Many in the US Congress are furious about China not letting the yuan appreciate more
Rohit Chawdhry-

With the anniversary of the July 2005 yuan two per cent revaluation just passed, the big buzz is on what China will do next. The conventional wisdom is that it will only modestly let the yuan to appreciate at the snail crawl rate (1.5 per cent in the last 12 months) that it has so far. However, an over-heating economy and prot-ectionist pressures from the US and Europe may make way for a faster process of getting the Chinese currency revalued upwards, which, according to various estimates, is undervalued by 30-40 per cent. China may make a significant move on the RMB in the next six months, at least a three per cent RMB appreciation and that a significant part of that appreciation will occur through another surprise step revaluation of the currency parity.

Undervaluation of the exchange rate is a powerful policy instrument for promoting growth. In a competitive world, often this is at the expense of growth in other comparator economies. By keeping its exchange rate fixed, China has allowed the real exchange rate to depreciate. But by doing so it has resulted in a dangerous and unsustainable overheating that may lead to high goods/services and asset inflation, a hard landing and financial sector distress.

Consider the state of the Chinese economy first. Despite desperate attempts by the Chinese policy makers, the economy has cont-inued to grow at a 'spectacular' pace. Economic growth continued to accelerate in China in 2Q06 despite macro tightening measures since April. The economy expanded 11.3 per cent YoY in real terms in 2Q (see chart), the strongest since 1Q95, and up from 10.3 per cent in 1Q (+10.9 per cent average for 1H06). Urban fixed investment (+31.3 per cent YoY in 1H06), industrial production (+19.5 per cent in June) and retail sales (+13.9 per cent in June) data generally suggest continued strong growth. China's trade balance is exploding close to US$120bn on an annual basis from recent averages of US$50-60bn.

Efforts to cool the economy through administrative controls on lending and property investment have met with limited success, prompting China to shift towards more market-based fiscal and monetary policies. The Chinese central bank hiked reserve requirements for banks again in July and let the currency drift upwards by a small notch. However, these measures have been largely symbolic in nature and haven't had much effect on growth. Why? Because interest rate tightening and credit cont-rol measures were used in isolation without using the exchange rate appreciation.

What should the investors expect now? Expect a 27 bps increase in both deposit and lending rates this quarter, and another 27 bps in 4Q06. In addition, a stronger exchange rate (RMB) is necessary to contain the pace of liquidity creation. A higher interest rate regime is unlikely to slow down the economy as long as the exchange rate continues to remain accommodative. Critics, who argue that the Yuan is now as much as 30 per cent undervalued, complain that even ten per cent would just keep pace with China's rapidly rising productivity – implying continuation of growth. Therefore, it would only be logical to expect Yuan revaluation along with other liquidity tightening measures to slow down the pace of economic growth.

The only part keeping the government from doing so is fear of a hard landing in the econ-omy driven by excess capacity built up over the last few years. Agreed, in the short-term the likely implications of a yuan revaluation would be crippling of profits in sectors such as textiles where the profit margin is just three per cent. However, in the longer term it will clear excesses from the economy. Maintaining this effective peg or an undervalued exchange rate implies that the rate of foreign exchange intervention has accelerated. In 2005 this intervention was about a massive US$250bn and in 2006 the reserve accumulation is as high as in 2005. The Chinese forex reserves, already at US$941bn in June this year will surely reach the phenomenal level of US$1tn by the end of the third quarter of 2006. This implies too much of cheap money in circulation producing asset bubbles, one of the biggest being the real estate sector.

Housing prices in Shenzhen, an industrial city near Hong Kong, were up 14.6 per cent over June 2005. In Beijing, the increase was 11.2 per cent. In 70 large and medium-size cities in China, the prices of what the National Bureau of Statistics defines as expensive housing climbed 9.7 per cent. Higher prices pull more money into real estate, of course. In the first six months of 2006, real estate investment climbed 24.2 per cent over the same period in 2005. According to the National Bureau of Statistics, 1.41bn square metres of housing were built from January through June 2006, up 21 per cent from 2006. And as the boom ages, prices soar and excesses multiply. Units in the Tomson Riviera luxury apartment complex in Shanghai, for example, are priced at as much as US$20mn.

So serious are the Chinese policymakers about cooling the economy that China's President, Hu Jintao, said yet again (in July'06) that China intends to dampen the demand for fixed assets there, which he said had been heretofore ‘overly rapid’. This is not new news, for China's officials have been making refe-rences to this sort of thing for the past several weeks, but it is important that President Hu has now made this official by making the sta-tement to Xinhua News, Beijing's official news agency. It implies that government's stance is more amenable to allowing the yuan to rise a bit more rapidly relative to the US dollar in the near future, and that 7.7700 could be the ultimate goal i.e. the long standing peg between the Hong Kong and US dollars and thus becomes a target for Beijing to achieve.

Then there are considerable (protectionist) pressures in the US and Europe. China barely avoided being branded as a currency manipulator in May but it has only a six-month respite until October or November, when another manipulation report is due. Many folks in the US Congress are furious about China not letting the yuan appreciate more. The Senators had extended their March 31 deadline by six months but appear dissatisfied by China's progress.

And given the slowdown in the US economy and the mid-term elections in November, a serious trade war with China cannot be ruled out if China does not move by a meaningful amount. China knows that and it will thus rationally move.

What would be the likely process of this mega macro event? In order to achieve three per cent and avoid another even more massive surge of speculative inflows it is necessary to surprise investors and do a step revaluation, say of two per cent, followed by another one per cent move via a faster crawl. To summarise, letting the currency appreciate will allow China to try and soft land the economy in three ways:

• It will slow down the politically unsustainable growth of exports, as protectionist pressures are surging in the US.
• It will lead to less forex intervention and will thus slow down the rate of growth of credit.
• It will allow China to increase interest rates without having to worry that this increase would lead to even more capital inflows. Right now, China can't increase interest rates – which is needed to cool down the economy – if it keeps its peg because more money creating inflows will occur if rates go up.

Any possible opportunities from this likely mega event. Couple of them – the Malaysian ringitt and the Singapore dollar. Investors could look to buy these two currencies that would benefit from the China spill-over. Buying Malaysian ringitt against the dollar may be inflexible way of playing the event but is more rewarding as both the currencies are pegged. It is worth remembering that when yuan got revalued by two per cent in July 2005, the ringitt moved immediately from 3.8 to 3.6 or an appreciation of five per cent. The Malaysian ringitt would spike higher on any major yuan development. Alternatively, one could buy Singapore dollars – a more liquid proxy for playing yuan revaluation.

The bottomline is, both interest rates and the yuan are likely headed higher over the next six months, while economic growth is going to eventually slow down. The latter will have important implications for equity markets, commodity prices and global bonds. Structurally, China is a great story and so is Asia. However, the middle kingdom needs rapid cooling-off to sustain growth over the next ten years. This implies Chinese assets and other economic sensitive asset classes may see major correction over the next six to 12 months. As mentioned in the last column - Cash is King!