My Blog

January 2, 2008

The RMB keeps strengthening, to 7.2948 as of yesterday.  This has it rising at its fastest pace since the peg was broken in July, 2005.  According to my friends, some local currency traders see the burst of appreciation we have experienced recently as a sort of back-door “revaluation”.  By forcing up the currency over the past few weeks at its fastest pace (2.3% in the past two months), the PBoC is effectively engineering a revaluation over several weeks, while seeming not to violate its promise that it would not do so after the first revaluation in July 2005.

This may well be true.  By now I think the old argument about whether or not the RMB needed to appreciate is more or less over.  The mistake made by many was that contrary to the assumptions of many the need for China to appreciate had little to do with the direct impact of the value of the RMB on the relative prices of Chinese exports and everything to do with China’s lack of domestic monetary policy.  

Those of us who have been arguing sine 2003 or 2004 that the country’s currency regime had left it locked into a monetary trap that was going to lead to ever-increasing trade surpluses and ever-expanding domestic money, however, still have one big disagreement.  One side argues that China needs to adjust the currency as quickly as possible and the best way is to speed up the rate of appreciation.  The other side argues that China has forced itself into a position in which the only possible solution is a large (say 15-20%) one-off maxi-revaluation.  Over the next few months we will see whether the more-rapid-appreciation school or the one-off-revaluation school will do a better job of predicting what the government actually does, but for the record I believe that China has no choice but for a maxi-revaluation.

The main thing to watch, I think, is hot money inflows.  If these pick up substantially as the RMB continues appreciating, the impact of the current rate of appreciation will be at first to make monetary conditions even worse as more money floods into the country.  This will result in greater fixed asset investment, rising industrial production and, what may at first seem paradoxical, a high and even rising trade surplus.  It will also keep pressure on inflation. 

If we see reserves rising as fast as ever as the currency’s appreciation speeds up to 7-10% a year, this will almost certainly be an indication that the new policy is not working.  By the way, and as an aside, an important problem with the appreciation strategy, although this will not be apparent for a while, is that once the RMB has reached its targeted level there is no way for the PBoC to signal credibly to the market that the currency has reached its target and will no longer appreciate, and hot money will continue to pour in, putting more appreciation pressure on the currency.

At any rate if reserves continue to surge as the currency rises, the impact of currency appreciation on bringing control back to monetary policy will be negligible or even negative – and currency appreciation is the last tool the PBoC has left with which to combat inflation and overheating.  In that case the PBoC will be forced to something far more dramatic to stem capital and current account inflows, and it seems to me that only a one-off maxi-revaluation followed by a credible peg will do the trick.  The argument in favor will also seem easier to sell domestically because policy-makers will be able to see that the currency can appreciate rapidly with no real collapse in the export sector.  The argument will be faulty, of course, because this was never about relative export prices, but it will still make it easier to sell the maxi-revaluation policy to local authorities.

The bottom line, I think, is that if the currency continues appreciating at 1/2-1% every month, we should watch reserves growth carefully, and of course make sure we back in transactions that result in reductions in headline reserves but which will have no domestic monetary-contraction impact. If reserves still grow at their furious pace, the PBoC will be forced to shoot the last arrow it has left in its quiver

Comments (6) for "Is China sneaking in a reval...

Michael, 1. How can we know before-hand that the one-off maxi-revalution is on target or not. Did any government ever get it right with one-move? 2. If not, any over/under corrections are likely to be followed up by additional policy measures to right the course. If this is true, how is it different from the "gradual appreciation" approach. It seems that you only have an issue with the pace of appreciation (1/2-1%) vs. growth rate of the reserve. Suppose that PBoC "engineers" a much higher appreication rate consistently, would that be a viable approach? By ZH - 1/2/2008 6:07 AM

I am not sure a reval + repeg would work, in part b/c china would have to repeg to something, and there isn't an obvious anchor for as dynamic an economy as china. that said, a gradual but entirely expected appreciation is a recipe for massive capital inflows -- and (best I can tell) hot money inflows are running at about the same rate (on a rolling 12m basis) now as before the june 05 reval. That measurement in billions of dollars, tho, so they would be a bit smaller v. GDP. the main difference is that most of the inflow is coming below the line, and it hinges on getting the adjustment right. that isn't something I am sure I have nailed down, tho if i had to guess, i would guess that I am underestimating not overestimating inflows. By bsetser - 1/2/2008 2:16 PM

Prawf Pettis, here's a dumb question for you. If the yuan has appreciated relative to the dollar, but the dollar has declined against all global assets by more than the yuan has appreciated relative to the dollar, then hasn't the yuan lost value? Thanks, happy new year, and keep up the great work. By E Cartman - 1/3/2008 8:51 AM

ZH, you are right in that there is no way to decide what he “right” amount of a revaluation is. This is as much art as science. If the revaluation is perceived as too low, it will set off a stampede of inflows betting that the government will do it again, and this could be very destabilizing. I would argue that anything less than 15% would be a huge problem for this reason. Whatever the revaluation, it must be credible, and one way to make it credible is immediately to peg against the dollar in a fully credible way. One way to signal credibility is for the PBoC or some other official or quasi-official institution to be willing to sell unlimited amounts of dollar puts to all and sundry. This would allow the country to absorb additional speculative inflows in a non-destabilizing way (there would be no need to bring dollars into the country to bet on a further revaluation) while signaling a strong commitment on the part of the authorities. Brad, I agree that there is no obvious anchor against which to peg, but I think China’s financial system is fragile enough that there are good reasons for it to continue pegging against the dollar, at least for a few more years. In addition I think, as you know, that we may see some serious turbulence in the next few years and it is probably a good idea to lock in a few areas of stability. By the way last night I was having drinks with one of my former students who now trades domestic interest rates and he told me that there are all kinds of illegal, or at least questionable, transactions that basically involve speculative inflows and that these have risen recently. As we discussed in an earlier posting this is one of the reasons the PBoC has been eager to force up domestic dollar rates – to eliminate the forward arbitrage. All the problems we have identified with a maxi-revaluation, and more, are true. I still think it must happen, however, because the alternatives are worse. EC, yes, on average the RMB has depreciated against the currencies of its trading partners. That is why the Europeans are now screaming just as loudly as the Americans about China’s currency regime. When the dollar was strong and rising they didn’t care. By Michael Pettis - 1/3/2008 2:52 PM

Rmb is moving at 15% annualized pace vs. USD since Nov, the steady US dollar since Oct means Rmb is also rising at similar pace on effective basis( probably more as China inflaiton surge) At this rate, I think China real trade account could adjust rather quickly when Global demand is weakening fast. China net export probabaly peaked in 2007 in both absolute terms and % to GDP. this could mean FX reserve and domestic liquidity conditions peaking in 2007 too, Whether this pace could quickly dampen local inflation remain to be seen but we already have signa that domesti asset prices correcting, A shre off 15% from TOP in October and Property price plunge in Pearl river and sales cooling nationally if all things seem move in right direction, why risk a MAXI reval while fast incremental move takes you in same place?? By isaac - 1/3/2008 2:58 PM

In my model the trade surplus is driven by and contributes to domestic monetary expansion, so even if global demand declines, China's trade surplus will remain high -- in fact government estimates suggest it will be 20% higher in 2008 than in 2007. I guess the trick is to see whther reserve accumulation really does slow and if inflation comes down. If they don't, and I don't expect them too, the PBoC will be forced to do something more drastic. By Michael Pettis - 1/3/2008 7:22 PM