A Chinese revaluation?

American lawmakers, supported by some Europeans are clamouring for a strengthening of the Yuan or the introduction of a tariff on Chinese imports, aimed at protecting the domestic industry. China retorts out that there is no reason to listen to American claims, as the US trade deficit is structural and has not been helped by the steady decline in the value of the USD over the past decades.

The fact of the matter is that China pegged the Yuan to the USD for years until 2005. The Chinese authorities let the Yuan appreciate some 21% between 2005 and 2008, but when the crisis struck, the Yuan was again locked to the USD, and has been there ever since. My best guess is that we are about to see a slow appreciation of the CNY sometime in 2010.

Through its exchange rate policy since early 2008, China has profited from the weaker dollar, in the sense that exports have remained competitive to the USA and have gained strongly towards Europe and Japan. Together with a very quick response in terms of fiscal stimulus, China has been pulling out of the current downturn earlier than other large countries. It has also helped that the Chinese banks are government owned, removing any need for dealing seriously with bad debts.

If we for a moment ignore the political noises, there are two elements that strongly point to a coming strengthening of the Yuan. For years China has claimed that the domestic financial system was unfit for living in a world of floating exchange rates. While this may have been a valid objection 10 years ago, it is certainly not the case anymore. Hong Kong has for years been a major hub in Asian FX trading, and the transfer of knowledge from there has been significant.

The problem now seems to be the opposite. The peg to the USD is becoming a problem. Perusing official Chinese newspapers quickly reveal concerns over the domestic monetary situation. The combination of a huge export surplus and a fixed exchange rate towards the major trading partner is creating a healthy capital inflow. Without a bond market designed to soak up the extra liquidity, foreign currency (read: dollars) wind up in the currency reserve, while domestic liquidity increases quickly. This forces the government to introduce quantitative measures in order to restrict lending towards certain economic activities, such as construction. This has now reached a level, where domestic monetary policy is rapidly losing effectiveness, and despite trying to put a spin on it, it is obvious that the situation is getting untenable.

Letting go of the dollar peg would lead to a rapid increase in the Yuan, to less competitive exports, cheaper imports, and would immediately stop the inflow of capital. Given that Chinese exporters were already suffering at the beginning of 2008, it is unlikely that China would accept a sudden – and very possibly, disruptive – appreciation of the CNY.

But given the economic situation of the Chinese economy, the increasing exasperation of US congress members, and the difficult domestic monetary situation, all odds are that China will resume the "crawling peg". We are just waiting for a situation where it will not look as if the People's Bank of China is giving in to American pressure.