China resorts to ‘back-door revaluation’ of the yuan

But ‘hot money’ inflows could derail policymakers’ plans

HONG KONG: China may have resorted to a “back-door revaluation” of the yuan by letting its tightly controlled currency appreciate at a faster pace in recent weeks. But the policy, aimed at fighting inflation and combating trade tensions with the US, could be undone if ‘hot money’ inflows continue, say experts.

On Thursday, the yuan hit a new high against the US dollar, bursting through the 7.30 mark to close at 7.2725 yuans to the dollar. At that level, the currency has surged by over 2.3% in the past two months, against a 6.9% appreciation for the whole of 2007. Since July 2005, when Chinese authorities dramatically abandoned the yuan’s peg to the US dollar, China’s currency has risen about 13%.

Currency traders and experts in Shanghai and Beijing see this “burst of appreciation” in recent weeks as amounting to a “back-door revaluation”.

“By forcing up the currency over the past few weeks at its fastest pace, the People’s Bank of China 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,” notes Michael Pettis, a professor at Peking University’s Guanghua School of Management and a specialist in Chinese financial markets.

UBS economist Jonathan Anderson expects the pace of appreciation of the yuan to strengthen in 2008. “Our current forecast is for 8% bilateral strengthening (during 2008), which would bring the renminbi to 6.8 against the dollar; this is very much in line with current pricing in the offshore non-deliverable forward market.”

Just last week, officials at China’s central bank had reportedly recommended a “one-off” appreciation in the value of the yuan to signal a tough policy aimed at fighting excessive liquidity, controlling inflation - and combating residing trade surpluses with the US.

But, says Anderson, “We don’t see a significant chance for another one-off revaluation - although that could become an option if pressures build.”

From an average foreign exchange reserve accumulation of only $1-2 billion a month from 1998 to 2001, central bank purchases jumped to $15 billion a month in 2004, $25 billion a month in 2005-06 and nearly $40 billion a month in the first three quarters of 2007. “The main driver has been the dramatic increase in the trade surplus, but China has also seen sharp volatility in portfolio capital flows,” says Anderson.

The main thing to watch, according to Pettis, is hot money inflows. “If these pick up substantially as the renminbi continues appreciating, the current rate of appreciation will make monetary conditions even worse.”

“And, currency appreciation is the last tool the People’s Bank of China (PboC) has left with which to combat inflation and overheating,” Pettis says.

In that case, Pettis believes, the PBoC will be forced to do something far more dramatic to stem capital and current account inflows. “It seems to me that only a one-off maxi-revaluation followed by a credible peg will do the trick.”  

The bottom line, in his estimation, 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.”

Anderson, however, doesn’t expect a renewed pick-up in foreign exchange reserve accumulation. “Not only do we expect the current account to remain relatively stable, we also expect an increase in outward foreign direct investment (FDI) by Chinese firms. On the capital flows side, rising domestic interest rates, falling US rates and faster renminbi appreciation should increase the attractiveness of net inward portfolio investment, but in our view the main driver of ‘hot’ money in China has been asset market returns, and over the past two years this has meant the booming domestic equity market. With stock valuations already at excessive levels - and with the market now correcting  - we don’t see much room for further upside next year, which means that we also don’t expect further capital inflows of the same magnitude we saw over the past year.”