Capital influx will likely increase further if the government continues to allow market forces to play a bigger role, resulting in the further strengthening of the renminbi and putting off much-anticipated exchange rate reforms.
Large foreign exchange (FX) inflows have been putting appreciation pressure on the currency. In the first quarter of the year, China’s official FX reserves increased by US$157 billion, compared to US$99 billion for the whole of 2012. April 2013 saw another US$66 billion in FX purchases by banks, according to UBS in a research report published on May 29.
UBS is boggled by the Chinese government’s move to allow the renminbi to appreciate steadily and persistently in recent months when most other Asian currencies weakened against the US dollar.
“In the current environment of weak economic growth at home and lacklustre recovery abroad, the steady and relatively quick – annualised rate of 8% since early April – appreciation is particularly puzzling to many market participants and economists alike,” said Tao Wang, China economist at UBS.
The USD/CNY fixing reached 6.1818 on May 28. Overall, the currency has appreciated by about 1.7% against the dollar since April – small compared with the movements in most other major currencies but larger than renminbi appreciation in the whole of 2012.
If the Chinese government continues to permit capital inflows, this will pile on appreciation pressure on the Chinese currency, potentially putting a hold on much-needed reforms.
“This could delay the stated reform in renminbi exchange rate or lead to more-than intended renminbi appreciation,” said Wang. “If China intends to widen the trading band, as the central bank said so, it should do so quickly so as to have an element of surprise.”
“Announcing the intention early while allowing the currency to appreciate steadily and persistently will only fuel more capital inflows and increase appreciation pressure, not reduce the pressure,” he added.
UBS puts forward several reasons why Beijing has allowed the renminbi to rise against the dollar.
Economists point out that a more reformed exchange rate regime is supposed to allow market forces to play a bigger role, which is what is happening now. An appreciation will also help release some market pressure so that when the daily trading band is widened the exchange rate does not immediately hit the strong end.
Moreover, an appreciation will help deflect US criticism ahead of the bilateral Strategic and Economic Dialogue which is going to take place in July and more importantly, earn some room for possible future deflation.
However, UBS believes that this is not the right time to allow its currency to strengthen.
“This is perhaps not the best time to simply let market forces, unleashed by zero interest rates and quantitative easing in advanced economies that cater to their needs, overwhelm economic fundamentals at home,” said Wang. “That is why many economies have recently increased capital controls in order to reduce the pressures on their currencies. Against this backdrop, China’s decision to let the renminbi appreciate in line with market pressure is indeed unusual.”
UBS maintains its forecast of USD/CNY fixing staying around the 6.2 at end 2013. However, taking into account the central bank’s desire to push through exchange rate and capital account liberalisation sooner rather than later, the bank thinks there is more risk that the renminbi could end the year 1% to 2% stronger than it currently expects.