Will Renminbi Benefit from China's Recovery?

 
FX Outlook
November 10, 2009 Posted by:

China's Recovery Firmed
Recent data all pointed to a recovery in China. GDP growth in Q3 2009 was in line with expectation, at 8.9 percent annually. This was higher than the 7.9 percent in Q2 and 6.1 percent in Q1. At the same time, other measures such as industrial production, investments and retail sales all showed monthly increases. Even China's State Council changed its tone in its official assessment in late October that economic recovery has been "consolidated." This marks a clear shift of rhetoric from months of insistence that the world's third largest economy was not yet on a solid footing.

Focus Shifts to Normalization
While the large scale stimulus package and asset purchases by the U.S. and UK this year have had little tangible success, China's proactive stimulus measures and loosening of credit have driven China back on its remarkable growth track. But the accommodative monetary policy has also fueled rapid investment and an asset boom, potentially leading to overheating. Thus, the resurgence of growth means that China is likely to change its focus to tightening in the coming months and start "normalizing" policy. As stressed by the State Council, managing inflation expectations will be a policy priority in coming months.

We do not expect China to emulate the Reserve Bank of Australia and raise interest rates soon. Sucking in more speculative capital with higher interest rates is what China wants to avoid now. Stepping up open market operations is another option. But premature withdrawing liquidity from the system may cut short the recovery. Instead, policymakers are more likely to step up their guidance to the banks, using moral persuasion to slow down the pace of lending.

Will CNY Appreciate Soon?
Now that China's economic outlook has improved, the question is whether the Chinese renminbi (CNY) will be allowed to appreciate in coming months. China revalued the USD/CNY rate in 2005 and allowed it to steadily appreciate 17 percent until the middle of 2008. It then re-established a virtual peg against the USD to help cushion its economy against the impact of global financial crisis and to support the export sector. The People's Bank has maintained the CNY steady around 6.83 against the USD since January 2009.

The non-deliverable forward (NDF) market, which signifies market expectation of CNY levels in the future, has started to price in an appreciation path, currently at around 2.4 percent by year-end 2010. However, it is still premature to assume a resumption of monetary tightening will necessitate a move in the exchange rate. There are strong arguments that China is not in a hurry to change its stable CNY policy in the near term.

First, despite the strong growth in Q3, exports declined at double-digit rates leading to a 54 percent drop in China's trade surplus in Q3 09 from Q3 08. As China's growth still hinges on export growth, concerns about high unemployment as a result of falling export and subsequent social unrest make it difficult for the policymakers to renew CNY appreciation hastily.

Second, CNY is not that weak and remains relatively strong when compared with other regional currencies, particularly those in Asia where China has substantial bilateral trade flows. According to the real effective exchange rate (REER), a measure of trade competitiveness, the CNY has appreciated 6.6 percent since July 2008, the second strongest currency in the region after the Taiwan dollar (TWD).

Against this backdrop, exchange rate will be the last instrument used by China to mitigate the risk of an investment-led overheating. CNY exchange rate will become flexible only when China's export returns to a sustained growth pattern. That again will depend on a solid recovery in consumption among the major industrial countries. As such, it will be at least the second half of 2010 before China will embark on a gradual CNY appreciation path.

A Stronger CNY is Not the Cure
In the current economic environment, Beijing and Washington have too much to lose from a major escalation of currency disputes. International pressure on the CNY appreciation has been somewhat subdued as most major countries are counting on the emerging countries to lift the global economy out of recession. But current debate of China's balance of payments surplus solution continues to be dominated by the perceived need to let the CNY appreciate. The rationale is that stronger currency will increase prices of exports from China and curb demand from the U.S.

Empirical evidence has suggested that exchange rate policy played a limited role in China's trade surplus. China's trade surplus really took off in 2005 when it more than doubled over the previous year. Up to 2005, CNY had actually appreciated 25 percent in trade-weighted terms from its 1994 low.

China's large surplus with the U.S. is not simply the result of currency valuation, but rather due to other factors that give China a competitive advantage. A CNY appreciation of 5 to 10 percent per year will not impede China's competitiveness and will not solve the China/U.S. trade imbalance.

The drivers of China's trade competitiveness lie in its infrastructure and the flexibility and low cost of production. Between 2001 and 2008, China experienced a productivity boom which saw output per worker almost double. During the same period, labor cost rose by a mere 42 percent, a fraction of that in the U.S. As such, U.S. companies have become heavily reliant on China as their manufacturing partner. Low cost of production has benefited many American companies and improved consumer choices as well. Trade imbalance between the U.S. and China benefits both by raising the growth potential of both regions.

An effective long-term solution is to tap the high percentage of savings in the Chinese economy and increase its resilient domestic consumption. On the other hand, the U.S. needs to reduce its reliance on debt-financed consumption and improve its production efficiency.



The views expressed in this column are solely those of the author and do not reflect the views of SVB Financial Group, or Silicon Valley Bank, or any of its affiliates. This material, including without limitation the statistical information herein, is provided for informational purposes only. The material is based in part upon information from third-party sources that we believe to be reliable, but which has not been independently verified by us and, as such, we do not represent that the information is accurate or complete. The information should not be viewed as tax, investment, legal or other advice nor is it to be relied on in making an investment or other decisions. You should obtain relevant and specific professional advice before making any investment decision. Nothing relating to the material should be construed as a solicitation or offer, or recommendation, to acquire or dispose of any investment or to engage in any other transaction.


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