China Looks Cheap

When China first announced on 19 June that it was going to reintroduce flexibility into its exchange rate mechanism, we advised caution; warning that it may take some time for China's intentions to be clarified. The market's euphoric response was quickly unwound as it became clear that China's position is more nuanced than it may have first seemed.

The flexibility that the US (and others) call for means the primary source of rigidity, that prevents the yuan from appreciating, namely the hand of the government, should be removed. What Chinese officials mean by flexibility is greater two way movement in relatively narrow bands.

However, now two weeks after the new policy was announced China's intentions are clearer. It will accept some currency appreciation as well as greater two way movement. Ironically, though it looks like the market is over correcting its initially euphoria and now appear to be pricing China cheaply.

Currently indicative prices for the 1-month non-deliverable forward implies small yuan depreciation over the next month. The 12-month NDF implies about a 1.5% appreciation over the next year.

Over the past two weeks, the dollar has slipped 0.8% against the yuan. This pace of 0.4% a week cannot be expected to be sustained for the year or even for a quarter. However, over next month, some modest appreciation, even if 0.2% a week on average seems reasonable and is not priced in. Over the next 12-months, we suspect a modest 3-5% appreciation is likely.

Back in the July 05-July 08 period of yuan appreciation, China allowed the yuan to appreciate on average about 7% a year against the dollar. This was during a different set of macro economic conditions, including better growth prospects in its biggest export market, Europe. During that previous 3-year yuan appreciation phase, the dollar was generally weak.