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It’s still anyone’s guess as to if and when China will allow the Yuan (RMB) to continue appreciating. You can see from the chart below – which shows the trading history for the RMB/USD December 2010 futures contract – that expectations of revaluation have eroded steadily since December 2009. At that time, it was projected that that Yuan would finish 2009 at 6.57 RMB/USD, 4% higher than the current level. Fast forward to the present, and investors now only expect a modest 2% appreciation rise on the year.

What’s behind the change in expectations? The answer is a combination of economics and politics. On the economic side, China’s trade surplus is much smaller than in recent years, as import growth outpaces export growth. “Double-digit annual growth in exports is all but assured in coming months due to a low base of comparison in early 2009, but…sequential growth momentum went into reverse in January, with exports down 16 percent from December.” Moreover, while GDP growth appears strong, it appears tenuously connected to exports and fixed-asset investment. In addition, if the Central Bank of China raises interest rates to counter property speculation, it will have even less room to maneuver in its forex policy if it wishes to maintain high GDP growth. In terms of politics, the CCP doesn’t want to lose a crucial bargaining chip in international relations, and it also doesn’t want to mitigate the threat to its political legitimacy posed by a prolonged economic slowdown.

On the other hand, China still desires to turn the Yuan into a global reserve currency, again both for economic and political reasons. In order to accomplish such a feat, one of the prerequisites would be dual convertibility. Financial institutions and foreign Central Banks are still extremely reluctant to hold RMB currency since it’s difficult to convert into other currencies. “Citing data from the Bank of International Settlements (BIS), it [Citigroup] said the renminbi’s share in the global foreign-exchange market turnovers was only 0.25 percent in 2007, ranked 20th in the world and fifth among Asian emerging-market currencies.” This is pretty incredible considering that China’s economy is the world’s third largest, and will only change when the exchange rate regime is loosened.

While some analysts predict that the Yuan will continue rising as soon as next month – and at least by a slight margin for 2010 – the modest pace of appreciation will ensure that China’s foreign exchange reserves continue to grow. They are currently estimated at $2.4 Trillion, and while their composition is largely a secret, analysts estimate that more than 2/3 is denominated in USD-denominated assets. Recently, there was a perception that China had begun to diversify its reserves out of Dollars, as US Treasury data indicated that its Treasury purchases had all but stopped. As it turned out, China had merely moved to conceal its purchases by conducting them through a UK Bank.

The biggest threat to the USD posed by China is not an end to the RMB peg – for such is unlikely – but rather a change in its structure. Currently, the RMB is pegged directly to the Dollar, which means that the Bank of China MUST stockpile its trade surplus in USD-denominated assets, namely US Treasury securities. If the peg were to shifted to a basket of currencies, however, it would have more flexibility in the denomination of its reserves. Until then, China’s forex policy will continue to favor the Dollar.

Last month, I reported on how anticipation is (was) building towards a revaluation of the Chinese Yuan (RMB), confidently stating that “The only questions are when, how and to what extent.” While I’m not ready to recant that prediction just yet, I may have to temper it somewhat.

On the one hand, the case for RMB revaluation is stronger than ever. Among large economies, China’s economy is by far the strongest in the world, clocking in GDP of close to 2009% while most other economies were lucky to “break even.” Meanwhile, its export sector – supporting which is the primary purpose of the RMB peg – is once again robust, having recovered almost completely from a drop-off in demand in 2008 and the first half of 2009. In fact, exports grew by 30% in January, on a year-over-year basis. China’s share of global exports is now an impressive 9%, up from only 7% in 2006. From an economic standpoint, then, the case for an artificially cheap currency is no longer easy to make.

At the same time, the RMB peg is contributing to bubbles in property and other asset markets. That’s because the Central Bank of China has been forced to mirror the monetary policy of the Fed, as a significant interest rate differential would stimulate uncontrollable capital inflows from yield-hungry investors. While the US can still handle interest rates of close to 0%, China’s economy clearly can not. Thus, consumer prices are slowly creeping up, and property prices are soaring. The most effective (and perhaps the only) way for China to contain both consumer price and asset price inflation is to hike interest rates, which which in turn, would necessitate a rise in the RMB.

There is also the notion that the peg is becoming increasingly costly to maintain. China’s forex reserves already total $2.4 Trillion, and each Dollar that it adds will be worth less if/when it ultimately allows the RMB to appreciate further. In addition, China’s economic policymakers continue to fret about its exposure to the fiscal problems of the US, with one pointing out that, “China has effectively been kidnapped by U.S. debt.” Of course, they no doubt realize that there isn’t a better option at this point; its attempt to diversify its reserves into other assets proved disastrous. The solution to both of these problems, of course, would simply be to allow the Yuan to fluctuate based on market forces, or at least for it to resume its upward path of appreciation.

Political pressure on China to revalue, meanwhile, is even stronger than it was last month. While not invoking China by name, President Obama has been increasingly blunt about the need to pressure it on the RMB: “One of the challenges that we’ve got to address internationally is currency rates and how they match up to make sure that our goods are not artificially inflated in price and their goods are artificially deflated in price.” In addition, rumor has it that the Treasury Department could finally label China as a “currency manipulator” in its next report, which would allow Congress to impose punitive trade sanctions.

Developing countries, which now account for a majority of China’s exports, are also increasingly unhappy with the status quo. The peg to the Dollar caused many emerging market currencies to appreciate rapidly against the Yuan in 2009, and there is evidence that many of their trade imbalances with China are rapidly worsening, “with exports to India, Brazil, Indonesia and Mexico growing by 30% to 50% in recent months.” As one analyst pointed out, however, the potential backlash from this development could be massive: “It’s one thing to produce job losses in the U.S., but it’s another to produce job losses in Pakistan,’ with which China has close military ties.”

On the other hand, however, is China’s massive reluctance to allow the Yuan to appreciate. Part of this is related to face; with the US and other countries stepping up pressure on a number of fronts, China’s leaders don’t want to be seen as weak, and could act contrary to their own interests if it thinks it can earn political points in the process. “China is unlikely to make significant concessions to U.S. pressure on the yuan, particularly now when the two countries are involved in a range of disputes, including U.S. arms sales to Taiwan,” explained one analyst. More importantly, the leadership is nervous that the nascent economic recovery is not sufficiently grounded for the peg to be loosened. While 9% growth in most other economies would be cause for celebration, in China, it is being interpreted as evidence of fragility.

There you have it. Reason on one side, and politics on the other. Unfortunately, it seems that politics always triumphs in the end. Despite Treasury Secretary Geithner’s recent assertions that the RMB will rise soon, investors know that China ultimately calls the shots: “When it comes to the exchange rate, China’s main consideration is China’s own stable economic growth and the structural adjustment of its economy. Foreign pressure is only a secondary consideration.” In short, the RMB is now projected to appreciate only 2% in 2010, according to currency futures, compared to 3.5% last month.

The Chinese Yuan (RMB) spent all of 2009 pegged to the Dollar at 6.83. Since the Dollar depreciated against almost every other currency during that time period, the Yuan has fallen against these currencies, undoing most of its appreciation in 2008. As a result of both international pressure and internal economic conditions, however, the Yuan’s stasis should come to an end soon. The only questions are when, how and to what extent.

In hindsight, the Central Bank (i.e. state economic planners) of China were probably justified in holding the Yuan in 2008. At a time when forex markets (and other capital markets, for that matter) were behaving erratically, the Yuan was a baston of stability. China’s premier, Wen Jiabao, recently boasted, “Keeping the yuan’s value basically steady is our contribution to the international community at a time when the world’s major currencies have been devalued.” In fact, there is evidence that the Central Bank went against market forces in the opposite direction during the height of the credit crisis, and successfully prevented the Yuan from depreciating, thus proving that a currency peg can work both ways. The result was price stability, and a boost to exporters that had been damaged by the falloff in foreign demand for Chinese goods.

With the global economy emerging from recession, the argument for maintaining the peg is becoming less tenable. China’s economy, itself, grew at an impressive 8.5% in 2009, and is forecast to grow even faster in 2010, by 9.5%. Thanks to a surge in bank lending and the government’s massive economic stimulus program, inflation is also ticking up. It has been approximated at 2.5%, but is contradicted by spikes of 50%+ in the prices of certain staple goods, and certainly doesn’t take into account the rise in asset prices. China’s benchmark stock market index surged 90% in 2009, and property prices increased by 30% in some areas.

The dual concerns, of course, are that the money supply is expanding too fast and that bubbles are forming in certain asset markets. The weak RMB is certainly not helping either. Thanks to relaxed capital market controls and expectations of further appreciation, speculative “hot money” is once again pouring into China. Holding down the Yuan in the face of such pressure is becoming prohibitivel expensive: “China’s foreign-exchange reserves climbed 17 percent in the first nine months of 2009 to $2.27 trillion, the world’s largest holdings.” Some of the demand is naturally being tempered by bubble concerns, but the trend is still money coming into China.

There is also the argument, much mooted in economics circles, that an appreciation of the RMB would be good for the Chinese economy. Because of a perennially weak currency, its economy has become to addicted to exports to drive growth. “As a report from research firm Euromonitor International notes, in U.S. dollar terms, China’s consumer market lags those of the U.S., Japan and much of Europe, with private consumption just over one third of GDP in 2008.” This is probably a product of social and cultural forces, which still emphasize saving. Skeptics of the usefulnes of RMB appreciation point out that rebalancing the Chinese economy would start with changing the culture of saving, but a stronger currency would certainly provide a powerful incentive. Not to mention that a more valuable RMB would give Chinese companies more leverage in consummating outbound corporate M&A deals and natural resource acquisitions that they have been so keen on in recent years.

On the other side of the debate are skeptics of a different sort- those that think RMB appreciation is justified by forward-looking macroeconomic fundamentals. Some fear hyperinflation of the sort that China faced in 2007 and was only brought under control by the global economic recession and concomitant decline in resource prices. “Franklin Allen, a professor of finance at Wharton [University of Pennsylvania], estimates the likelihood of inflation reaching between 10% and 20% to be around one in five.” Any inflation beyond what is experienced in other economies would have to be reflected in the RMB. In a hyperinflation scenario, the Central Bank might even have to deliberately depreciate the currency.

Then there are the skeptics that forecast an economic crash in China. James Chanos, a wealthy hedge fund manager is leading this chorus, “warning that China’s hyperstimulated economy is headed for a crash, rather than the sustained boom that most economists predict. Its surging real estate sector, buoyed by a flood of speculative capital, looks like “Dubai times 1,000 — or worse.’ ”

While this view is gaining some traction, it is still relegated to the minority. Investors and economists are now operating under the firm assumption that China will allow the RMB to resume its appreciation soon. As for when, it could be any day, though probably not for a few months still. As for the questions of how and to what extent, some economists have argued for a one-off appreciation (10% has been suggested) in order to discourage future inflows of speculative capital. Most analysts, though, expect the rise to be gradual. Futures prices currently reflect a 3% rise over the next year, and the consensus among economists is similar. It also depends on how the Dollar performs over the near-term: “If better-than-expected growth in the U.S. helps the greenback recover this year…That would take some of the pressure off Chinese policy makers.”

Personally, I think expectations of a 3-4% rise over the next twelve months are pretty reasonable. The Chinese government doesn’t have much to gain (neither politically nor economically) from a rapid appreciation in the currency, so if/when the RMB rises, it will probably only be in “baby steps.”

Subtle title, right? I couldn’t resist, considering that literally all economists and government officials (outside of China, of course) have sounded off on the Chinese Yuan in the last month. Recent additions to this list include President Obama, Chiefs of the IMF and World Bank, President of the Asian Development Bank, US Commerce Secretary Locke and Treasury Secretary Geithner, Nobel Laureate Paul Krugman, ECB Chief Jeane-Claude Trichet, Harvard University Professor Martin Feldstein, Japan’s finance minister…not to mention the thousands of others that didn’t make international news for their denunciation of China’s currency policy.

This rhetoric has also been accompanied by several important developments, including a Presidential visit to China, several meeting of the G20, a summit in Singapore, a slight change in the wording of China’s forex strategy, the release of economic data that suggest China’s economy is strengthening, etc. At the same time, their remains an obstinate  insistence from every corner of the CCP that despite this pressure, there are no imminent plans to further revalue. Investors are erring on the side of appreciation, however, and futures prices reflect a 3.5% rise in the value of the RMB over the next 12 months.

This disconnect is indicative of the fact that there is both a political and an economic side to this issue. When examined exclusively from either side, it looks like pretty cut-and-dried, since economics suggests that a revaluation is both necessary and desirable, but the misalignment of political interests suggests that it won’t be carried out any time soon.

More specifically, a chorus of economists (backed by hard data) is arguing that the RMB is one of the foremost causes of the widening imbalances. After a brief hiccup, China’s trade surplus is once again expanding, and is on pace to reach $300 Bill ion in 2009, more than half of which can be attributed to the US. Meanwhile, while GDP is projected at 10.5%, the rest of the world is still sputtering along. “China is ’stealing’ jobs from developing countries and hindering a global recovery by keeping the yuan low, Nobel laureate Paul Krugman says. ‘China’s bad behavior is posing a growing threat to the rest of the world economy.’ ”

Economists also argue that a revaluation would also be in China’s own best interest. Foreign capital is now pouring into China at a record pace – largely in anticipation of an imminent appreciation in the Yuan – such that asset prices have almost doubled over the last year. “Risks of asset-price bubbles and misallocation of resources amidst abundant liquidity need to be addressed,” said the Chief Economist from the World Bank. Echoed the head of the IMF: “An undervalued currency encourages companies to invest in ways that may not be viable once the currency rises. ‘If you have wrong prices, you make wrong decisions, especially concerning investment in the long run.’ ”

Foreign politicians, especially those from the US, have been hammering these points home. President Obama made the RMB a key issue during his visit to China this week. Senator Chris Dodd chimed in with his two cents, that “You can’t give your competitor, your adversary in this case, a 40 percent advantage in global economies.” As analysts pointed out, the US, unfortunately, doesn’t have any leverage on this issue, as it is basically dependent on China to fund its budget deficits through Treasury Purchases. Thus, Chinese Prime Minister Hu JinTao couldn’t even be bothered as to so much mention the RMB when summarized the meeting with Obama for reporters.

Other Chinese Ministers rebuffed reporters in separate sessions who even dared to bring up the RMB: “Any policy changes by China, including on the exchange rate, will be based on its assessment of its own interests, not on external pressure.” Meanwhile, “Chinese officials refused to sanction a statement at the Asia Pacific Economic Co-operation summit in Singapore that would have pressed it to adopt ‘market-oriented’ exchange rates for the yuan.” In fact, they have begun to push back against criticism, by arguing that a weak Yuan has actually been economically beneficial. “China keeping a basically stable exchange-rate policy is, in reality, good for the global economic recovery,” argued the Minister of Commerce .

This political/economic dichotomy is also evident within China. The Central Bank recently changed some of the language which governs its forex policy; going forward, the Yuan will apparently be tied to a basket of currencies, with its value also influenced by trends in capital flows. However, “The central bank’s position is getting a determined push-back from manufacturers and exporters –especially along China’s wealthy coast –who stand to reap significant gains in the short term.” Given that the decision to lift the RMB will ultimately be made in the political arena, it’s understandable that the latter group has such a strong bearing on the process.

As I indicated above, investors are cautiously optimistic that the government will eventually relent to its critics and allow the currency to resume its steady upward path. Futures prices have risen steadily since September, when they reflected a flat RMB over the next twelve months. According to one analyst, ” Officials may, starting in the second half of 2010, allow it to recoup the drop of about 10 percent on a trade-weighted basis it’s had since March.” Goldman Sachs, long respected for its economic forecasts, remains one of the lone naysayers, arguing that the Yuan isn’t going anywhere until at least 2011.

Personally, my money is an appreciation in the near-term, as soon as the first quarter of 2010. Chinese leaders are stubborn, but they aren’t stupid. It won’t be pressure from the US that will shake them from their moorings – but a further inflation of property and stock market bubbles and concerns over the economy’s unhealthy dependence on exports for growth.

The Economist recently published a special report on China and America (”Round and round it goes“). As the title suggests, the article described the increasing interdependency between the economies of the US and China. In a nutshell, China maintains an undervalued currency, in order to stimulate exports. The resulting overseas (American) demand puts upward pressure on the RMB, which China defuses by buying US Treasury securities. This results in artificially low US interest rates, causing American consumers to import more, putting even more pressure on the RMB, which is further defused by buying more US Treasuries. And the cycle continues ad nauseum.

The article focused primarily on the political side of this precarious relationship, at the expense of the financial implications. It got me thinking about the forex forces at work, and how a disruption in the cycle could have tremendous ramifications for currency markets. It’s clear that in its current form, this system keeps the Yuan artificially low, but does that means that the Dollar is also being kept artificially high.

Given the depreciation of the Dollar over the last six months, this seems almost hard to believe. Over the same time period, though, China (as well as many other Central Banks) have vastly increased their Treasury holdings. This would seem to imply that indeed, the Dollar’s fall has been slowed to some extent by the actions of China. It’s kind of a paradox; as US consumers recover their appetite for Chinese goods, the Dollar should decline. But as China responds by plowing all of those Dollars back into the US, then the net effect is zero.

As the Economist article intimated, there are a couple of developments that would seem to upset this equilibrium. The first would be if the Central Bank of China began diversifying its forex reserves into other currencies. By definition, however, it would be impossible for China to continue pegging the RMB to the Dollar without simultaneously buying Dollars. Thus, the day that China stops recycling its export proceeds into the US, the RMB would start to appreciate, almost instantaneously. In addition, the sudden surcease in US Treasury bond purchases would cause interest rates to rise. Both higher rates and a more expensive currency would presumably result in lower demand for Chinese exports, and hence eliminate some of the need to recycle its trade surplus back into the US. In this way, we can see that China’s Treasury purchases are actually self-fulfilling. The sooner it stops purchasing them, the sooner it will no longer need to purchase them.

I’m tempted to elaborate further on this point, but it seems that I’ve already taken it to its logical conclusion. China must recognize the dilemma that it faces, which is why it refuses to break from the status quo. If it allows the Yuan to appreciate, it will naturally face a decline in exports AND the relative value of its US Treasury holdings will decline in RMB terms. Both would be painful in the short-run. However, by refusing to concede the un-sustainability of its forex/economic policy, China is merely forestalling the inevitable. With every passing day, the adjustment will only become more painful.

In its semi-annual report to Congress, the Treasury Department once again failed to officially label China (or any country for that matter) a currency manipulator. No surprise there. While it’s self-evident that China manipulates the RMB (via the peg with the US Dollar), the political implications of such a label prevent it from being used except in the most extreme cases. Nonetheless, there is mounting pressure on China, both domestic and international, to “adjust” the peg and allow the Yuan to move closer to its fundamental value.

Most of the international pressure has been soft, coming in the form of roundabout pleas for China to allow the Yuan to float “for the sake of global stability.” Said one US Senator weakly, “I hope that with strong leadership from the United States, the G-20 nations and our international institutions will undertake what has been missing — a focused, sustained and meaningful multilateral engagement to address currency manipulation and current imbalances.” At the same time, some of this rhetoric has recently been translated into action. Last month, the Obama Administration enacted a 35% tariff on Chinese tire products. Other countries have also begun to raise concerns about Chinese dumping, and bringing their cases to the WTO for good measure.

Many of these countries are in fact suffering more than the US. Since the Yuan is effectively pegged to the Dollar, the decline of the latter has been mirrored by the former. Since many other currencies of developing countries are also fixed, this leaves only a handful to absorb the shock. For example, the Euro and Yen have both risen about 15% against the RMB over the last year, in line with their appreciation against the Dollar. The handful of floating currencies in the region, such as the Korean Won, Indian Rupee, Malaysian Ringhit, etc. have also faced strong upward pressure. For them, it is not so much the weak Dollar that they fear so much as the weak RMB, since China is a direct competitor to all of them.

More importantly, there are now voices within China’s ruling Communist party that have also begun to press for a stronger Yuan. The Nationalist camp, for example, is pressing for China to make the Yuan a more prominent currency on the international trade scene. While such doesn’t inherently require a floating currency (in fact, all of the trade/swap agreements involving Yuan are based on fixed exchange rates), a loosening of capital controls and liberalizing of financial markets would probably bring about a stronger Yuan.

The other group pushing for a stronger Yuan is doing so on more fundamental, economic grounds. Just-released 2009 Q2 GDP data showed prelimenary growth estimates of a whopping 8.9%! Not bad, especially when you consider that the rest of the world remains mired in recession. Chinese economists largely ignore the political implications of the notion that this growth probably came at the expense of the rest of the world, and focus instead on the economc implications.

First is that the economy remains hopeless dependent on exports to drive growth, which can only be remedid through a stronger Yuan. Second, it heralds the coming of inflation. Many foreigners continue to pour “hot money” into Chinese asset markets hoping to reap the upside from both asset and currency appreciation. In response, “Analysts say China could let the yuan appreciate to help restrain inflation, since a stronger yuan would reduce the cost of imports. But some caution that Beijing tried a similar strategy in early 2008, but didn’t achieve great success in containing inflation or stemming the inflows.”

While analysts don’t expect the Bank of China to allow the RMB to rise until after the Chinese New Year in January, investors are pricing in incremental appreciation every month beginning with the next. In fact, futures prices already reflect the expectation that the RMB will rise 3% over the next twelve-months. My bet is that this will be kicked off by another one-off appreciation, in the same vein as July 2005. Now as was the case then, China needs to make up for lost time.

I concluded my last post by promising to discuss the implications of a change in the status quo, regarding the Dollar’s role as the world’s reserve currency. As it turns out, the last few days have witnessed a few developments on this front.

First of all, the G7 concluded its latest round of talks. Despite previous indications to the contrary, the organization continued its practice of releasing a communique. in which it noted that global economic balances persist and that policymakers should work together to mitigate them. While seemingly benign and desirable, the proposition couldn’t have come at a worse time for the Dollar.

The only reason why the Dollar hasn’t collapsed completely is because economies largely continue to recycle their surplus wealth and trade surpluses back into Dollar-denominated assets. One columnist connects the dots with regard to the forex implications: “Less Chinese intervention to prevent yuan strength would mean China, slowly over time, would build up fewer dollar reserves.” In other words, economies no longer concerned with pegging their currencies would have very little reason to build up large pools of reserves.

In fact, China is fully on board with this notion. Following the G7 talks, Chinese officials announced that it would support a stronger Yuan as soon as the global economic crisis resolved itself. By its own reckoning, this would facilitate a shift in its economy, from one dependent on exports for growth to one focused around domestic consumption. Still, obstacles remain, and “It is far from clear how China can engineer a shift up for the yuan against the dollar, which analysts note would almost certainly translate into a gain against other currencies as well.”

Speaking of China, it is also among the most vocal of nations laboring for alternatives to the Dollar. Towards this end, it has reportedly formed a secret coalition with the other BRIC countries (Brazil, India, and Russia), as well as Japan. The goal is to end the pricing of oil in Dollars by 2018. That the group has given itself nine years to complete this task speaks to its extraordinary ambition.

The implications for the Dollar cannot be understated. A handful of oil-producing nations in the Middle East hold a combined $2.1 Trillion in Dollars, which are solely a product of selling oil in exchange for Dollars. Already, the government of Iran has mandated that in the future, all of its reserves be held in non-Dollar-denominated assets. Thus far, no other countries have followed suit. China is aware that pushing for further developments could roil the US, which would be unlikely to sit on the sidelines and watch its currency be summarily jettisoned. “Sun Bigan, China’s former special envoy to the Middle East, has warned there is a risk of deepening divisions between China and the US over influence and oil in the Middle East.”

Robert Zoellick, president of the World Bank, doesn’t harbor any illusions, and announced during a recent speech that the a decline in the role of the Dollar is inevitable. “He said the United States ‘would be mistaken to take for granted the dollar’s place as the world’s predominant currency. Looking forward there will increasingly be other options to the dollar,’ ” such as the Chinese Yuan and the Euro.

Zoellick’s warnings were prescient, when you consider that the IMF just announced that the share of Dollars in global foreign exchange reserves declined significantly in the most recent quarter, perhaps to its lowest share since the Euro was introduced in 1999. [The latter, however, has yet to be confirmed].  “The dollar’s share in global reserves declined to 62.8% from 65.0%…The euro’s share increased to 27.5% from 25.9%.”

JP Morgan’s research team has discovered a similar trend- that accumulation of US assets accounts for only half of the global increase in global forex reserves. “Quantifying this trend is always imprecise. But the circumstantial evidence — official buying of U.S. assets runs at only half of the pace of global reserve accumulation — suggests that diversification has accelerated since June.”

So, there you have it. The Dollar’s demise (to borrow a characterization by one of the columnists featured in this post) is no longer theoretical. It may have already begun…