Back in April, when we were piecing together our last quarterly outlook on China, we projected that China would begin to allow renminbi appreciation against the U.S. dollar around mid-year. Last weekend’s announcement, then, came about two weeks ahead of schedule... We won’t complain!
We are now left with the question of what the more flexible renminbi will mean heading forward. This week’s newsletter is drawn from a couple new pieces examining this question. First, we have a new Strategy View, “Yuan-Upmanship: Implications for CNY and Global Markets,” examining the implications for currency traders. We also have a new Critical Issue, “How Significant is China’s Announcement of More Currency Flexibility?” which takes a broader look at the move in the context of the Chinese and global economies. Both these pieces are available exclusively for clients.
Our general takeaway is that the increase in flexibility could help China manage price pressures and asset markets better, but any moves are likely to be gradual. It seems likely that the approach of the G20 meetings had something to do with Beijing’s timing—and some analysts have called it a clever stroke that is likely to shift attention away from China and toward the U.S. as delegates at the summit discuss global economic imbalances.
We expect China to allow a modest and nominal appreciation against the USD of no more than 4% on an annual basis in the next year. Yet even though we expect gradualism and caution from the PBoC, we expect global markets—and particularly risk assets and proxies for China revaluation, especially in Emerging Market Asia—to react positively to the move in the short-term.
Even if gradual, FX flexibility should not only facilitate more appreciation of the RMB against G3 currencies, but also aid in the external adjustment of other countries—especially those in EM Asia that supply China with both intermediate goods, commodities and some consumption goods. But China’s actions—not its announcement—will determine whether the increasing “flexibility” adds to or subtracts global aggregate demand.
A change away from the almost-two-year-old U.S. dollar peg, implemented in mid-2008 as the U.S. financial crisis intensified and the dollar fell sharply, was widely expected as part of China’s exit strategy from crisis management. However, many market participants expected that the euro’s sharp fall against the dollar would delay a Chinese revaluation at least until July. The specifics remain uncertain, but the PBoC seems likely to return to the multi-currency basket, within a band, with a crawling peg regime of the type that prevailed from mid-2005 to mid-08 (the composition of the basket is undisclosed).
Aside from political pressures ahead of the G20 summit, the regime change may be interpreted as a way to address the urgent need to stoke domestic demand in surplus countries (including China). This shift will be necessary in order to rebalance and sustain global growth, given that deficit countries are retrenching.
However, we caution that greater flexibility in the CNY regime, especially if combined with a BBC of undisclosed or uncertain characteristics, could create more room for two-way spot FX movement against major currencies within the basket. The uncertainty could provide the PBoC greater discretion to manage the CNY's real effective exchange rate, albeit at the cost of some autonomy in monetary policy. The longer-term effect could well be a paradoxical eventual depreciation against the USD, which would help offset the competitiveness losses from the recent sharp fall in the EUR. After all, the eurozone (EZ) is China's largest export destination.
Greater flexibility of China’s exchange rate is necessary for Chinese and global adjustment. An economy growing as fast as China’s needs tighter monetary conditions than a sluggish U.S. economy which continues to need monetary stimulus. Importing U.S. monetary policy limits the tools China has to promote domestic demand, forcing it to rely instead on financial repression to channel funds to increase production and reduce inflationary pressures. Chinese private consumption has continued to pick up, but allowing the RMB and thus Chinese purchasing power to appreciate is a pre-condition for Chinese and global growth. Macro-prudential regulations, including a shift away from policy based loans and a gradual increase in interest rates to reduce the transfers of Chinese household savings to corporations are even more important.
Even if the Chinese authorities allow two-way movement against the dollar to reduce speculation, Chinese policies could support the U.S. Treasury market, commodities and risky assets more generally—especially if other EM countries might take a cue from China and allow only gradual depreciation. A sharp appreciation against the euro and dollar, without other policies to support Chinese consumption, could contribute to much slower global growth and higher inflation as higher Chinese production costs are transmitted to G10 consumers. China’s labor costs have already resumed the gradual upward grind that began in 2007 and 2008; demographics, labor unrest and militancy (strikes) and policies to develop rural areas suggest that they will continue to climb. This world could be one in which countries compete for a shrinking market share, putting risky assets under more pressure.
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