Tuesday, June 22, 2010

Jottings on China yuan's reform

The announcement: PBoC recently announced that it will cancel the yuan's peg against USD which has been in place since mid 2008 during the global financial crisis, citing reasons such as a strong economic recovery in China and gradual global recovery. This move could also help China to deal with its inflation rate which in May exceeded its target of 3% for 2010 and probably may reach 4% by the end of this year, coupled with preventing asset bubbles. Nonetheless, the government's move to maintain the yuan's daily trading limit of +/- 0.5% was a disappointment to the market as this means that the yuan will only appreciate rather gradually and not as fast as what others may want. Having said that, this was still a surprise to many as the market expected yuan to only move away from the USD peg in 3Q owing to the lingering Europe debt crisis. This could have explain the rally in the markets on Monday.

Other reason for the announcement? There could be other hidden reason why China made this announcement at this point of time. One could be due to the upcoming G20 summit in Toronto next weekend where China might face the onslaught from members of the summit in particular US. With this announcement, China could at least deflect some of the attention away from its 'unfair' currency peg and focus more on tackling the crisis of highly indebted countries.

How much will the yuan appreciate in the short term? Probably not much. Some reports are stating 4% to 6% appreciation against the USD by end of this year, which is expected to have little effect to their external trades. There could be further pressure for China to allow greater flexibility for yuan to appreciate. There is a possibility for more reforms on yuan after the G20 summit i.e. widening of daily trading band and revaluation of the yuan. Yuan appreciation could actually work in favor for the country. It can help the country to cope with its inflation and surging asset prices (which is of a higher priority now) coupled with aligning the country's economic model to a more domestic-driven one instead of an invest-export model.

However, I believe yuan appreciation has to be moderated and not let it be revalued too rapidly, lest it will suffer the same consequences of Japan in the 1990s when Japan revalued its currency upwards drastically under the pressure of US while being reinforced by Japan's asset bubble burst in 1990-91, causing a deflationary slump from which it has yet to fully recover.

Appreciation of yuan could help lift regional currencies: Historical data has shown that Asian currencies actually benefitted from yuan appreciation, mainly due to China’s rising position as a major trading partner among the Asian countries. To recap, Chinese government allowed its yuan to appreciate against USD in July 2005. The yuan had since appreciated by 1.6% over the next twelve months, giving rise to the appreciation of Asian currencies. Consequently, the Singapore dollar, Indonesian rupiah and Malaysian ringgit appreciated by 5.1%, 7.0% and 2.7% respectively during the same period. CIMB is forecasting Malaysian Ringgit to appreciate to 3.05 against the USD by end 2010.

Implication to Malaysia: Probably less competition from China's exports coupled with stronger exports to China. Exporters might be slightly affected such as palm oil players, electronic exporters and glove manufacturers. Importers such as automakers and food producers coupled with companies with high foreign borrowings such as Tenaga could benefit. Higher domestic currency could also attract foreign investors to park their money in our capital markets especially bonds which is further supported by the interest rate differentials between Malaysia and other countries.

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