Will China re-value the renminbi?

One of the big issues over the next year may be a more flexible exchange rate policy in China. From an international perspective, there seems to be a case for a stronger renminbi. But will China re-value?

The renminbi (CNY) has been under appreciating pressure, as seen in China's surging foreign exchange reserves, due to strong capital inflows and current account surplus. The sharp and steady decline in the CNY non-deliverable forwards reflects increasing confidence in the CNY, and hence reducing its risk premium, which fell to negative levels at some point recently (see chart). Anecdotal evidence also shows that the CNY/USD black market rate had appreciated above the official exchange rate.

Falling Chinese Premium

The CNY's underlying strength is putting the Chinese authorities in a policy dilemma. On one hand, they are under increasing pressure, especially after entry to the World Trade Organisation (WTO), to speed up financial and currency liberalisation. On the other hand, if they let go of controls, a rising CNY would add to the economy's deflationary pressure and hurt exports that are facing weak global demand.

Japan is lobbying international support for urging China to re-value the CNY to help reduce China's competitive stress on her external trade. China has been gaining export market share at the expense of Asia's, including Japan's, since the Asian crisis in 1997/98. But Chinese tariffs are coming down after WTO entry, and a rising CNY will only aggravate the initial WTO shock on China's domestic producers, who compete with imports, and exporters, who compete in a tough global market.

Not the time to re-value

Thus, from Beijing's perspective, this is hardly an appropriate time for a stronger currency. Indeed, Beijing is taking other measures to curb CNY strength. It is mulling to allow mainlanders to invest abroad under a Qualified Domestic Institutional Investor (QDII) programme. The China Securities Regulatory Commission (CSRC) is also working on a proposal, with approval from higher authorities expected soon, to allow Hong Kong-listed companies to issue China Depository Receipts (CDR) to mainlanders.

The CDR plan is a stone that can kill three birds at a time. Its implementation will help lessen the CNY's appreciating pressure, as capital flows out towards Hong Kong. It is also part of a raft of proposals aimed at injecting a dose of reform into China's securities markets and it will also create new opportunities for Hong Kong's financial sector.

Hong Kong's H-shares (Chinese companies listed in Hong Kong) are expected to benefit because they are still trading at deep discounts to their counterparts on the mainland. China's closed capital account has prevented arbitrage, but the QDII and CDR programs will allow the H-shares to be re-rated more in line with the valuations in China's markets.

Crucially, the QDII system could be a predecessor for China to implement the Taiwan-style Qualified Foreign Institutional Investors (QFII) scheme, which will allow foreign investors to buy Chinese stocks upon approval by Chinese authorities. Since both the QDII and QFII are schemes that allow freer portfolio flows, they are in fact a step towards capital account convertibility. These partial capital account convertibility schemes will give China's financial reform a breathing space after WTO entry and before full currency convertibility is implemented.

A small band-widening expected

The CNY currency regime is officially described as a managed float, although the currency is effectively pegged against the US dollar. Thus the Chinese authorities could allow a more flexible exchange rate without overall currency policy changing. The strong CNY's policy dilemma is an important reason for expecting Beijing to allow only a small band widening for CNY trading after WTO entry. The CNY's appreciating pressure is not expected to abate in the coming year, due to a continued favourable balance of payments (BoP) position.

Since there is little portfolio flows in China, the basic balance (the sum of the current account and long-term capital account balances) will be the deciding factor for the CNY's underlying pressure. The current account may start moving into a deficit under WTO in late 2002. However, expected strong foreign investment inflow will keep the basic balance, hence the BoP, in surplus, underpinning the CNY.

While realising the importance of having a flexible foreign exchange policy to absorb the external shocks, the concern about the damaging impact of a rising currency will likely prompt the authorities to remain conservative and test a wider trading band with gradualism. They may not even announce an official range, but just keep the CNY within its desired limits through intervention, as in the present situation. It may implicitly enforce a 5% trading initially, only widen it gradually as competitive pressure from the WTO rises. Any widening is more likely to result in initial CNY strength than weakness.

No parity with HKD yet

There has been speculation that the CNY would converge to par with the HKD, which is about 6% higher than the CNY. Given the expectation that the HKD peg would remain intact in the medium-term, a devaluation of the HKD towards the CNY is not in the cards. This would then mean a re-valuation of the CNY against the HKD. While the economic reasons for merging the HKD and the CNY are strong, it may not be practical until the CNY becomes a hard currency.

The case for a HKD/CNY peg is getting increasing attention, as Hong Kong's economic cycle is more integrated with China's than with the US in recent years. The HKD/USD peg ties Hong Kong's interest rate cycle with that of the US. This could be problematic when their business cycles are moving in opposite direction, as seen in the early 1990s when the US recession and declining US interest rates dictated lower interest rates in Hong Kong just when the local economy was overheating. Tying the HKD with the CNY, which has a similar underlying cyclical movement as Hong Kong's, would be less destabilising.

Further, with China moving towards partial capital account convertibility using the QDII and CDR schemes, Hong Kong has been chosen as the test ground for the pilot projects. This means that capital flow between Hong Kong and the mainland will become more integrated, making sense for a HKD/CNY peg.

But practically, this will be implausible. First, Hong Kong's Basic Law, the equivalent of a constitution, rules out a HKD/CNY peg because it dictates that the HKD must be pegged against a hard currency. But the CNY is still a soft currency. Second, the Basic Law aside, parity between HKD and CNY would mean full convertibility between HKD and CNY. But the CNY is still not fully convertible against all other currencies. Unless there were capital controls, a forced HKD/CNY peg at parity would destabilise China's and Hong Kong's financial systems, as rampant arbitrage could arise between HKD and CNY assets. But imposing capital controls would beat the purpose of having the HKD/CNY parity peg, which would be to foster capital flows between Hong Kong and the mainland.

Currency risk low

In a nutshell, there is strong regional and international pressure on China to re-value the CNY. Yet a currency revaluation would add significant deflation to China, making it impractical to do in the coming months. Continued upward pressure on the CNY also argues for a cautious PBoC to allow only a small band widening for CNY trading in the coming year. Before the CNY becomes fully convertible, it is also impractical to peg the CNY to the HKD at parity. As a result, the currency regimes in China and Hong Kong are expected to remain unchanged, suggesting low currency risk in investing these economies, in the medium-term.

Chi Lo, chief economist (NE Asia), Standard Chartered Bank Global Markets, Hong Kong.

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