Market Outlook - BNP PARIBAS - Investment Services India

domestic-demand led one is underway, but will take
many years. Similarly, central to the retooling of the
Chinese economy is the development of a deep and
liquid domestic bond market able to intermediate
capital and price risk. This is also many years away.
Diplomacy is letting someone have it your way
It is clear to us that Beijing’s decision on the peg will
be taken in the national interest, and not in response
to outside pressure. But, where these coincide, it will
be in Beijing’s interest to try to extract whatever it can
from the situation rather than revaluing unilaterally. In
that respect, the G20 forum is likely to become a
focus for negotiation, with China holding out the
prospect of a stronger CNY, perhaps in return for a
much greater say in the IMF. While there is scope for
movement around the Toronto meeting in June, more
likely perhaps is the November meeting, to be held in
Seoul, firmly within Beijing’s sphere of influence.
Assuming that the decision is taken to revalue –
whether for economic or political reasons – what
form is the revaluation likely to take? A stronger than
expected global recovery would suggest a more
robust export sector more able to take the pain of
faster appreciation. This scenario might see a one-off
minor revaluation of 2-3% followed by a relatively
steep 5% annual pace of appreciation. A slower
recovery might see a slower pace of appreciation,
without an initial jump. If the global recovery were to
stall completely, the postponement of any move
should be viewed as more than a possibility.
On the issue of trade balances: expectations are that
a shift in the currency will restore some balance to
global trade. However, the original de-peg in July
2005 led to a 17.5% appreciation of CNY over a 3-
year period; over the same period, China’s trade
balance soared (Chart 7). Thus even a relatively
significant appreciation might be expected to leave
trade balances largely unaffected.
However Beijing’s inherently cautious approach
implies that a large one-off revaluation of 10% or
more is unlikely: our favoured scenario is a return to
a crawling basket peg in the second half of this year.
Initially the ‘basket’ is likely to be composed almost
entirely of the USD, with a shift to a more tradeweighted
basket to be slowly implemented over a
period of years.
Is China changing its reserve status?
When China re-valued its exchange rate in July
2005, currency reserve growth only paused for a
short period. In fact, in 2006 reserve growth
accelerated once again despite the currency moving
closer to is equilibrium. Indeed, the crawling peg
invited investors to move hot money into China in
expectation of further currency gains. In addition, the
USD mn
Chart 7: Trade Balance vs USDCNY in 2005
50,000
40,000
30,000
20,000
10,000
0
-10,000
-20,000
Jan-04
Jul-04
Jan-05
Source: CEIC, BNP Paribas
15%
10%
5%
0%
-5%
-10%
-15%
-20%
Trade Balance
Jul-05
Jan-06
Jul-06
2005 appreciation was not accompanied by a change
in the growth composition in China. China continued
pushing export capacity growth, running an
increasingly productive supply-oriented economy.
This constellation triggered capital inflows while
bringing about continued export surpluses and
domestic savings. Unsurprisingly, the trade surplus
widened and so did currency reserves.
The difference between 2005 and 2010
Now the situation is different. Export capacity is no
longer being pushed; rather, all the emphasis is on
promoting domestic demand. The composition of
China’s economic growth is in transition and this
transition will reduce foreign surpluses and domestic
savings. A side effect of this development will be that
China no longer acts as the anchor for global
inflation. Instead, China will inflate prices for tradable
goods as it will reduce their supply by using an
increasing share of its production domestically.
Hence, there is a fundamental difference between
the China of 2005 and the China of today. This
difference has been generated by the global crisis or,
more specifically, by the implosion of China’s export
markets. In 2005, China was able to rely on
continued demand for its products in global markets
due to booming Western demand. However, the
Jan-07
USDCNY (RHS)
Jul-07
Jan-08
Jul-08
Jan-09
Jul-09
Chart 8: EURUSD vs Asian FX Reserves*
Jan-08
Apr-08
Jul-08
3-Month change in
EURUSD (LHS)
Oct-08
Jan-09
Apr-09
Jul-09
Oct-09
3-Month change in
FX Reserves* (RHS)
8.5
8.0
7.5
7.0
6.5
6.0
7%
6%
5%
4%
3%
2%
1%
0%
-1%
Source: BNP Paribas *Asian Reserves are FX-Adjusted Reserves of
China, India, Japan, Korea, Thailand & Singapore
Rob Ryan 29 January 2010
Market Mover, Non-Objective Research Section
49
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