Foreign exchange markets will focus keenly on the communique from today's meeting of G7 finance ministers for signs that China will move earlier than expected to a more flexible exchange rate regime, so opening the door to wider East Asian currency realignments.
The US gesture of inviting a Chinese delegation to attend the finance ministers' formal dinner could provide Beijing with the face to justify such a move. It would also would provide President George W Bush with a major pre-election coup.
IMF Managing Director Rodrigo Rato yesterday welcomed the use of "informal fora" such as the G7 dinner to increase international contacts with China and suggested this could help policy-makers in making "political decisions."
He said that China now has "room to manoeuvre to start moving towards a more flexible exchange rate" because of its strong economic growth and that it "does not need to abandon the capacity to protect its capital account" by doing so.
Beijing officials have indicated that they regard China's admission to G7 deliberations as a precondition for liberalizing the exchange rate of the yuan, a senior Japanese source told Emerging Markets.
Japan has jealously guarded the privilege of being the sole Asian member of the G7, but it is willing to support China's G7 membership in return for support on its bid for a permanent seat on the UN Security Council, the source said.
Foreign exchange markets cannot afford to be wrong-footed a second time after last year's G7 finance ministers meeting in Dubai produced a surprise declaration on the need for "greater flexibility" on exchange rates. Reflecting this anxiety, dealers have been taking positions in the yuan ahead of the G7 meeting, and any hint in the communique of a more flexible Chinese stance would also send them scrambling to cover their positions in other East Asian currencies.
If China was to allow the yuan to appreciate by 15% to 20% from its rate of around 8.28 to the dollar, that would also allow other East Asian nations (including Japan) to appreciate their currencies without losing out vis-a-vis China.