CHINA. RMB Tracking 3-5% Annual Appreciation Trend

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Frank Merritt
5 years ago
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1 RMB Trackig 3-5% Aual Appreciatio Tred Summary Despite a more rapid pace of dowtred i USD/RMB i recet weeks, volatility remais stable compared to the previous quarter. The USD/RMB tradig bad has yet to be tested so far, ad the probability of a bad wideig for the pair remais low at this poit. With the RMB trackig a steady appreciatio, our ed-2007 target is set at 7.47/USD, or a 4.4% appreciatio. We are projectig Chia's real GDP growth to tred lower to 9.5% i 2007 from 10.4% i 2006, margially below historical average. We see o let up o pressure i 2007 from the US for faster RMB appreciatio, possibly through aother retaliatory trade bill. Higher RMB tradig volatility i 2H06 As expected, the RMB cotiued to maitai its stregtheig tred agaist the USD throughout 4Q06, albeit i a choppy maer. USD/RMB o the OTC market closed at o 20 Dec, a gai of 3.8% sice the 2.1% revaluatio i Jul Nevertheless, volatility has stayed relatively similar to 3Q06, whe market pressures rose sigificatly ahead of the IMF/World Bak meetigs i Sigapore. The RMB appreciated a daily average of 0.02% o the OTC market so far i 4Q06, i lie with the Aug-Sep period, ad about 2.3 times the daily average of % i 1H06. RMB's volatility has actually eased somewhat i 4Q06, as the daily stadard deviatio came i at vs i Aug-Sep. The pace of RMB's appreciatio agaist the USD picked up ear ed-nov, with key levels of from 7.85 to 7.82 take out withi a space of 3 weeks (from 24 Nov to 14 Dec). Ideed, the RMB gaied a daily average of 0.06% durig USD/RMB Daily Tred USD/RMB Jul 05 Oct 05 Ja 06 Apr 06 Jul 06 Oct 06 1

2 that period, ad importatly, stadard deviatio has remaied largely similar at RMB Volatility Measure 2006 OTC Market Daily Parity Fixigs Stadard Deviatio Ja - 28 Feb 1 Mar - 31 Jul 1 Aug - 30 Sep 1 Oct - 12 Dec Statistics for RMB OTC Closig Values i 2006 Period No. of Largest daily RMB Largest daily RMB Avg daily move i Stadard moths gai vs. USD (%) loss vs. USD (%) RMB vs. USD (%) Deviatio 1 Ja - 28 Feb Mar - 31 Jul Aug - 30 Sep Oct - 12 Dec Source: Bloomberg; UOB Statistics for RMB Daily Fixigs i 2006 Period No. of Largest daily RMB Largest daily RMB Avg daily move i Stadard moths gai vs. USD (%) loss vs. USD (%) RMB vs. USD (%) Deviatio 1 Ja - 28 Feb Mar - 31 Jul Aug - 30 Sep Oct - 12 Dec Source: Bloomberg; UOB Tradig Bad Limits Yet to be Tested Two observatios ca be made from these statistics. First, despite the fast pace of RMB appreciatio i the 24 Nov-14 Dec period, volatility has remaied quite cosistet with prior periods. Secodly, the daily moves have yet to reach the 0.3% daily bad, with the largest moves at just 0.25%-0.26% o the OTC market i Aug-Sep. The maximum moves are eve smaller o the daily fixigs, which maxed out at 0.25% i Aug-Sep, ad dow to aroud % i 4Q. This suggests that the risk of a bad wideig, while preset at this poit, may ot be as cosiderable as some might thik. I additio, recet official remarks also suggest that the probability of a bad wideig ear term may ot be sigificat. The average daily appreciatio pace for the RMB so far i 2006 is aroud %, or 5% aualized. Coicidetally, this is cosistet with the widely discussed 3-5% aual appreciatio for the RMB agaist the USD. We believe PBoC is usig this 3-5% rate to 2

3 RMB Daily OTC closig 2006 Largest daily RMB gai vs. USD (%) Largest daily RMB loss vs. USD (%) Ja - 28 Feb 1 Mar - 31 Jul 1 Aug - 30 Sep 1 Oct - 12 Dec guide the currecy's rise. Agaist this backdrop, we aticipate the RMB to ed at 7.47/ USD by ed-2007 ad 7.18 by ed-2008, from the projected 7.80 at ed RMB Daily Fixigs 2006 Largest daily RMB gai vs. USD (%) Largest daily RMB loss vs. USD (%) % chage 1 Ja - 28 Feb 1 Mar - 31 Jul 1 Aug - 30 Sep 1 Oct - 12 Dec Policy-Egieered Growth Moderatio i 2007 O the back of the slew of austerity measures i 2006, recet batch of idicators cotiue to poit to moderatig growth tred goig ito Value added idustry i Nov gaied 14.9, slower tha the 16.6% pace i the same moth i 2005, ad largely similar to the 14.7% rate i Oct Idustrial output has remaied o a dowward tred sice peakig at 19.5% i Ju 2006, with output from light idustry seeig the largest dowward adjustmet. The closely watched fixed asset ivestmet (FAI) data have also slowed sice Ju 2006 but remais above official target of 25% growth for Residetial ivestmet has adjusted at a faster rate compared to overall FAI data, as the govermet tighteig measures i large part are focused o residetial ivestmet to curb overheatig i the sector. 3

4 Value Added Idustry 22 Overall VAI VAI: Heavy Idustry VAI: Light Idustry Feb 06 Mar 06 Apr 06 May 06 Ju 06 Jul 06 Aug 06 Sep 06 Oct 06 Fixed Asset Ivestmet Growth Fixed Asset Ivestmet FAI: New Costructio Source: CEIC Ja 04 Jul 04 Ja 05 Jul 05 Ja 06 Jul 06 However, moetary data are showig mixed sigals. While loas growth has respoded to the hikes i iterest rate ad reserve requiremet ratios through 2006, moey supply growth has diverged somewhat. I fact M2 has rebouded i the most recet moth, after tredig dow sice mid-2006, while M1 has yet to show ay sigs of slowig. Part of the reaso for such resiliece i the moey supply data is the fact that forex reserve icreases are ot offset by capital outflows due to the closed capital accout. However, the issue of the capital accout ad RMB covertibility will take years to solve. While the authorities are faced with possibility of growth reacceleratig i 2007, there are sigs that the PBoC is leaig i favour of admiistrative measures, istead of iterest/ exchage rate policy aloe. The mai reasos beig 1) poor trasmissio mechaism i Chia; 2) the eed to coordiate policy moves with other Miistries; ad 3) to mitigate the risks of overtighteig from iterest rate hikes ad RMB appreciatio. The most recet of such admiistrative measure was the aoucemet o 21 Nov of the doublig of lad use fees for costructio begiig 1 Ja The latest reserve ratio hike o 3 Nov was yet aother maifestatio of the gradual shift away from a oe-size-fit-all iterest rate policy measure. Policy trasmissio mechaism is still at its early stage i Chia, as a Libor-like 4

5 Loas ad Deposits Growth Deposits Loas Ja 03 Jul 03 Ja 04 Jul 04 Ja 05 Jul 05 Ja 06 Jul 06 Moey Supply Growth Moey Supply M1 Moey Supply M Ja 03 Jul 03 Ja 04 Jul 04 Ja 05 Jul 05 Ja 06 Jul 06 iterest rate, called Shibor, will oly take off o 1 Ja This will be the begiig step to create a complete yield curve ad market drive iterest rates. This led us to believe that there is just a 60% probability of oe last hike to the bechmark 1Y ledig rate to 6.39% from 6.12%. For the reserve requiremet ratios, there is plety of headroom available at the curret rate of 9% (effective sice 15 Nov), give that the ratio stayed at 13% betwee We look for at least aother 2 more reserve ratio icreases of 50bps each by mid-2007, to brig the rate to 10%. Despite pockets of stregth i idividual data, a moderatio i overall growth pace is evidet. Chia's GDP has slowed i the most recet quarter to 10.4 i 3Q06 (vs i 2Q06 ad 10.3 i 1Q06). With GDP havig expaded 10.7 i the Ja-Sep period, Chia's GDP growth is o track to achieve our 2006 forecast of 10.4%. This would imply growth mometum deceleratig to 9.5 i 4Q06, which is cosistet with the average aual growth rate of 9.9% over the period of

6 Bak's Required Reserve Ratio Bak s Required Reserve Ratio Source: Bloomberg % Ja 98 Ja 99 Ja 00 Ja 01 Ja 02 Ja 03 Ja 04 Ja 05 Ja 06 1Y Ledig ad Deposit Rates Chia 1Y Workig Capital Ledig Rate Chia 1Y Deposit Rate Source: Bloomberg 1 % 0 Ja 03 Ja 04 Ja 05 Ja 06 GDP Growth GDP (y/y%) Q 03 3Q 03 1Q 04 3Q 04 1Q 05 3Q 05 1Q 06 3Q 06 6

7 While FAI ad maufacturig data are likely to tred lower ear term, there is a risk that these same data could re-accelerate especially i 2H07, as excess liquidity remais ad base effect would kick i after mid We thus see Chia's ecoomic expasio moderatig to aroud 9.5% i Pressure o RMB i 2007: From Udervaluatio to Misaligmet Exteral pressures are expected to stay o the RMB goig ito With the RMB gaiig just a modest 3.2% YTD i 2006 (vs. THB s rise of more tha 15%) ad with cotiued buildup i Chia s foreig exchage reserves, trade ad currecy issues will cotiue to be domiat topics i US-Chia relatios. Oe key source of pressure will be from US Cogress, as aother trade bill, by Ses. Charles Grassley ad Max Baucus, is pedig ad expected to be revived ext year. Recall that the much publicized Schumer-Graham bill was evetually withdraw o 28 Sep 2006, at the urgig of both US Presidet Bush ad US Treasury Secretary Paulso. It should be oted that from the begiig, there was little chace that the Schumer- Graham bill would get very far by threateig a geeral 27.5% puitive tariff o all Chiese imports if Chia did ot revalue the RMB. This is because the puitive tariffs would most certaily be ruled illegal uder World Trade Orgaizatio (WTO) rules of trade. A lesser oticed proposal is lyig i wake i US Cogress, which is ow cotrolled by the Democrats. The Grassley-Baucus bill, while still aimed at RMB s udervaluatio, operates withi WTO rules ad focuses o whether a coutry s currecy is misaliged. Currecy misaligmet will thus attract puitive measures, which iclude blockig the coutry s votig rights at the IMF ad limitig isurace ad guaratees for U.S. ivestors give by the Overseas Private Ivestmet Corporatio. The Grassley-Baucus proposal gets aroud a problem faced by other bills aimed at Chia, give that the US Treasury is geerally uwillig to label Chia as a currecy maipulator, as reflected i the most recet semiaual report i May 2006 despite tough stace by the Treasury Secretary Joh Sow. Uder curret rules, the Treasury is costraied by difficulties i provig that a coutry itetioally udervalues/maipulates its currecy. The Grassley-Baucus bill, however, suggests likig trade eforcemet actios o currecy misaligmet, itetioally or otherwise. With currecy misaligmet likely to be defied broadly to give much latitude to the US govermet, the Grassley-Baucus act would be eve more cotetious tha Graham- Schumer s versio ad exert more pressure o Chia. I additio, with the US Cogress ow i Democrats cotrol after the mid-term electios o 7 Nov, there are already sigs of leaig toward trade protectioism. The first amog which were plas by the Democrats to isert restrictive provisios ito 2 pedig trade deals with Peru ad Colombia, which would limit duty-free access to the U.S. market for goods made i those coutries that flout labour protectio practices. There are also plas to itroduce similar restrictios to pedig trade deals with South Korea, Malaysia ad Paama. While exteral pressure o the Chiese currecy is likely to remai itese i 2007 uder the Democrat-cotrolled US Cogress, we believe the Chiese authorities to stay its course i maagig its moetary policy, which has stability of the domestic ecoomy foremost i its mid. As such, we cotiue to see the RMB appreciatig at a restraied pace of 3-5% aually, with ed-2007 target at 7.47/USD ad 7.18 by ed

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