By Emily Kaiser and Brian Love
WASHINGTON/PARIS, June 22 (Reuters) - China's looser grip on its currency won't alter sluggish U.S. or European growth prospects unless Beijing is prepared to assume the mantle of the world's consumer of last resort.
In the short run, a stronger yuan would help neutralize a small but worrisome deflation threat in advanced economies, and boost prospects for U.S. exporters hurt by a weak euro.
If Saturday's surprise announcement of greater yuan flexibility is to pay long-term dividends, however, China will need to back it up with structural shifts that encourage its consumers to spend more and save less.
Judging from China's words and actions in the past 48 hours, the yuan policy shift appears to be more about Beijing protecting its exports to Europe rather than bowing to U.S. pressure for a stronger currency to reduce trade imbalances.
"By far the most important motivation is China's concerns regarding the euro crisis," said Donald Straszheim, head of China research at Los Angeles-based ISI Group.
The yuan had risen 15 percent against the euro in the last two months as European debt worries sent investors flocking to the perceived safety of the U.S. dollar, threatening China's exports to its largest trading partner.
By linking the yuan to a basket of currencies rather than just the dollar, China can better respond to euro swings. But that also means the dollar-yuan exchange rate is likely to be "more ragged and jagged" in the future, Straszheim said.
"This is going to drive Washington nuts," he said.
The yuan's gyrations so far this week illustrate that. Beijing allowed the yuan to rise sharply on Monday but then fall on Tuesday, a bid to discourage investors looking to profit on a one-way currency appreciation bet.
JUST KEEP GROWING, PLEASE
Lost in the excitement of the yuan's unshackling is that Beijing thinks its economy is strong enough to withstand it. That may be more meaningful for the United States and Europe than any modest movements in China's currency.
In its announcement of the more flexible currency policy, the People's Bank of China said the country's economic recovery "has become more solid." First-quarter economic growth clocked in at an explosive 11.9 percent.
The United States and Europe are both facing sluggish growth as their own consumers -- and governments -- dig out of debt. Both regions are looking to exports to pick up the slack. Both need China's relatively untapped consumers.
"We need to find a (new) consumer of last resort," said Gilles Moec, senior European economist at Deutsche Bank in London. "China's a good candidate."
A gradually strengthening yuan increases the purchasing power of Chinese consumers.
Euro zone exports to China rose 334 percent in the decade from 1999 to 2009, according to statistics published by the European Union's statistics office, Eurostat. Euro zone exports to the United States, although still much bigger in absolute terms, rose just 11 percent.
It is a similar story in the United States. While the United States exports three times as much to the European Union as it does to China, its Chinese exports jumped 431 percent from 1999 to 2009, while EU exports rose just 43 percent.
SMALL DOSE OF INFLATION
Back in 2005, the last time China eased its grip on the yuan, the worry was this would trigger a rise in inflation among advanced economies that had benefited from cheaper Chinese goods, and a drop in demand for U.S. government debt because Beijing's purchases would fall.
Neither prediction proved accurate.
Between July 2005, when China began its revaluation, until July 2008 when it was halted, China's holdings of U.S. Treasury debt rose to $550 billion from $300 billion, according to David Rosenberg, chief economist at money management firm Gluskin Sheff in Toronto.
China's Treasury holdings stood at $900 billion as of April, according to the latest Treasury Department report on international capital, released last week.
Core U.S. inflation, which excludes food and energy, fell to 0.9 percent year-over-year in May, the lowest since 1961, compared with 2.1 percent back in 2005.
With U.S. unemployment near 10 percent and the housing market weak, deflation poses a modest but not insignificant threat, so a little import price pressure coming from China would not be such a bad thing right now.
"The world is awash with $222.5 trillion of total liabilities across public and private sector claims, or the equivalent of 362 percent of global GDP," Rosenberg said. "Extinguishing this debt will be deflationary."
REBALANCING? MAYBE NOT
Those hoping China's embrace of currency flexibility is the first step along the path to reducing its emphasis on exports may be disappointed.
China and the rest of the Group of 20 nations signed on to a U.S.-backed framework for balanced economic growth in September, but so far there is little evidence of policy adjustments that would curb China's reliance on exports.
The weekend's currency announcements were not accompanied by any structural moves that would encourage domestic demand, such as enhancing the social safety net so that households would be less inclined to save.
To be sure, Beijing would never have endorsed the currency shift if authorities thought domestic demand was set to fall, Deutsche Bank's Moec pointed out, and giving its 1.3 billion citizens greater buying power will no doubt boost consumption.
But Straszheim, the China researcher from ISI, said he had misgivings about Beijing's commitment to global rebalancing.
"To China, the best way to assure a robust consumer sector is to have an economy that is generating jobs, and that is still heavily (dependent) on the trade side," he said.
"It's sort of like the old saying in America: The best welfare program is a good job." (Editing by Chizu Nomiyama)