We believe the [Chinese] authorities will face increasing pressure in considering the role of currency appreciation in policy tightening. While the trade surplus has fallen markedly this year, it remains substantive, at US$135 billion year-to-date.
The recent depreciation of the nominal effective exchange rate (Neer) by close to 8% from the peak in March has increased the international pressure on renminbi appreciation. Domestically, pressure on currency appreciation is likely to rise as growth sustains at a high level, inflation rises and exports rebound.
We take a view that a break from the tight range in the US dollar/Chinese renminbi is likely to happen in 2010, although the exact timing is uncertain and will depend upon the future developments in domestic and external conditions. In terms of the form of the change, we have the following views.
A one-step significant appreciation is a small probability event. A potential advantage of this approach is to kill appreciation expectations and speculative inflow pressures, but it is difficult to know what would be the required size of appreciation, and the authorities will be mindful of the adverse effect on the economy.
Secondly, any weakening in the US dollar/Chinese renminbi exchange rate will initially be associated with weaker US dollar cross rates. We have already seen a slight weakening of the US dollar/Chinese renminbi rate in recent months. The reference to a basket is likely to rise as pressure for currency appreciation increases.
Neer appreciation – that is, a weaker US dollar/Chinese renminbi foreign exchange rate when US dollar cross rates are stable or strengthening – is likely to take place when inflation and overheating concerns develop into an advanced stage.
We are unlikely to get into that situation before the second half of 2010, in our view. In the last round of policy tightening in 2007-08, currency appreciation was also initially associated with US dollar weakness, and Neer appreciation only started in the first part of 2008 as inflation became a major concern.
Overall, assuming US dollar cross rates that are not be significantly different from the current levels, which is in line with our house view, we revise our baseline projection of the US dollar/Chinese renminbi rate to 6.5 by the end of 2010 from the current projection of 6.7.
This implies roughly 5% appreciation in the Neer and assumes an average inflation gap of 1% to 2% between China and her main trading partners in 2010, entailing a rise of the real effective exchange rate (Reer) by 6% to 7% from the current level. This would basically reverse the recent fall in the Reer.
The risks to our baseline view are related to domestic macroeconomic conditions and the US dollar cross rates. In particular, a stronger US dollar would reduce appreciation pressure on the renminbi.