RMB Appreciation

As discussed last week, it appears the RMB is poised to appreciate rapidly. This is from China financial markets:

According to a Bloomberg article today, the RMB was up 0.56% last week, reaching 7.456 to the dollar. This may not sound like a lot if you trade dollar/euro, but it is easily the biggest one-week jump in the US dollar value of the currency since it was suddenly revalued by 2.1% in July, 2005. According to a Bloomberg article, RMB forward contracts imply a price of 7.38 by the end of this year and 7.25 by the end of the first quarter. The article did not list the contract expiration date or a more precise RMB value, so my calculations may be slightly off, but this implies a 6.4% annual appreciation between now and the end of the year and a 7.0% annual appreciation between now and the end of 2008’s first quarter. Implied annual appreciation during the first quarter of 2008 is 7.3%.

Two reasons are generally given for the increase in appreciation rate, and both probably are true. The first, and more cynical, reason is that there will be a meeting later this month between Chinese finance officials and their European counterparts, along with a meeting between France’s President Sarkozy and President Hu, and everyone expects the currency to be a very important topic of these meetings. As they often do before such discussions, the Chinese authorities may be allowing the currency to appreciate to help deflect some of the expected anger. One of the claims much beloved of journalists and China-watchers is that foreign pressure on Chinese authorities is almost always counterproductive, a claim about which I am extremely skeptical.

The second reason for the more rapid rise in the currency is that the inflation scare is ringing serious alarm bells in Zhongnanhai (the leadership compound), even while publicly the authorities still insist that inflation is a one-off temporary food thing. Given the anxiety, it is striking to me that fuel prices were raised by nearly 10% last week and that there are rumors that other controlled prices may also rise. This can’t help but feed into inflationary expectations. I think the only thing that can easily explain the timing of such rises must be that the costs of the subsidies must be higher than the authorities are willing to support, although perhaps there is also a sense that they should get all the bad news out of the way as quickly as possible.

If market assumptions are correct and the RMB does begin to appreciate at 7.3%, with bank deposits yielding 3.8% you can earn 11.4% in US dollars if you can smuggle money into China and deposit it in a bank. Even the most intrepid of my hedge fund friends in New York wouldn’t sniff at those kinds of returns, especially since the biggest risk is upside risk – a sudden maxi-revaluation. There’s the problem – an obvious danger of speeding up the appreciation rate is that it might set off another wave of speculative inflows, thus pushing monetary conditions even more out of whack. Poor PBoC – dammed if they do, damned if they don’t.