China Heads for FX Stability
Speculation about an imminent Chinese reval has increased recently with a wave of banks reporting revised views on their outlook for the CNY. Some are now calling for a policy change before the current quarter is finished. Others are calling for a radical change in CNY policy sometime this year with the yuan to be traded against a basket of up to ten currencies, with the USD dollar weighting less than 20% of the basket. We are sceptical about the calls for a near-term revaluation and move to a broad basket.
Our view is unchanged from that given in the FX Navigator, 25 September 2003. We expect the CNY to be revalued to 7.8 (conveniently on par with the HKD) against the background of continued weakness in the USD against major currencies through this year. Our best guess on the timing is August-September. We do not foresee a significantly larger revaluation because that would jeopardize China’s development (which relies on FDI to take advantage of China’s massive labour pool).
Chart 1 places the CNY’s exchange rate in a broader context by comparing it with the IMF’s SDR (which comprises USD, EUR, JPY and GBP). Based on our forecasts for major currencies this year, the yuan will fall to its weakest level versus the SDR since the 1994 CNY devaluation. We have not incorporated inflation differentials in the chart. But since the beginning of 1996, inflation differentials have been minimal with China averaging 1.7% annual inflation whereas the SDR weighted global inflation rate averaged 1.9%. China’s massive restructuring over this time period also raises a question mark over the usefulness of inflation adjusted real exchange rate measures.
We do not see a shift to a market-oriented exchange rate system. The central theme influencing our view is that – in our opinion – the Chinese authorities will be loathe to experiment with a policy change that could unleash potentially destabilising speculative forces in the CNY. The Asian financial crisis found resonance with a degree of mistrust toward market forces on the part of the Chinese leadership that won’t be quickly forgotten. Consider a recent speech (19 January 2004) by the head of the Hong Kong Monetary Authority (HKMA) in China’s freewheeling sibling, HK. In a lunchtime speech, the HKMA’s CEO mentioned the 1997-98 crisis four times. He remembers it vividly as do, we are sure, the Chinese leadership.
Therefore, we do not anticipate China moving to a trade-weighted basket similar to Singapore’s system. Movement in major currencies versus the USD would promote on-shore and offshore speculation against USD/CNY that would serve little purpose. Let us backtrack slightly; a move to a basket that is heavily focussed on the USD (circa 80% of the basket) is possible. But unless accompanied by a one-off revaluation, there would be minimal change in the USD/CNY rate unless the USD plummeted or rose significantly. And we doubt the authorities would experiment with the potential double whammy of a one-off revaluation and a move to a basket-type trade weighted index. The potential shock of such a move to the (heavily) encumbered financial system that is poorly equipped to cope with currency volatility is just too large. And from a geo-political perspective, China wouldn’t make any friends – especially not in the US – for implementing such a move unless the yuan moved considerably against the USD.
The advantages of a one-off revaluation to a new fixed rate against the USD are several. First, it will slow the build-up of inflationary forces that are becoming evident due to rapid domestic investment-led demand growth by reducing the price of imported goods, especially the capital goods needed for China’s modernization drive.
One point that we feel is neglected in this context is that (literally) millions of workers already displaced from state-owned firms (and many millions yet to come), exist on a low nominal income supplied by their former employer or the government. Their plight is already difficult and will be made extremely so if inflation continues rising and erodes their purchasing power. China’s government values stability and would not like to see unrest stemming from this source.
Second, given current US concern about the loss of manufacturing jobs in the US (jobs taken by China, many claim) and the looming US presidential election, China is in a strong position to extract concessions from the US in return for a revaluation of the CNY. We do not have a firm view on the type of concessions China might get. They may involve better access to sensitive US technology or could be geo-political in nature. The point is that the China-US relationship is so broad that there are many areas where concessions would benefit China.
As a final point, note that China’s trade accounts have improved markedly in recent months. The return to a healthy trade surplus from deficit early in 2003 makes the modest revaluation we foresee a low cost option for the authorities.
