A Contrarian View on China's Currency Move

The latest push by Beijing to accelerate the opening of China's capital account to foreign investment is undoubtedly a good thing. A good thing for the world as it helps reballance the global economy. However it is being hailed as a cure-all for China's slowing economy in China Currency Move Nails Hard Landing Risk Coffin. Not meaning to pick on Paul Markowski here (although as long-term adviser to Beijing he is hardly impartial) - this is the general view across the financial media at the moment.

We believe it is also incorrect. Beijing is clearly aware of the undeserved benefits that acrue to the

Can China Micromanage the Convertibility of its Currency?

China has recently signed a series of bilateral agreements for limited direct settlement of FX transactions. First with Russia, Indonesia, Australia and more recently with Thailand and now Japan (see BBC article). All of the agreements are aimed at facilitating trade settlement without the need of using US dollars. Also they all seem to be restrictive enough to allow for careful monitoring and control by Beijing. As an example, the agreement with Thailand only allows CNY/THB settlement in the province of Yunnan (bordering Thailand) by the local branches of 4 designated banks. This approach to gradual convertibility is similar to the Special Economic Zone model that China used in the past to introduce capitalism to the country in a limited way. Despite all the media hype, the yuan is very far from challenging the dollar as a global reserve currency. But gradually allowing convertibility of the current account (currency flows based on trade in goods and services) may just work out.

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.