As China's economy is recovering from the global recession quickly—it is likely to report first quarter GDP growth around 11.5% year-on-year this week—accusations that the yuan is undervalued have increased. Expectations of imminent appreciation have also increased.

 

Signals from government officials suggest that an initial step could involve a widening of the yuan trading band, which would lead to a resumption of the gradual appreciation of the yuan against a basket of currencies. Market expectations for yuan appreciation have increased slightly as a result. 12-month yuan forwards currently trade at 6.6183/USD, implying expectations of a 3% appreciation in the yuan over the next 12 months.

 

Deciding the fundamental value of a currency is difficult and there is not a clear cut case that the yuan is undervalued. Some widely circulated academic studies conclude that the yuan is around 25% to 40% undervalued against the dollar, some other studies find a much smaller differential while there are some studies that find no undervaluation at all.

 

But at the end of the day, one visible piece of evidence of the yuan’s undervaluation is simply that the People's Bank of China has to intervene in foreign exchange markets virtually every trading day to keep the yuan from rising against the dollar. The PBoC increases the supply of yuan and uses it to purchase excess dollars that arise from exporters' revenues and investment inflows. China’s US$2.4 trillion official foreign reserves show the scale of the intervention that has occurred.

 

With the U.S. economy still recovering from recession, relative price levels between the U.S. and China are not market clearing. In other words, relative wages and prices are too high in the U.S., and too low in China. Under normal circumstances this would be solved by easier monetary and fiscal policy in the U.S., and tighter policy in China. Essentially this would prop up demand in the U.S. and cool it in China.

 

With the U.S. fed funds rate near zero and concerns about public deficit levels high, however, the U.S. is not in a position to increase its level of stimulus. Hence the burden of adjustment has fallen to China. But by keeping the yuan stable, China’s policymakers are preventing an adjustment in relative prices. This means that conditions have to reach equilibrium the long way: through prices and wages, or in other words, unemployment in the U.S., which would slow U.S. wages growth, and inflation in China, which would raise wages there.

 

Inflation is clearly a risk to China’s recovery. Consumer prices rose a relatively benign 2.7% y/y in February but producer prices rose 5.4%. Both are likely to rise higher in coming months. In January overall residential property prices in 70 major cities rose 10.7% y/y.

 

Although property market activity is manageable so far, the government remains concerned. It has adjusted regulations in various sectors with some success, but consensus appears to be shifting toward favouring a broader tightening. The official line is that the yuan will remain "basically stable" but there are signs that policymakers understand that it is in China's interest for the currency to appreciate.