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The most likely scenario is that China will gradually widen the trading band for the Renminbi. China is grappling with political pressures and may be compelled to appease their critics with a marginal compromise. Political pressure has only intensified in recent months, with a bipartisan group of Senators calling for a 27.5% tariff on all products from China to force a revaluation. Europe, Japan and the US have already imposed marginal restrictions and tariffs on certain Chinese imports. We expect China to be comfortable with at least a 1%-5% revaluation, but by no means will China allow for a 40% appreciation in the Renminbi in one year. Also, a moderate
revaluation will not significantly hurt exports. Foreign corporations have invested billions of dollars in partnering with local firms or building factories in China. A moderate revaluation would not significantly hurt the competitiveness of Chinese exports or threaten the outsourcing advantages that foreign corporations are currently benefiting from, forcing them to move their factories/businesses to countries with more inexpensive labor. China would finally be carrying a bit of the USD depreciation, making this choice the most equitable for everyone. A hint that this scenario may be their preferred choice comes from an unconfirmed statement by a "local monetary source" that China is planning a 30% revaluation of the Renminbi over the next five years. If China elects to widen their trading band marginally, speculators will probably push USD/CNY down to the bottom of the new trading band. While this might be the simplest solution to implement, it is also an extremely risky one. Much of a country's ability to fix its currency depends on its credibility to leave it fixed at that rate. Even a minor revaluation of 5%, for example, might lead speculators to believe that more revaluations might follow, |
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and thus encourage them to buy yuan. The PBoC would then have to purchase more and more dollar-denominated assets, leading to a further widening of its trade deficit with the US. As speculators observe the increase in China's currency reserves, they might become increasingly convinced that revaluation is in order, leading to a vicious cycle in which China might eventually have to abandon its peg. As we have already seen, a sudden return to a free-float would probably result in some severe economic shocks.
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