The U.S. decision to delay a ruling on whether China manipulates its currency may have defused political tensions enough for Beijing to let the yuan resume appreciation as early as the next few months.
Beijing has flagged to Washington that foreign pressure may in fact stifle any yuan move, and it seems, the U.S. Treasury Department has understood that message.
China has effectively repegged its currency some 20 months ago around 6.83 to the dollar as the financial crisis spread and offshore forwards market has been reflecting expectations it will allow the yuan to rise again over the next 12 months.
Here is a look what Beijing might do in months ahead.
RESUMPTION OF GRADUAL APPRECIATION
• Probability: Likely.
Many analysts expect Beijing to let the yuan start strengthening as early as in the second quarter and allow it to climb 3-4 percent over the 12 months.
Central bank chief Zhou Xiaochuan said in March that the decision to keep the yuan stable in mid-2008 was a "special policy" to cope with the global downturn and Beijing would have to let the yuan resume its rise at some point.
Offshore yuan forwards are currently pricing in 2.8 percent appreciation against the dollar over the 12 months, roughly in line with a Reuters poll last month.
However, how such a measured climb would be engineered is subject to much debate.
A gradual appreciation, possibly combined with a widening of the yuan's daily trading band appears most likely.
But a small one-off revaluation, as in July 2005, still cannot be ruled out, though Beijing might be concerned that it could be seen as yielding to pressure from the United States.
• Market impact: Even though such scenario is largely priced in, offshore non-deliverable forwards may up the appreciation bets. The impact on commodity markets and commodity-linked currencies is harder to predict, as such a move would make imports cheaper but could also be seen as a tightening measure that would temper Chinese growth in the medium term.
DE FACTO PEG MAINTAINED THROUGHOUT THE YEAR
• Probability: less likely.
China's reluctance to let yuan rise is, in large part, a function of deep-seated concerns about the strength of its economic recovery.
The Commerce Ministry has repeatedly said that a stable yuan has benefited both China and the world during the global crisis and the yuan should not be blamed for global imbalances.
China is expected to report its first monthly trade deficit in six years this week, giving Beijing an excuse to ignore calls for a stronger yuan.
But keeping the yuan stable runs the risk of fueling inflation as the economy recovers, while a lack of action might lead to increased tensions between Beijing and Washington in the run-up to the mid-term U.S. elections in November.
• Market impact: Yuan rises implied by offshore NDFs, particularly short-dated forwards, are likely to fall.
NEW EXCHANGE RATE REGIME
• Probability: Less likely but garnering attention
Economists have suggested that China would benefit from a new model for determining the yuan's exchange rate.
Although the exchange rate is theoretically set against a basket of currencies, it has in practice been overwhelmingly centered on the dollar. Beijing let the yuan gain 21 percent against the dollar between July 2005 and July 2008.
Ting Lu, an economist with Bank of America Merrill Lynch, has said that Beijing should follow Singapore's example and target a basket of currencies, keeping the basket's composition a secret to keep markets guessing when the central bank might intervene.
Jun Ma, an economist with Deutsche Bank, advocates a "flexible crawling peg against a basket" that would generate uncertainty, as in Singaporean, but with daily and monthly volatility limits against the dollar to avoid hurting companies.
Researchers from the Chinese Academy of Social Sciences, a top government think-tank, have suggested a policy of making it clear the yuan will appreciate by 3-5 percent each year, but in an unpredictable pattern to keep speculators at bay.
• Possible market impact: Markets may price in faster yuan rises if China allows greater yuan flexibility, but there will be greater uncertainty about its moves.
BIG ONE-TIME REVALUATION
• Probability: Unlikely
A substantial one-time revaluation would fly in the face of Beijing's promised policy continuity and might appear to domestic critics as if the government was caving in to foreign pressure.
Goldman Sachs chief economist Jim O'Neill said Beijing could let the yuan rise as much as 5 percent, while Societe Generale expects a revaluation of 5 to 10 percent around April or May.
A big enough revaluation would, in theory, deter hot money inflows by dampening expectations of further major gains. But if it was deemed insufficient, investors might still pile into Chinese assets on expectations the yuan would rise further.
Conversely, if the adjustment was big enough to deter speculators, it might batter the very exporters that Beijing has tried so hard to support.
• Possible market impact: A major revaluation could initially boost currencies such as the yen and Australian dollar, which tend to have high correlations with Chinese growth.
But the sharper the move, the greater the risk that it would also hit commodity and equity markets due to concerns about its impact on exporters and growth.
Shares of companies geared toward Chinese final consumption, from luxury goods retailers to automakers, might rally on the hope that cheaper imports would drive China's demand.
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