Sen. Charles Schumer, a New York Democrat, and Sen. Lindsay Graham, a South Carolina Republican, pushed an amendment to the annual State Department spending bill that would impose 27.5% duties on all Chinese imports if Beijing didn't agree to revalue its currency. A vote to reject the amendment was defeated, 67-33. It was an overwhelming vote of support for the anti-China legislation -- especially coming from a chamber not known for its protectionist passions -- and it surprised the Bush administration.

Within the Treasury Department, the tone shifted markedly. "There was a sense of exhaustion over defending the Chinese," said a Treasury official. "There was a general sense of being tired."

On May 19, Mr. Snow appointed a special envoy to China on the currency issue, Olin Wethington, a longtime Treasury official who had just brokered a huge settlement for much of Iraq's international debt. Mr. Wethington left the next day on the first of what became three unpublicized, weeklong trips to Beijing during the next three months. "We made a judgment that...there was ample room for a quiet discreet effort out of the limelight," said another Treasury official. "But we realized we needed to broaden the dialogue within the regime and to reach into other parts of the government and to raise the issue much higher in the hierarchy."

During the next seven weeks, Mr. Wethington and his team met with political and business leaders in China, including officials in the Foreign Ministry, the president's office, the central bank and the upper ranks of the Communist Party. Mr. Wethington told the Chinese that if they didn't give significant flexibility to their exchange rate, there could be adverse consequences on the U.S. side.

By May, according to officials with the International Monetary Fund, it was becoming clear the Chinese were preparing to value the yuan against a basket of currencies and were spending a great deal of time with monetary authorities in Singapore to see how their system worked. The IMF had been pushing Beijing for several years to adopt the basket-of-currencies approach.

Inside China, people who deal with the central bank say, the bank was pushing for an initial 5% revaluation of the yuan against the dollar. But under pressure from other ministries that feared the impact on China's exports, China's State Council, or cabinet, decided instead on 2.1%.

On his final trip to China, late last month, Mr. Wethington picked up strong signals that the Chinese were ready to move on the yuan. But they also made clear that they would do nothing under direct pressure from the Bush administration or Congress. So on June 30, in a highly visible move, Fed Chairman Alan Greenspan and Mr. Snow went up to Capitol Hill for a highly staged closed-door session with Sens. Schumer and Graham.

The Chinese were ready to budge, the senators were told, but only if the Senate put aside its tariff threat. The senators emerged from the meeting and announced that they were delaying any vote on the amendment until after the August recess.

Late Wednesday, hours before the rest of the world heard of China's decision, the Bush administration received official word from Beijing that China was ready to alter its exchange rate and adopt what the central bank calls a managed floating-exchange rate that includes reference to a basket of unnamed currencies. Hong Kong was also told in advance, said a person with knowledge of the situation.

The next day, shortly before 7 p.m., Chinese officials delivered the government's official statement to the chief editor of China's main evening news program with directions that it be read at the top of the news. The statement was also placed on the Web sites of China's central bank and the official Xinhua news agency, both of which crashed under an avalanche of Internet hits.