Some Thoughts On China FX Policy
By Win Thin
The sheer number of comments from China officials is noteworthy, and are worth sifting through for any nuggets of new information. PBOC Deputy Governor Hu noted that increased flexibility in the yuan may “ease imported inflation pressures.” Last week, Premier Wen said that that flexibility in the yuan may play a role in efforts to tame price pressures and so it appears that there has been a more public embrace of the virtues of a strong currency. PBOC advisor Xia adviser said China would not rule out a one-off revaluation of the yuan, and also added that PBOC should expand the band within which the yuan trades. Xia added that said China only needs $1 trln of foreign reserves and that the rest should be used to accelerate strategic investments. This is a bit different from PBOC Governor Zhou’s remarks, as he simply said foreign reserves have exceeded a “reasonable” level, and that the management and diversification of holdings should be improved as “the build-up could cause big risks.” Zhou seems to be saying that accumulation should stop, while Xia is calling for a sharp reduction in the actual holdings.
Analyzing official China comments in order to make a currency call is a fool’s errand. However, suffice it to say that all of these comments suggest a reduced patience for the status quo and an increased willingness to recalibrate China FX policy. At the start of the week, CNY 12-month NDFs were pricing in only 2.2% appreciation over the next year, well below actual y/y gains right now of about 4.6% in spot. With price pressures remaining too high, our view has consistently been that markets were underpricing CNY appreciation. With regards to currency policy, we are putting forth the following three possibilities along with odds: 1) keep current pace of appreciation (10%), 2) do one off revaluation (25%), and 3) speed up pace of appreciation (65%).
There is nothing scientific about this, but it seems clear from the data and from the official comments that the current way of doing things is being called into question. Given the gradualist approach from China, we lean away from a big one off move and downplay talk of a 10% revaluation. Back in 2005, when the strict peg was eliminated, the yuan was revalued by only 2% vs. the dollar and then was allowed to gain steadily thereafter. At first, the y/y gains were kept around 2-4% from 2005 to mid-2007, and then picked up in H2 07 to the 5-6% range. For the period between March 2008 until July 2008, pace was around 10% y/y as the economy was overheating. However, this changed when the PBOC stopped the crawling peg when the global crisis hit China from July 2008 until mid-2010, when the crawl was restarted.
Our base case is that the pace is increased back to double digits (65%), but recognize that there are not insignificant odds (25%) of a one off reval. To us, the recent spate of official comments suggest that keeping FX policy the same seems very unlikely, hence the 10% weight. We also believe other tightening measures will be seen, both orthodox rate hikes as well as more unorthodox macroprudental ones that include reserve requirement hikes and potential price controls. One potential concern for China is that none of the likely policy changes will address the issue of foreign reserve build-up. Until CNY is allowed to float freely, PBOC will always be facing inflows of USD that is must mop up. Even a big one off revaluation is unlikely to turn away the money that is flowing into China, both from trade surpluses and investment inflows. So for now, China is unlikely to shift from being a significant buyer of USTs no matter the shift in FX policy.