Elite Chinese Politics and Political Economy

Noted economist and now entrepreneur Nouriel Roubini recently predicted a 10% RMB revaluation in 2006 (see quote below). I would have to respectfully disagree with him. While there will be revaluation in 2006, the magnitude will be much smaller than his prediction. My reasoning, briefly, is two-fold. First, there are powerful interests within the Chinese government against large-scale revaluation. Chiefly, I remain convinced that Premier Wen is against it because his main policy focus is a rise in rural welfare. In order to maintain the income of domestic farmers without a transitional disruption, RMB cannot appreciate too quickly, or domestic consumers would have a strong incentive to buy grain from abroad. His other main policy priority is maintaining employment, and a 10% revaluation would definitely have a marginal impact on that.

Is China going to worry about US protectionist measures? Sure they are, but they surely will not act until the threat of protectionism becomes credible. Right now, it remains unclear how far protectionists will get, as Roubini points out. Even with protectionist measures, China will still not move as dramatically as 10% because China will not appear as if it is caving in to foreign pressure. Neither Hu or Wen can afford to appear as such.

So how large will the revaluation be in the coming year? My guess is that it will be between 2.5% to 3.5%. They are allowing private banks to serve as market makers in the forex market, which gives the PBOC room to allow the RMB to slowly creep upward over the course of the year. There is an outside chance that US pressure will result in a revaluation of 5%, but that is the upper tail of the probability distribution. At the lower end, if there is a world wide recession (Roubini's other prediction), China might choose to slow revaluation below 2.5% to maintain the competitiveness of Chinese goods.

From: http://www.rgemonitor.com/blog/roubini/113485

"- China will allow its currency to appreciate by at least 10% and the rest of Asia, including Japan, will follow. In 2005, China moved its currency by 2.1% and then effectively repegged it - in spite of otherwise claims of more exchange rate flexibility. Thus, China continued to be the core of the BW2 periphery, maintaining this system of vendor financing of the US twin deficits alive. In 2006 China will move its currency by at least 10% for various reasons. First, protectionist pressures in the US will lead to a China move. If China has to choose between a 27% tariff slapped on its exports to the US or a 10% RMB appreciation that prevents this, it will go for the latter. Of course, chances of Schumer-Graham being voted, overrule a presidential veto and become law and then successfully avoid a WTO challenge are low. But, still China cannot afford having Schumer-Graham even being voted positively or having the US Treasury brand it as a "currency manipulator" in the spring assessment of its exchange rate regime. Thus, it will do what is necessary to avoid these politically dangerous outcomes. There are also domestic reasons - that I fleshed out in detail in the past - why China will move: the large expected losses on a fast rising stock of U.S dollar reserves; the need and desire to diversify such reserve holdings towards non-US dollar assets; the financial and real imbalances that partially sterilized intervention is causing in the Chinese economy such as the continuation of the credit, asset, investment and real estate bubble that risk causing a hard landing of the Chinese economy. So, China will realize that it is in its own interest to move its currency by a significant amount to engineer a soft landing - as opposed to a hard landing - of its economy. Note that, if China moves, the rest of Asia will also move. It is true that Chinese and Asian forex intervention in the last few months has been more moderate than in the early part of 2005 or in 2004 as the US dollar has been strong and the costs of dollar-shorting carry trades higher; but the factors that were keeping the dollar strong in 2005 are already fizzling out putting more appreciation pressure on China and other Asian currencies such as the Korean won or the Japanese yen. So, once China moves, the market reaction will be one of pressures towards Asian currencies revaluation of similar size as the Chinese one. And with the Yuan stronger, other Asians will be more comfortable to let their currencies appreciate as well. So, see the yen moving towards 100 by year end."