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Pressures point to fresh yuan appreciation in coming monthsTom Holland24 February 2010In recent days market chatter about the yuan has reached deafening volumes. Lots of people agree; at some point soon Beijing is going to change the way it manages its exchange rate policy.Exactly what the pending change will involve, no one is too sure. Or rather, to be more accurate, plenty of people are sure they know what Beijing should do. It’s just that they all have different opinions.On the whole, however, most analysts expect Beijing will bow to economic pressure and allow a resumption of the yuan’s appreciation against the US dollar, which it halted back in July 2008 as the global financial crisis deepened.And there is a remarkable unanimity about when the policy change will be sprung on the market: some time in the second quarter, after next month’s National People’s Congress, but probably before the end of June.If Beijing does resume yuan appreciation over the coming months, it will not be in response to criticism from politicians in the United States and Europe, who accuse the Chinese authorities of deliberately undervaluing their currency to gain an unfair trade advantage. Rather any strengthening of the yuan will be dictated by mounting domestic stresses.To understand why a return to yuan appreciation is probable, it helps to go back to first principles. In rich countries stuff tends to be more expensive than it is in poor countries. So if an economy develops rapidly, the domestic price of goods and services will tend to rise relative to prices of goods and services in other more slowly growing countries.This can happen either through higher domestic inflation, or through an appreciation of the currency against the currencies of other countries, or by a combination of the two.Whichever way, the economy will undergo what economists call an appreciation of its real effective exchange rate, which basically means an increase in relative prices.For much of the last year and a half, Beijing has been swimming against the economic tide. As the second chart shows, China’s real effective exchange rate did appreciate between the yuan’s 2005 revaluation and late 2008. But since then, thanks to the government’s renewed peg to the US dollar, China’s real effective exchange rate has actually been falling, not rising.Economic wisdom says this cannot continue indefinitely. Beijing may have bought time by operating capital controls and ramping up its reserves, but at some point either the government must allow the yuan to appreciate or it will face mounting inflation at home. Most observers are in little doubt about which Beijing will choose. Over the last year or so currency appreciation has been fiercely resisted by struggling exporters and their champions in the Commerce Ministry. But with monthly exports now back to pre-crisis levels and projected to grow strongly over coming months, the export sector’s arguments are losing force.Meanwhile, domestic inflationary pressures are mounting. Over the last decade, every occasion that money supply growth approached 20 per cent was followed a year or so later by a sharp uptick in inflation. Last year money supply rose by almost 30 per cent thanks to the government-mandated expansion in bank credit, fuelling fears of steep price rises to come.A stronger yuan could help contain inflation on two fronts. Firstly, it would cushion the impact of rising import prices, especially for imported commodities destined for local consumption.Secondly, a stronger currency and a more flexible exchange rate would give the central bank more control over domestic monetary policy, allowing it to raise interest rates to control inflation. At the moment, the fixed exchange rate forces the central bank to keep rates low lest it attract destabilising inflows of hot money.
And in the longer term, more control over monetary policy and interest is essential if the Chinese financial system is to allocate capital more efficiently, something it will need to do if the economy is to be rebalanced away from investment and more towards consumer demand.So an exchange rate policy change is looking increasingly likely. Analysts will continue to disagree whether Beijing should resume gradual appreciation or go for a big one-off revaluation; both options have their advantages and drawbacks. Meanwhile, some economists even argue that the authorities should let the inevitable adjustment happen mainly through higher domestic inflation.Given the political damage that a runaway bout of price rises could wreak, that option is hardly likely to win many supporters in Beijing. As a result, there is good reason to believe the market chatter has some foundation, and that we could once again see a stronger yuan over the coming months.
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