NEWS / Foreign Exchange

China: Is the gradual CNY appreciation policy sustainable?

 Todaythere has been some speculation in the markets about a possible one-offrevaluation. While a CNY revaluation is not our main forecast, we believe thelikelihood of a CNY revaluation is increasing because it is the most sensiblesolution for everybody including the Chinese. In our opinion the cost ofmaintaining the gradual appreciation policy is increasing fast for China and the policy could prove unsustainable.

 Our main argument is that the gradualappreciation policy against the USD has mainly been possible because theexpected CNY appreciation has been broadly in line with the money marketinterest spreads between the US and China. In other words, the excess return inCNY (relative to USD) has been close to zero (see chart 1 below). However,recently the excess return on CNY has soared as business and interest cycles inChina and the US have decoupled and expectations of fasterCNY have increased. In other words CNY has increasingly become a one-sided betagainst USD (see chart 1).

 Does it matter for China? Yes, it does. Even though China has extensive capital controls, capitalinflows have historically been very responsive to changes in expected excessreturns on CNY (see Chart 2). According to our indicator, -hot money- inflows have surged since the beginning of2007 as the expected excess return on CNY has surged. Hence, the Peoples Bankof China (PBoC) currently will not only have to struggle withthe liquidity effect from the current account surplus but probably increasinglyspeculative capital inflows too. In 2007 we expect even on conservativeestimates that capital inflows (excluding foreign direct investments) willcontribute significantly to an accelerated pace of FX reserve accumulation (seechart 3).

 PBoC is of course trying to sterilisethe liquidity effects of the FX reserves. Its main instrument has been thereserve requirement for commercial banks that since mid-2006 has nearly doubledfrom 7.5% to 13.0% currently (see chart 4). If the monetary policy continuesalong these lines the reserve requirement ratio could possibly end at 20%. Isthis policy sustainable? In our opinion this policy will have considerablecosts for China. Firstly, it is creating a structuralliquidity problem (excess liquidity in the banking system) that China will have to deal with sooner or later. Secondly,in this environment it will be increasingly difficult to continueliberalisation of the capital account and the financial sector, both importantpillars in the current Chinese liberalisation process. Notice that even theminor July 2005 revaluation did at least temporarily manage to stabilise marketexpectations and curb speculative capital inflows.

 Finally, the achievements of the gradualappreciation policy have, as of yet, been modest. According to our calculationsthe gradual appreciation policy since July 2005 has at best been able to curbfurther undervaluation of CNY. We estimate CNY on effective terms currently isundervalued by 17%-34% - largely unchanged since July 2005 (see chart 5). Thisargument may not directly be important for China but indirectly it could be costly if  China??™s trading partners?’ patience runs out and possibleprotectionist measures against China are introduced sometime during 2008. For China the most important argument for itssemi-USD peg has been domestic price stability but even on this account thegradual appreciation policy has failed lately.

 While the possibility of a one-offrevaluation of CNY should be taken seriously, we do not expect it to beimminent.

•  ?• The current financial market environment is probablynot appropriate for a major revaluation of CNY. China will behave responsibly and will notrevalue if there is any chance of major negative reaction on global financialmarkets. Financial markets will have to stabilise further for revaluation ofCNY to be a real possibility.
  
  
•  ?• With the 17th Communist PartyCongress out of the way the Communist Party??™s ability to make major policy decisionshas certainly improved. However, the political transformation will only becomplete after an expected major government reshuffle and most likely theappointment of a new PBoC board governor in March 2008.