Morgan stanley -CNY exchange rate reform by riteshbhansali

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CNY exchange rate reform: A well-expected surprise

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									                                                               MORGAN                STANLEY                RESEARCH
                                                               ASIA/PACIFIC


                                                               Morgan Stanley Asia Limited              Helen Qiao
                                                                                                        Helen.Qiao@morganstanley.com
                                                                                                        +852 2848 6511

                                                                                                        Yuande Zhu
                                                                                                        Yuande.Zhu@morganstanley.com
                                                                                                        +852 2239 7820

                                                                                                        Yin Zhang
April 29, 2013                                                                                          Yin.Zhang@morganstanley.com
                                                                                                        +86 10 8356 3954


China Economics
CNY exchange rate reform: A
                                                               Forecast Summary
well-expected surprise                                                               End of period
                                                                                                     USD/CNY Forecast
                                                                                                                               Annual average
                                                                               Appreciation           Appreciation        Appreciation          Appreciation
                                                                        New                 Previous               New                 Previous
                                                                                    %                      %                  %                     %
                                                               2011     6.30       5.1        6.30        5.1      6.44       5.0        6.44       5.0
Not a political gesture – deliberate steps to advance          2012     6.29       0.2        6.29        0.2      6.31       2.1        6.31       2.1
                                                               2013F    6.10       3.0        6.30        -0.2     6.20       1.8        6.29       0.3
renminbi internationalization: That’s how we see the           2014F    5.90       3.3        6.15        2.4      6.00       3.4        6.19       1.7

recent appreciation of CNY central parity against the          Source: PBoC, CEIC, Bloomberg, Morgan Stanley Research

dollar, as well as the potential trading band expansion –
contrary to the consensus view of a political move.
                                                               CNY has been trading on the strong side of
The direction of these moves is largely expected,              the band since early March
but the timing is somewhat surprising: Continued                USD/CNY                                                                       pips
                                                                6.29                                                                                 -550
currency appreciation against a very strong dollar could
add more cyclical headwind against the fragile growth
recovery in China, especially during a soft patch in             6.26
global growth. Nor is there any evident currency
misalignment against the dollar that needs to be
                                                                 6.23                                                                                -600
addressed.

In our view, the unusual timing of the exchange rate             6.20
                                                                                   Spot rate minus fixing rate (RHS)
reform indicates that the government is determined to                              Fixing rate
                                                                                   Spot rate
promote a more market-driven exchange rate                       6.17                                                        -650
mechanism, which is essential for further capital account           3/1/2013 3/11/2013 3/21/2013 3/31/2013 4/10/2013 4/20/2013
liberalization. By appearance, the exchange rate reform
is likely to precede interest rate reform in financial         Source: CEIC, Datastream, Morgan Stanley Research

liberalization.

We expect the new government to allow market
forces to play a more important role in determining
the CNY exchange rate: We cite three areas: 1)
narrowing the gap between central parity and spot
trading rates, 2) expanding the trading band from +/-1%
to +/-2% in the near future, and 3) enlarging the market
participant base.

As a result, we expect more fluctuations in the spot
exchange rate amid a slow appreciation against the
dollar.

We adjust our annual average USDCNY forecasts to
6.20 and 6.00 for 2013 and 2014: This implies annual
average appreciation of 180bps and 340bps,
respectively. If USDCNY follows a linear path as we
currently forecast, it will break through 6 yuan to 1 dollar
in mid-2014.                                                   For important disclosures, refer to the
                                                               Disclosures Section, located at the end of
                                                               this report.
                                                                       MORGAN          STANLEY        RESEARCH

                                                                       April 29, 2013
                                                                       China Economics




The same old gesture again?                                            We think appreciation is probably not guided by the
                                                                       U.S. this time
CNY appreciation amid several US official visits and
global conferences is widely seen as a political move.                 We have a different view. To us, the recent CNY appreciation
USDCNY started to move more notably (see Exhibit 1) soon               doesn’t appear to be “U.S. guided”, for three reasons:
after the US Secretary of the Treasury, Jacob Lew, visited
China in mid-March and days before Secretary of State John             1)     Our analysis of the US Treasury report on currency
Kerry’s official visit and the annual World Bank and IMF                      manipulation suggests a slightly less aggressive stance on
meetings in DC in mid April. Like before, central parity rates                CNY appreciation than before. In its most recent report,
have inched down towards the spot rates, allowing a faster                    the US Treasury affirmed the CNY is still significantly
pace in renminbi appreciation against the dollar.                             undervalued, but admitted “the estimated range of
                                                                              misalignment has narrowed.” This backdrop is much less
Since the timing of the exchange rate move has again fallen                   intense as compared to all previous occasions when CNY
into a sensitive period with multiple diplomatic events, many                 initiated or resumed appreciation (see Exhibit 2).
have dismissed it as another political gesture. Every year, the
US and Chinese governments hold semi-annual strategic                  2)     The semiannual S&ED will probably take place after June,
dialogues (S&ED) around May. Exchange rate misalignment                       instead of in May this year, perhaps due to the late
remains as a longstanding topic for negotiations.                             appointment of officials in charge of the talks on either side
Coincidentally, faster episodes of renminbi appreciation in the               during a government transition.
past often took place around the S&ED, official visits of top
leaders on either side, or the issuance of the semiannual US           3)     Instead of keeping FX moves in the dark, Chinese central
Treasury report on currency manipulation.                                     bank officials made comments on favorable conditions for
                                                                              further capital account liberalization – indicating a potential
Exhibit 1                                                                     expansion in the currency trading band 1.
CNY has been trading on the strong side of the band
since early March                                                      Unlikely a deliberate countercyclical measure
 USD/CNY                                                 pips
 6.29                                                           -550   If the CNY appreciation did not come as a result of US
                                                                       pressures, could it be a countercyclical measure to help
                                                                       stabilize the macroeconomic environment? It probably isn’t.
  6.26                                                                 Continued currency appreciation against a very strong dollar
                                                                       could add more cyclical headwind against the fragile growth
                                                                       recovery in China.
  6.23                                                          -600

                                                                       1)     It is often argued that CNY appreciation will increase the
                                                                              purchasing power of Chinese consumers and therefore
  6.20
                  Spot rate minus fixing rate (RHS)                           help rebalance the economy more towards
                  Fixing rate                                                 consumption-driven growth. However, ceteris paribus, it is
                  Spot rate
  6.17                                                        -650            likely to weaken aggregate demand growth through
     3/1/2013 3/11/2013 3/21/2013 3/31/2013 4/10/2013 4/20/2013               exports and investment, especially during a soft patch in
                                                                              global growth currently.
Source: CEIC, Morgan Stanley Research
                                                                       2)     Cross-currency exchange rate movements year to date
                                                                              also suggest an adverse environment for appreciating
                                                                              against a very strong dollar.




                                                                       1
                                                                           “PBOC’s Yi Says Yuan Floating Band to Be Widened Further” –
                                                                       http://www.bloomberg.com/news/2013-04-17/pboc-s-yi-says-yuan-flo
                                                                       ating-band-to-be-widened-further.html



                                                                                                                                          2
                                                                              MORGAN       STANLEY        RESEARCH

                                                                              April 29, 2013
                                                                              China Economics




Exhibit 2
US Treasury Report to Congress on International Economic and Exchange Rate Policies
                                                             Key Summary on China
Apr-2013                … while the estimated range of misalignment has narrowed, China's real effective exchange rate continues to
                        exhibit significant undervaluation…
Nov-2012                … the real exchange rate of the RMB remains significantly undervalued, and further appreciation of the RMB
                        against the dollar and other major currencies is warranted.
May-2012                ... the available evidence suggests the RMB remains significantly undervalued and we believe further
                        appreciation of the RMB against the dollar and other major currencies is warranted…
Dec-2011                ... in light of the persistent misalignment of the RMB at a substantially undervalued level, Treasury assesses that
                        movement of the RMB to date is insufficient and more progress is needed...
May-2011                ... treasury has concluded that the standards identified in Section 3004 of the Act during the period covered in
                        this Report have not been met with respect to China. Treasury’s view, however, is that progress thus far is
                        insufficient and that more rapid progress is needed. Treasury will continue to closely monitor the pace of
                        appreciation of the renminbi by China...
Feb-2011                … treasury’s view, however, is that progress thus far is insufficient and that more rapid progress is needed…
Jul-2010                ... it will take time before we can assess whether China's recent exchange rate change will produce a sufficiently
                        market-determined exchange rate to correct the undervaluation... suggest that the renminbi remains
Oct-2009                    treasury d
                        ... d       l remains of the view that the renminbi is undervalued…
Apr-2009                … to engage the Chinese authorities to permit greater flexibility of the exchange rate and to encourage further
                        policy measures to rebalance the Chinese economy in the direction of greater domestic demand led growth…
Dec-2008                ... the pace of appreciation in early 2008 needs to be resumed. Treasury continues to use every opportunity to
                        impress upon Chinese authorities the importance and urgency of exchange rate reform…
May-2008                ... the pace of appreciation needs to continue in order to address the continuing substantial undervaluation of the
                        RMB...
Dec-2007                … China should significantly accelerate the appreciation of the RMB’s effective exchange rate...
Jun-2007                … treasury was unable to determine that China’s exchange rate policy was carried out for the purpose of
                        preventing effective balance of payments adjustment or gaining unfair competitive advantage in international
Dec-2006                ... this increased flexibility, however, is considerably less than is needed…
May-2006                ... China’s advances are far too slow and hesitant given China’s own needs... the delay in introducing additional
                        exchange rate flexibility is unjustified given the strength of the Chinese economy and the progress in China’s
                        transition. China needs to move quickly to introduce exchange rate flexibility at a far faster pace than it has
                        done to date...
Nov-2005                ... the United States applauded China’s July 21st announcement that it had abandoned its eight-year peg to the
                        dollar and committed to enhance the flexibility and strengthen the role of market forces in the exchange rate...
May-2005                … if current trends continue without substantial alteration, China’s policies will likely meet the statute’s technical
                        requirements for designation...
Dec-2004                … assist China to move as soon as possible to a flexible exchange rate regime…
Apr-2004                ... assist China to move as soon as possible to a flexible exchange rate regime…
Source: US Treasury Department, Morgan Stanley Research




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                                                                                                     April 29, 2013
                                                                                                     China Economics




Not aiming to reduce any misalignment                                                                costs on a favorable downward trend (see Exhibit 3). However,
                                                                                                     ULC has been largely on the rise since 2009 as the result of
In our view, the CNY is close to its long-term equilibrium level
                                                                                                     slower productivity gains and further rises in wages.
without major misalignment against the dollar. Despite the
growth slowdown in China, wage growth remains robust. It has
                                                                                                     The comparison with the US manufacturing ULC shows no
more than offset the gains from labor productivity in the
                                                                                                     need for further exchange rate appreciation to help adjust
manufacturing sector in recent years, which implies little if any
                                                                                                     international competitiveness. Relative to year 2000, China’s
room for CNY appreciation.
                                                                                                     manufacturing sector is not enjoying any cost advantage over
Exhibit 3                                                                                            its US counterpart now, because faster wage growth in China
Rising unit labor costs in China implies little room                                                 has fully offset the productivity differential (see Exhibit 4).
for further appreciation
  yoy %
                                                                                                     In other words, we do not see the CNY being substantially
                                                    Manufacturing nominal wage
    35
                                                    Manufacturing labor productivity
                                                                                                     undervalued against the USD as far as international
     30                                             Manufacturing unit labor cost                    competitiveness is concerned.
     25

     20                                                                                              It could be a deliberate reform initiative
     15
                                                                                                     If the CNY is close to equilibrium level and the US government
     10                                                                                              has not pressured China for currency appreciation, we believe
      5                                                                                              the motivation has to come from China’s own reform agenda. In
      0                                                                                              our view, the government is trying to promote a more
     -5                                                                                              market-driven exchange rate mechanism, which is essential for
    -10                                                                                              further capital account liberalization. In addition, the exchange
    -15                                                                                              rate reform will likely precede the interest rate reform in
      2001       2002     2003    2004       2005    2006     2007     2008    2009    2010   2011   financial liberalization by appearance.

Source: CEIC, Morgan Stanley Research                                                                What to expect from here?
Exhibit 4                                                                                            We expect the new government to allow market forces to play a
Faster manufacturing-sector wage growth in China                                                     more important role in determining the CNY exchange rate: We
has fully offset the productivity differential against                                               cite three areas:
the US
Index, year 2000=100                                                                                 1)   Narrowing the gap between central parity and spot trading
    600                 China nominal wage (effective in USD)                                             rates;
                        US nominal wage
    500                 China productivity
                                                                                                     2)   Expanding the trading band from +/-1% to +/-2% in the
                        US productivity
    400
                                                                                                          near future;

    300                                                                                              3)   Enlarging the market participant base.

    200                                                                                              Since the beginning of March, central parity of USDCNY has
                                                                                                     been loosely following the dollar index, with a slight bias toward
    100
                                                                                                     more CNY appreciation (see Exhibit 5). Along with the changes
                                                                                                     in the fixings, spot trading sent USDCNY even lower, as more
       0
       2000     2001    2002     2003     2004   2005    2006   2007    2008   2009    2010   2011   capital inflows returned in the early months of 2013 (see Exhibit
                                                                                                     6).
Source: CEIC, Haver, Morgan Stanley Research
                                                                                                     It is hard to pin down whether the increase in the RMB position
China can no longer afford currency appreciation that is as fast                                     for FX exchange came from trade settlement, FDI, portfolio
as before. Our analysis of unit labor costs (ULC) shows that                                         investment or the accumulated domestic FX deposits. But with
during 2001 – 2007, China used to enjoy much faster growth in                                        the establishment of an appreciation trend at the beginning of
labor productivity than nominal wage growth, leaving unit labor                                      the FX reform, we will likely see growing interests in CNY.



                                                                                                                                                                          4
                                                                                     MORGAN                STANLEY                RESEARCH

                                                                                     April 29, 2013
                                                                                     China Economics




As a result, we expect more fluctuations in the spot exchange                        Exhibit 6

rate amid a slow and gradual appreciation against the dollar.                        Capital inflows returned since the beginning of 2013

                                                                                       RMB bn
We adjust our annual average CNYUSD forecasts to 6.20                                                                                                                        CNY/USD
                                                                                           800            Monthly change of RMB position for FX purchase (RMB bn)              7.0
and 6.00 for 2013 and 2014: This implies annual average
                                                                                           700            CNY/USD (RHS)                                                        6.9
appreciation of 180bps and 340bps, respectively. If USDCNY
                                                                                           600                                                                                 6.8
follows a linear path as we currently forecast, it will break
                                                                                           500                                                                                 6.7
through 6 yuan to 1 dollar in mid-2014.                                                    400                                                                                 6.6
                                                                                           300                                                                                 6.5
Exhibit 5
                                                                                           200                                                                                 6.4
USDCNY rate fixings partially reflect the dollar index
                                                                                           100                                                                                 6.3
in the past month
                                                                                             0                                                                                 6.2
 6.29                                                                                     -100                                                                                 6.1
                                                                              83.0
                                                                                          -200                                                                                 6.0




                                                                                                 Jan-10



                                                                                                               Jul-10



                                                                                                                         Jan-11



                                                                                                                                    Jul-11



                                                                                                                                              Jan-12



                                                                                                                                                        Jul-12



                                                                                                                                                                    Jan-13
 6.28
                                                                              82.5

 6.27                                                                                Source: CEIC, Morgan Stanley Research
                                                                              82.0


 6.26
                 CNY/USD fixing                                               81.5
                 USD index (RHS)
 6.25
                                                                              81.0


 6.24                                                                         80.5


 6.23                                                                         80.0
   3/1/2013     3/11/2013    3/21/2013    3/31/2013   4/10/2013   4/20/2013

Source: CEIC, Datastream, Morgan Stanley Research




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                                                                                             April 29, 2013
                                                                                             China Economics




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