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Research Note: Chinese Yuan Revaluation: What Does it Mean?
Brian Dolan, Director of Research
What happened?: On July 21, the Peoples Bank of China (PBOC), the Chinese central bank, changed the official USD/RMB exchange rate to 8.11 from 8.27, a revaluation (strengthening of RMB) of about 2.1%. The PBOC has also declared an end to the peg against the US dollar, and will instead manage the RMB against a basket of other currencies, making the new currency regime a "managed float" arrangement. The USD/RMB rate will be allowed to fluctuate in a 0.3% band around a "parity" rate based on the prior day's close of USD/RMB as determined by the PBOC. The trading price of other currencies against the RMB will be allowed to fluctuate within a 0.15% band either side of the central parity rate.
What is a managed float?: Theoretically, the PBOC has adopted a currency management regime that could allow the RMB to appreciate against the USD by as much as 0.3% each day; this is also known as a 'crawling' peg. However, in practice the PBOC appears to have simply adjusted the fixed rate of the RMB against the USD and is still actively intervening in the market to prevent a further rise in the RMB. In the three trading days since the revaluation, USD/RMB has not traded below 8.1097 and has essentially been in a 0.02% range around 8.11.
What is in the basket?: The PBOC has not disclosed the composition of the basket of currencies against which it is managing its currency. This leaves the market guessing as to what changes, if any, China must make in the composition of its foreign currency reserves. Generally, speaking, though, the prevailing market view is that US dollar holdings would be reduced in favor of other Asian regional currencies, conceivably causing them to appreciate against the USD. However, since the PBOC appears to still be aiming for a steady RMB rate, any changes in its foreign currency reserves are likely to take place slowly, with an eye to ensuring minimal market disruption.
Why did they revalue the RMB?: China has been under pressure from its major trading partners, mainly the US and Europe, to allow its currency to strengthen. The belief in the West is that China has maintained an unfair trade advantage by keeping its currency artificially weak. Estimates are that the RMB is between 10-40% undervalued against other major currencies. This has led to calls for protectionist legislation and threatened to start a trade war between China and its trading partners which would threaten to disrupt global growth. The Chinese government has also been taking measures to selectively slow particular segments of its economy. By allowing the RMB to strengthen, the PBOC has made Chinese exports marginally more expensive and hopes to slow the export sector's explosive growth and reduce the potential for the economy to overheat and stoke inflation.
How will this affect other major currencies?: Because the PBOC has made the smallest of revaluations, and appears set to hold the new rate steady for the foreseeable future, there is little immediate direct impact on other major currencies. The 2% revaluation is too small to affect the terms of trade between China and its major trading partners, so there should be no measurable change in the pattern of US trade deficits and Chinese trade surpluses. Also, because the PBOC appears intent on maintaining the new USD/RMB rate at 8.11, essentially buying US dollars to offset any RMB buying, there is little reason to expect that China will stop recycling its US dollar purchases into US Treasuries. Over the longer-term (3-5 years), however, China is believed to be prepared to allow the RMB to appreciate further against the USD, and this will likely be matched to some extent by appreciation of other Asian currencies relative to the US dollar.
Can I trade USD/RMB?: The RMB is not freely convertible or tradeable and is subject to strict governmental controls that essentially restrict trading to commercial-based buying and selling and prohibit market speculation. Financial institutions are able to access USD/RMB through the NDF (non-deliverable forward) market, the pricing of which currently suggests that the RMB would appreciate by an additional 4-7% in one year's time if it were allowed to float.
Is there a trading opportunity here?: Since the RMB is not freely traded, currency market participants utilize 'proxy-trades' that seek to emulate the anticipated movement of the USD/RMB. The most popular and liquid of these has been to buy JPY/sell USD based on the notion that a stronger RMB will lead to competitive revaluations of other Asian currencies, including the JPY. However, these proxy-trades are far from foolproof and the underlying assumption (that RMB strengthening will lead to other Asian currencies strengthening) is open to question. For example, the Japanese Ministry of Finance, through the Bank of Japan, is suspected of having intervened following China's revaluation announcement, suggesting that Japanese policy is still to limit any appreciation of the JPY so as not to disrupt Japan's stop-and-start economic recovery. Moreover, the Japanese economy has little in common with the Chinese economy, so it need not follow that a stronger RMB will equate with a stronger JPY. The Bank of Korea has also indicated it will continue to intervene to stem any rise in the Korean won. Other Asian monetary authorities have also declined to alter their exchange rate management policies: the Hong Kong Monetary Authority has maintained its pegged rate of the USD/HKD; the Bank of Taiwan and the Monetary Authority of Singapore have maintained their managed-rate currency regimes; only Malaysia followed China's lead and revalued the ringgit and switched to a managed float against a basket.
So why is the US dollar stronger?: The disappointment over the degree of the Chinese revaluation and the apparent fact that the PBOC will not actually let the RMB 'float' within its announced 0.3% daily band suggest that contrarian, counter-trades are likely to be the short-term reaction. For short-term speculators who sold US dollars based on the belief that the dollar would weaken as a result of foreign currency reserve shifts by the PBOC or competitive revaluations of other Asian currencies, the result has been short-covering. The PBOC has also heaped further disappointment on speculators as it has indicated that further RMB adjustments are unlikely in the foreseeable future. The PBOC has explicitly noted its concerns that speculative forces (i.e. hedge funds) would overwhelm an orderly transition to a freely convertible RMB. The PBOC has also stated that this revaluation was intentionally small in scale, so as to allow Chinese firms to slowly adjust to a stronger currency. For these reasons, the PBOC appears likely to proceed on the path to a freely convertible RMB at an excruciatingly slow pace.
When will the RMB be allowed to float freely?: At this point, all indications are that the Chinese are aiming to allow for a freely-traded RMB in the distant future. The first likely timeframe coincides with the Beijing Summer Olympics in 2008; the rationale being that China will seek to announce its 'arrival' as a global economic player, and a freely-convertible currency is a hallmark of a global economic power. After that, speculation centers on a shift by 2010. China faces numerous logistical and administrative problems in moving to a free-floating currency. Among these are a state-run banking sector in financial disarray, an overheating economy in danger of igniting rampant inflation, and the need to develop the physical and regulatory infrastructure of a currency market.
What are the political implications of China's move?: The Chinese revaluation has temporarily stifled calls for punitive trade sanctions against China by US and European legislators, but the scale of the revaluation has been extremely disappointing and some voices in the US manufacturing sector have already declared the revaluation as essentially meaningless. This suggests that political pressure for further revaluations will continue to build, likely culminating in the run-up to the 2006 US mid-term congressional elections. Pay attention to US trade balance data with China in the months ahead for signs of improvement/deterioration, the larger the US-Chinese trade deficit, the sooner congressional action can be expected.
So what has really changed?: At the moment, not very much, but keep in mind we are watching a story develop and each day brings new indications of the PBOC's intent. Generally speaking, though, the scale of the Chinese revaluation is not significant enough to alter trade patterns between China and the rest of the world and thus is unlikely to affect global currency rates. More importantly, in the days since the revaluation, PBOC officials have been actively suggesting that no further revaluations are contemplated in the 'foreseeable future.' Taken together, these developments suggest that the RMB revaluation is mostly a non-event. This suggests that the market themes that were driving major currencies prior to the RMB revaluation will quickly, if they haven't already, reassert themselves. Those major themes are: US interest rate differential set to continue to widen in favor of the USD; US growth differential also continues to favor the US over other major economies (with the exception of commodity currencies AUD & CAD, which are also benefiting from solid global demand); sluggish, but possibly rebounding, European growth continues to weigh on EUR, GBP, and CHF; political uncertainty in Japan as PM Koizumi presses forth with postal reform, likely resulting in a call for early elections. Finally, the overarching causes of dollar weakness over the past four years (the twin US deficits) are far from over. That this theme has been in abeyance for most of 2005 does not signal an underlying shift in the fundamentals, just that the market has seen fit to focus on the positive elements of the US dollar for a little while.
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Overview