China: Faster yuan appreciation ahead
May 20, 2011
On 9-10 May, China and the United States held the third Strategic and Economic Dialogue in Washington. Generally, the United States uses this forum to put additional pressure on China to increase the rate of RMB appreciation. However, in this meeting, U.S. authorities softened their tone, as China let the RMB appreciate to a record high during the meeting. According to media reports, Chinese officials showed a higher willingness to use the exchange rate to fight inflation as other policy tools appear less adequate in the current circumstances. On the one hand, the repeated increase of the Reserve Requirement Ratio (RRR) has proven as not being sufficiently effective to contain inflation. On the other hand, the government is reluctant to hike interest rates more aggressively, as such tightening measures threaten to burst the asset bubble in the real estate sector. Therefore, most analysts expect that Chinese authorities will allow further RMB gains going forward, as a faster RMB appreciation would alleviate inflationary pressures by reducing the cost of imports. However, Chinese authorities are likely to maintain a course of gradual appreciation as a sudden adjustment could erode the competitiveness of the country's export sector. That said, in the last decade, China has moved up in the value-added chain, away from cost-sensitive low-end manufacturing towards more sophisticated manufacturing, which is less prone to suffer from an appreciating currency. In addition, foreign companies, which manufacture a large share of total exports, are trapped by their large accumulated investments and cannot relocate their production facilities in the short term. So far this year, the RMB has appreciated 1.9% against the USD in nominal terms. The nominal effective exchange rate (NEER) has even depreciated slightly, as most other currencies gained against the RMB.