The peg with the dollar is by no means all negative to China’s competitors. It helped to stabilise the global foreign exchange market when almost all major currencies were depreciating against the dollar in the early period of the crisis.
The renminbi did not fall apart when the dollar had partly exacerbated the sharp drop of exports and trade surplus – both scaled back by 21.3% and 26% respectively year-on-year in the first three quarters this year.
It is the direction, not the level of valuation, that had worried the market. Thanks to the peg, the renminbi, measured by nominal effective exchange rate (Neer), gained 10.5% between August 2008 and March 2009, and then fell with the dollar to the pre-crisis level.
Meanwhile, many emerging market currencies had run in the opposite direction, and are now moving back to the pre-crisis levels, with pressures to rise further.
If the renminbi weakens more alongside the dollar, other emerging economies could feel squeezed in their export markets.
But how much more would the US dollar depreciate? Our in-house forecast expects the US dollar to depreciate 8% versus the euro and 7% versus the Japanese yen by September 2010. That is smaller than the depreciation in the past half-year, when the dollar lost 17% against the euro and 10% against the yen.
A weak dollar could be a key push to de-peg the renminbi, a pattern similar to the first de-peg in July 2005. The lack of restructuring in China’s growth model, rising trade protectionism, mounting capital inflows, elevating inflation expectation, and surging foreign exchange reserves indicate that external imbalance is not repairable without price adjustment.
Expectations for further appreciation may accelerate, but policymakers are in no hurry given weak external demand and overcapacity. Gradual moves, to the tune of 3% to 4% annually, are more likely.
Structural reforms, including reducing export tax rebates, could accompany currency revaluation next year and beyond.
A stronger renminbi is likely the beginning of China’s restructuring. In the near term, it could invite more capital inflows, but in the medium-to-longer term, a fairly valued renminbi should trigger more investment overseas, contain imported commodity inflation, and turn China from an export economy to a consumer one.