RMB Revalued!

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RMB Revalued!
Joe Horn
November 19, 2005
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Table of Contents

• Causes of Revaluation
• Chinas New Currency Regime
• Impact of Revaluation
• Themes for the Future

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• Causes of Revaluation

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Chinas Macro Economy

• Chinas economy ranks 5th in terms of total size
• China has managed to sustain growth at above 8
  for most of past 25 years
• Average growth over that period close to 10
• Managed to keep up growth even through the Asian
  Crisis
• China is the worlds factory, and is the largest
  producer of many of the worlds commodities and
  consumer products
• China is also the largest importer of many of the
  worlds commodities
• Chinas demand is affecting prices of everything
  from steel, gold to oil

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Economic Challenges
Until 2003
Uphill bicycle
Social issues
Rely on growth to solve problems
Environment
Financial system
Global competition
Shuttle reentry to earth with faulty
instruments
Since 2003
All of the above

Chinas growth itself
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Drivers of Currency Revaluation
Shift in Economic Policy
External Pressure
Inflation Control
Continued Liberalization
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Drivers of Currency Revaluation
External Pressure
Inflation Control

• With a restricted capital account, the
  Government needed another tool to fight
  inflation, should it ever become a problem again

• US Senate threatening to impose an
  across-the-board duties on Chinese products

Growth in Q1 2004
China CPI
Source Reuters
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Drivers of Currency Revaluation
Economic Policy Shift

• Government policy will gradually shift towards
  promoting consumer- driven rather than
  export-driven economy
• Revaluation forces exporters to become more
  efficient
• Revaluation increases buying power for
  corporates and consumers alike

Continued Financial Liberalization

• The medium term goal of Government is to
  continue liberalization of the capital account
• Currency flexibility is an important
  pre-condition for a healthy liberalization

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• Chinas New Currency Regime

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Evolution of the RMB Regime
During the planned economy (1949-1978)

• Bank of China was the only specialized bank
  involved in FX business
• All FX receipts/purchases were surrendered to the
  State
• The nation never incurred foreign borrowing or
  allowed FDI
• The State Administration of Foreign Exchange
  established to control FX matters
• The RMB exchange rate regime was reformed and two
  currencies were established FCY and RMB only
  the former was convertible
• Enterprises were permitted to retain a portion of
  their FX earnings
• Dual exchange was unified into a common RMB, de
  facto pegged to the US
• Standard inter-bank FX market was established

During the transition period (1979-1993)
After 1994
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Description of New Regime

• July 21, 2005, China adopted a managed floating
  exchange rate regime based on market supply and
  demand with reference to a basket of currencies
• PBOC China Monetary Policy Report

RMB vs US
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Comments

• Revaluation carefully timed in July 2005
• 2 is less than many had expected
• Basket is unknown, but heavily US weighted
• Reference to a basket not linked to a basket

• 0.3 variation allowed per day
• Government will not let RMB rise much further
  until they are certain that transition is smooth
• Transition has been considered smooth by most, so
  can expect more flexibility in 2006

Euro, Yen, RMB vs US 100 Jul 2005
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Challenges in the Months Ahead

• Development of currency hedging instruments
• Further liberalization of capital account
  transactions to allow for such instruments to be
  traded

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• Impact of Revaluation

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Effects of China on the World Economy
Inflation
Interest Rates
US Fed Funds Rate
US CPI
Yield Curve
Profitability

• Due to threat of relocation, wage increase in
  the developed world has been suppressed
• US and European companies have benefited from
  unparalleled profitability in the past 75 and 30
  years respectively

US vs France Yield Curve
The world will increasingly get used to dealing
with the RMB as a major currency
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The Road Ahead
Banking Sector Reforms
Interest Rate Reforms
Development of Financial Products
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• Themes for the Future

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Long Term Themes

• China remains growth story and should be able to
  maintain average growth above 7 over next 2
  decades
• Resource dependency
• Ability to cope with global slowdown
• China will have to address growing social
  inequality

Key factors
GINI Coefficient

• China will have to increase real productivity
• Otherwise terms of trade will deteriorate

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Long Term Themes

• Population expected to peak in 2030, but is
  ageing more rapidly than other countries did at
  this stage of development

Source UNDP, UBS estimates

• Liberation of precautionary savings as safety net
  is enforced
• Development of services sector
• China is not crash-proof, but is resilient