Dec 19, 2011

Has the Chinese Yuan Topped Out?

Ever since the initial 8.1 peg to the USD was scrapped in 2005, the Chinese yuan (a.k.a. RMB) has only gone up. Investors have been piling up into dim-sum bonds and US politicians keep ratcheting up the pressure on Beijing to revalue its currency. Now if the RMB is so undervalued, why did hte PBOC need to intervene to support it on Friday? (see WSJ article). In fact, it had already hit the lower limit of its officially stipulated trading band for a few days in a row.

If capital controls are lifted, the country's large current account surpluses should drive the value of the yuan higher until the resulting drop off in exports (as they get pricier) and pick-up in imports (as they get cheaper) balances out. This is according to popular wisdom and Economics 101, but completely misses the capital account part of the equation. And that one is tricky.

If investors could freely move funds across the border, would money flood into the Red economy driving the RMB higher? Or would the enormous pool of currently captive domestic savings instantly rush out to seek returns higher than the deposit rates of state-owned banks? The market is telling us the latter is more likely.

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