Chinese values

According to Jason Kindopp, China analyst at Eurasia Group, Beijing will revalue the yuan 6-10% within months and widen the trading band between 1.5-3% either side of the new rate. "Most people are saying the renminbi is about 20% to 40% devalued," Kindopp says. But where a free-floating yuan would land, he adds, is "anyone's guess."

But policy aside, what is the yuan's real worth?

Economist Joe Stiglitz argues it is in no way undervalued, and fine where it is.

One banker calls all the revaluation hype nothing but a product of political pressure. "There is no compelling [economic] reason for China to rush into revaluation," says Qu Hong Bin, China economist at HSBC in Hong Kong.

Ivan Chung, managing director of Xinhua Finance's ratings division in Beijing, says it's hard to tell where the yuan should be. "In terms of its current account position, China is only running a slight surplus with the rest of the world," he says. "While China is exporting a lot of low value-added products, it imports a lot of commodities like oil and copper [and] as it gets richer, it imports more high value-added items like aircraft and IT."

Mountains of reserves
That said, China's reserves keep piling up, and that means more pressure on maintaining the peg while trying to contain inflation. "That indicates a need to revalue to restore the balance of capital and current accounts," Chung says.

Chung sees two uncertainties: One, the government has been using the reserves to recapitalize the deeply troubled banking system, injecting billions of dollars into the big state banks while the system may yet need much more to cover for more non-performing loans.

And two, if China opens its capital account further, allowing easier flow of money in and out of the country (a prerequisite for the yuan's full convertibility), "nobody is certain whether there will be a net outflow or inflow of hot money." If the inflow is "tremendous," the yuan will have to be revalued further; if changes result in a net outflow, the yuan would have to be devalued, he says.

Bottom line: "If China is to maintain economic and political stability, the yuan deserves a moderate revaluation," Chung says, before slipping into prediction mode. "I think China is likely to make a slight revaluation by widening the trading band to 3%, when President Hu Jintao meets with G8 leaders this summer and before his official visit to the States in the fall," he says. Even if this turns out to be short of the mark, and a bigger revaluation is needed to right things, Chung says Beijing will take things very gradually, adding that "the impact can be disastrous if it revalues too much." Longtime, now Stockholm-based, China watcher Frederic Cho says pronouncing on the yuan's proper worth makes for a tough assignment – but he plunges in. "The yuan is probably really worth its current fixed exchange rate," he says. "I am not convinced that the currency would strengthen sharply if it were to float. "Okay, on one hand you have the growing trade surplus and the growing currency reserve [but] on the other, you have large parts of the economy still in deflation, a problematic banking sector, etc, etc – all this added together could equally lead to a depreciation of the currency over time as much as an appreciation." You might call Cho a bit of a stick-in-themud. He doesn't seem to budge, whether powerful voices argue for the currency to go either up or down. "I still haven't had reason to change my view since I stated it in the largest Swedish business daily, Dagens Industri, on the 29th of January 1998 – that I didn't expect China to change its currency in the foreseeable future (when a great part of the Western world expected an imminent depreciation). "But, now seven years, three months and one week after 29 January 1998, the currency remains unchanged." (Add more days, since this interview.)

Okay, so he wins this month's contrarian award – but how does Cho see Beijing playing its cards with all this revaluation pressure? His answer is like a slow-mo version of Xfn's Chung's: "I think the most plausible next step will be for Beijing to raise the daily flotation band in a gradual way from today's plus or minus 0.3 % to first, say, plus or minus 1 % and then to plus or minus 3 %. Noting Beijing's move last month to introduce eight new currency pairs at the China Foreign Exchange Trading System in Shanghai, he says: "I construe this as a way for Beijing to start acquiring experience from several currencies in order to be mentally prepared for the next step, which I think will be shifting over to a trade-weighted currency basket with the US dollar still being the dominant currency."

A certain comfort level
Cho says China's record for prudence tells him both the central government and central bank will have to feel very comfortable with these mechanisms before there is any switching to a currency basket – which could take the rest of this year. "As for the widening of the band, I expect – but am not fully convinced – that this could happen sometime in the second half of this year.

"Beijing will say, as it has consistently, that the currency is under a managed float regime (which it technically is, though under extremely tight leashes), and by widening the band the managed float regime has been made even more flexible."

Some are looking for something looser than that. "A 5% revaluation will let a little air out of the bubble," says Michael Woolfolk, senior currency strategist for Bank of New York. It will slow the economy a bit, and "the economy could use being slowed," Woolfolk says.

A revaluation accompanied by more flexible capital controls would allow Chinese nationals – responsible for 50% of investment in China – to invest overseas. This would restore some sanity to stampedes like the Shanghai real estate boom, cooling some of the 'hot money' fears.

The ultimate cost of a revaluation to China's export industry would be minimal, Eurasia's Kindopp says. "While there would be a price increase, it would be slight. The gross trade balance will not be highly affected."

A 6-10% increase won't have any major consequences for the world economy. China will continue to export; the US will continue to import; oil prices will continue their upward climb. "The only sector to feel immediate consequences will be the currency markets," Kindopp says.

And just possibly America's export sector, insofar as China goes: As Stanford economist Ronald McKinnon has argued in these pages, a slower Chinese economy will only reduce China's ability to import. When in the past the US forced revaluation – notably on Japan, South Korea and Taiwan – the net change in US exports to these economies was zero.