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                                                      TD Economics
                                                      Topic Paper
                                                       April 18, 2005

                          PRESSURE ON CHINA COULD DELAY
• G-7 call for more flexibility in exchange rates aimed
                                                                                   CHINA: TRADE SURPLUS AND FOREX RESERVES
  at China
• A stronger Chinese renminbi is in China’s interests                        700
                                                                                   Billions of U.S. dollars

• Political pressure could backfire and delay adjust-                        600           Trade surplus
  ment                                                                                     Forex reserves
• Still expect a 10 per cent appreciation in China’s                         500

  currency, but timing is impossible to call                                 400

    This weekend’s G-7 finance ministers’ meeting saw in-                    300

creased pressure put on China to allow its currency to ap-                   200
preciate. Although there was no explicit reference to China
in the G-7 communiqué, there was no doubt as to who the                      100

call for “more flexibility in exchange rates” was aimed at.                    0
While the U.S. was arguably the loudest proponent, with                             1998       1999        2000   2001   2002    2003   2004e

Treasury Secretary Snow stating that “They are ready to                        Source: IIF

move to flexibility…Now is the time”, it was not alone in
the demand for change, with officials from Europe also                     In China’s interests to have a stronger currency
making strong comments supporting the cause. Japan was                         In our opinion, it is in China’s self interest to allow its
far more tentative about the proposition. The real ques-                   currency to appreciate, either by widening the band around
tion is whether China will acquiesce.                                      the current peg to the U.S. dollar or by adopting a new peg
                                                                           to a weighted basket of currencies including the euro. The
                      CHINA ECONOMIC OUTLOOK                               central government authorities have clearly indicated that
                                                                           they want the Chinese economic boom to slow from the
       Y/Y % change                                Y/Y % change
                                                                  12       torrid 9.5 per cent pace posted in 2004. In particular, they
                                                      Forecast             are concerned about an investment bubble forming, which
  10                     China Real GDP                           10
                                                                           could lead to deflationary pressures if the bubble were
   8                                                              8        eventually to burst. Maintaining the currency peg at its
                                                                           present level is aggravating these pressures. The result-
        World Real GDP
                                                                           ing build-up in foreign exchange reserves has led to rapid
   4                                                              4        money supply growth, which China’s weakly supervised
                                                                           banks have churned into new loans, further stoking in-
   2                                                              2        vestment growth in sectors of the economy that were al-
   0                                                              0
                                                                           ready overheating.
       95   96   97    98   99   00   01   02   03 04E 05F 06F                 Thus, an appreciation in the Chinese renminbi could
       Forecast by TD Economics as at March 2005                           be beneficial, by simultaneously dampening real GDP
       Source: IMF, TD Economics                                           growth and imports of investment inputs, while reducing

China’s FX Outlook                                                     1                                                        April 18, 2005

liquidity in the financial system.
                                                                                                                          U.S. TRADE DEFICIT WITH CHINA
    In addition to meeting these domestic economic objec-
                                                                                                               Billions of U.S. dollars
tives, China could also reduce the looming threat of inter-                                                0
national trade disputes by changing its foreign exchange                                                 -20
policy. The U.S. trade deficit with China has ballooned in                                               -40
recent years and is poised to continue widening, raising                                                 -60
the spectre of a protectionist backlash. For example, the                                                -80
U.S. Senate is already considering legislation that would                                              -100
impose duties as high as 27.5 per cent on Chinese imports.
And, while the White House has appeared more tolerant
than Congress over China trade issues in the past, the pres-
sure from the Bush Administration appears to be intensi-
fying. Meanwhile, the European Union is also consider-                                                 -180
                                                                                                                93     94     95     96     98     99     00     01     02     03     04
ing legislation to restrict Chinese textile imports.
                                                                                                               Source: Bloomberg
Markets look for 3-5% appreciation, but could be more
    Given this backdrop, markets have been speculating                                             value the peg. And, prior to the G-7 finance ministers’
about an eventual appreciation in the Chinese currency,                                            meeting this weekend, futures markets had scaled back
with the consensus call being a modest 3 to 5 per cent                                             their anticipation of a strengthening in the renminbi.
increase in the peg, accompanied by a shift to a mixed
basket of currencies with undisclosed weights. TD Eco-                                             International pressure could backfire
nomics, along with a few other forecasters, have been an-                                              With the financial market conditions for an adjustment
ticipating a more aggressive 10 per cent appreciation in                                           in the peg increasingly in place, the renewed pressure on
the Chinese currency at some point in 2005 or 2006, un-                                            China from the international political community may
der the assumption that the Chinese government would                                               prove untimely, as it could actually delay the foreign ex-
want to signal to markets that this is a ‘once and for all’                                        change adjustment. China has repeatedly stressed that it
change in the level of the peg, thereby eliminating any                                            will not change the peg in response to political pressure.
speculation that the appreciation is only the first step of                                        It is a Chinese policy decision that will occur when the
many. However, Chinese officials have clearly stated that                                          central government authorities decide that the time is right,
they will not respond to financial market pressure to re-                                          and not a moment sooner. Moreover, there is no question
                                                                                                   that China is prepared to incur economic and financial costs
                       CHINA: FIXED INVESTMENT                                                     to achieve political objectives. So, the more the interna-
       % of GDP
                                                                                                   tional community pushes China, the more likely China will
  60                                                                                               push back, delaying the eventual change in the foreign
                                                                                                   exchange rate. As a result, while we continue to expect
                                                                                                   China to permit a 10 per cent appreciation in its currency,
  40                                                                                               the odds of such a move before the autumn of 2005 have
                                                                                                   fallen and some point in 2006 may be an even better bet.
                                                                                                   This is unfortunate, as it raises the risk of international
  20                                                                                               trade disputes between China and many of its trading part-
                                                                                                   ners in the near term.

                                                                                                               Craig Alexander, VP & Deputy Chief Economist
       1986       1989         1992        1995         1998        2001        2004e

       Source: IIF                                                                                                                               Gillian Manning, Economist

       The information contained in this report has been prepared for the information of our customers by TD Bank Financial Group. The information has been drawn from sources believed
       to be reliable, but the accuracy or completeness of the information is not guaranteed, nor in providing it does TD Bank Financial Group assume any responsibility or liability.

China’s FX Outlook                                                                            2                                                                        April 18, 2005

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