Making sense of China's renminbi revaluation

China's revaluation of its currency has finally begun, albeit a little sooner than reports had suggested. Earlier today the People's Bank of China (PBOC) announced that it would be "reforming the RMB exchange rate regime":

1. Starting from July 21, 2005, China will reform the exchange rate regime by moving into a managed floating exchange rate regime based on market supply and demand with reference to a basket of currencies. RMB will no longer be pegged to the US dollar and the RMB exchange rate regime will be improved with greater flexibility.

Initially this involved only a 2.1% appreciation, moving the renminbi from 8.28 to 8.11 versus the US dollar. But in addition, the currency peg to the dollar has, supposedly, been replaced with a peg to an undefined basket of currencies (much like Singapore does). This is how the PBOC put it in their statement:

2. The People's Bank of China will announce the closing price of a foreign currency such as the US dollar traded against the RMB in the inter-bank foreign exchange market after the closing of the market on each working day, and will make it the central parity for the trading against the RMB on the following working day.

4. The daily trading price of the US dollar against the RMB in the inter-bank foreign exchange market will continue to be allowed to float within a band of 0.3 percent around the central parity published by the People's Bank of China, while the trading prices of the non-US dollar currencies against the RMB will be allowed to move within a certain band announced by the People's Bank of China.

The operational details and trading implications should soon become clear. John Snow, US Treasury secretary, said the mechanism provided “significant amplitude for the currency to move”. But the statement is vague on some key details. Typically currency baskets are based on the shares of major trading partners. but which currencies are in the basket? What are their weights? And what will the "certain band" be? Answers may emerge, or the PBOC could choose to remain ambiguous.

The two key issues are (1) whether this is a one-off revaluation or the beginning of a sustained currency appreciation and (2) if the latter, just how much is China prepared to strengthen its currency by over the next 6-12 months?

We don't yet know the answers to these questions. Not only are financial market strategists divided (see below), so too are Chinese academics, according to the Financial Times' Richard McGregor in Beijing:

Professor Song said the renminbi would experience only “gradual adjustments” until the establishment of a free-floating currency. “But that takes time - there won't be another move in the second half,” he said. Mr Gong disagreed, saying he expected an additional 5 per cent adjustment by the end of the year, and a total of 10 per cent in 12 months.

As to what a "managed floating exchange rate regime" actually means, there are three main possibilities:

(1) This is a one-off adjustment, with the PBOC to keep the renminbi roughly stable against the basket of currencies. (This appears to be the HSBC view).

(2) It is the first in a series of small revaluations in the future. (This is the view of JP Morgan Chase and Goldman Sachs).

(3) It is a move to a creeping or 'crawling peg' system, allowing the renminbi to rise against the dollar by 0.3% a day, with the closing price becoming the opening price the next day. In theory that is up to 1.5% appreciation per week - quite a lot over the course of a month or two's trading. This is reportedly the US Treasury's interpretation. (And is what Todd Cromwell at Asia Cable predicted back in March). A host of countries, including Australia, Poland, Nicaragua and Vietnam, have used this system.

The first of these three regimes is mere tokenism - neither credible nor sustainable. It would do precious little to cool China's overheated economy or narrow US-China trade imbalances, and may even exacerbate trade tensions if other Asian currencies appreciate faster than China's.

That is certainly possible. While Hong Kong kept its currency peg to the US dollar, Bank Negara scrapped the Malaysian ringgit's seven-year peg to the greenback and said it will allow it "to operate in a managed float", monitored "against a currency basket". The yen, as expected, rallied strongly today, while the renminbi's revaluation should see most other Asian currencies strengthen. However at least some authorities will resist currency appreciation. There are already press reports this evening of Singapore's central bank intervening after its currency rallied by 2%.

G7 Daily Briefing called it a 'baby step revaluation". Quite so. Currency markets will be pricing in further appreciations, whether they be incremental (via a currency peg) or jerky (via periodic small revaluations). Now that a modicum of flexibility has been introduced, there will be clamour for more.

John Snow, Treasury secretary, said the mechanism provided “significant amplitude for the currency to move”. The Treasury would track how well it reflected underlying market conditions over time, officials said. A senior Tresury official added: “They have not indicated that it is capped. We take them at their word at this point that this mechanism will be orientated toward market supply and demand.”

Politically, US lawmakers will welcome this move as a helpful first step, but at best it will only delay - not avoid - US protectionist pressures such as the vote on the China Act.

I expect it will prove difficult for the Chinese authorities not to allow further revaluations. However if the total appreciation over the next year or so is limited to 5-10% it will not have marked economic or trade repercussions for China or the US. Bloomberg columnist Caroline Baum summarised this well in her piece China Revalues; Trade Gap Still a Basket Case, looking at the US impact:

1. It would take a huge revaluation of the yuan to arbitrage the wage differentials between the two countries. By some accounts, U.S. workers are paid on average 20-25 times as much as their Chinese counterparts.

2. It won't affect the U.S. trade deficit one iota. The bilateral trade deficit with China rose 24.3 percent to $103.9 billion in the first five months of the year compared with the same period a year earlier. An appreciating yuan may reduce the amount of goods the U.S. buys from China if other low-cost producers resist the upward pull of the yuan, but it will not reduce the total deficit.

3. It won't help the U.S. manufacturing industry. ...The yuan revaluation won't prompt manufacturers to dust off mothballed factories. Other low-cost producers, such as Pakistan, Malaysia and the Philippines, that lost out to China's comparative advantage may regain some market share.

4. It will raise the prices consumers pay for boxers, bandanas and other low-end products.

5. It's a negative for Treasuries since the PBOC will need to diversify its foreign-exchange reserves away from dollars.

Likewise, the short-term impact of this revaluation on China’s economy will be very limited.

On capital flows and Treasuries, Ian Morris at HSBC makes the point that China may need to recycle fewer dollars:

A reasonable RMB appreciation may help settle the debate on how large the impact of Asian central bank buying on US long rates has been. Many believe the Asian impact has been large, perhaps up to 100bp on 10-year yields. Our feeling has been that it has been smaller, perhaps in the range of 20-30bp, as we note that Bunds have outperformed Treasuries in recent quarters, and one should have expected the opposite if central banks had distorted Treasuries.

I will include a separate post on other econobloggers comments.

UPDATE: While I argue above that the short-term impact on China’s economy "will be very limited", a piece by Xu Haihui of International Finance News on the Financial Times website, Revaluation: a double-edged sword for China, suggests otherwise - particularly in textiles. To summarise:

Textiles: If the renminbi were to appreciate by 3 per cent, the textile industry could face export losses of up to 30 per cent mainly due to a lack of value-added products.

...Real estate: A possible renminbi appreciation would bring the property sector under enormous pressures caused by the massive influx of hot money.

...Banking: The initial effects of a revaluation on the banking system will be centred on two aspects: a contraction of banks’ core capital, and an increase in bad debt of trade companies.

Geoff Dyer, writing in the Friday 22 July FT, is a little less alarmist, arguing that the revaluation "will not have a dramatic immediate impact on the economy" - though Textile goods to be worst affected:

Exporters of products with slim profit margins will be most affected by the shift in currency policy but economists do not expect a sharp slowdown in the Chinese export machine - which led exports to increase 30 per cent in the first half of the year.

...China's textiles industry has seen a surge in exports this year after the elimination of quotas on exports allowed it to take more advantage of its low costs. However, the small profit margins in many areas of the textiles industry mean it could be hurt the most by a renminbi revaluation.

“Exporters of low-value added products such as textiles will be the most affected, as even a 2 per cent change can have a significant impact on profitability,” said Ivan Chung, managing director at Xinhua Finance, the Chinese credit ratings agency. “There are other developing countries such a Bangladesh and Indonesia that are also highly competitive in this area.”

However some sectors will gain, particularly those dependent on the import of raw materials, oil or coal. And politically it will reduce the amount of US protectionist pressure, at least for a time.