The prospect of currency gains has long been a key attraction for investors seeking exposure to Chinese assets. But this week, The People’s Bank of China said China’s currency, the renminbi, was now close to its “equilibrium value.” We think the currency’s appreciation is far from over, as my colleague Anthony Chan explains below.
The Renminbi Remains Undervalued
The People’s Bank of China (PBOC) appears to be reacting to the recent reduction in China’s trade surplus. The surplus has shrunk in recent months, and in February, China posted its biggest monthly trade deficit since 1989. This was partly due to economic weakness in Europe and other developed markets, which dampened demand for China’s exports. At the same time, rising energy and commodity prices have boosted the price of imports, hurting China’s terms of trade. The recent decline in the trade surplus, coupled with increased capital outflows from China in the second half of 2011, has slowed the growth of China’s vast hoard of foreign reserves, easing upward pressure on the renminbi (RMB).
But we think those focusing on February’s trade deficit are missing the big picture. The February data was distorted by the timing of China’s week-long Lunar New Year holiday, which tends to cause a seasonal drag on China’s trade balance early in the year. If history is a guide, the trade account should improve noticeably in the second quarter.
We expect that China’s trade surplus will continue to hover at around 2% of GDP (or US$150 billion) in 2012—and possibly even more if oil prices ease or export demand improves as the year progresses. As such, the fundamentals will continue to support a stronger, rather than weaker RMB.
Since China loosened the shackles on its exchange rate in mid-2005—moving from a fixed rate to a “flexible” system—the RMB has appreciated around 20% against a trade-weighted basket of major currencies, as the Display below shows. Over the same period, the country’s foreign reserves increased more than fourfold, as the PBOC bought huge quantities of foreign currencies (primarily US dollars) to slow the RMB’s rise. This suggests the currency still has plenty of catching up to do.
We also expect further currency appreciation because it helps China to rebalance its economy from excessive dependence on export growth. Chinese policy makers are aiming to reduce China’s dependency on export growth by boosting domestic consumption. A stronger RMB can help facilitate this transition in China’s growth model by making imports more affordable to Chinese consumers.
In addition, a stronger currency can help suppress inflation. This is especially important given rising energy and commodity prices. Asia is now the biggest consumer of oil and commodities in the world, with China accounting for the largest share. Stronger Asian currencies help reduce the burden of these energy imports.
And last, as China continues to liberalize its financial sector we expect foreign direct investment to increase. Inflows of foreign capital—attracted by yields that are significantly higher in China than in the developed world—are likely to put continued upward pressure on the currency in the years to come.
The bottom line? Despite any talk to the contrary, we think the RMB is set to continue appreciating at a moderate pace in 2012—and beyond.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
Hayden Briscoe is Director of Asia Pacific Fixed Income and Anthony Chan is Asian Sovereign Strategist—Global Economic Research, both at AllianceBernstein.