We still assume that US Treasury Secretary Timothy Geithner is the only spokesman in Washington whose comments on the RMB carry any weight. Let’s also assume that the current Murphy-Ryan legislation under consideration in the US Congress is but a puff of hot air that will never go anywhere because the methods used to calculate CNY undervaluation would probably not pass a formal legal challenge under WTO rules.
For their part, the Chinese government seems to think that the Schumer-Graham proposals have the greatest probability of passing in some form, hence the trade delegation hastily dispatched to Trenton by Beijing. It is unlikely that this delegation will bring promises of enough jobs for New Jersey to substantially alter Senator Schumer’s position, and this leaves at least some of the policy remedies in the Senator’s earlier proposals as a guide for a formal Congressional response should the Treasury Department formally label China as a ‘currency manipulator.’
Back to Secretary Geithner, he significantly raised the stakes in this war of diplo-speak when he added an extra ‘very’ to the official characterization of the pace of RMB appreciation: it had been moving ‘very slowly’, and after further consideration, this was in fact ‘very, very slowly.’ The Chinese have made a nominal effort to address US concerns, which has become a normal feature of the US election cycles, with the USD/CNY rate having edged downward a bit and with senior Chinese corporate leaders sent to the US with instructions to buy something. Is this enough to placate the Obama administration?
Probably not, but it also probably doesn’t matter: if the administration decides to label China as a currency manipulator it will put into motion mechanisms that it cannot control to its satisfaction, making further bilateral wrangling behind the scenes (and away from the US Congress) a more desirable choice. We think it is unlikely that the Obama administration would take such a step, but our answer to the original question above: not very far.
With this in mind, what should we reasonably expect from the future path of the CNY?
CNY forward rates imply that markets are taking a more conservative view on the coming pace of RMB appreciation than market forecasters. As of September 16, one-year forwards on the CNY had a mid-point quote that implied a 1.1% appreciation of the currency, with comparable two and three-year rates at just 3.3% and 5.5% respectively. This compares with a forecast mean of 3.8% based on a sample from major market forecasters for the next 12-months, and mean forecast appreciation of 7.8% over the next 2-years. Based on our assessment, these forecasts seem to assume that China will allow the CNY to advance more than the average annual inflation differential between China, the US, the EU and a handful of other countries, breaking with recent tradition.
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It is probably no coincidence that by the end of 2010 the cumulative appreciation of the CNY relative to the USD will pretty much match the sum of the cumulative net differential between Chinese and US CPI since China first started to allow the CNY to appreciate in 2005: around 23% (if we assume year-end increases for 2010 of around 3% and 1.5% to CPI for China and the US respectively).
Even if rising food prices in China increase year-end CPI growth to 4% and widen the overall consumer price differential vis-à-vis the US, and assuming recent experience as a guide for the near-term trend of the CNY/USD rate, it would appear unlikely that a significant acceleration to the pace of appreciation of the Chinese currency will commence any time soon.
Current forecasts predict a CPI differential of around 1.5 percentage points for China and the US in 2011, and if policy makers in China intend to keep the CNY/USD rate close to a level consistent with conventional measures of purchasing power parity, this gap implies a very moderate pace to short-term appreciation. Real exchange rate targeting is alive and well.
On the supply side of the equation the gap between rates of growth to overall producer prices in China and those in the US has been far wider than that observed in respective consumer economies. This, along with estimates of the relative purchasing power of the Chinese currency relative to the USD, is a key factor to what we see as a mainstream view among some circles of policy advisors Beijing: the CNY is close to a fundamental equilibrium level relative to major currency pairs.
Such a view, however, appears to be losing out to others that put more emphasis on the negative incentives and distorted allocation of domestic resources that have resulted from managing the exchange rate according to parameters that are too narrow.
According to this logic, the pace of correction to the relative price of foreign exchange in the Chinese economy should track more closely with that necessary to reduce external imbalances, and in the process prompt more investment in the competitiveness of domestic oriented sectors (this is also what forecast models assume should happen, hence bigger numbers for the appreciation of the CNY in 2011 and 2012 than current expectations in forward markets).
Some in Beijing would tell you that the future pace of CNY appreciation will be consistent and moderate. In the context of July 2005 to July 2008, this meant about 7% per year. With annual GDP growth rates in China expected to moderate, it is unlikely that the pace of appreciation to the CNY under ‘normal’ circumstances, if they exist yet, will return to those seen during the years that immediately preceded the global financial crisis simply because it will be harder for China to replace frictional job losses during the domestic transition that would follow.
China needs to hold onto as many domestic manufacturing jobs as possible to absorb newly urbanized populations. But would appreciation on the order of 4% to 6% per year, for example, be adequate to bring about the necessary focus on domestically focused sectors, such as services, that would reduce the relative importance of investment and external demand to growth? Probably not. An adjustment to the exchange rate regime is just one of the policy reforms necessary to build a more sustainable growth model in China.
So where does that leave us where it comes to the near-term future of the CNY? A return to a policy stance like that seen during the 2005-2008 period is most likely if those groups within the bureaucracy who were successful then in breaking through the vested interests that favor a mostly fixed exchange rate are successful in doing so again. Just as it is a political season in the US, the inter-factional battles and jockeying for power ahead of China’s formal leadership reshuffle in 2010 are also underway.
As described in a recent research note, these groups are set to do pretty well politically, and view reform to the CNY exchange rate regime (and the short-term pain that it implies) as a necessary precondition for a more sustainable growth model for China. They will have to contend with those who have tried very hard to prevent the equivalent of what they call a “yen revaluation recession”, referring to their interpretation of the effects of the Plaza and Louvre Accords on 1990s Japan, among others.
With this in mind, an annual trend rate of appreciation of 4% to 6% to the CNY/USD rate seems might be politically acceptable in Beijing, and though inadequate to bring external accounts into significantly better balance any time soon, this pace of appreciation is also not wholly inconsistent with that goal. This might still be too slow for Secretary Geithner, and would undoubtedly be too slow for US congressional leaders, but it might still be enough to allow China to balance domestic and external interests, for now.
Disclosure: No positions