Flash Comment - China: Revaluation is not off the table

• The European debt crisis has probably postponed a Chinese revaluation into Q3, although we cannot rule out this will happen ahead of the G20 heads of state meeting scheduled for late June.

• In the forward market a Chinese revaluation has now largely been put off the table and it has now become very cheap to insure against a Chinese revaluation. We particularly recommend hedging CNY expenditure in 2011.

Growth still appears to be solid

The recent turmoil on financial markets has probably postponed a Chinese revaluation but we believe a revaluation is certainly not off the table. This in our view was the main message from the Strategic & Economic Dialogue Meeting between the China and the US, closing in Beijing yesterday. Exchange rates was discussed at the meeting and overall comments do not suggest a major disagreement on the exchange rate issue. The message from China to the US yesterday was that it would eventually move on the exchange rate. In its recent statements The Peoples’ Bank of China (PBoC) has indicated that China would soon return to an “adjustable exchange rate with reference to a basket of currencies.” This would basically be a return to an exchange rate policy started in July 2005 and effectively ended in late-2008.

European debt has become a major concern. The Chinese leadership fears that the impact on Chinese growth from the European debt crisis could hit with a ‘double whammy’ of domestic tightening and slower global growth – as it did in 2008. In addition the effective CNY exchange rate has appreciated by close to 4% since early May, mainly on the back of a stronger US dollar, weakening the case for an appreciation of CNY.

Hence, the Chinese leadership will probably be cautious and both an interest rate hike and a revaluation has probably been postponed to Q3, although we can still not rule out a revaluation ahead of the G20 meeting scheduled for late June. In our view, there still is a significant political payoff by resuming the appreciation process, particularly ahead of the mid-term election in the US on November 2 and Chinese president Hu Jintao’s visit in November/December. That said considerable uncertainty remains. However, longer term this uncertainty will mainly be reflected in the pace of appreciation against the US dollar.

Implications

Our main message is that it has now has become very cheap to buy insurance against a Chinese appreciation. The USD/CNY non-deliverable forwards basically no longer discount any appreciation of CNY against USD on one- and three-month horizons. 12- month NDF now only implies a 0.9% appreciation of CNY against the dollar. We have argued that despite our expectations of Chinese revaluation there were really no strong arguments for hedging CNY expenditure as our expectations were largely discounted in the forward market. This is no longer the case. CNY in our view now looks cheap on the forward market. Remember in the worst case scenario (with the financial crisis intensifying further) CNY would likely be left unchanged against the dollar. Hence, the current forward premiums are a modest price to pay for the considerable appreciation potential against the dollar. Particularly longer term, as admittedly there is considerable uncertainty in the short run..