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Global Economic & Strategy Research

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UBS Investment Research Asian Economic Perspectives

The Complete RMB Handbook (Third Edition)

Revised and updated: Everything you need to know about China’s exchange rate system and policy, compiled in one easy reference volume

I. How the peg worked

II. The new system

III. What drives China’s balance of payments?

IV. Is the RMB undervalued?

V. What is the optimal exchange regime?

VI. What is the path ahead?

VII. What effect does a RMB move have on China?

VIII. What effect does a RMB move have on its neighbors?

25 July 2005

www.ubs.com/economics

Jonathan Anderson Chief Economist, Asia

[email protected] +852-2971 8515

This report has been prepared by UBS Securities Asia Ltd

Asian Economic Perspectives 25 July 2005

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First things first—defining our terms

What is the proper name of China’s currency? “Yuan” or “renminbi”?

This is a seemingly simple question, but one that has caused significant confusion among investors. Here’s the answer: The legal and official name of the PRC currency is the “renminbi” (which literally means “the people's currency”). “Yuan” is the denominal unit, so that in Chinese you would refer to one yuan renminbi, one hundred yuan renminbi, etc., rather than one renminbi or one hundred renminbi. This is a very specific feature of the Chinese language, which regularly separates denominal units from actual names—although interestingly, the closest analogy in English is also a currency, i.e., the “Pound Sterling”.

When referring to the Chinese currency in English, both names can be used interchangeably. In currency markets and news agencies, the currency is listed as the CNY, or Chinese yuan. However, most China watchers and Chinese speakers favor “renminbi”, in line with official PRC practice, and in our economics publications we favor this usage as well.

What is the difference between “flexibility” and “convertibility”?

We often see these two concepts misdefined in discussions of renminbi policy. A “flexible” currency refers to a floating exchange rate, as opposed to a fixed peg. By contrast, currency “convertibility” has nothing to do with the fixity of the exchange rate, but rather with capital controls; a convertible currency is one that can be used to purchase foreign exchange without restriction. By these definitions, the renminbi is currently neither flexible nor fully convertible.

One very important additional point: as we will show further below, not only are the two concepts different, they are separated in practice as well. A country can have a convertible currency that is not flexible, and a flexible currency that is not convertible. In other words, for China the processes of adding renminbi exchange rate flexibility and moving to renminbi convertibility are not necessarily related.

What is the difference between “revaluation” and “appreciation”?

This is another question that often plagues investors not familiar with academic economics. Formally speaking, “revaluation” and “devaluation” refer to adjustments in a pegged exchange rate regime, i.e., in the case of revaluation, an administered upward revision from one fixed exchange rate level to another, stronger fixed level (and similarly but in the opposite direction for a devaluation). More loosely, the terms are often applied to an exit from a fixed exchange rate, so that we can refer to the “devaluation” of the Indonesian rupiah when in fact the regime was changed from a crawling band to a managed float.

The official Chinese name for the currency is the renminbi.

However, in English both “renminbi” and “yuan” are commonly used

Convertibility and flexibility have little to do with each other

Revaluation generally means an adjustment to a fixed exchange rate


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The terms “appreciation” and “depreciation” are much broader, referring to any trend strengthening or weakening of the exchange rate (to make things more complicated, we often talk of both nominal and real exchange rate appreciation or depreciation). So, for example, if we ask whether the Chinese authorities will let the renminbi appreciate, we could be speaking of an administered revaluation or a more flexible strengthening.

By the same token, and somewhat more informally, we could also refer to a revaluation of the renminbi even if we mean the gradual introduction of more flexibility. In the discussion below we use both terms, but try to make it very clear when we are talking about an administered shift in a fixed exchange rate or a move toward a float. It sounds confusing, but the key is simply to keep the directions straight, and everything else will follow.

Appreciation refers to any trend strengthening of the currency

Below, we use both terms to refer to potential movements in the renminbi


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I. How the peg worked

In this first section, we discuss China’s traditional exchange rate regime as it worked from 1994 up to mid-2005. In the section that follows, we look at the recent institutional changes and what they mean for currency management.

Was it a fixed exchange rate?

Yes … and no. If you refered to a “fixed RMB exchange rate” in meetings with the Chinese monetary authorities, more often than not you would be reprimanded for the usage; the preferred phrase in official parlance is a “closely managed float”.

In fact, formally speaking China had neither. According to PBC regulations in effect since 1994 when the various official exchange rates were unified, the renminbi is allowed to fluctuate within daily bands of 0.3% on either side of the previous day’s close against the US dollar.

This means that on paper, the renminbi exchange regime has always been best described as a crawling peg. And in theory, the exchange rate could appreciate (or depreciate) against the US dollar on a trend basis without any change in the formal arrangement.

Between 1994 and 1996, that is exactly what happened; the currency strengthened from RMB8.7=US$1 to below RMB8.3=US$1 over an 18-month period, and continued to fluctuate around the latter level through the latter part of 1997 (Chart 1). It was not until the onset of the Asian crisis that the decision was taken to intervene significantly in order to dampen volatility.

Chart 1: China under the “peg” Chart 2: The PBC had been tightening exchange policy

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The RMB appreciated by 5% betw een early 1994 and mid-1995 It w as not until the Asian

crisis that the quasi-peg w as adopted

RMB per US$1

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RMB per US$1

The PBC has tightened effective trading bands since 2000

Source: CEIC Source: CEIC

Since then, the renminbi was virtually fixed against the US dollar—but not completely. The quoted exchange rate changed slightly every day, as the PBC did allow the currency to fluctuate within a set of “effective” bands; however, over the past few years those bands were tightened, first to a level of roughly

Formally speaking, the RMB was under a “crawling peg” regime

However, since 1997, the RMB was effectively pegged to the US dollar


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0.002%, and then to virtually zero from late 2004 as speculative pressures continued to build (see Chart 2).

For this reason, we consistently referred to the renminbi exchange rate arrangement as a “de facto peg” or simply a “peg”.

How did the peg work?

All fixed or quasi-fixed exchange rate regimes run according to the same principle: The central bank stands ready to buy or sell its national currency in exchange for other currencies at a certain parity. If there is an excess supply of foreign exchange on the market (in other words, a balance of payments surplus), the central bank buys forex and sells domestic currency. In the case of excess demand, the central bank sells forex and buys domestic currency.

Chinese practice has been no exception. The PBC was (and is) by far the largest participant in the mainland foreign exchange market, intervening to buy and sell forex to keep the price of the renminbi stable. When mainland exporters earn US dollars and want to sell them in order to pay domestic costs, more often than not the Chinese counterpart bank will sell the dollars on to the PBC in exchange for renminbi, and vice versa for importers looking to buy forex.

The main difference between country practices lies in capital controls, i.e., who is allowed to transact in exchange markets. China’s market is open for current account transactions involving trade in goods and services; however, the capital account is relatively closed, limited to foreign direct investment and a small range of borrowing, lending and asset transactions. This broadly protects China from so-called “hot money” flows that could otherwise put undue pressure on interest rates or the currency—although as we will see below, that protection is far from complete.

Does China have a black market for foreign currency?

Before 1994, when the current exchange regime was instituted, China had multiple official rates—and a sizeable black market, usually with a sharp premium on the US dollar. Over the past decade, however, with the unification of rates and continuous liberalization of external transactions, black market spreads have virtually disappeared. There is still an informal market for some capital account-related activities (for example, firms wishing to borrow abroad or remit large amounts of capital overseas; both of these transactions are restricted under the current foreign exchange regime), but these tend to carry a “handling charge” on both sides of the official exchange rate rather than a large one-way skew. As of this writing, the street market for cash in many cities is not significantly different from official cash rates.

What role does the offshore forward market play?

China may not have a significant black market for the currency onshore, but offshore prices can vary wildly. Non-deliverable forward, or NDF renminbi quotes have been receiving a lot of attention over the last few years—and

Thus, we refer to a RMB “peg”

As in any other peg regime, the PBC maintains the exchange rate by intervening in forex markets

Relatively strict capital controls also help maintain renminbi stability

Black market spreads have dwindled into insignificance.


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generating a good deal of confusion among investors who are not familiar with the Chinese market.

In a “normal” forward currency market, the forward exchange rate often has little to do with actual expectations of future strengthening or weakening; instead, the forward rate is determined by interest rate differentials between various currencies. In China’s case, however, the closed capital account means that money cannot easily flow between the renminbi and foreign currencies to arbitrage interest rate differentials, and China does not have not have active onshore forward or futures markets.

Moreover, the NDF market is completely offshore and outside of Chinese regulation or PBC intervention, and is basically a mechanism for outside participants to take bets on the future direction of the renminbi—just as punters in the UK might bet on the outcome of a football match in Brazil. NDF market movements have very little direct influence on financial markets in China (although the psychological effect on mainland market participants is potentially significant).

Traditionally, the NDF market priced the US dollar at a sharp premium against the renminbi; in other words, for a long time the market expected a renminbi devaluation (Chart 3). Since December 2002, however, prices shifted to an often sizeable discount, reflecting general expectations of renminbi appreciation. That discount fluctuated over the past three years, widening on rumors of imminent policy actions and contracting during periods of inactivity, but never completely moved back to zero.

Chart 3: No more US dollar premium

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RMB per US$1, 12m NDF

Market expectations have shifted to RMB appreciation

Source: CEIC

The main factors behind the sharp change in pricing have been (i) the acceleration in official FX reserve inflows over the last two years (these flows have a mutually reinforcing effect; higher inflows lead to stronger revaluation expectations, which lead to even greater inflows); (ii) expectations of trend US dollar weakness going forward; (iii) growing external political pressure to adjust

China does not have active forward and futures markets onshore

The NDF market is offshore and does not have any real effect on the domestic economy

The US dollar now trades at a discount against the RMB


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the RMB exchange rate; and (iv) an increasingly active domestic debate on the peg.

Can China control its domestic money supply?

One of the standard tenets of international monetary theory is that a small open economy can choose to fix its exchange rate, domestic interest rates or the domestic money supply—but not all three at the same time. The logic runs as follows: if the exchange rate is fixed, then interest rate differentials will naturally lead to large inflows or outflows of capital; these flows will either cause significant fluctuations in the domestic money stock, or else move domestic interest rates (or both). And if the monetary authorities attempt to skirt the inevitable—say, for example, by “sterilizing” capital inflows through offsetting borrowing operations to reduce liquidity—they usually end up exacerbating the reaction in another area (in this case, by causing interest rates to rise).

In China, the math is strongly dampened by the simple fact that the mainland economy is neither small nor particularly open. With a relatively closed capital account and a large domestic economy, China traditionally has not had to worry much about differentials between domestic and foreign interest rates, or capital inflows and outflows. Even annual FX reserve inflows in excess of US$250 bn—an enormous sum, more than 15% of Chinese GDP—imply base money growth of only 35%, an amount that can feasibly be offset by domestic liquidity operations.

In short, so far the answer to the above question is yes. One of the most popular myths about China is that the credit boom of the last few years was been fueled by capital inflows from abroad. Nothing could be further from the truth; as we discuss in the next few paragraphs, the PBC has been actively and successfully sterilizing inflows to date (although this could change going forward). The credit boom was purely and simply a domestic phenomenon, fueled by large pre-existing excess liquidity holdings in the banking system, which in turn were the result of aggressive PBC monetary stimulus in earlier years.

Note that we said the math is “dampened”—not that it doesn’t work at all. Obviously external flows have some impact on mainland financial markets, and we do believe that the task of managing money and interest rates could eventually become more difficult going forward (see Section VI for a complete discussion); however, we are still very far away from a full-scale external “blowout”.

How does China’s sterilization work?

To add more detail to points in the previous paragraphs, consider how China deals with foreign inflows. China runs a sizeable overall balance of payments surplus, which in layman’s terms means that there is a significant excess supply of foreign exchange coming into the economy. In order to maintain the peg, the PBC is forced to purchase the forex overhang, usually from domestic banks, which increases official FX reserves. And every time the PBC buys one US

In a small open economy, a peg means loss of control of monetary policy

But China is neither small nor open

Contrary to consensus, external inflows are not driving China’s credit boom

A peg means that the central bank prints money at home every time it buys FX


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dollar of foreign exchange, it credits the selling bank’s renminbi reserve account at the central bank—in other words, it effectively prints eight renminbi of new “base” money, and if left alone this new liquidity emission would fuel domestic credit growth and inflation.

In many economies, the monetary authorities are not happy with such an inflationary liquidity emission, but are also not willing to stop intervening in the foreign exchange market and let the exchange rate go. In this case, the standard answer is to “sterilize” the effect of forex purchases on domestic base money by effectively borrowing back the funds. The central bank can sell government bonds, issue its own bonds, lock up the money in a time deposit, or simply freeze liquidity through administrative measures such as reserve requirements.

And this is exactly what the PBC has been doing in China, issuing short-term debt instruments in order to vacuum up liquidity and cool down the credit cycle. The result is shown in Chart 4, which should be read as follows: Over the course of the past five years, FX reserve growth (the green bars in the chart) has made an increasing contribution to overall renminbi base money growth, accounting for more than 30pp in the past few months. Sometimes the PBC has created additional base money on top of this amount through domestic operations, as was the case in 1999 and 2000. At other times, the net domestic impact has been negative, i.e., PBC has been borrowing back (or simply freezing) the money it created through forex intervention. This happened through most of 1998 and 1999, and it has been going on in much larger amounts for the last two years.

Chart 4: China is sterilizing Chart 5: Operations are moderate by regional standards

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Operations as a share of GDP (%)

Source: CEIC, UBS estimates Source: CEIC, UBS estimates

However, while the trend in Chart 4 may look alarming, we should point out that whether we measure sterilization as a share of base money or a share of GDP, the amounts are still relatively moderate compared to neighboring Asian economies. The scope of Chinese operations over the last 12 months amounted to roughly 20% of outstanding base money and 9% of GDP; meanwhile, the average for Korea, Malaysia Singapore and Taiwan was closer to 100% of base money, and around 11% of GDP (Chart 5).

Many central banks try to neutralize the domestic liquidity implications through sterilization

The PBC has been actively sterilizing, selling bonds to domestic banks to vacuum up liquidity

Operations are still moderate by Asian standards


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Sterilization is expensive, right? In a gross sense, of course it is, as the PBC has to pay interest on the bonds it sells to banks. However, the PBC also earns interest on the other side of the balance sheet from the foreign assets it purchases, and with nearly US$700bn in FX reserves compared to some US$200 bn in outstanding sterilization debt, the PBC is clearly earning money on average.

In other words, we’re not worried about the central bank running into financing trouble. But in fact, this is not the real issue. What we are worried about in China, as we would be in any other economy, is the effect of sterilization on the domestic economy and the external balance. If the PBC is an active borrower in liquidity markets at home, this should cause interest rates to rise. And as interest rates go up, so do external inflows—and with it the size of the problem, as this in turn means greater intervention and sterilization. To date this has not been a serious concern in the mainland, as banks have a stable pool of excess liquidity and interest rates have actually been falling since the beginning of the year. However, as we will see in Section VI, this could change at some point going forward.

We are not worried about the PBC losing money

But we are worried about the effect on domestic interest rates—and external inflows


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II. The new system

What changed?

On July 21, 2005, the Chinese authorities announced a set of adjustments to the renminbi exchange rate system, as follows:

! The exchange rate was immediately revalued by roughly 2% against the US dollar, from 8.277=US$1 to 8.11=US$1.

! Going forward, the renminbi will be managed against a basket of currencies rather than solely against the US dollar.

! The government also reiterated the existing band system, whereby the renminbi can fluctuate against the US dollar by up to 0.3% per day against the previous day’s closing exchange rate.

So compared to the old system, the new renminbi regime has three new elements: (i) a slightly more appreciated starting exchange rate, (ii) a basket peg rather than a US dollar peg, and (ii) at least the possibility that the currency could drift more against central parity than in the past. In the following subsections we discuss each issue in turn.

Does the revaluation matter?

The first issue is the 2% up-front revaluation against the US dollar; what does this mean for the economy, for the trade balance and for currency management? The short answer is—very little, if anything. We will discuss the logic in Section VII below, but for the purposes of the present discussion simply keep in mind that the July move was too small to have any real effect on economic variables in China.

How does a basket peg work?

This brings us to the second element, i.e., the move away from the dollar to a “basket” management arrangement. The idea of a basket peg is simple: instead of fixing the exchange rate against one foreign currency, the nominal exchange rate is fixed against a weighted basket of foreign currencies.

Chart 6 below shows a simple, hypothetical numerical example. Assume for the sake of argument that the renminbi is fixed against an equal basket of the three major global currencies, and that at the start of this arrangement, the yen is trading at 110 to the dollar and the euro is worth 1.22 dollars. The following month, the yen appreciates by 9% against the dollar and the euro weakens by around 1.5%; as a result, the renminbi would appreciate from 8.11 to the dollar to around 7.91, a 2.5% move.

In month two, both major currencies weaken against the dollar, and the renminbi follows along, also depreciating on a bilateral basis. In month three, both the yen

China changed the renminbi peg on July 21, 2005

The new elements are a 2% revaluation, a new basket arrangement, and a potential widening of bands

The revaluation should have almost no effect on growth or the economy

The new basket means the renminbi will be managed against a group of currencies instead of the dollar


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and the euro strengthen considerably, sending the renminbi back to a level of 7.67 against the dollar.

Chart 6: Hypothetical basket peg example

currency RMB USD JPY EUR

weight 33.3% 33.3% 33.3%

start 8.11 1.00 110 1.22month 1 7.91 1.00 100 1.20month 2 8.29 1.00 110 1.15month 3 7.67 1.00 105 1.40

Source: UBS estimates

The above hypothetical example is of course overly simplified; in practice, things get a little more complicated. To begin with, what weights should the PBC actually use? At one extreme, the basket weights would correspond strictly to the relative share of each partner country in overall trade; this is the “classical” approach based on economic theory, but as you can see in Chart 7, which shows the relative weights for 16 major trading partners, this implies a very complicated structure, too cumbersome to use on a daily basis.

At the other extreme, the authorities could use currency invoicing weights. Most studies show that at least 80% of China’s foreign trade is invoiced in US dollars, with the rest split between euro and yen; this would give a very simple three-currency structure as shown in Chart 8.

Chart 7: China trade weights, 2004 Chart 8: Currency invoicing weights

SG 2.9%

TW 8.1%EU 23.3%

US 19.5%

JP 18.5%

UK 2.3%

CA 1.7%HK 2.7%

NZ 0.3%

PH 1.4%

TH 1.8%ID 1.5%

AU 2.2%

KR 9.6%

MY 2.8%

IN 1.5%

US 80.0%

EU 10.0%

JP 10.0%


In practice, we believe the PBC is likely to choose an intermediate mix, managing the renminbi against six to eight major partner currencies, with a relatively heavy weight on the US dollar—but only time will tell.

What weights will the PBC use? Trade-weighted or invoice-weighted?

In practice, the PBC will likely choose an intermediate mix


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Does it matter which basket the PBC uses? Very much so. To highlight this fact, we show two hypothetical basket peg arrangements in Chart 9 below. The first (the dark line in the chart) shows the counterfactual path of the renminbi against the dollar if the PBC had adopted a strict trade-weighted basket peg beginning in the year 2000. The second (light) line shows the exchange rate if the PBC had adopted an invoice-weighted peg. As you can see, a trade-weighted rule would caused much more volatility against the dollar, with peak annual swings of 5% to 7% over the last few years (Chart 10).

Chart 9: The RMB under a basket peg Chart 10: Implied y/y movement against the US dollar

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Average RMB exchange rate against the dollar

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And this brings us to the next question: should the central bank try to formally publish its trade weights and central parities against all currencies? As of this writing, the PBC has not revealed the weights it will use in the basket arrangement. Instead, the Chinese are effectively following the example of most prominent and long-standing basket peg arrangement, i.e., Singapore. The Monetary Authority of Singapore formally manages its currency against a basket of trading partner currencies, but chooses not to publish the composition of that basket, or the trading bands within which the MAS lets the currency move.

Over the past years, this arrangement has been successful in promoting confidence in the currency, and has also allowed the MAS wide latitude in adjusting the exchange rate. As we discuss below, given China’s future need for flexibility in both the level of the renminbi as well as the exchange regime itself, we suspect an opaque management structure would be the most effective for the renminbi as well.

A tight peg—or a loose drift?

As we saw above, at the same time the PBC announced a move to basket exchange rate management, they also reiterated the formal band arrangement which effectively allows the currency to move away from the central basket parity at a rate of 0.3% per day. Although this was the historical arrangement in the past, it was never used after 1997; could we now see a return to the “old” days of 1994-97, when the PBC allowed the currency to drift (and to strengthen on trend) against the peg?

The choice could be important

The PBC has not published the basket weights, similar to the Singapore model

We believe the PBC will allow more flexibility going forward


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We believe the chances are very good. As we will show in the next sections, the shift to a basket is not an end goal in itself, but rather a first step on the road to greater flexibility. We will also see that, according to most measures, the renminbi is undervalued, and there are good reasons for the authorities to reduce the level of undervaluation going forward. Both of these points suggest that instead of maintaining a tight basket rule, the optimal policy for China would be to allow the renminbi to gradually drift toward more flexibility; in the medium term, this would imply a trend real appreciation against trading partner currencies.

The Singapore example is very instructive. According to Chart 11, from 1998 onwards the Singapore dollar fluctuated very closely with our estimated NEER index, i.e., the authorities were following a rather strict basket peg rule. However, that was not always the case; between 1990 and 1997 the MAS allowed the Singapore dollar to appreciate by nearly 25% in nominal effective terms, while the NEER index would have implied a nearly flat exchange rate. So even in a “basket peg”, central banks can allow for trend movements in the currency.

Chart 11: The Singapore basket regime in action

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And sometimes they weren't

Source: CEIC, UBS estimates

A basket arrangement is still a peg

So far we have highlighted the key changes under the new renminbi regime. However, we need to stress that in a fundamental sense, the similarities far outweigh the differences. The authorities may have shifted to a basket arrangement and added a bit more room for marginal flexibility, but the renminbi exchange rate today is still effectively fixed rather than floating, and it should remain so for a good while to come.

This means that our discussion in Section I on exchange rate management under a peg is very much still in force. China still faces large amounts of intervention in FX markets and extensive sterilization operations at home, and still faces the eventual question of the independence of domestic interest rate and monetary

In Singapore, the basket peg has been managed differently at different times—i.e., it allows for flexibility

Despite the change, the RMB is still much closer to a peg than a float


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policies. As the authorities move toward a more fundamentally flexible rate, these issues will fade—but again, this promises to be a very gradual process.


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III. What drives China’s balance of payments?

A short introduction to balance of payments concepts

Before we continue on to the analytical sections below—and in particular, before we can discuss the question of undervaluation or overvaluation of the renminbi in Section IV—we need to take a few pages to introduce some key balance of payments concepts. The main elements you need to know are the relationship between FX reserve inflows, the overall balance of payments, the “basic balance” and portfolio capital flows.

Let’s begin with the “overall” balance of payments. When economists talk about the overall balance, they are normally referring to official FX reserve purchases by the central bank. Why? Because by definition, the overall balance is the sum of all public and private external transactions excluding those of the monetary authorities. In a pure floating exchange rate system, the central bank doesn’t intervene at all and the exchange rate always moves to equilibrate supply and demand in the marketplace; here, the overall balance of payments is always zero.

In a fixed exchange rate system, the currency doesn’t move; instead, the central bank automatically intervenes to buy up the excess supply (or, in case of excess demand, sell the shortfall) of foreign exchange in the market. In this case, the overall balance is by definition equal to the change in official FX reserves.

Chart 12 shows the overall balance of payments trends in China for the past seven years. Prior to 2001, the PBC was not accumulating large amounts of reserves; however, since then the overall balance has risen steadily, to the point where the PBC is now purchasing more than US$20bn per month in the foreign exchange market in order to maintain the value of the exchange rate.

Chart 12: Monthly official FX reserve accumulation

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Monthly FX intervention, US$ bn, sa 3mma


The overall balance of payments is the same as official FX reserve accumulation

PBC FX purchases have been rising steadily for the past five years


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Portfolio flows and the “basic balance”

Now turn to Chart 13 below, which shows the composition of the overall balance in any economy. The key aggregates we want to focus on are (i) the “basic” balance of payments, which is the sum of the current account balance, net FDI flows and other medium- and long-term operations, and (ii) the “other” capital balance, which includes identified short-term capital flows plus so-called errors and omissions.

Chart 13: BOP aggregates

Goods trade balance + Services trade balance Current account balance+ Net income flows

"Basic" balance+ Net FDI flows+ Private medium- and long-term debt operations+ Government medium- and long-term debt operations

+ Equity capital flows+ Short-term debt capital flows+ Other portfolio capital flows "Other" capital account

+ "Errors and omissions"

= Official FX reserve flows Overall balance of payments

Source: UBS estimates

For China, the corresponding trends are shown in Chart 14. The bars in the chart show monthly FX reserve accumulation as a share of GDP, and the two lines show where those reserves come from, i.e., the basic balance and other capital flows.1

What is Chart 14 telling us? As you can see, the basic balance has been stably positive for most of the past decade (as we will see in Section IV below, this is a good indicator that the renminbi is undervalued); by contrast, most of the variability in FX reserve growth is explained by the very large swings in the net “other” capital balance.

Between 1997 and 2000, for example, the highly positive basic balance was offset by a sharp, sizeable exodus of short-term capital following the end of the bubble at home and then the onset of the Asian crisis. Indeed, net outflows actually reached US$10 bn per month in early 1998.

1 The basic balance measures the current account, foreign direct investment and other net flows of medium- and long-term capital, in order to try and capture a country’s “fundamental” position vis-a-vis the rest of the world. These international transactions are offset by other “accommodating” flows: short-term lending and borrowing, portfolio flows, outright capital flight, and of course net purchases of official reserves by the central bank.

Most of the swings in FX reserves have come from “other” capital flows

Before 2001, China had significant outflows


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Over the last few years, however, the capital drain slowed as the economic environment improved, and then turned positive in the second half of 2002. Over the past 18 months, the surplus on “other” capital flows has averaged some US$7bn per month, or 5% of GDP.

Chart 14: Where reserves come from Chart 15: Where the “basic” balance comes from

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Where do all the inflows come from?

This is not a simple question, either for outside observers or Chinese policymakers. Chart 16 shows the data once again, broken into four different stages of development.

Chart 16: Where capital flows come from

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Now the balance has shifted the other way

The increase in FX reserves caught policymakers off guard


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Phase 1: Natural recovery

The first stage ran from 1998 to 2000, and could be called the “natural recovery” phase. The key trend here was the gradual unwinding of outflows pressures that had plagued the mainland following the bursting of the early 1990s bubble. Chinese institutions had been paying down external debts accumulated during the bubble years, but these payments faded by the end of the decade. The initial post-bubble downturn and the subsequent onset of the Asian crisis had also fueled flight into offshore assets, but as domestic profitability recovered and the economy picked up at home, firms and households had less incentive to hold assets abroad (Chart 17).

Chart 17: The domestic upturn began in 1999 Chart 18: By mid-2001, the RMB carry was positive

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Phase 2: Interest rate arbitrage

The second stage was caused by the sharp decline in US interest rates in 2000 and 2001, which was mirrored in the decline of onshore US dollar deposit rates in the mainland. The growing positive carry on renminbi assets led to a visible reallocation of domestic cash and deposit holdings back into domestic currency, and also fueled some further repatriation of assets held abroad (Chart 18).

Phase 3: Exchange rate speculation

The real repatriation wave, however, began in earnest in 2002, with changing expectations about the renminbi exchange rate. As of the middle of the year, the offshore NDF market was still pricing in a renminbi devaluation, with continued worries about capital outflows. Over the last two years, however, with the further strong acceleration in domestic activity, expectations have swung sharply in the other direction, and the renminbi now trades at a significant premium to the US dollar (refer back to Chart 3 above).

The “revaluation trade” has fueled a very pronounced correction in the external balance, with net outflows turning to large net inflows. The main contributors have been the repatriation of offshore holdings, further conversion of domestically-held assets, and more recently a move to leveraged positions; to

The first phase was the unwinding of post-bubble outflows

The second phase was driven by the sharp decline in US interest rates in late 2000

The third phase has come with RMB revaluation expectations


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the extent possible, banks and firms have been borrowing abroad in order to hold renminbi long.

Phase 4: Consolidation

The past 12 months have seen yet another stage in external capital flows: consolidation. Since the middle of 2004, short-term capital inflows have peaked as a share of GDP, and actually look to be abating in 2005 to date. We believe this reflects the reversal of most of the previous trends discussed above. To begin with, growth has begun to slow, and with it profit margins have been declining, reducing the incentive to bring capital back on shore for real investment purposes. As you can see in Chart 18, the positive RMB carry trade has also faded as the US Fed raises short-term interest rates. And for the past year the authorities have been intensifying their enforcement of capital controls, in the process closing some of the most eggregious loopholes in the regulations.

Now we see the reversal of many of the previous trends


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IV. Is the renminbi undervalued?

In this section we tackle what is certainly the most controversial—and, we believe, the most misunderstood—topic relating to China’s exchange rate: is the renminbi undervalued?

Our answer would be yes, the renminbi does show up as undervalued according to our benchmarks. At the same time, we need to stress two points: (i) the extent of undervaluation—around 15% to 20% by our best measure—is less than most of the breathless reports in the financial press would suggest; and (ii) most of the common “street” valuation techniques turn out to be misguided.

To make matters worse, it turns out that there is no single conceptual framework that perfectly captures “valuation”. Economists use one set of tools to think about the proper exchange rate level in the very long run, another to determine valuation in the medium term, and yet a third to talk about near-term market equilibrium.

Near-term pressures

In the immediate sense, valuing any currency is a simple proposition: is the market clearing or not? Or, put another way, are official FX reserves rising or falling? If the authorities are intervening to buy foreign exchange, this means that supply of foreign exchange is above demand at the current spot price, i.e. the currency is “undervalued” in today’s terms. If the authorities are selling reserves, then the currency is “overvalued” at the present moment.

As we saw in the previous section on balance of payments trends, the PBC is currently intervening very heavily in the FX market, buying up nearly US$125bn in official reserves in the first half of 2005 alone. This implies that if the authorities were to stop intervening and move to a pure float tomorrow, the renminbi would appreciate—and by a very considerable amount at that.

Where would the rate go if the authorities stopped intervening immediately and let the currency find its market level? Here we use bog-standard international trade methodology, i.e. assume that the adjustment would come through the current account and apply reasonable estimates for the elasticity of imports and exports to the exchange rate.2 Based on this methodology, the renminbi would likely appreciate by 35% to 40% in order to re-equilibrate the market for foreign exchange.

2 We derive Chinese trade elasticities from partner country estimates published in Abdelhak S. Senhadji and Claudio E. Montenegro, “Time Series Analysis of Export Demand Equations: A Cross-Country Analysis”, IMF Staff Papers Vol. 46, No 3 (September/ December), 1999. The implied elasticities for China relatively low, in part reflecting the fact that nearly one half of mainland trade value is processing trade for re-export purposes; this trade has a smaller domestic value-added share than other trade categories.

Is the RMB undervalued?

Yes – we estimate by 15% to 20%

There is no single “best” conceptual valuation framework

Near-term estimates of exchange rate pressure focus on FX accumulation

The large PBC intervention clearly points to sizeable appreciation pressures


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The real story – medium-term valuation (part 1)

35% to 40% sounds like an enormous amount, and by international standards it is. However, these figures are actually very misleading. Why? Because as we discussed in the previous section, the size of China’s FX reserve inflows is temporarily inflated by short-term portfolio capital inflows, which are now very high relative to the historical trend; over time, we expect these to subside back to a more balanced position, especially as China gradually opens its capital account, allowing domestic residents to move more funds offshore.

If we ignore short-term capital flows, we are left with the “basic balance of payments”, as defined above. For this reason, emerging market practitioners generally focus on the basic balance as a more stable medium-term indicator; If the basic balance is consistently positive, the currency is considered undervalued, and overvalued if the basic balance is negative. Referring back to Chart 15 above, you can see that the basic balance is still strongly positive, but less so than the overall balance of payments (9% of GDP compared to a 15% of GDP overall balance). Using our trade elasticity methodology once again, we find that the renminbi is undervalued as before, but now on the order of 25%.

The real story – medium-term valuation (part 2)

This is still not the end of the story, however. The basic balance can also fluctuate for cyclical reasons, and indeed, one reason for the strong current basic balance position is the sharp rise in the trade surplus over the past 12 months (see Chart 15 above) as the economy has slowed, and as excess capacity has built up in the system following the overheating of the past few years. As with the capital balance, we expect the trade surplus to subside over the next few years as the economy continues to grow and excess capacity gradually fades; we also expect the net FDI balance to come down as more Chinese companies invest abroad.

If we take our forecasts of balance of payments trends over the next five years, we find that the implied medium-term undervaluation of the renminbi is on the order of 15% to 20%, i.e., in today’s terms the currency “should” be trading at a rate between RMB6.5=US$1 and RMB6.8=US$1 rather than today’s level of 8.11 to the dollar.

Another way of looking at the same issue is to take a historical 3-5 year moving average of the basic balance, and use this to calculate relative undervaluation. The results are shown in Chart 19 below. The light green line in the chart shows the near-term pressure gauge we discussed in the first subsection above; as you can see, according to this measure the renminbi looks very undervalued—but mostly due to short-term capital flows. The grey line show the current reading of our medium-term valuation estimate based on the basic balance of payments. Finally, the dark line shows our best indicator, i.e., the 3-year moving average of the medium-term spot estimate; once again, we find an undervaluation range of 15% to 20%.

However, medium-term estimates point to more moderate undervaluation

The basic balance is significantly positive

We still need to adjust the basic balance for cyclical fluctuations as well

When we do, we get undervaluation of 15% to 20%

We get the same number looking at a moving average of the basic balance-based indicator


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Chart 19: RMB valuation estimates

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Is the renminbi more undervalued than other currencies in the region?

Chart 20 below shows the results of a similar exercise for the Asian region. The methodology is the same as that used for China above, i.e., the three-year moving average of the undervaluation indicator using the basic balance of payments. According to the chart, the renminbi is one of the weaker currencies in the region—but by no means a standout. Our estimates show that Taiwan, Japan, Malaysia, Singapore and Korea all have currencies that are undervalued by 10-15% or more (for a general discussion of exchange rate policy in Asia and the factors leading to undervalued currencies, refer to A New Plaza Accord For Asia?, Asian Economic Perspectives, July 3, 2003 and The Asian Liquidity Primer, Asian Economic Perspectives, March 29, 2004).

Chart 20: Asian valuation estimates

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China is not an exception—other Asian currencies are also undervalued


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Real equilibrium valuation

If you look at academic economic literature, you will usually find very different tools for medium-term equilibrium currency valuation. From a theoretical point of view, the most sound method is choose a point in the past that corresponds most closely to fundamental equilibrium, and then project that value forward using a host of economic variables, most prominently relative productivity and price trends. To use a simplistic example, if we believe that the renminbi was properly valued five years ago, and we know that Chinese domestic inflation was lower and domestic productivity growth higher than in neighboring countries, we can estimate how much the renminbi should have strengthened against other currencies in order to maintain dynamic equilibrium.

The problem here is that although real equilibrium models are very successful in tracking underlying valuation for developed currencies, they are much harder to implement and interpret for emerging markets. In transition economy like China, rapid liberalization and structural change make it extremely difficult to pinpoint a fundamental equilibrium in the past or measure trends over time, which brings an enormous element of uncertainty into the calculations. As a result, academic equilibrium estimates for the renminbi tend to fall over the map, depending on the assumptions used and the time frame chosen.

You can see this problem visibly in Chart 21 below, which shows the path of China’s real effective exchange rate, or REER index, based on the official PBC exchange rate. One common “rule of thumb” is to look simply at the REER index to gauge where the currency is today relative to historical trends. But which point should you choose as the past equilibrium?

Chart 21: Real exchange rate index for China

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If you take the late 1980s as a benchmark, then the renminbi appears to be 20% undervalued in real terms. If you choose the first half of the 1990s instead, then the renminbi becomes 10% overvalued. And if you take the average value of the past five years, the currency actually looks fairly valued. Given the rapid

Real equilibrium estimates are a much better theoretical gauge of valuation

But in emerging markets they are notoriously tough to measure

Using the REER to try and gauge RMB undervaluation is extremely difficult


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changes in the structure of the Chinese economy, it’s very difficult to know which of the above paths is valid—and for this reason, we do not use real equilibrium valuation techniques to gauge the proper level of the renminbi.

Common myths (1) – the bilateral US deficit

In the subsections that follow, we look at some of the common misconceptions about currency valuation. The first point concerns bilateral trade deficits. In the first half of 2005, the US deficit with China had ballooned to roughly 25% of the total US trade imbalance, and more than half of the total bilateral deficit with Asia—on the face of it, evidence that the renminbi is enormously undervalued. However, this claim is very misleading. As any economist will confirm, bilateral trade balances don’t necessarily tell us anything about underlying currency pressures. And in China’s case, the bilateral balance is significantly overstated due to the effects of processing trade for re-export; see Section VIII below for details.

Common myths (2) – the 1994 RMB devaluation

At the beginning of 1994, China unified its various official exchange rates into a single rate for all external transactions—and in the process carried out a significant official devaluation, moving from a headline rate of RMB5.8=$US1 for trade transactions to RMB8.7=$US1 virtually overnight. Throw in the fact that our valuation framework puts the market-clearing renminbi rate very close to the pre-1994 level (see Chart 19 above), and it is not surprising that many outside observers claim the 1994 devaluation is to blame for all the woes of China’s neighbors.

Chart 22: REER at official and shadow exchange rates

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Leaving aside for a moment the question of whether renminbi undervaluation has caused China’s neighbors significant woes (we return to this issue in Section VIII), it is hard to agree with the devaluation claim. Look at Chart 22 above, which identifies two telling trends.

The bilateral US deficit with China is not a valid indicator of renminbi valuation

It is fashionable to blame the 1994 devaluation for Asia’s woes

However, the data don’t support the claim


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First, based on official exchange rates the 1994 unification did indeed involve a substantial real depreciation of more than 30%. However, the early and mid-1990s were a period of very high inflation as well, and subsequent domestic price increases (together with nominal renminbi appreciation) had already brought the real exchange rate back to the pre-1994 level by 1997, i.e., within three years.

Second, keep in mind that before 1994 official renminbi exchange rates were highly distorted. If we instead use “shadow” exchange rates—rates that were used between enterprises in informal transactions or cash rates in the black market—the story is rather different. The estimated shadow REER was much more depreciated in the years up to 1994, and there was no real depreciation when rates were unified.

Common myths (3) – capital account opening

Perhaps the most common response by Chinese academics and policymakers when challenged on renminbi valuation is to point out that as China opens its capital account and allows firms and households to move from renminbi holdings into foreign currency assets, the resulting capital outflows could easily put net downward pressure on the renminbi. In other words, once external capital transactions are fully liberalized, we might find that instead of being undervalued at the current exchange rate, the renminbi could in fact be overvalued.

We have no problem with this argument. Again, our valuation framework is based on current balance of payments trends—which could indeed reverse themselves under a large structural change in capital flows. It is virtually impossible to adequately model the response to a capital account opening, and in the absence of consensus fundamental equilibrium estimates no one can say with any certainty that the renminbi is undervalued in a long-run sense.

However, for any discussion of renminbi policy over the next, say, three to five years, arguments over the capital account are almost surely beside the point. The reason is that the authorities are is highly unlikely to undertake a radical liberalization in that time frame. Until China has fully cleaned up its large state banks, which account for roughly two-thirds of renminbi deposits, any significant capital account opening would carry the risk of destabilizing the banking system. And while the recapitalization program is already underway, fully resolving banks’ problems is very likely to be a long-term process.

Common myths (4) – PPP valuation

Perhaps the best-known currency indicator among the general public is purchasing-power parity, or “PPP” for short. The concept is simple: take a catalogue of all goods and services produced in China and revalue them at current US prices for each item. The result is “PPP-adjusted GDP”, the internationally comparable size of the economy—a very useful construct for academic purposes, which enables researchers to compare tons of steel to tons of steel, and square meters of housing to square meters of housing.

The real exchange rate appreciated very quickly after 1994

And shadow exchange rates were much more depreciated than official rates in the early 1990s

The RMB could well be overvalued once the capital account is fully opened

However, we don’t expect full capital account liberalization within the next five years

On a PPP basis, the RMB looks massively undervalued


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If you then take the ratio of PPP-adjusted GDP to actual US dollar GDP at the current exchange rate, you will get the implied differential of under- or overvaluation on a PPP basis. For example, the World Bank 2002 PPP GDP tables show the Chinese economy more than four times larger than the reported level using actual exchange rate, which means an implied PPP exchange rate of close to RMB2/US$1.

In other words, the renminbi is massively undervalued on a PPP basis. But what does this mean? If you check PPP estimates for other emerging market economies in the region (for example, Indonesia, Philippines, Malaysia, Thailand)—or anywhere else in the world, for that matter—you would find undervaluation of a similar magnitude. The fact is that PPP estimates have nothing to do with near- or medium-term currency movements or valuation. Actual exchange rates should not be expected to converge with PPP rates until domestic productivity and relative price levels approach that of the G3 markets—which for many emerging economies including China may occur over a 50-year time horizon.

In economics terms, looking at PPP exchange rate estimates is similar to looking at Chinese manufacturing wages of US$100 per month. On the face of it, they may look and feel “too low” when compared to developed country wage levels, but again, this is true in every developing country; history shows us that wages and incomes can only rise gradually in line with economic growth and development, and simple wage comparisons don’t tell us anything about exchange rate valuation.

If the renminbi is under pressure, why doesn’t the real exchange rate adjust?

Think back to the discussion in the previous section. In a standard open economy, if the authorities peg the exchange rate they risk losing control of domestic financial policies; or, put the other way round, in order to fully control domestic money and prices the authorities have to let the exchange rate go.

The implication is that the “real” exchange rate (by which we mean the headline exchange rate adjusted for relative price and cost movements) is beyond policy control, regardless of whether the nominal rate is fixed or not. Specifically, in the case of a significantly undervalued currency, the resulting external inflows should lead to inflation at home and thus real exchange rate appreciation as wages and prices rise.

In China, however, despite our finding that the renminbi has been consistently undervalued for the last seven years, CPI inflation has been broadly flat and we have seen only minimal real appreciation of the currency (Charts 23 and 24). How can this be?

However, this is true for all emerging markets—and doesn’t tell us anything about near-term trends

The same is true when looking at Chinese wages

Generally speaking, policymakers cannot control the real exchange rate

China “should” have real appreciation … but doesn’t


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Chart 23: Where’s the inflation? Chart 24: And where’s the big real appreciation?

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There are two factors at play here. As we noted above, China is not a classical small, open economy, and the sheer size of the domestic economy and the relatively closed capital account mean that real appreciation pressures coming from external inflows are much weaker than they would be in many other emerging economies. And to date, China has had relatively little trouble sterilizing the corresponding domestic liquidity impact.

Second, China has had a relatively unique combination of domestic deflationary influences that have further dampened the price impact of money creation. Households and firms have limited access to alternative asset holdings, such as bonds, equities and foreign exchange, which means that China’s extremely high savings rate feeds directly into high bank deposit growth, i.e., despite rapid broad money growth, much of that money is saved rather than spent. And until the recent upturn, continued excess capacity in many sectors after the bursting of the mid-1990s bubble and strong productivity increases kept prices relatively low.

During the course of 2004 CPI inflation picked up, reaching a level of more than 5% at mid-year. However, as we saw above, this is not because of inflow pressures as a result of an undervalued exchange rate; most of China’s FX reserve growth has been soaked up by sterilization operations, and base money growth has been fairly muted. Rather, the main culprit was overheated domestic lending growth and its effect on agricultural and raw materials prices—lending growth funded from sizeable pre-existing liquidity balances in the banking system. And in any case, downstream inflationary pressures have faded fairly quickly as monetary tightening took hold, and as food and other upstream commodity prices stabilized.

Again, China is not a small open economy, and the PBC is sterilizing inflows

And there are internal deflationary tendencies at home


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V. What is the optimal exchange regime?

It’s not the level of the rate, it’s the choice of regime

From a theoretical standpoint, there are really two key questions about renminbi. The first is whether the current level of the exchange rate is optimal for China (or, indeed, for the rest of the world). For many politicians and pundits, this is “the” hot issue (“is China too cheap?”), and we agree that in the long run, as in any economy, a weak renminbi would prop up exports, dampen import demand and contribute to net inflows. However, as we show in Sections VII and VIII below, we also find that the net impact of undervaluation is very small, whether as a share of trade or overall GDP. In other words, the level of the renminbi does matter, but is nowhere near as critical for China or its neighbors as the current outcry would suggest.

Instead, we believe it is the choice of exchange regime, between a fixed and a floating exchange rate, that will make a much larger difference at the end of the day. And in our view, a flexible exchange regime is much more suitable for China in the medium term, as it would allow the economy to avoid long-term speculative pressures and adjust dynamically to future structural changes in trade and capital flows.

The case for a fixed exchange rate

The main argument for maintaining a renminbi peg is simple: China needs stability. Predictability on the exchange rate has helped the mainland attract large amounts of FDI and develop rapid export growth, and any undue fluctuations could put these achievements at risk. Moreover, a significant renminbi appreciation could wipe out weak exporters’ low profit margins—and the export sector is one of the largest, most labor-intensive employers in the country. Finally, while the capital account is relatively closed, controls are far from airtight, and once you start playing with the exchange rate you run the risk of significant, destabilizing capital inflows and outflows.

We have sympathy for these points in principle, but also find that they tend to be overstated in practice. In fact, the estimated impact of exchange rate movements on exports, growth and FDI is quite small, and it’s difficult to see how reasonable renminbi movements could kill the export sector. And while a more flexible rate might encourage speculative flows in the near term, the historical record clearly shows that fixed exchange rate regimes are usually the main culprits in encouraging speculation and volatility.

The case for a flexible exchange rate

By contrast, we see more convincing arguments in favor of a floating rate in the medium term. First and foremost, international experience shows that China would be well advised to move to a flexible exchange regime before it goes for a significant capital opening. Otherwise, it could eventually go the same path as the Asian crisis economies, facing “one-way bets” with large inflow pressures

We don’t see the level of the renminbi exchange rate as the crucial factor

Instead, we believe the exchange regime itself is the key—and China needs a floating rate in the medium term

Stability is the main argument for a peg

But we believe the benefits are overstated

China needs a floating rate before it opens the capital account


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under a perceived guaranteed return—which can then turn to debilitating capital outflows when the markets begin to worry about the strength of the peg. A floating rate serves as a “safety valve”, letting the exchange rate take the blows while protecting the real economy. Indeed, nearly every emerging market financial crisis in recent memory was associated with a fixed or quasi-fixed exchange rate before the final blowup occurred.

The same point holds for the trade sector. China currently has a moderate and stable trade balance, but the combination of WTO-related import liberalization and cyclical policy tightening over the next few years could easily cause much more volatile fluctuations in the external position. Rather than protecting domestic employment and growth, a pegged rate could end up amplifying the effect of these fluctuations on the domestic economy. Once again, a floating rate would allow China to absorb external pressures without unduly affecting real activity.

Finally, as we discuss in the next section, China cannot enjoy relative “domestic policy immunity” forever, and we already see signs that interest rates and monetary aggregates could react more strongly to external inflows over the medium term. The effect would be far too weak to force the renminbi off the peg, but this trend once again highlights the benefits of currency flexibility in warding off unwanted pressures at home.

What about a revaluation?

As the previous paragraphs should make clear, we don’t see much merit in an administered revaluation, i.e., simply adjusting the level of the exchange rate in the absence of measures to add more flexibility. Why? Because while such a move could potentially remove speculative inflow pressures in the near term (and even here there’s no guarantee, as a small adjustment could actually intensify expectations of a further move), it would not resolve any of the longer-term issues discussed above. The economy would still be locked into external inflexibility, and thus subject to the same potential imbalances that have destabilized emerging markets around the globe.

Big or small?

In other words, we conclude that China would be better off with a flexible exchange rate in the medium-term. But how should the authorities move from point A to point B, i.e., from the original peg to a fundamental float? Should they go all at once? Or move very slowly, as they did in July of this year?

Although we do not see any serious chance of this outcome, we have a good deal of sympathy for the view that a fairly aggressive move is the least costly solution. A sufficiently large up-front liberalization would take the wind out of speculative inflows, while as we showed above, a gradual move almost certainly means continued structural speculative capital pressures in the near term. A significant liberalization would also remove potential constraints on domestic monetary policy and allow the authorities to adjust economic growth without worrying about external reactions. Finally, and crucially, our analysis suggests

A flexible rate would also help absorb structural volatility

China cannot enjoy “domestic immunity” forever

China needs a floating rate before it opens the capital account

Should China go all at once or take it slow?

In theory, a faster move could be better—but don’t hold your breath


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China has little to worry about at home if the renminbi were to strengthen to near-term fair market value.

This is not to say that the current gradual scenario is a “bad” choice. Quite the opposite, an initial move to trade-weighted basket management and a subsequent widening of trading bands does allow the authorities to minimize the near-term impact on real competitiveness. And we clearly feel that the adjustment process will be stable and manageable given China’s relatively closed capital account regime. The key concerns are (i) that the authorities could decide to stop or reverse course early on in the process, and (ii) that potential policy mistakes could allow more room for speculative pressures along the way. Only time will tell.

A gradual scenario cushions the impact at home—but also brings potential risks down the road


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VI. What is the path ahead?

Why did it take so long?

In the original October 2003 issue of the RMB Handbook, we stated that there was a very good chance for a change to greater flexibility over the next few quarters. However, it was not until 24 months later that China actually moved. What happened?

Looking at the situation in late 2003, with a rapidly accelerating economy and persistent external political pressures, it seemed very likely that the Chinese leadership would make an early decision. And indeed, the level of public discussion in mainland academic and policy circles reached a zenith at the end of the year and in the first months of 2004. Over the next four quarters, however, as the economy turned the corner and the authorities intensified macro tightening measures, attention visibly shifted to the domestic economy and the pace of the slowdown. The level of overseas attention also cooled considerably as GDP growth numbers picked up in the US and Japan. As a result, renminbi issues temporarily moved to the “back burner” as the government focused on policies at home.

On the other hand, as we expected, this hiatus proved temporary, for three reasons. The first was the visible slowing of the economy beginning in early 2004 and continuing through mid-2005, together with the fading of inflationary pressures, which gave policymakers greater confidence that a “soft landing” had been achieved.

The second was the sharp increase in the current account and the trade surplus, as shown in Chart 15 above. Until mid-2004, the government could safely argue that FX reserve pressures were coming solely from short-term capital movements, and that these were only a temporary phenomenon. By early 2005, however, it was clear that FX reserve inflows were still accelerating—and that capital flows were no longer the problem. Instead, falling imports were driving the trade balance up, and although this is also a “cyclical” issue, it is not one that would be resolved in the near future.

Finally, external political pressure from the US and other G7 countries almost certainly played a role. We don’t believe these pressures were crucial in the choice of regime, but by all accounts they did have an impact on the timing of the move.

Once again, it’s the regime – not the level

In every statement on exchange rate policy over the past few years, the Chinese authorities have made it very clear that they agree with our assessment in the previous section above: the level of the exchange rate matters much less than the exchange regime itself.

Why such a long wait for the RMB move?

The macro slowdown moved exchange rate issues off the main stage for the moment

But as tightening worked, the RMB got more attention

A rising trade balance helped focus minds ...

... as did external political pressures

The authorities are focused on moving to flexibility rather than the level of the exchange rate


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We cannot overstate the importance of this distinction. As the economy accelerated in 2003 and inflation picked up in 2004, many investors were convinced that the central bank would reset the peg at a revalued rate as a cyclical tightening tool. However, there is no evidence that the authorities ever seriously considered a cyclical exchange rate move—and, of course, in retrospect macro tightening was achieved through other measures.

Nor, despite external pressures, have policymakers seemed particularly concerned about the current level of the exchange rate. As we noted earlier, it’s easy to show that the renminbi is undervalued, but very difficult to provide a credible answer the question of where the renminbi “should” be trading in the medium-term horizon. There are also a number of forthcoming structural changes which could easily reverse the present appreciation pressures over the next five years or so.

Instead, the mainland authorities have consistently and publicly maintained a medium-term goal of returning to greater exchange rate flexibility, and eventually allowing the renminbi to find its own market-clearing level rather than requiring the central bank to do so administratively. Both the current PBC governor and the former chairman of SAFE (the State Administration for Foreign Exchange) have spoken of the need to move the renminbi toward a float in the five-year horizon, and in this view they are supported by the IMF, the US Treasury and much of the academic world.

Against this backdrop, it’s easy to understand why the authorities have decided on a gradual approach. Even with general agreement on medium- to long-term strategy, there have been many conflicting views on how to proceed in the near term. China had even years of nearly absolute exchange rate stability, and this was seen as a key contributing factor to the strong recovery since the beginning of the decade. And the leadership’s main structural concerns are on the domestic economy, with social stability, employment, rural-urban transition and enterprise and financial restructuring at the top of the policy agenda.

Another factor to consider is that until very recently, China’s current external strength was still viewed with surprise and some suspicion at home. As late as mid-2002 the Chinese authorities were still worried about speculative devaluation pressures against the currency. It has only been in the last two years that the non-FDI capital position turned positive, FX reserves began to accelerate rapidly and the offshore dollar premium changed to a discount. This all happened suddenly; couldn’t the external position reverse itself once again with equal speed?

Further added to the mix are significant concerns about the potential impact of a large or rapid upward renminbi move. Mainland observers generally point to tight margins and excessive capacity in low-wage, labor-intensive export industries—industries which could be hurt by a big exchange rate revaluation. In practice, we don’t necessarily share these fears (see Section VII below), but the arguments resonate strongly in domestic industrial circles.

This explains why the RMB has not been used for cyclical tightening

Both the PBC and SAFE talk of moving toward a float in the medium term

No real desire to “shake things up” today

The current external strength has also caught policymakers by surprise

Mainland producers fear the effects of a large revaluation


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More RMB movement ahead

The key findings from the above discussion are (i) the government is not interested in a sharp renminbi adjustment; but also (ii) they are also not interested in simply repegging the rate or maintaining a basket peg over the medium. The upshot is that we are clearly looking for a gradual move to flexibility, i.e., more news to come.

What would the future path of the renminbi exchange rate look like? We don’t believe we will see any more one-off revaluation adjustments such as the 2% move we saw in July. Instead, as with Singapore in the pre-1997, we expect the PBC to allow the currency to drift away from the current basket parity by adopting a more liberal approach within the existing band structure. And given our findings on exchange rate valuation in Section IV above, we don’t expect “aimless” flexibility; instead, we would look for a relatively steady appreciation trend into the medium term.

Any pitfalls along the way?

In this section we return to some of the points we made very early on in the report on managing a fixed or quasi-fixed regime. The first question is on short-term capital movements: could speculative pressures could become so great that the authorities are faced with a choice of either imposing a draconian clampdown on external activity or giving up their new basket regime altogether?

This is a favorite theme of many brokers and investors—i.e., the “wall of speculative capital” that is waiting to hit the central bank once they begin to move the exchange rate. In our minds, this should prove to be just another market myth. The NDF market may be open to all players, but actual inflows into the mainland are mostly a Chinese game, played by domestic banks and companies (including foreign-invested firms) and driven primarily by the reallocation of asset holdings in favor of domestic currency. Existing capital controls make it very difficult to borrow abroad at will—and much more difficult still for foreign institutional money to move in and out of the mainland. Moreover, as we noted earlier, the government has been tightening enforcement of the existing restrictions, and short-term capital inflows actually subsided in the first half of 2005. The bottom line is that the current regime puts a ceiling on the size of real external pressures China is likely to face in a gradual flexibility scenario.

The next issue is sterilization. In section I we explained that so far the PBC has had little trouble in severing the link between FX reserve inflows and the domestic money stock, “neutralizing” liquidity effects through sterilization policies. We also noted that these circumstances could change going forward. Now let’s take a look at the potential challenges faced by the monetary authorities in greater detail.

The bottom line—look for more flexibility ahead

This means gradual drift rather than one-off moves—and it also means appreciation

We don’t foresee a speculative “blowout”, where China would be forced off the peg

The PBC has had no problem sterilizing inflows to date ...


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The key concern is as follows: so far FX reserve inflows show no sign of slowing down. If, as we expect, the authorities allow the renminbi to appreciate gradually over the medium term, this is a virtual guarantee that the net short-term capital balance will remain positive going forward. And although we do forecast a gradual decline in the current account balance in the next few years, China should still be living with a very strong basic balance for the next 12-24 months. Under these conditions, we would not be surprised to see the PBC buying US$20bn or more per month for a good while to come.

And this raises the question of whether the PBC will be able to sterilize the inflows. In the previous edition of the RMB Handbook, we noted that money market interest rates were rising, and raised concerns that large-scale sterilization operations were fundamentally incompatible with the need to continue tightening the domestic macroeconomy.

The good news is that today, those concerns don’t seem nearly as pressing. To begin with, the authorities have done a surprisingly good job of slowing bank lending and economic activity, as you can see from Charts 25 and 26.

Chart 25: Money and credit growth Chart 26: UBS physical activity index

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And more important, they have done it without having to resort to draconian liquidity measures that would have raised interest rates further. In fact, the success in applying administrative controls has allowed the PBC to loosen liquidity—which in turn has brought market interest rates down to historically low levels (Charts 27 and 28 below).

Eventually, the Chinese authorities should still face a difficult choice between maintaining a tight monetary policy or taking action to ease pressures on the external account, and in this case the textbook macroeconomic prescription is to let the exchange rate appreciate. However, as the economy cools down and overinvestment pressures fade, the authorities seem to have earned themselves a very long window of opportunity to come.

... but FX inflows are still accelerating

The good news is that administrative tightening measures have worked ...

... which allowed the PBC to inject liquidity and lower interest rates

Eventually, however, rising rates could still create problems


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Chart 27: Commercial bank liquidity Chart 28: Money market interest rates

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What about recent measures to promote capital outflows?

Faced with strong capital inflows, it is only natural to look for other ways to slow FX reserve growth, and it should come as no surprise that since the beginning of 2003 China announced a number of steps to loosen capital restrictions in an attempt to promote capital outflows. Exporters are no longer required to convert the bulk of their export earnings into renminbi. Corporates and financial institutions are being granted greater access to overseas bonds, as well as new domestic dollar-denominated issues by the policy banks. And many Chinese companies are almost literally being pushed out the door, with expedited approvals for overseas direct investment as well as full retention of overseas income earned.

Unfortunately, we believe these measures are too weak to make a big impact. To paraphrase the old saying, it’s one thing to lead the horse to water, and quite another to convince it to drink. At a time when the market expects the renminbi to strengthen, simply allowing firms to hold on to foreign currency assets doesn’t guarantee that they will want to do so. And even if the pace of outward FDI (which has averaged around US$5 bn per year since 2001) were to triple over the next years, this still would only amount to six weeks’ worth of current reserve inflow pressures.

The authorities could try more aggressive capital account liberalization, but this a highly unlikely outcome. The reason is very simple: China has not yet fully cleaned up its large state banks. Estimated impaired loan ratios of some 25% imply that some state banks are fundamentally insolvent on a market valuation basis, and maintaining a closed capital account is one of the key pillars in keeping banks liquid, by preventing firms and households from fleeing the domestic economy. Obviously, a significant capital opening would mean jeopardizing banks’ current liquidity position, which is why the Chinese authorities have not done so—and why we don’t believe they will be in a hurry to do so anytime soon.

China has been liberalizing outflows to take pressure off of FX reserves

However, we don’t believe these measures will be effective

And state banks stand in the way of a more aggressive capital account opening


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Does the banking system stand in the way of RMB flexibility?

Speaking of banks, one popular argument held that China could not move the exchange rate until state financial institutions had been cleaned up and bad debts resolved. The government has already begun to adjust the exchange rate—but could the banking system still slow the process down, or bring it to a halt altogether?

Our answer is no. It’s very important not to confuse exchange rate flexibility with capital account convertibility—and it’s the latter that depends on the state of the financial system. In order to have a significant capital market liberalization, China does need recapitalized and profitable banks at home; otherwise, we could see domestic capital fleeing the financial system and destabilizing the economy. But this has very little to do with the exchange rate regime. A widening of renminbi trading bands does not imply a loosening of capital controls; firms and households would still face the same restrictions on capital transactions as before.

Some argue that banks also stand in the way of a RMB move

But we don’t see any real connection


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VII. What effect does a RMB move have on China?

Appreciation (or depreciation) of the renminbi affects the real economy through three channels. The first is the trade account, as the exchange rate causes the relative price of exports and imports to shift. The second is the direct investment account, with a change in the costs structure potentially impacting the attractiveness of foreign investment. The final channel is the portfolio capital balance, as speculative expectations are already driving external inflows.

In the local and international press, most attention and worry is focused on the first two channels. According to the common argument, Chinese growth has been driven primarily by an undervalued exchange rate; if the renminbi strengthens, then Chinese wages will rise in US dollar terms and exports will lose competitiveness. This in turn will push down FDI inflows, and at the end of the day domestic growth will plummet.

In fact, we are not very worried about this scenario, and we believe domestic worries about the negative impact of appreciation are probably misplaced. Any sensitivity analysis on renminbi movements is ad-hoc at best, but most available evidence suggests that even a very significant movement in the exchange rate would cost perhaps 1pp to 1.5pp of real GDP growth annually over a few year—and much less, around 0.1pp to 02pp of growth, under our baseline scenario of gradual appreciation. Given the estimated starting point of around 9% real growth, this would be barely noticeable.

How sensitive are exports to the RMB?

Chinese policymakers are naturally concerned about the potential impact of a renminbi move on exporters, particularly since the sector is one of the biggest mainland employers, and continued job creation is a top priority for the country. To make the discussion more concrete, let’s imagine what might have happened if the authorities had revalued the renminbi from the previous level of Rmb8.3/US$1 to, say, Rmb7.5/US$1, i.e., an immediate 10% appreciation of the renminbi against all trading partners. What would this have meant for exporters?

In all likelihood, not much. Why? To begin with, since China is the region’s premier processing and assembly base its exports have a high import content; the domestic wage and materials component is around 30% on average for re-export trade (which accounts for half of total exports), and perhaps 50% for total exports. So for a 10% increase in renminbi costs, the total price of a typical product coming out of China might only increase by 3% to 5%.

Moreover, China faces little competition from the production side in its end markets; exporters sell mostly to developed-country consumers, where labor-intensive manufacturing is a much smaller share of the economy (we return to this point in the next section). Add in the fact that other low-wage Asian producers should generally respond to a renminbi strengthening by letting their

If the RMB strengthens, could exports and FDI plummet?

We don’t believe so—our forecasts suggest a growth impact of only 0.1% of GDP for the current move

What would happen to exports if the RMB appreciated by 10%?

The export price pass-through would be much less due to high import content

And there is little end-market competition


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own currencies appreciate (another issue discussed below), and the exchange rate impact on domestic exports is likely very low.

Based on these considerations, as well as studies on Asian regional exporters and partner countries (see for example footnote 2 above), we use a medium-term export elasticity to exchange rate movements of 0.3 in our own calculations. An elasticity of 0.3 means that a 10% appreciation of the currency would lower exports by 3%; based on total 2004 exports of US$590bn and 2004 GDP of US$1.6tn, this implies a cumulative medium-term impact of 1.0% of GDP, or 0.3% of GDP per year assuming a three-year adjustment period.

The import impact would be somewhat larger

Everyone talks about the need to support mainland export growth, but in fact our estimates show that domestic producers in import-competing industries would have more to lose from a renminbi appreciation.

China’s exports may have a sizeable foreign currency component, but we would be very surprised if China’s imports had any noticeable renminbi content—which means that a 10% renminbi strengthening would lower import prices by the full 10%, a higher “bang for the buck” than for exports. It is true that roughly half of mainland imports are for processing and re-export, but this does not preclude substitutability between domestic products and imports.

And the price substitution effect is certainly larger for imports than for exports. China has domestic competitors for virtually everything it imports: fuels, agricultural products, consumer goods, machinery and equipment. And under WTO agreements the mainland is dismantling a number of trade restrictions, which should serve to raise the sensitivity to external price movements.

As a result, we use an import elasticity of 0.7—still on the low side, but twice as high as for exports. With 2004 exports of US$560bn, this translates into a cumulative medium-term impact of 2.2% of GDP for a 10% renminbi move, or 0.7% of GDP per year.

The bottom line on growth

If we take our estimates for the export and import impact and put them together, we get a graph resembling the one in Chart 29. In total, a 10% renminbi trade-weighted revaluation would lower Chinese GDP growth by 1.0pp per year over a three-year period (if trade is more sensitive to renminbi changes than we assumed, the figure could be as high as 1.2pp; for lower-than-expected elasticities, the impact would be around 0.7pp).

Of course, as of this writing the authorities have not moved by 10%; the initial July revaluation was only 2%, and we’re not looking for anything close to another 8-10% move in the near term, although we believe we could potentially see that kind of movement in the three-year horizon. If we just focus on the effect of the initial 2% adjustment, this translates into a negative GDP growth

This means a low export elasticity, and a low impact on overall growth

The import price pass-through would be greater

And there is more import competition at home

Thus, the estimated import elasticity is higher

Putting it all together, a 10% RMB move means 1.0pp lower GDP growth

And the current 2% revaluation means only around 0.1pp lower GDP growth


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impact of just over 0.1pp—i.e., barely noticeable against the China’s current rapid expansion.3

Chart 29: RMB appreciation and real GDP growth

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Would appreciation hurt FDI?

To the casual observer, it would appear that with monthly manufacturing wages of US$100 and rapidly rising productivity, China is grabbing investment resources and export market share because it is cheaper—full stop. And any exchange rate move that raises costs in US dollar terms would make the mainland less attractive as a production base, significantly harming FDI prospects.

We surely agree that Chinese labor is both inexpensive and productive. But then again, this is also the case in most of China’s neighbors; comparative studies of the region’s low-income economies routinely find little differentiation in total labor-related outlays. What does China offer that others don’t? To answer this question, look at the composition of Chinese FDI inflows (Chart 30). By our estimates, less than one third goes into export-oriented sectors such as electronics and light manufacturing. The rest is aimed squarely at Chinese domestic demand: automobiles, machinery and equipment, chemicals, retail, catering, property, mining, energy, etc. In short, what attracts foreign investors above all else is the large, rapidly growing Chinese market.

3 These estimates come from “direct”, first-order calculations on the GDP growth impact, which means that they do not account for additional pass-through from lower exports and domestic production into lower employment and thus lower domestic demand. However, for the small changes in the RMB we are talking about, the indirect impact is likely to be neglible.

Are cheap manufacturing wages driving FDI?

Not really—most FDI is aimed at domestic demand, not export processing


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And even if we focus solely on export-oriented investors, would they balk if manufacturing wages rose from US$100 per month to US$110 per month? Probably not; surveys of mainland-based export manufacturers suggest that logistics infrastructure, proximity to suppliers and commercial stability are the top considerations in choosing a location, while relative labor costs actually appear very low on the list.

Chart 30: Chasing the Chinese consumer Chart 31: How important is FDI?

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Finally, while the inflows look big in absolute terms—we expect around US$60 bn of headline foreign investment this year—the FDI share of total investment is actually shrinking, from a peak of around 20% in 1993 to only 8% in 2004 (Chart 31). And even this figure is likely too high, as a portion of recorded FDI is actually “roundtripping” of domestic funds through foreign partners in order to take advantage of tax and other preferences.

And even export FDI may not be price-sensitive

The FDI share in total investment is also falling


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VIII. What effect does a RMB move have on its neighbors?

Could the renminbi save the US economy?

Let’s start with the straightforward part: the effect of renminbi movements on developed economies such as Japan, the US and the EU. For ease of exposition—and since the United States have been behind many of the recent headlines on the Chinese currency—we use the US economy as the main example here, and then broaden the conclusions to the rest of the developed world below.

The US “case” against the renminbi is based on two key trends: First, the bilateral deficit with China has been growing in leaps and bounds; and second, the economy is losing manufacturing jobs. The common claim from pundits and observers is that China’s undervalued exchange rate is to blame, and if the renminbi were to appreciate these trends would be reversed.

Once we take a closer look at the evidence, however, we don’t see much validity in these arguments. In fact, we conclude that the direct impact of renminbi strengthening on the G3 economies would be extremely minimal.

That pesky deficit

It’s certainly true that the US records a widening trade deficit with China; the bilateral imbalance was US$125bn in 2003, and reached US$144bn in 2004. This is a full 25% of the total US trade deficit, and primarily reflects very rapid Chinese import penetration into US markets.

However, we have two problems with using this statistic to draw conclusions about renminbi valuation. The first is that processing and re-export trade distorts the data; according to Chinese customs statistics, exports of assembled goods using imported components are more than half of overall exports—and this implies that the “real” bilateral deficit with China is much smaller than the headline figures.

According to raw data, the mainland market share in the US economy has risen rapidly to 1.5% of US GDP, overtaking the rest of non-Japan Asia, which actually saw market share fall since the beginning of the last decade—suggesting that the renminbi is far too competitive (Chart 32). But when we strip out the proportional value of imported components for processing from US import and export data (we use an average share of 50%; see section VII above for a more detailed discussion) and reapportion them back to mostly Asian suppliers, the adjusted market share gains have been much more muted, and there is less indication of a derating in China’s Asian neighbors (Chart 33).

Developed countries complain that the RMB is behind job losses and rising deficits

We don’t find evidence to support this

The US bilateral deficit is certainly growing

But the US-China balance is distorted by processing and re-export trade

When we adjust, China’s market share gains are smaller


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Chart 32: China’s market share … Chart 33: … is not what it seems

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Second, looking at the US-China deficit is conceptually the wrong way to think about the currency issue. As any economist will confirm, bilateral trade balances don’t necessarily tell us anything about underlying exchange rate valuation. As we saw in above, China’s overall trade balance may be growing sharply on a cyclical basis, but is still much smaller than the bilateral surplus with the US. In fact, just looking at global current account balances, China overall 2004 current account balance was just 9% of the US current account deficit and 17% of the total Asian current account surplus (Chart 29).

Chart 34: China’s current balance in regional perspective

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Outsourcing … or not?

US business associations and labor unions assert that low-wage outsourcing (with Asia, and in particular China, as the main culprit) has resulted in the loss of 2 million to 3 million domestic manufacturing jobs over the past three years alone—roughly one-sixth of total industrial employment. If so, this would

Looking at the overall current account balance is a better gauge of valuation

Some claim that 2-3 million job losses are caused by China


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buttress the case for greater trade protection and sanctions against so-called currency manipulation on the part of the mainland.

However, we find that current outsourcing fears are grossly overstated. A detailed look at Asian data suggests the migration of manufacturing capacity to this part of the world accounts for only a small fraction of the headline figure derived above (little more than one-twentieth, as it turns out), with the rest due to cyclical downturn as well as the natural flow of labor from manufacturing into services sectors.

The details are provided in Outsourcing, Shmoutsourcing (Asian Weekly Focus, September 2, 2003); to give a summary here, if the US is shifting overall manufacturing capacity to Asia, then the economy must be a growing industrial importer, i.e., it must be the case that the US net manufacturing trade balance is falling, or at least shifting visibly to net imports of labor-intensive goods. This is in fact happening—but the problem is in the magnitudes, as the most liberal estimate of the resulting job losses still yields a number around 30,000 to 40,000 per year, far less than the headline claims.

So what happens when the renminbi moves?

Now we get to the real question: what would be the effect on the US economy if the renminbi appreciated?

Our estimates from the previous section give a good sense of the headline impact. An export elasticity to exchange rate movements of 0.3 means that for a hypothetical renminbi strengthening of 10%, US consumers would reduce their annual purchases of Chinese goods from US$196bn in 2004 terms to US$187 bn—a very small margin, only 0.05% of US GDP. And again, we are not expecting the renminbi to move as much as 10% in the near term.

Would China buy more from the US? Well, yes, and we do find that the import elasticity to a renminbi move is somewhat higher, but keep in mind that mainland purchases of US goods were only US$34 bn in 2004—a mere one-sixth of export sales and a negligible share of total US income (and as we discuss below, a near-term slowdown of Chinese domestic demand would easily offset any increase in sales to the mainland). In other words, the headline impact of renminbi appreciation on bilateral trade is tiny by any reasonable measure.

And even if it weren’t, we still would not look for any significant boost for US producers and US jobs. Just because consumers are switching away from Chinese-made goods does not mean they are buying more at home; in fact, we find that most of the expenditure would go to other low-wage producers, with almost no positive impact on the US economy.

Why? Because China is not a significant direct competitor for US manufacturers. When we examine the underlying structure of Chinese exports with that of the US economy, we don't find much common ground. For capital-intensive sectors accounting for more than half of the US non-food manufacturing sector, such as metals, machinery, chemicals and motor vehicles,

However, the true number is probably only one-twentieth as large …

… based on the net manufacturing trade balance

If the RMB strengthened, the reduction in US imports would be very small

And the rise in US exports would be smaller still

Moreover, US producers might not see any gains …

… because production structures don’t overlap between the two economies


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China is almost completely absent from the market—while the composition of imports from the rest of the world is strikingly similar to US production patterns (Chart 35). Meanwhile, of the top processing-adjusted Chinese export categories—clothing, light manufacturing and electronics—only in the electronics sector do we see any significant overlap with the US.

Chart 35: No overlap between the US and China

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Couldn’t a renminbi move stimulate other Asian currencies to appreciate as well; in other words, isn’t the renminbi now the “key” currency in the region? And wouldn’t this have a greater impact on the US? We agree that a joint Asian strengthening would help US growth—but as we argue below, to say that the region is simply waiting for China to move is a strong overstatement.

And what about Japan and Europe?

Expanding these findings to other developed economies, the arguments are very much the same; indeed, if anything, the impact of a renminbi move on Europe and Japan would be less than in US. The bilateral European deficit with China is smaller as a share of GDP, and Japan’s bilateral trade is virtually balanced. Chinese import penetration as a share of GDP is smaller as well in these economies—as are estimates of manufacturing outsourcing to low-wage Asian countries. And a comparison of domestic industrial production structure with the composition of Chinese imports gives exactly the same result as in the US.

A few points on China’s Asian neighbors

On the face of it, China’s middle- and lower-income neighbors should be the biggest beneficiaries of any move to liberalize the renminbi exchange rate. ASEAN, India and to some extent the Asian NIEs (i) are direct competitors in China’s export markets, (ii) have more similar production structures with the mainland compared to developed countries, and (iii) are much more exposed on Chinese import demand. So they should obviously make out like bandits as the renminbi appreciates.

Could the RMB unlock a move in other Asian currencies? We don’t think so

All the above findings apply equally to Europe and Japan

To the untrained observer, Asian neighbors should gain the most from a RMB move


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Ah, but there are two small problems with these arguments. The first concerns export competitiveness, and boils down to this: with the exception of Hong Kong, Malaysia and Singapore, all major Asian economies now have flexible exchange rates. What does this mean? It means that any talk about Asian “price competitiveness” is theoretically meaningless; Asian countries not have to wait around for China to move; if they are losing competitiveness, their currencies naturally weaken against the US dollar on their own, lowering domestic costs and raising domestic margins.

And this is precisely what we have seen. After 1997, nearly every major Asian currency depreciated significantly in real terms against both the US dollar and the renminbi, and has remained relatively weaker ever since. And as we saw above, most Asian currencies are undervalued.

The second problem concerns Chinese import demand. On the one hand, we argued above that any strengthening of the renminbi would boost spending on imports, and ASEAN and the Asian NIEs are clearly much more dependent on exports to China than the developed nations (Chart 36).

But on the other hand, Chinese import growth has already slowed sharply as a result of macroeconomic tightening and excess capacity creations. And as Chart 37 shows, the negative impact on Asian neighbors from a another 2pp slowdown in Chinese domestic demand (which is our baseline forecast for 2006) is much larger than the positive impact of a 10% renminbi appreciation (which far exceeds our actual forecast for next year).

Chart 36: Who sells to China? Chart 37: Don’t get too excited about RMB moves

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The bottom line is that even though we have seen the renminbi begin to move, we probably shouldn’t be putting on party hats for the rest of the Asian region.

One final note: We just argued that most Asian currencies are undervalued, by more than 10% on average, which means that central banks across the region are intervening heavily to avoid letting exchange rates strengthen to their market-clearing level. To revisit the question posed above, is this China’s fault? Is the

But Asian currencies are already flexible

In fact, Asian currencies have weakened substantially

Asian would benefit from better access to Chinese import markets

But this should be more than offset by a coming domestic slowdown in the mainland

Could the RMB unlock Asian currency appreciation?


UBS 46

renminbi holding up currency appreciation in the region, and would a decision to move the exchange rate stimulate other Asian countries to do the same?

We can’t completely ignore China’s influence, of course, but there are a host of factors causing Asian policymakers to keep their currencies weak—and in our view the level of the renminbi is probably the least among them.

We laid out the arguments in full in No Help From Asia (Asian Economic Perspectives, 27 June 2005); to summarize here, we find that domestic weakness and lack of visibility on the global environment are the key determinants of exchange rate policies. In this environment, it is only natural for Asian authorities to attempt to keep exchange rates from appreciating in order to squeeze a bit more growth from their economies.

And even so, many Asian countries have been letting their currencies appreciate against the US dollar, and we expect them to continue doing so in the future. In the medium-term horizon, we suspect much of the Asian undervaluation we see today will have dissipated as the recovery process moves ahead—with or without the renminbi.

China Government Int: UBS AG, its affiliates or subsidiaries has acted as manager/co-manager in the underwriting or placement of securities of this company or one of its affiliates within the past 12 months. Within the past 12 months, UBS AG, its affiliates or subsidiaries has received compensation for investment banking services from this company/entity. UBS AG, its affiliates or subsidiaries may hold a significant non-equity financial interest in this company as at the date of this report.

Probably not—Asian central banks are keeping currencies weak because of the poor economic environment, not because of the RMB

And as recovery progresses, they can strengthen without the RMB as well


UBS 47

Notes:


UBS 48

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