Fallacies behind RMB speculation

China will move on currency reform at her own pace. Rampant speculation on RMB revaluation will only increase Beijing''s policy inertia.

The market has been betting on Renminbi (RMB) revaluation since 2002. Official comments about China's flexibility towards currency reform and a series of small steps to relax the RMB control, including allowing insurance and pension funds to invest overseas, Chinese emigrants to transfer their asset out of China, and Chinese tourists and students to take larger amount of money out of China, have revived speculation that an RMB revaluation is imminent. Many also believe that Beijing would heed US pressure to revalue the RMB to help cut America's huge current account deficit (amounting to 5.6% of US GDP).

The RMB bet

Based on such beliefs, some money managers have been longing commodities and shorting US dollar as a profitable strategy. Their bet is that China would revalue the RMB to fight inflation and to lower the cost of commodity imports for China's huge demand growth.

Continued robust Chinese growth would, in turn, boost commodity prices. Meanwhile, an RMB revaluation would allow China to take over from the US as the driver of global growth. This would, in turn, justify a lower dollar resulted from the huge US current account deficit.

Low interest rates have made this strategy possible. Even after four rate hikes, US real interest rate is still negative. The liquidity sloshing around has allowed fund managers to borrow at very low cost to buy commodities and short the US dollar.

Since most money managers are seeing the RMB revaluation as a one-way bet, they are on the same side of the market. Their bet will only pay off when a sharp RMB revaluation plays out, so that the assets underlying this long-commodities short-dollar strategy could be re-priced (ie commodity prices rise and US dollar falls sharply). Otherwise, the carry trade would be un-profitable.

There are also large positions built up in Hong Kong, as can be seen in the sharp divergence in its interest rate from the US (see Chart). In theory, this should not happen because the HK/US dollar peg should ensure Hong Kong rates track US rates closely. But the bet that the HK dollar would follow a revaluation of the RMB because its economy is closely tied with China's has led to massive capital inflow to Hong Kong's banking system, driving rates way below those of the US.

The likely disappointment

The trouble is that an RMB revaluation is unlikely, despite market speculation. While foreign analysts fret about the value of the RMB, whether it is under/over-valued and by how much, China cares about getting the exchange rate right. The current de facto RMB/USD peg has served China well since 1994, when the RMB was devalued. Beijing wants to make sure a new exchange rate regime would work equally well, if not better, for China's economy in the medium-term.

Beijing will want to change the RMB regime with minimal disruption to the economy. But the current rampant speculation will create a big disruption to the economy. Imagine if the RMB is revalued sharply - say by 25-30% as some see. That would not only hurt Chinese exports and kills jobs in China. It would also prompt those overseas Chinese speculators who had parked money in Chinese banks to take profit and withdraw their funds.

Because of the huge positions built up, the withdrawal would be massive and that would depress money supply and create a devastating impact on the economy. The damage would go further, as Asia and the world commodity market have grown dependent on China's huge import demand for sustaining their own growth.

Further, China is experiencing economic bubbles in some sectors, such as property, steel, autos, heavy chemicals and cement. A sharp revaluation would pop these bubble pockets and trigger a domino effect on the rest of the economy.

The combination of a bursting bubble and currency appreciation would trap an economy in the doldrums for years, as seen in Japan during the 1990s. So Beijing would not want to revalue under the current economic environment.

Beijing is not likely to do it under International pressure either. China has won kudos by resisting enormous international pressure to devalue the RMB after the 1997-1998 Asian crisis.

The country earned big political dividends as a responsible player in the global economy and renewed confidence from foreign investors. Having reaped the benefits of riding out the devaluation wave in 1998, Beijing is more likely to ride out this revaluation pressure because the RMB is undervalued, which is more manageable than an overvalued one.

Generally, an undervalued currency delivers better-quality economic growth by boosting a country's exports, thus generating an external surplus and building up foreign reserves for fending off external shocks. Exporters can adjust to a gradual rise in the exchange rate later by moving up the value-chain. But an overvalued currency is more likely to deliver lower-quality growth and create economic bubbles by encouraging excessive cheap foreign borrowing.

Any currency depreciation threatens massive capital outflow, locking the country into defending the overvalued currency, depleting its foreign reserves and triggering an economic crisis.

What about the PBoC's rate hike, the abolition of the interest rate cap on bank lending and the allowance for banks to set deposit rates according to market forces in October, which many have taken as signs for a change in the RMB value?

The rate hike is for balancing the impact of Beijing's recent relaxation of some of its administrative measures on cooling the economy. The partial liberalisation on the banking system marks the transition from administrative measures to market-driven policy. These liberalisation moves are all part of financial reform, but they are not necessarily linked to RMB revaluation.

A long-term goal, not immediate need

The Chinese authorities want to move towards a flexible RMB regime, not necessarily a currency revaluation. But that is a long-term goal, not an imminent need. Any RMB policy shift will have to wait until China's banking system is sound enough to handle volatile capital flows and when the speculative mood subsides.

Currently, China's financial market infrastructure remains insufficient for a big change in the RMB regime. In particular, a prerequisite for moving towards currency flexibility is the depth of the derivative market and the availability of hedging products.

However, Mainland firms can only buy and sell RMB forwards with maturities up to one year in the on-shore market. Longer maturities, currency swaps and RMB futures are not available. Further, the forwards market can only handle a tiny portion of the potentially huge hedging demand arising from China's annual $1.2 trillion international trade.

Another precondition for loosening the RMB grip is that Beijing must have better control of other monetary tools, notably control on interest rates. Otherwise, economic chaos could result. However, the PBoC still does not have a coherent interest rate policy because China does not yet have deep money markets with different interest rate maturities set by market forces.

Without these, the PBoC is unable to intervene effectively via open market operations to keep interest rates within its target range. It takes time to build these markets, and so will freeing up the exchange rate.

Beijing's choices

As macroeconomic management will keep Beijing's policy agenda full in the coming months, it is unlikely that the authorities would want to take on additional risks of a big currency shift. So the market's bet on an imminent RMB revaluation is likely to be wrong. If speculation recedes and the government's selective measures to cool the economic hot spots yield the desired results, a policy shift may come in the next year. A large one-off revaluation is very unlikely, as Beijing has already ruled that out on the basis that the resultant negative economic shock would be unbearable. A small revaluation is also unlikely as it would lack credibility and invite more speculations on further revaluations, thus creating more economic uncertainty.

A likely option would be a wider trading band for the RMB, in the range of 3-5% above and below the central rate set by the PBoC. Whether the central rate would be anchored on the US dollar, a trade-weighted currency basket or an undisclosed black-box that may keep changing remains an open question.

But over the longer run, China is likely to follow a crawling peg regime like that in Taiwan and Singapore, where the authorities intervene in the market to control the pace and magnitude of the exchange rate movement. The purpose is to allow sufficient time for the economy to adjust to changes.

Both Singapore and Taiwan held onto fixed undervalued currencies in their early development stage. Then Singapore shifted to a crawling peg system in 1970 and Taiwan in 1980. Under this system, the Singapore dollar appreciated slowly, doubling in value against the US dollar between 1970 and 1995.

The New Taiwan dollar initially fell but then appreciated gradually by 50% against the US dollar between 1985 and 1995.

A crawling peg system, with an upward bias for the RMB, is an attractive option for Beijing because it will minimise exchange rate risk for investment decision. A slow RMB appreciation will also reduce the cost huge imports of raw materials and capital goods needed to spur China's modernisation. It will also push up export prices, albeit gradually, and compel Chinese exporters to become more efficient and climb the value chain.

Enjoy the party while it lasts

Those who are betting on the HK dollar to follow an RMB revaluation are going to be disappointed. This is not only because the RMB will not be revalued, but also because the HK dollar will not have to follow the RMB even if the latter were revalued.

Hong Kong has no inflation to fight, so it does not need a higher exchange rate. Its economy is tied closely to those Chinese sectors (foreign trade-related) that are US-dollar denominated.

The Yuan's impact on the Hong Kong economy is mainly in foodstuff imports, which account for a small 1.2% of Hong Kong's GDP. There is thus no particular reason for the HK dollar to follow the RMB move. Further, with Hong Kong's increasing dependence on Chinese tourism to boost growth, there is no reason to revalue the HK dollar to make it dearer for tourist visits.

Chi Lo, Economic Strategist based in Hong Kong and author of "The Misunderstood China", Pearson Prentice Hall 2004

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