Thursday May 5, 2005 - 13:36:26 GMT
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INVESTICA Ltd - www.investica.co.uk
Waiting for Beijing - Yuan pressure will continue
There looks to be a 50% chance of a change in the yuan policy within the next few days. Initially, this would be likely to involve a relatively small widening of the trading band, potentially to around 5%, and a possible move to a trade-weighted basket. Markets would unlikely to be satisfied with a small move and there would be pressure for a further band widening over the next few months.
A yuan change would certainly not cure the US trade problem and inertia may still be seen as attractive by China, but the crucial factor is that the Chinese economy will increasingly demand a move away from a fixed currency regime. Even if a near-term shift is resisted, it strongly appears to be a question of when, not if, there is a policy change. On a six-month view, gains to 7.80-7.85 against the dollar appear realistic.
Although markets have to some extent discounted a move to let the yuan strengthen, there is still likely to be upward pressure on Asian currencies in general if the Chinese currency is allowed to appreciate. There would also be strong pressure for a change in the Malaysian currency peg. In global terms, there would be a small risk of a wider dollar selling, but overall upward pressure on the Euro should eventually ease slightly.
Yuan speculation intensifies
Speculation over a change to the Chinese exchange rate has intensified over the past week. The Securities Journal, a state-run newspaper, reported that following reforms of the commercial banking sector and foreign exchange market, conditions were now ripe for a policy change.
The Chinese markets will re-open from Sunday after a week-long holiday leading to speculation that the authorities are using the holiday period to prepare for a change in the currency regime. The rumours were also increased by the fact that the yuan briefly traded outside its official narrow band last Friday. Finance Minister Jin dampened expectations to some extent by stating that the market pressures made it difficult to sanction a move, but he also repeated the strong commitment to yuan reforms.
Economic pressures continue
The economic pressures for a change in the yuan policy will continue to build. China had a capital account surplus of over US$111bn in 2004 with a current account surplus of US$70bn. The authorities, therefore, bought close to US$200bn during 2004 to stem upward pressure on the yuan. Inflows will continue this year and it will be increasingly difficult to mange these inflows and avoid a destabilisation of the financial sector.
It will also be increasingly untenable to maintain a fixed yuan peg at the same time as allowing increased capital account freedom. The trade account recorded a US$16.5bn surplus for the first quarter of 2005, reinforcing complaints that the Chinese currency is undervalued by US and Asian economies. Estimates suggest the yuan could be overvalued by around 40%, but a currency move of this magnitude is highly unlikely
The strong investment inflows will also pose significant inflation risks. The evidence so far suggests that the pressures are manageable with headline consumer inflation below 4.0%, but there will be an increasing risk of hidden inflationary pressure. Investment levels also remain strong and there will be further pressure for a tighter monetary policy to curb investment and property capital spending. Higher interest rates would increase the risk of speculative inflows, although higher US rates should give the Chinese central bank greater freedom to tighten domestic policy without attracting fresh investment inflows.
Political demands also increase
The economic pressures have also intensified over the past few weeks with strong calls for Chinese action by senior US officials. In particular, the comments from Fed Chairman Greenspan were potentially important as Greenspan aims to tread carefully in the political arena and his comments suggest that he is expecting a near-term policy change.
The timing paradox
The Chinese authorities will continue to face the difficulty that they would like to change policy when attention is focussed elsewhere and the yuan is not a subject of speculative inflows. The difficulty is that any hint of a move or technical changes in preparation for a shift, leads to fresh speculative inflows which then, in turn, discourages any currency reform. Any small move will also create pressure for further steps. In this environment, the authorities will have to consider a sudden and possibly unannounced policy.
Dollar trends unlikely to help
The pressure for a yuan revaluation would ease if the US currency secured a strong rebound in global markets. The tightening of monetary policy in the US should help alleviate downward pressure on the US currency to some extent, but the dollar appears unlikely to secure a significant gains against Asian currencies.
Dangers in currency float
There will still be heavy opposition to a free float and this would not be a sensible policy move. The Chinese economy would find it difficult to manage the financial pressures and economic stability would be a high risk. The authorities are, therefore, left with the possibilities of a new peg at a stronger rate against the dollar, a wider trading band or a switch to a trade-weighted basket. There would also be the potential for combining a wider band with a trade-weighted basket.
There are clear dangers in a gradualist approach as there could be an increase in speculative inflows on expectations of a further widening. These fears will increase the attractiveness of resisting a near-term policy change.
What would be the implications?
Markets have been speculating over a yuan policy change for months and a limited move to widen the trading band could, therefore, have limited implications, although it would be dangerous to be complacent over the risks of volatility. Sharp upward appreciation on regional currencies could also be avoided initially, but the underlying pressures would be likely to continue. There would be pressure for a Malaysian ringgit policy change away from a fixed peg and the Japanese yen would also be likely to appreciate. Yen gains through 100 against the dollar would be likely to result in some protests from the Bank of Japan.
What are the alternatives?
China could decide to impose tariffs on exports and this would help alleviate the protectionist pressure that has built up over the past few months. The US, for example, is threatening to introduce tariffs on all US imports of Chinese goods unless the authorities let the yuan float higher. Export tariffs would help ease the US political pressure, but the Chinese authorities will find it increasingly difficult to control trade in this fashion.
The authorities could decide to do nothing, but the economic and political pressures are likely to intensify unless there is a strong and sustained rebound in the US currency, a decline in the trade deficit and a cooling of the Chinese economy. There could be a large one-off yuan revaluation, but this would be likely to destabilise the industrial sector and this is likely to be resisted.
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