The revaluation debate has been far from Sino-centric, with the issue of China's interest in having a more flexible set of exchange rate arrangements largely obscured by discussion of the needs of the United States. Despite what some would believe, the value of the renminbi will be determined by what happens in Beijing not Washington. That said, the definition of China's self-interest is a broad one.
It is the stated policy of the PRC authorities to move to more flexible arrangements. Leading financial officials in Beijing understand the need for liberalisation. Dr Yang Gang, head of monetary policy at the People's Bank of China (PBOC), wrote two years ago "as a large economy, China must have full monetary policy autonomy. This implies the country should move towards a flexible exchange rate as it integrates into the global economy."
State Administration of Foreign Exchange (SAFE) head Guo Shuqing recently made it clear that while maintaining "basic stability" in the currency is a long-term policy objective, China will take steps to improve the exchange rate formatting mechanism, including widening the trading bands.
In fact, the current official line of "maintaining basic stability in the exchange rate" closes the door on a large move in the renminbi, but leaves the window open for a more gradual adjustment.
The question is the sequencing and timing of such moves. The three critical factors driving that are:
¤ financial restructuring;
¤ commodities; and
¤ overheating.
Policymakers have mapped out a three-year plan to reform the banking system before full WTO compliance in 2006. Regardless of WTO, it is also critical that the capital allocation process become more efficient and prevent the kind of over-lending that threatens economic and financial stability through over-investment in real estate and infrastructure. An efficient capital allocation process ultimately needs exchange rate and capital account liberalisation.
Interest rate liberalisation and banking reforms have already started to gain momentum. Over the next two to three years, lending rates should be fully freed up and controls over deposit rates relaxed.
SAFE also plans to increase gradually the number of participants and introduce more products for investment and hedging purposes in the onshore FX market. Combined with progress on banking reforms, this should improve the infrastructure needed to operate a flexible exchange regime.
This three-year timetable suggests that policymakers feel under no pressure to move short-term on the exchange rate. Any move to a free-float or a basket is unlikely to come about until further progress has been made on restructuring. However, taking the first step - probably a gradual widening to +3%/-3% from the current +0.02%/-0.02% is less hamstrung by the reform timetable.
If policymakers feel that good progress is being made, then moves to a more flexible currency policy can be brought forward. There is no doubt that financial restructuring is the number one policy priority for China this year, and rapid progress could precipitate an earlier than expected adjustment in the currency.
Medium to long term, commodities will be important on exchange rate thinking. China is becoming an increasingly large strategic importer of commodities. With limited self-sufficiency in key commodities, such as oil and copper, China will need a stronger currency to improve its terms of trade. Against a backdrop of a secular increase in commodity prices, and with US dollar weakness likely to last medium-term, the importance of commodities in FX policy cannot be ignored.
We think that, given inflationary pressures are concentrated in the non-tradable sector, a revaluation is not the perfect tool. If China does move to a basket, we see no requirement for a major re-balancing of reserves.
Cyclical forces dominate again
Between early November and early January, the FX market appeared to focus primarily on structural imbalances as the driver for prices. Now, however, cyclical factors have resurfaced, with monetary policy changes in various countries (Canada, Norway and New Zealand, among others) causing significant FX market reactions.
The focus on the structural imbalances in the US in the final part of last year meant that the dollar fell, despite signs of accelerating growth. The dollar was under pressure, despite strong US economic data, because of fears that a cyclical recovery would only serve to exacerbate the current account imbalance, especially with the Fed seemingly committed to keeping policy very loose for a protracted period.
Over the past weeks, however, cyclical factors seem to have become more important again. In particular, actual or expected monetary policy moves have driven significant changes in FX rates.
For sterling, an interest rate increase materialised, as the economic data (retail sales, Q4 GDP, CBI industrial trends, Gfk survey) have all been strong. In addition, the political risks have passed and, if anything, the Hutton report has bolstered the government's authority.
While we remain concerned that the structural imbalances in the UK economy will cause problems in the longer term, these are not the market's primary focus at the moment and the apparent attractions of the UK - strong economy, relatively high and rising yields and political stability - are likely to dominate.
It became clear when the Japanese released their intervention data for January that they have no intention of letting the yen appreciate markedly. After years of under-performance, the banks have been doing well since the summer of last year, as the yen has appreciated.
The yen buying seen in the portfolio inflows seems to reflect a belief in Japanese recovery and re-structuring, and is unlikely to be quickly reversed. This suggests that upward pressures on the yen will remain over the coming months.
The fundamental support for the Canadian dollar has largely evaporated. Recall a year ago? Canada was set to lead the G7 in growth. Monetary policy was on a tightening trajectory and interest rate differentials between Canada and the US were widening, attracting international capital flows. Prime Minister Chretien's legacy budget was stimulative, resulting in a currency-friendly policy mix.
The picture now is nearly opposite. The Bank of Canada has reduced rates three times since mid-2003. As for interest rate differentials with the US, these have now narrowed considerably.
This report has been compiled by HSBC Bank Malta plc on the basis of economic research carried out by HSBC International Bank's team of economists and financial analysts.