- Political pressure on China from within Asia has increased with the finance ministers fromboth Indonesia and Singapore yesterday calling for yuan appreciation, and the APECfinance ministers today pledging to embrace flexible exchange rates. The Peoples Bank of China in its quarterly report yesterday prepared the ground for a change in China’s exchange rate policy.
- With China’s exports recovering, the leadership is sounding more confident about growth,and with political pressure intensifying, we believe the conditions are ripe for a change inChina’s exchange rate policy. We still expect the gradual appreciation of the yuan to beresumed by mid 2010. However, the risk that it could start earlier has increased. A major one-off revaluation cannot be ruled out, while a complete float is highly unlikely.
Political pressure on China within Asia increasing
The political pressure on China to let the yuan appreciate is intensifying. It is becoming increasingly clear that Barack Obama’s trip to Asia in the coming week will be used to argue the case for an appreciation of the yuan. US Treasury Secretary, Timothy Geithner, is currently preparing the ground for meetings with Asian finance ministers.
The most important development is that other Asian countries are becoming increasingly vocal in their demand for a yuan appreciation. In today’s edition of Wall Street Journal, Geithner, the Indonesian Finance Minister, Sri Mulyani Indrawati, and Singapore’s Finance Minister are together calling for “market-oriented exchange rates in line with economic fundamentals”, please see Wall Street Journal. This is the polite way to ask for a yuan appreciation. In addition, the final communiqué from the APEC finance ministers meeting held today in Singapore included a call for “flexible exchange rates”. The APEC group includes 21 countries in the Asian-Pacific Region including the US, Japan, China Australia, India and the ASEAN countries.
That the call for yuan appreciation is gaining support within Asia is an extremely important development. The multilateral cooperation within Asia has been a major focus in Chinese foreign policy in recent times, and the cooperation with the ASEAN countries has been a cornerstone in this regard. Two of the most important ASEAN countries are calling for an appreciation of the yuan – this will be noticed in China.
The escalating call for yuan appreciation among Asian countries reflects the fact that the dollar scarcity during the peak of the global financial crisis has reverted into a flood of USD liquidity. Across the board, Asian central banks are intervening to stem currency appreciation, and in October the FX reserves for Asian countries excluding China and Japan reached a new record high. Earlier this week, Taiwan was the first Asian country to introduce capital controls to stem capital inflows. The cost of this massive currency intervention is a major boost to liquidity.
China laying the ground for change in exchange rate policy
The second important development is that there are signs that China is preparing for a resumption If the appreciation of yuan against USD. Yesterday, the Peoples Bank of China (PBoC) in its quarterly report said that it will improve the setting of the yuan exchange rate in a “proactive, controlled and gradual manner based on international capital flows and movements in major currencies”. In its previous quarterly reports, PBoC just stated a goal of keeping the yuan “stable”.
There are many possible interpretations of this PBOC statement and the most important conclusion probably is that the Chinese authorities and PBoC are giving themselves flexibility to change the exchange rate policy. Officially China is targeting an effective exchange rate, in reality China has targeted USD. The reference to “major currency movements” in the statement might te an acknowledgement that a weak USD would be an argument for an appreciation against USD if China’s effective exchange rate targeting is to be taken seriously.
Finally the inclusion of the “desirability of flexible exchange rates” in a communiqué from the APEC Finance Minister meeting - where China was present - might be a sign that China is becoming more flexible on the exchange rate issue.
Gradual appreciation policy to be resumed
There is no profound resistance against yuan appreciation in the Chinese leadership in our opinion. China allowed its currency to appreciate previously, and it will do so again when conditions are right, i.e. when exports have started to recover and sustainable inflation has replaced concerns about growth as the main priority in economic policy. Second, international political pressure could prove decisive.
We are fast moving to a situation where these three conditions are being met. China’s exports have recovered strongly in recent months. In addition the Chinese leadership is sounding increasingly confident about growth and turning its attention to sustainability issues like inflation and bubbles in financial markets. Finally, the political pressure is heating up, and is likely to heat up further in H1 2010 when the G20 countries start the review process of individual countries’ economic policies.
Our base scenario remains that China will resume the gradual appreciation of yuan by mid- 2010. However, based on recent developments, the likelihood of this happening earlier has increased. We envisage an appreciation against USD of about 5-6% annually. A major one-off revaluation cannot be ruled out. Actually we believe a major one-off revaluation would be the best policy solution. A gradual appreciation policy would in our view be very challenging, because it risks turning the yuan into a one-sided bet in a situation when the monetary cycle between China and the US is likely to diverge. A free float of the yuan is unlikely at this stage, although the daily trading band might be widened to allow for some flexibility. 12M NDF forwards currently price a 3% appreciation of CNY against USD. In light of risks skewed towards an earlier appreciation and the risk of a major one-off revaluation, we believe it is too little an appreciation.
