Wednesday, January 05, 2005

Back to the revaluation of the RMB. I know, I am tired of it too, but Wen said at the December Central Economic Conference that RMB exchange rate would maintain a "basic stability." So what does that mean.

While the international investor community expects a de facto appreciation of around 5-7% this year, I remain a bit skeptical. By de facto appreciation, I mean either a shift in the dollar peg upward of 5% or a switch to a basket peg that de facto revaluate the RMB by 5% vis-à-vis the dollar, but not the Euro. From the accounts of the recent Central Economic Working Meeting in December, it seems that Wen remains reluctant to change the exchange rate regime. There are good reasons to maintain the current peg.

Currently, the center is tackling the “three agriculture” problem. If successfully implemented—and there are signs that some aspects are successful--, these policies would decrease farmers' opportunity cost of remaining in the farms instead of seeking jobs in cities. That is, if their livelihood improves as farmers due to tax reduction, they have less incentive to seek jobs in the cities. This is already driving up labor costs and creating labor shortages in some places, although the precise extent is still unknown. Obviously, an appreciation of the RMB would further drive up labor cost in China and probably exacerbate employment pressure in the cities.

Second, the central government has used the foreign exchange reserve successfully to recapitalize the two state owned banks slated to go public this year. If the RMB appreciates, the central government would have to use a greater portion of its foreign exchange reserve to recapitalize ICBC and ABC. It would make sense to wait until the recapitalization of ICBC and ABC before revaluating the RMB.

Of course, the Chinese government also wants to surprise the international community, as it did for the interest rate increase last year. So, it is really anyone’s guess when they would revaluate.

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