Modest gains

China’s announcement that it would end the renminbi’s peg to the US dollar and return to a more flexible exchange rate regime was met with no small share of skepticism. Beijing had long promised greater flexibility in its currency, but its words were not backed by deeds. Still, many observers wondered whether China would be sufficiently tempted by the lure of cheaper commodities to surrender its marginal export advantage.

The question was answered in part by the government’s explicit statement that large-scale appreciation was out of the question. Even so, the currency issue was a distraction: While China’s purchasing power is enhanced by a rising renminbi, domestic demand will remain considerably more important than the currency’s incremental rise in determining the country’s appetite for commodities.

"In the short term, the impact [of appreciation] is going to be very limited in terms of actual demand for commodities," said Yu Yingxi, an analyst at Barclay’s Capital.

Furthermore, any global optimism for rising commodity prices due to long-term appreciation is undermined by present uncertainties. "The adjustment of the future exchange rate won’t cause much deviation from the current situation," said Ma Zhongpu, a steel analyst with China Commodity Marketplace.

Internally driven

The consequences of appreciation for the domestic price of end products like steel will be minimal. Ma noted that China’s iron and steel sector, designed to meet domestic needs, is not set up for large-scale exports. Steel prices are therefore determined by internal supply and demand, and are relatively unaffected by external factors like the exchange rate.

 The effect of the renminbi’s rise could be weakened further by appreciation of the currencies of major trading partners other than the US. Australia, Brazil and India account for 83% of China’s total iron ore imports, and the currencies of all three countries have the potential to rise against the US dollar and renminbi – whether because of greater global economic stability or a second downturn in the US economy.

Renminbi appreciation grants Chinese companies greater purchasing power, but when these firms go shopping for commodities overseas, they are evaluating many factors beyond price.

"Not only do Chinese enterprises consider renminbi appreciation, but also the grade of ore in a country, including physical, chemical and metallurgical properties that are suitable for their type of furnace," said Zhang Lin, an analyst at steel research firm Langesteel.

All these factors are affecting imports as domestic facilities increase production. Iron ore production in China grew to a record 91 million tons in May, an on-year increase of 38.5%. At the same time, iron ore imports during May fell to 51.9 million tons, down 3% from the record levels of the previous year, and down 6% month-on-month.

"As long as there is significant profit in the general trend of domestic mine production, Chinese iron ore imports will continue a slight decline for now," said Ma at China Commodity Marketplace.

The decline is part of China’s attempt to shift away from a reliance on imports to help the country avoid external economic shocks while maintaining stable domestic growth. Renminbi appreciation is only one instrument of this wider strategy. Pegging to the US dollar effectively protected exporters; now, the policy of gradual appreciation – rather than a one-time revaluation – continues to protect domestic industry, especially commodity producers.

Gradual currency appreciation also gives companies the opportunity to further develop their experience with China’s foreign exchange instruments. While the renminbi is expected to appreciate overall, removing the dollar peg will expose firms to some fluctuations, forcing them to improve their currency hedging practices, said Langesteel’s Zhang.

Wang Jiaomao, an economics professor at China Europe International Business School (CEIBS) in Shanghai said that Bejing’s primary concern is avoiding a hard landing: A sudden, sharp revaluation could lead to an unwanted flood of imports that could exacerbate overcapacity and destabilize inefficient but socially important sectors like agriculture.

There is little sign of an impending flood. As economic growth gradually slows from stimulus-fed double digits, expectations of stockpiling due to currency appreciation are being proven wrong. Indeed, rather than expanding stockpiles, firms are selling off inventories acquired at fire-sale prices in 2009. "China’s imports are falling off for most major commodities [as destocking continues]," said Barclay’s Xu. "People are more careful about stockpiles following the Great Recession."

The process of continued currency appreciation itself undermines any attempt to take advantage of temporary conditions. If the renminbi is worth more tomorrow than today, it makes business sense to delay purchasing.

Doomsday scenario

One outcome could make the incremental effects of gradual appreciation largely inconsequential: a renewed worldwide downturn. A "double dip" could tempt Chinese firms into stockpiling newly cheap non-ferrous metals – gold, copper, zinc and rare earth metals.

But in the absence of such a shock to the system, little is likely to change. Concerns over the stability of local economies in China’s less-developed regions will continue to encourage export-oriented policies. Moreover, as China eventually moves away from loose monetary and fiscal policies, renminbi appreciation will play only a small role.

"In terms of trying to control inflationary pressures in China, the government is targeting bank credit controls and tightening liquidity measures over an appreciation of the currency … Moderation in investment growth is going to be more significant," said Barclay’s Yu.

Slow appreciation and a recovering global economy could provide at least one long-term boost: helping Chinese firms expand mining and production facilities overseas. In early July, Wuhan Iron and Steel (WISCO; 600005.SH) reached an agreement with Australia’s Centrex Metals (CXM.ASX) to secure a steady supply of iron ore in South Australia’s Eyre Peninsula. More companies could follow suit with similar deals.

Limited exchange rate flexibility has not been the huge leap forward for commodity imports that some had expected, but it remains a small step reflecting China’s concern about market failures and sudden downturns. The appreciation of the renminbi – and its limited impact on China’s commodity imports – will remain carefully controlled and monitored by the central government, which remains the arbiter of Chinese commodity demand.

"You allow the market to play a role … but sometimes the government needs to correct the market," said Wang.