China
Fasten the Seatbelt
October 23, 2007

By Qing Wang | Hong Kong

G7’s growing impatience with China
In its communiqué released last Friday, the G7 stated that “In view of its rising current account surplus and domestic inflation, we stress [China’s] need to allow an accelerated appreciation of its effective exchange rate.” The relevant language in previous statements reads “In emerging economies with large and growing current account surpluses, especially China, it is desirable that their effective exchange rates move so that necessary adjustments will occur.”

According to my colleagues Sophia Drossos and Yilin Nie from our foreign exchange strategy team, this represents “...the first meaningful change in FX language since April 2006 and signals a growing impatience among the G7 with China’s only gradual pace of currency appreciation” (see G7: Commentary, October 19, 2007).

The G7’s explicit call for accelerated appreciation of the renminbi effective exchange rate suggests that the Euro Zone authorities have become more concerned about China’s exchange rate policy. Although the renminbi has appreciated against the US dollar, it has not appreciated much against the euro, resulting in rather limited renminbi NEER appreciation (i.e., renminbi exchange rate against a currency basket). Accelerated renminbi NEER appreciation would entail a meaningful renminbi appreciation against the euro, which in turn implies much faster renminbi appreciation against the US dollar, given the current US dollar weakness.

China’s steadfast gradualism
The growing impatience of G7 – especially the Euro Zone – with China is not unwarranted. I estimate that the renminbi NEER has actually depreciated by 1.5% since mid-June. This is mainly because, during the same period, although the renminbi appreciated against US dollar by 1.5%, it actually depreciated against the euro by 5.2%.

China has followed a gradualist approach. In 2006, the renminbi appreciated against the US dollar by 3.4% but against the currency basket (i.e., the NEER) by only about 0.8%. As of last Friday, the cumulative appreciation against the US dollar so far this year was 4%, but against the currency basket only about 1.4%. Moreover, I think that the relatively slow pace of renminbi appreciation in recent months has in part reflected the generally cautious approach in policy-making in China in the run-up to the CPC Congress meeting that started on October 15 and is due to conclude on Monday, October 22.

Time to fasten the seatbelt
I believe it is time to fasten the seatbelt, as the USD/CNY rate is likely to embark on a steeper and bumpier journey in the coming weeks. Since July 2005, when China’s exchange rate regime shifted from a de facto US dollar peg to a managed-float arrangement, the USD/CNY has been on a trend of gradual appreciation against the USD. It has not, however, been a straight-line appreciation. The slide of the USD/CNY rate has been appreciably faster in some segments of its downward trajectory than others. And the timing of these episodes of faster move appears to have been related to the timing of major international events that put the issue of renminbi exchange rate in the spotlight. Moreover, when major domestic events (e.g., NPC meeting, CPC meeting) take place, the renminbi appreciation tends to slow, as the policy-makers may not want the issue of exchange rate policy to influence the meeting agenda.

Looking ahead, the CPC Congress meeting will conclude on Monday, October 22. I expect that the authorities’ policy agenda will naturally become more active after this meeting. In fact, I expect a mini-tightening cycle that runs from late this month until early next year (see China Economics: Runaway  Monetary Growth Points to a Mini-tightening Cycle in the Coming Months, October 14). Faster renminbi appreciation will be an important component of the policy package, as it helps not only narrow trade surpluses but also contain inflationary pressures, which are the most important challenge to Chinese authorities at the current juncture, in my view. In fact, while the policy-makers have tried using all types of policy instruments in managing the macro-economy in the last couple of years, the exchange rate is the only potentially powerful tool that has not been used prominently in the policy package, in my view.

Besides domestic political and economic developments that point to faster renminbi appreciation, several major international events may serve as catalysts for accelerated appreciation, especially in view of the renewed international pressures on China on this issue. It is quite possible, in my view, that the Chinese authorities may use these high-profile events as opportunities to demonstrate to the international community in general and to their G7 counterparts in particular China’s repeated commitment to exchange rate flexibility.

Specifically, the IMF is expected to conduct its 2007 Article IV Consultation with China – an annual event that provides the international community an opportunity to review China’s economy and policies – sometime in late October or November. The renminbi exchange rate will likely be the most important issue for the year’s discussion. I think it is possible that the IMF will designate the renminbi exchange rate as “fundamentally misaligned”, in view of the IMF’s new policy framework that was made effective in June. China will of course challenge such a potential conclusion. A visible acceleration of the renminbi appreciation in the run-up to this meeting should help make the authorities’ case, in my opinion.

 

ECB President Trichet will travel to China on November 28-29. In view of changes in the language on China in the latest G7 communiqué, Mr. Trichet would certainly be discussing the renminbi exchange rate issue with his Chinese counterparts. Past experience suggests that renminbi appreciation tends to accelerate before or after these high-profile meetings take place.

The third China-US Strategic Economic Dialogue (SED) meeting will likely take place around mid-December. In the run-up to the first SED meeting, renminbi appreciation accelerated markedly. A couple of days before the second SED meeting took place, China widened the official USD/CNY daily trading band, and the appreciation pace picked up in the weeks following the meeting. While I cannot rule out completely the possibility that China may widen the trading band again as a gesture to its US counterparts before the third SED meeting, I believe that a much faster pace of appreciation is more likely and makes greater sense.

Our forecasts
Since I expect the pace of renminbi appreciation against the US dollar to accelerate markedly for the remainder of the year, I endorse our FX strategy team’s forecast that the USD/CNY rate will reach 7.30 by end-December (see FX Impulse, October 18, 2007). This year-end target implies about 2.7% appreciation of the renminbi against the US dollar for the remainder of the year and slightly less than 7% for 2007 as a whole.

Despite this seemingly aggressive USD/CNY forecast, I estimate – based on our FX strategy team’s forecasts of the exchange rates for China’s major trading partners – the cumulative appreciation of renminbi NEER for 2007 will be only about 3.9%. This is in part because recent depreciation of the renminbi NEER has created a cushion such that even a faster appreciation in the rest of the year will have only a moderate whole-year impact. Along its steeper downward trajectory, I also expect the USD/CNY rate to demonstrate much greater volatility.

No chance of another ‘one-off’ revaluation this year
If the renminbi appreciation pace were to accelerate substantially as we expect, I think it is quite possible that market speculation about another ‘one-off’ renminbi exchange rate adjustment will re-emerge and intensify. Indeed, there appear to be more people from academia or government-related think tanks criticizing the gradual appreciation strategy and calling for another one-off revaluation to completely change the one-way expectation of the exchange rate.

While I understand the rationale of these arguments, I attach a zero probability to another discrete adjustment of the exchange rate this year and a less than a 20% probability for next year. I think that, even if the authorities see the merit of another one-off revaluation, they are unlikely to make an adjustment of 10% or more in one go, given their hallmark gradualist approach to any major reform. At the same time, any revaluation of less than 10% is unlikely to solve the underlying problem. Rather, it would serve only to destabilize expectations and fuel more speculation, in my view.

Implications and risks
The impact of faster currency appreciation on the economy will be uneven, in my view. The export-oriented sectors – especially those low value-added ones with limited pricing power (e.g., textiles) – would be among the obvious losers. The domestic demand-oriented sectors with a large share of imported inputs (e.g., airlines) would likely benefit substantially. I believe that the impact on the banking system would be largely neutral, as the net FX exposure of the banks has been small.

One key risk to my call for accelerated appreciation has to do with the outlook for external demand. If the US economy were to be much weaker than our team has envisaged, concern about the sustainability of China’s export growth may make the authorities slow or even halt the appreciation with a view to safeguarding competitiveness in a less favorable market environment.

 

 

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