In early 2010 when China announced it would allow the RMB to appreciate, we fielded a number of phone calls from readers curious to know what kind of percentage changes western buyers might expect. Back then we suggested the changes would come only incrementally and certainly only within single digits. Depending on where one sits, the currency still appears anywhere from 24-40 percent undervalued relative to other currencies.
But no matter, the news this week has come somewhat as a surprise as China allowed the RMB to appreciate 0.72 percent against the dollar, according to the New York Times. So the question we now ask is why have the Chinese decided to finally appreciate its currency and what will likely happen in the future.
First, a look at the currency exchange rate vis-ÃƒÂ -vis the dollar since the beginning of 2010:
Source: Trading Economics
From our vantage point, we see three points of rationale supporting China’s move to tinker with its currency. The first rationale centers on a widening trade gap of $133.4 billion for the first half of this year versus a $119.4 billion gap during the same time last year. This gap grew “despite repeated U.S. and Chinese government pledges to bring trade into balance, according to the Reuters article (link above). The move by the Chinese, then, may signal its acknowledgment with the release of trade data that its currency policies have not gone far enough. A second rationale suggests China’s foreign exchange reserves may have placed international pressure to adjust exchange rates. China’s foreign exchange reserves grew by $350 billion during the first half of this year, according to the Times.
However, the third rationale behind the move represents the deciding factor in our opinion. The move to appreciate the RMB, at its root, centers on the need to stem runaway inflation currently reported at 6.5 percent for the month of July and according to the Times, “at the same time, China’s exporters are showing unusual strength despite economic weakness in the West. In other words, it has become both politically necessary and expedient to make the tweaks. Inflation has become untenable within China. We know this both anecdotally (our own liaison office in Shanghai requested cost of living adjustments) and quantitatively as the chart below shows:
Source: Trading Economics
The real question on our minds now involves the mid- to longer-term where will China take its currency going forward? Fearful of upsetting its export lifeline, the PRC will continue to tinker at the corners. We still don’t see any big adjustments coming anytime soon. All of this of course will add to the pressure on Washington to act on a currency reform bill still making its way through Congress. But given the state of American national politics, we wouldn’t hold our breath.