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The IMF recently released a report on China that declared the RMB to be moderately undervalued against the USD [emphasis added]:

Currency appreciation continues to be an important component of the package of reforms needed to transform China's economy. A stronger renminbi would increase household purchasing power, help expand the service and other nontradable sectors, boost the labor share of income, and facilitate financial sector reform. The recent widening of the intraday trading band is an important step in this regard, as it will allow the market to play a stronger role in determining the exchange rate. Using this increased flexibility would also have the benefit of allowing for a more independent monetary policy. As reserves are well above all standard metrics and the currency is moderately undervalued, the real effective exchange rate should be allowed to continue appreciating by reducing intervention over the medium term.

This view of the CNY/USD exchange rate equilibrium represents conventional wisdom. China's currency is slightly undervalued against the dollar and she needs to continue to take incremental steps to bring the exchange rate into fair value.

Could the RMB fall?
What if conventional wisdom is wrong and CNYUSD were to fall upon further exchange rate liberalization? Andy Xie has observed that capital is fleeing China because of a weakening economy [emphasis added]:

Emerging economies face capital outflows. Between 2009 and 2011, low interest rates in developed economies sparked massive flows of hot money into emerging economies. The hot money fueled asset inflation and spiced up economic growth too. The latter gave the perception of emerging economies decoupling from developed ones and incited even more inflow. The asset inflation eventually sparked general inflation, which slowed economic growth and diverted money from asset markets. The resulting asset deflation further decreases economic growth. Hot money is now leaving because it sees the unsustainability of the growth dynamic in emerging economies.

The Indian rupee and Brazilian real have declined by one-fifth from their recent highs, reflecting pressure from capital outflows. Because China has a controlled exchange rate, the outflow has come later, as investors believed in the safety of a government-supported exchange rate. The weakening economy this year appears to have sparked expectations of yuan depreciation. The government support of the exchange rate has become an accelerator for capital outflow, as it is increasingly viewed as a subsidy for early leavers.

Similarly, Izabella Kaminska at FT Alphaville has reported on a USD shortage in China, which has been also interpreted as funds flow leaving the country:

A while ago, we dared to suggest that a new trend was emerging in China's foreign exchange operations. Instead of being a net buyer of foreign currencies from the market - and conducting monetary policy operations in line with that position - the Chinese state was becoming a net seller of foreign currencies onto the market, and adapting its monetary policy accordingly.

A natural outcome of there not being enough foreign currency inflow into the country. But also of yuan outflows, and fears that the yuan may depreciate more generally.

Let's suppose that Washington got it want from the Chinese in the form of greater exchange rate liberalization, but instead of rising against the USD, CNY fell instead. How would Congress react?

Disclaimer: Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Source: What If The Renminbi Were To Fall?