A report by DBS Group Research

Appreciation pressure on the CNY this time is much larger than in 2005
In Real Effective Exchange Rate (REER) terms, the yuan (CNY) has depreciated 7% owing to its peg to the weakening US dollar up to August this year ever since Oct 2008 (Chart 1).

Many argue that this is unfair because it has strengthened the competitiveness of Chinese exporters as evidenced by running larger bilateral trade surplus with the US in the past two quarters (Chart 2).

Notwithstanding, China's exporters have been struggling this year too. In fact, the trade surplus this year is likely to fall substantially to around US$180 billion from US$296 billion (RM608.4 billion from RM1 trillion) in 2008. When measured as a share of gross domestic product (GDP), the size of the current account surplus will probably shrink to 6% from 11%.

China allowed the CNY to appreciate in July 2005 when the trade surplus rose fourfold from US$25 billion in 2003 to US$102 billion in 2005. Subsequently, the surplus more than doubled to over US$200 billion by end-2007, while the CNY appreciated steadily.

The situation nowadays is clearly very different from that of 2005. Even assuming that the deterioration of the trade surplus in China is transitory due primarily to the sudden collapse of global trade in 2009, the reemergence of a rapidly rising trade surplus is unlikely to occur overnight.

It ultimately depends on how soon global demand returns. Although the global economy will be better in 2010, China's export growth will unlikely return to the average growth of 26% during 01-07 next year. It will most likely to be around 10%-15%.

For the time being, China's most optimal strategy is to keep a status quo on its exchange rate policy.

That said, the appreciation pressure on the CNY this time round is a lot larger than the episode in 2005. This is because:
1. the US has a lot more political/economic incentive to persuade China to appreciate the CNY;
2. China's neighbour, including Japan (yen appreciated by 12% since April 2009), has allowed their currencies to appreciate;
3. The elevation of China's international status after the credit crisis meant that international responsibility has risen on her part; and
4. China's potential economic growth is still very strong. We expect real GDP growth of 9.5% in 2010.

Lessons learnt from Japan
From China's perspective, the four trillion yuan (RM2.07 trillion) fiscal stimulus has helped stabilise global confidence. The faster-than-expected rebound of the Chinese economy has also helped other countries recover sooner. However, this mega fiscal programme has not been getting enough credit. Instead, focus has been placed too much on the exchange rate issue.

From the perspective of the US, it may seem like global rebalancing cannot be achieved without committing China to appreciate the CNY. Yet, if we look at the Japanese experience, currency appreciation may not always be the optimal solution. Back in the 1980s, Japan appreciated the yen by a total of 48% in 1985 to 1987 period.

Domestic monetary policy was encouraged to be loosened so as to strengthen domestic demand. However, Japan's bilateral trade surplus with the US continued to increase from US$41 billion in 1985 to US$53 billion in 1987.

There was a notable fall to US$38 billion in 1990 from US$46 billion in 1989, but that was owing to the bursting of the asset bubble. In the subsequent 10 years, the average bilateral trade surplus with the US amounted to US$44 billion per year, not too much different from the trade surplus in 1989.

The painful aftermaths following Japan's 1989 bubble burst is a reminder for China not to follow its footsteps. Sharp appreciation of the exchange rate alongside a loose monetary policy will only create asset bubbles. Moreover, capital movements nowadays are much more rampant than two decades ago.

This suggests that a mild appreciation of the CNY— even in a controlled manner alongside loose monetary policy may easily generate the same risks in the asset market. During the 2005-2007 period when the CNY was steadily appreciating, hot capital – as proxied by the difference between foreign reserves increment and the sum of trade surplus and actual utilised foreign direct investment (FDI) – totaled US$148 billion despite the inconvertibility of China's capital account. (Chart 3)

Availability of Policy
The sharp rebound of the A-share indices and property prices this year has already generated a lot of concerns over asset bubbles. Under such a scenario, what policy options does China really have?

Option 1
Appreciate the CNY by around 3% per annum, and keep monetary policy loose to support growth. This policy combination would satisfy most parties and comply with the global rebalancing theme. This is similar to Japan's policy combination except that the magnitude of currency appreciation is much more gradual. The risk of asset price inflation will deepen and this would likely be a multi-year process. This is the most likely outcome, in our view.

Option 2
Do nothing on the exchange rate front and keep monetary policy accommodative. Under this scenario, the US will continue to pressure China to appreciate the CNY, which will feed into CNY appreciation expectation. Hot money will continue to flow into China. Depending on the stringency of capital controls and administrative measures, asset inflation is also likely to be an inevitable outcome. One can argue that China can simply allow domestic inflationary pressure to rise to a level that will trigger the market to reverse the expectation of CNY. However, from a social stability standpoint, persistently high inflationary pressure between 5%-8% (measured by the consumer price index or CPI) is unlikely to be acceptable by the Chinese authorities.

Option 3
Appreciate the CNY by 3% per annum and adjust the rate as required by changing domestic and global economic fundamentals. Tighten monetary policy and credit policy to control asset inflation. Develop the capital markets and thereby reduce the reliance on the banking sector. That in turn calls for faster liberalisation of domestic interest rates. This is easier said than done, given the difficulty in defining an asset bubble.

Bottom line
What will be the most likely policy option given all the complications of the aforementioned factors? Option 2 is at best a short-term solution. Option 3 is difficult to maneuver because of difficulty in defining what asset bubbles exactly are. Moreover, it is not warrant that currency appreciation will have the tightening impact on trade and capital flows. Between 2005 and 2007, not only the trade surplus jumped three-folds to almost US$300 billion, foreign reserves also rocketed from US$818 billion to almost US$2 trillion when the CNY appreciated around 17% in REER terms during the same period.

Option 1 is thus the most likely scenario. As such, asset prices in China will likely have a lot more room to grow over the medium term. (It will not be a straight line but with intermittent disruptions from administrative measures.) But how it will end? Well, it maybe too early to think of an end now. This is only the beginning.