Will the Chinese renminbi start appreciating again? Standard & Poor's believes it's only a matter of time. The relevant questions are: How soon? How fast? And how far?
With Chinese exports now rebounding, we're not alone in this view. However, politics and the lack of domestic consensus over the costs and benefits of a stronger Chinese currency may complicate matters. We expect a policy-guided appreciation of the renminbi to shrink China's current account surplus over the next five to 10 years. But policy-induced appreciation would likely stop well before the surplus disappears. Unless there are dramatic policy changes, China's savings rate will remain high and will make a structural surplus inevitable. And eliminating that surplus through further appreciation could bring unacceptable economic pains.
Stronger capital outflows could ease currency pressure and we believe that China will ease capital controls to encourage this. When expectations of further appreciation recede, stronger capital outflows could allow the Chinese exchange rate regime to shift to a managed float system, but this all depends on the pace of structural reforms in the domestic sector.
Inflexible renminbi contributes to challenges
China doesn't face urgent economic or financial imperatives to revalue its currency. Importantly, there are few signs that unsustainable demand growth is stoking inflation.
Many put the country's consistently large current account surpluses down to an undervalued currency. Globally, China's surpluses aren't the highest relative to GDP, but their absolute size makes them the most important. In places like Malaysia, Singapore, and Switzerland, the build-up of domestic liquidity pressure is eased by openness to offshore investing.
In China, however, strict capital controls trap much of the country's savings within its own borders. Policymakers rely on direct credit controls and high reserve requirements to contain the effects of strong liquidity pressure, but we believe this increases the risk of policy errors.
Monetary authorities have to collect and accurately interpret significant amounts of data for direct controls to be successful. This becomes increasingly challenging as the Chinese economy grows larger and more complex. It's also why we view the reliance on direct policy tools as a key sovereign credit weakness.
Currency stability dampens domestic demand
Stronger currency appreciation would reduce the cost of imported goods and services for Chinese consumers, which would directly increase purchasing power and loosen purse strings.
A stronger renminbi could also indirectly increase consumption by tempering the price increases of domestic goods and services. Local businesses in China would benefit from cheaper imports, such as crude oil, machinery, and royalty payments. In competitive markets, the lower costs should also translate into reduced selling prices.
Domestic consumer sector investments may also benefit from a rising renminbi. For instance, where overcapacity exists it could accelerate industry consolidation. A currency appreciation that removes export support could pressure some companies to either allow acquisitions by stronger competitors or close. This could free the economic resources that such firms previously dominated and make it easier for consumer-sector investors.
Past appreciation helped ease pressure
We believe the renminbi's appreciation against the US dollar between July 2005 and July 2008 went some way to easing concerns. China's central bank bought less foreign exchange than if it had to maintain a constant exchange rate against the dollar. This also meant that it created fewer renminbi deposits and added less to domestic liquidity.
The slower foreign exchange accumulation also reduced risks to the central bank's balance sheet. Foreign assets accounted for 81% of the People's Bank of China's total assets at the end of 2009. The currency mismatch could cause severe losses for the central bank if the major world reserve currencies depreciate sharply against the renminbi.
We see the renminbi's three-year climb as also playing a part in slowing the slide in domestic consumption as a share of the economy. In the three years to 2005, when the renminbi was first de-pegged from the US dollar, the share of final consumption in GDP slipped by 7.8 percentage points to 51.8%. Over the next three-year period, it fell by a significantly smaller 3.2 percentage points to 48.6% in 2008.
Job concerns are likely to have halted the renminbi's appreciation since July 2008. New orders in the manufacturing sector, which employs about 104 million workers, were already falling due to the global recession. Early in 2008, surging commodity prices and a new labour law also added to many companies' costs. A further profit margin squeeze coming from a stronger renminbi would have been the last straw for many of these firms.
That said, we believe economic conditions are again ripe for renminbi appreciation. Chinese exports have begun to climb again and are likely to expand the trade surplus in time, despite the March deficit. And after massive recent retrenchments, manufacturing jobs are growing once again.
But even if the economic case is clear, politics may cause delays. China's main international trade partners and the multilateral financial agencies have called for a stronger Chinese currency, sometimes threatening trade barriers, and we believe Chinese policymakers will be unwilling to appear to yield to such calls.
Exchange rate regime change is some way off
We don't see a new round of appreciation changing China's exchange rate regime. China's persistently large balance of payments surpluses (from both current and capital accounts) make anything other than tight control unlikely. China is therefore likely to continue to actively intervene to closely manage the renminbi exchange rate, whether to maintain stability or to guide it up gently.
We believe that at least two conditions have to be in place before a managed float is possible. First, China's current account surplus must fall to a level that is closer to those of Germany and Japan, which averaged 6% and 3.9% of GDP over 2004-2008, respectively, compared to China's average of 8.1% in the same period. At these levels, China would find its surpluses politically easier to defend vis-à-vis those of major trade partners.
China can bring down its current account surplus by reducing the savings rate or increasing the investment rate, or both. But with overinvestment a frequent concern, lowering the national savings rate is likely to be preferred by policymakers -- although this will require deeper domestic reforms.
Second, freeing up capital accounts would make exchange rate controls easier. Total liberalisation is likely to be unnecessary. But allowing residents greater freedom to invest abroad and granting foreign direct investors the flexibility to tap local capital markets for financing would help create net capital outflows. This would reduce or even stabilise the balance-of-payment account and the need for the central bank to hold more foreign reserves.
China's transition to a managed float exchange rate regime is likely to be a long one. We expect an effective crawling peg of the renminbi against the US dollar to stay for some years to come. The rate of the crawl will probably vary, or even stop entirely, depending on China's economic circumstances. But short of major negative developments that trigger a prolonged slowdown in China, we believe a reversal is unlikely.
The author of this article, KimEng Tan, is a director of sovereign & international public finance ratings at Standard & Poor's.