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Wednesday November 17, 2004 - 16:15:52 GMT
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China set to revalue yuan

There will be further speculation over a Chinese revaluation and it will be increasingly difficult to resist a move, especially if the US dollar continues to slide. A policy shift will be difficult to manage, especially as limited move would risk a further increase speculative capital inflows. Nevertheless, there is likely to be a move to give greater flexibility within the next 2 months, potentially involving a shift to a trade-weighted basket, with a yuan revaluation of around 5.0%. Stronger Asian currencies would ease upward pressure on the Euro.

Pressure for policy change

The issue of China’s currency will remain an important market influence over the next few weeks at least, particularly ahead of the G20 meetings this weekend where currencies will be an important topic.
There will be further pressure for a policy change by the Chinese authorities. On domestic grounds inflation and excess investment are still important issues. Consumer inflation remains close to 5.0% and investment spending growth is still running at over 25%. The central bank increased interest rates slightly last month, for the first time in 9 years, but further measures will almost certainly be required to bring the economy under control.
If interest rates are increased further this will tend to generate further unofficial capital inflows and make it even more difficult to sustain the currency peg. There will also be pressure to use a stronger currency as an alternative to higher interest rates.
The US administration will remain very concerned over the trade deficit and there will be further pressure for a currency realignment in Asia to help ease the US trade difficulties. Protectionist pressures may be less under a Bush presidency that would have been the case if Kerry had won, but the US administration will still push for more currency flexibility.

Weak dollar compounds China’s problems

The weakening US dollar will increase the pressures for a domestic policy change. Given the effective dollar peg, the Chinese yuan will depreciate further against other major currencies after significant depreciation over the past year. The yuan for example has weakened sharply against European currencies. This will increase the Chinese inflation threat and intensify potential trade frictions.

Tough task for Chinese officials

The Chinese officials will want to maintain a competitive currency to support the export sector and employment. China will, therefore, want to avoid substantial currency gains.
Any hint over a revaluation would also draw in fresh investment funds and increase the pressure for a further currency realignment.
Competitiveness issues should, however, be less of an issue given that the yuan has depreciated on a trade-weighted basis. Given rapid growth in the Chinese economy and productivity gains, there will also be pressure for yuan gains in real terms.
The Chinese central bank is a massive holder of US Treasury bonds and a move to let the yuan appreciate against the dollar would result in capital losses.

Yuan Difficult to control.

A limited move to let the yuan strengthen would increase capital flows and reinforce market pressures for a further realignment. In this context, the authorities will see an unchanged policy as a tempting prospect. It will, however, be increasingly difficult to maintain the status quo given the underlying market pressures and increase in capital flows.
Regional and global implications.
Any move to let the yuan appreciate would tend to put upward pressure on regional currencies. The Asian economies would have less concerns over export competitiveness and would have greater scope to allow currency gains. There would also be further regional capital inflows. There would be the potential for significant gains in the yen and Korean won.
Significant Asian currency gains would alleviate pressure on the Euro, lessening the risk of further sharp Euro gains.

 

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