beyondbrics

One of the big risks for the Chinese authorities in beginning to gently appreciate the currency is that they set up a one-way bet for investors who believe that the renminbi can only get stronger from now on. Large inflows of hot money could make it difficult to conduct monetary policy, officials fear, and might potentially aggravate inflation.

That explains why there has been much more talk since Saturday about volatility in renminbi trading and using a currency basket as a reference. When China abandoned its currency peg in 2005, it said the renminbi would trade against a currency basket of its main trading partners, but in reality it trailed the US dollar and was much less volatile than the 0.5 per cent daily trading bands allowed.

“In one area, the emphasis will be different this time,” says Li Daokui, a central bank advisor who believes the authorities will pay more attention now to the basket in which the euro plays a large role. Economists who have been briefed by the central bank say that there will also be more daily volatility, in order to keep speculators on their toes.

This means that in principle, says Mr Li, that if the euro gets much weaker, the renminbi could fall against the dollar. Richard Yetsenga at HSBC says something similar: “This is a new regime involving more two-way volatility, a stronger renminbi if the dollar broadly weakens, but where renminbi depreciation is also possible.” That would be a pretty powerful disincentive for speculators who, according to a Reuters poll of economists, are only looking at a 2.4 per cent increase in the value of the renminbi by the end of the year.

Except that, not everyone is buying the idea that China is moving towards using the basket as the main reference. One Chinese economist believes that the country’s top leaders still prefer the dollar rate to remain the focus because it is more transparent and 70 per cent of Chinese trade is invoiced in dollars. And there would be political consequences from depreciation against the US currency. As analysts at Gavekal put it: “We highly doubt that China is looking to risk a protectionist backlash (and exacerbate the inflationary risk) by depreciating in the mid-term.”

Conversely, Michael Kurtz at Macquarie Securities thinks that some hot money inflows might be no bad thing, given the prevailing fears that current tightening measures could lead to a hard landing in the economy. “It may perversely help stabilise (or even lift) China’s sagging domestic real estate and equity markets,” he writes.

Related reading:
Beijing allows modest rise in renminbi, FT
Shares rise on China yuan move, but fears persist of US backlash, beyondbrics
Renminbi move catches critics off-guard, FT