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Economics: China Economics – Markets – Strategy CN: Re-thinking CNY appreciation • Evidence since Jul 21, 2005 suggests appreciation of the CNY has neither curbed the trade surplus nor tamed inflation. On the contrary, it has complicated the management of monetary policy. Appreciation has not only invited more hot capital inflows, but encouraged the growth of foreign currency loans • It is difficult to control lending without raising the cost of capital amidst an inflationary environment. Higher reserve requirement ratios and the imposition of a credit quota have not controlled loan growth • In light of our upward revision on Fed funds rate and a 6.5% 2008 inflation forecast for China, we now expect benchmark lending rate hikes (of 27bps each) in 4Q08, 1Q09 and 2Q09. Should this happen, the pace of CNY appreciation must be slowed down sufficiently to around 3%-4% in 2009 to reverse the ‘appreciation expectation factor’ • While this may be unappealing to the market now, the risk of not changing the policy mix soon would inevitably lead to more aggressive rate hikes in the future CHINA Exports to the US and EU have been declining Negative income shock hurts exports more than a strengthening CNY There is little evidence to suggest that the narrowing in China’s trade surplus so far this year is attributable the appreciation of the CNY. While a strong currency – on top of rising material and labor costs – have probably hurt exporters, most of the pain has probably come from the global slowdown. Exports to the US and EU have been declining (Chart Chart 1: China exports by destination 1). The Asian financial crisis % YoY, 3mma 70 in 1998 and the bursting Asia EU USA of the ‘tech bubble’ in 2000/ 01 demonstrated that China’s exports suffer when its 60 50 trading partners experience economic downturns. For 40 instance, China’s export growth dropped to 0.5% 30 in 1998 and 7.0% in 2001 from 21.0% in 1997 and 28.0% in 2000 – suggesting that a ‘negative income 20 10 shock’ could be an effective 0 tool to curb China’s trade Apr-00 surplus. Apr-02 Apr-04 Apr-06 Apr-08 Chris Leung • (852) 3668 5694 • chrisleung@dbs.com 70
Economics – Markets – Strategy Economics: China There is considerable academic evidence that the rising value of the CNY tends to reduce imports rather than to increase them. Econometric estimation of China’s import elasticity always results in a ‘negative’ sign in studies from organizations like the World Bank, the IMF and the BIS. These studies reflect the dominance of ‘processing imports’ included within China’s total imports (more than 50% in 2007) as well as the ongoing vertical integration with the rest of Asia. So tradable goods produced by Asian economies complement China’s exports to a greater extent than substitutes. Put simply, if exports decline due to a strengthening CNY, this will be counteracted by a corresponding reduction in imports. CNY appreciation tends to reduce imports, rather than to increase them Does CNY appreciation slow inflation? The claim that inflation can be tamed through currency appreciation is increasingly unconvincing. Headline CPI averaged 8.0% YoY in 1Q08, up significantly from 2.7% in 1Q07. Both inflation indices, CPI and PPI, have shown highs of 8.5% YoY and 8.1% YoY respectively in Apr 2008 despite the faster pace of currency growth (Chart 2). Indeed, evidence suggests little relationship between them since Jul 21, 2005. NEER shows that CNY only grew 5% between Jul 2005 and Apr 2008. In real effective exchange rate or REER terms the figure is around 9% (Chart 3). Chart 2: Inflation % YoY 11 CPI 9 7 PPI 5 3 1 -1 -3 -5 Latest: Apr08 -7 Oct-99 Feb-01 Jun-02 Oct-03 Feb-05 Jun-06 Oct-07 Chart 3: CNY REER Indexed 2000=100 125 120 115 110 109 105 100 95 90 85 80 75 1990 1993 1996 1999 2002 2005 2008 Food and energy prices are still the wild cards It remains unclear, however, whether inflationary pressures will result in the CPI falling below 5% YoY in 2H08 from 8% in 1H08. At this time, many economists predict that prices will start to stabilize in 2H08, basing their arguments on the ‘high-base’ effect carried over from 2H07. However, the Sichuan earthquake tragedy may put upward pressure on food prices over the next few months as pork, rice, wheat and corn account for 10.4%, 7.3%, 4.2% and 3.5% respectively of the nation’s gross output. Even if consumer inflation stabilizes, the currency can’t do much until food supplies return to normal. A stronger CNY will not help to lower food prices when shortages are due to domestic factors. CPI-based inflation in 2H08 looks set to range within 6.0%-7.0% YoY compared with 8% in 1H08. And inflation for the whole of 2008 could be at least 6% YoY - much higher than the official projection of 4.8%. Even if CPI stabilizes, normalization of food supplies will take more credit than the currency factor 71
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