SPEAKING FREELY The yuan, six months later
By Huw McKay
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On the weekend of December 3 and 4, finance ministers and central bankers from
the G-7 countries met in London. The portion of the communique they issued
relevant to foreign exchange matters read like this: "We expect that further
flexible implementation of China's currency system would improve the
functioning and stability of the global economy and the international monetary
system."
Bearing this in mind, what does the next year hold for the US$/yuan exchange
rate? On the "Thursday surprise" day of July 21, when China increased the value
of the yuan from 8.28 per dollar to 8.11 per dollar (an appreciation of 2.1%),
I wrote the following assessment of the second half outlook:
A
quasi-official statement was issued this morning along the lines of
"expectations of a larger move were seriously misplaced". That implies that
China is not interested in allowing significant further appreciation. If they
thought that one-year non-deliverable forward contracts [NDFs - essentially a
bet on the value of a currency one year in the future] were well priced at -6%
(calculated from the 8.28 yuan per dollar level: the figure would be -4% from
the post-revaluation 8.11 yuan per dollar level), they could have revalued
further. Our intuition is that the market is in for a fight if they expect
today's one-year forward contracts to mature "in the money". The yuan-dollar
exchange rate should still have an eight-handle [ie, remain in the 8.00-8.99
range]at year's end.
Five months on, I see no compelling
reason to alter this initial view. Furthermore, I am willing to extend the
duration of the eight-handle to the end of 2006. This prediction has been
stress-tested from several different angles.
The first method used was to study the historical precedent of Korea, which
moved to a very similar regime in 1990, and limited the movement in the won to
3.6% over the first 12 months of operation. Noting that China is better placed
to manage volatility than Korea was, I was comfortable forecasting a smaller
move in the yuan in the initial year of the more flexible exchange rate regime.
Second, the obvious step was taken of waiting for the new foreign exchange
regime to betray its de facto character, given that its de jure design was more
obfuscating than enlightening (for example, the exact composition of the
foreign currency basket used to define the yuan was never revealed).
With China's new currency system now five months old, it is now reasonable to
estimate a smooth trend over the regime's short history, and extrapolate that
over the next year's worth of trading days. This method would put the exchange
rate between 8.01 and 8.00 at the end of 2006.
This statistical exercise was conducted over the full "floating" history of the
exchange rate since the July 21 revaluation. If we had chosen to divide the
sample into smaller time periods, our result would have changed marginally. But
it is important to note that choosing a more recent period, say from October to
the present, would have generated a smaller rather than a larger appreciation
of the currency.
That is because the daily trend appreciation has actually decelerated slightly
in more recent months, consistent with a firmer US dollar against the yen and
euro. While extrapolation is not a tool generally recommended for forecasting,
it does provide a useful benchmark.
Third, a weighted yuan currency basket from the dollar, euro, yen and the
Korean won (all currencies assumed to be held in large quantity by China) was
assembled for calculation purposes. Using forecasts for these other currencies,
it is possible to estimate a move in the yuan if it were to be managed tightly
against this basket.
In contrast to the other two methods, this technique implied a dollar/yuan rate
of 7.97 by the end of 2006. But the magnitude of the difference is small:
neither the basket nor the trend-extrapolation approach gives us a compelling
reason to move much from the original number.
Evidence does exist for a stronger yuan than these approaches would predict.
One such benchmark which some have cited is the People's Bank of China's
(PBoC's) recent one-year cross-currency swap transactions with domestic banks,
which incorporated a year-ahead dollar/yuan rate of 7.85.
Superficially, it is tempting to see this information and deduce that the PBoC
is willing to countenance appreciation up to this level over the coming 12
months. However, currency swap pricing demands both an interest rate and an
exchange rate assumption. Given the under-developed state of the local money
markets, the PBoC may just as well be signaling where they would like interest
rates to go, rather than their foreign exchange tolerance.
Furthermore, the underlying demand for these swap transactions is created by
the need to reduce the US dollar exposure of China's domestic banks, which are
about to face far stricter operating guidelines as they seek to float on
offshore stock markets. That would imply that the swap pricing may be designed
as an implicit subsidy to weak banks, rather than signals to the foreign
exchange market.
It is true that recent commentary from PBoC officials has generally been
slanted towards preparing domestic organizations for a stronger appreciation.
Yet it is not uncommon for central bankers to advocate a more laissez-faire
policy mix than their finance ministry and industrial policy counterparts. And
one must also take into account the political imperatives in a surplus-labor
economy such as China's, where a stronger currency threatens exports and
thereby, employment.
There are many ways to estimate equilibrium exchange rate levels, and this is
not the forum to debate the relative merits of the various methods. However, it
is appropriate to recall the dictum that all politics is local. That is why the
timeline of China's exchange rate reform remains a politically determined path.
That being the case, any "fair value" estimate of the yuan's future value based
on methods that do not adjust for the maintenance of internal stability can be
safely rejected.
Recall that the most aggressive calls for appreciation (those averaged out by
US Senator Charles Schumer to conclude that the yuan was undervalued by 27.5%)
have come from those analysts focused on the global imbalances issue, which is
nothing more than the achievement of aggregate external balance among the
community of nations, rather than for China alone. Those methods that
simultaneously account for the need to maintain internal stability show smaller
required adjustments, of less than 10% from the old peg of 8.28 yuan to the
dollar.
Threats to the achievement of internal balance in China are most likely to come
from three main areas: the financial system, rural unrest and inflation. The
first is an obvious constraint on exchange rate reform, and by extension
capital account deregulation. The second constrains reform due to the current
need to absorb excess rural labor in the export-industrial complex under
China's skewed economic structure. By contrast, sponsoring a stronger currency
would actually help policymakers to mitigate the third potential problem. But
inflation is not a current threat. Indeed, the prevailing condition through
2005 has been disinflation (a reduction in the level of inflation).
When all these factors are considered, a rational policy mix from China would
include the exchange rate lever being set for a slow, steady, grinding
appreciation. That is what the previous five months of history have prepared us
for; and that, in all probability, what we are going to get.
Huw McKay is a senior international economist at Westpac Bank in Sydney,
Australia. He is the bank's spokesperson on pan-Asian economic and market
issues.
(Copyright 2005 Huw McKay. Used by permission.)
Speaking Freely is an Asia Times Online feature that allows guest writers to have
their say.
Please click hereif you are interested in
contributing.
