Yuan gets a taste of things to come

Central bank swift to quash buying frenzy amid speculation over policy change

Chatter about an impending change in China's currency policy hit fever-pitch yesterday as buying pressure pushed the yuan briefly to its strongest in years on the Shanghai market.

The short-lived lunchtime run-up in the currency prompted swift intervention from the central bank and a hasty denial that there had been any change in policy. Even so, some pundits took the fleeting move as a taste of things to come, forecasting that Beijing will switch from its exchange rate peg to the US dollar to a managed float against a basket of currencies as early as next week.

Although any initial move in the yuan's exchange rate following a policy change is likely to be small, unprecedented levels of speculator and investor interest mean that even a yuan appreciation of 3 per cent to 5 per cent will have a significant impact on financial markets and economies across East Asia.

Yesterday, the People's Bank of China denied any policy change was imminent. Last weekend, however, bank governor Zhou Xiaochuan said China might need to speed up reform, and a front-page commentary in the China Securities Journal said preparations for a change of exchange rate policy were now in place.

That article was partly responsible for a flurry of yuan buying in thin trade before next week's mainland holiday, which pushed the exchange rate to as low as 8.27 yuan to the US dollar. That is the strongest level the yuan has hit since its 33 per cent devaluation in 1994.

Frank Gong, China economist at JP Morgan in Hong Kong, said the authorities were conducting a test run before announcing their new policy.

Mr Gong said it was 'very likely' that Beijing would take advantage of the window of opportunity afforded by next week's holiday to switch to a managed float 3 per cent either side of a daily reference rate.

Although other analysts dispute the timing, many now agree with Mr Gong about the likely form a new exchange rate policy will take.

In a research report last week, economists at investment bank Goldman Sachs said that with the implementation of planned reforms, China would have in place the essential market infrastructure it needed to operate a managed float against a basket of currencies 'over the next quarter or so'.

Economists argue that a policy change is needed to quell speculative capital inflows, which have created a property bubble in Shanghai and Beijing and raised fears of broader inflation.

If China does move to a managed float, it is likely that buying pressure will rapidly push the yuan to the stronger limit of its new band, with the exchange rate falling to about eight yuan to the US dollar. However, if the authorities think such a small move will be enough to dampen speculation in the yuan, they will be sorely disappointed.

With any move to a a managed float against a selection of currencies, it was likely that Asian currencies would make up a significant weight in the basket, possibly as much as 60 per cent, said James Malcolm, a foreign exchange strategist at Deutsche Bank in Singapore.

But many of China's Asian trading partners have kept their currencies undervalued to maintain their competitiveness. If China allows its currency to rise, so will they. That will boost the value of the trade-weighted basket and, in turn, raise the yuan's value further. The result could be run-away appreciation.

Some investors are already betting on it.

Yesterday, rates on offshore dollar-settled yuan forward contracts were implying an exchange rate one year from now of 7.79 yuan to the US dollar, more than double any likely initial gain from a widening of the yuan's permitted trading band.

Investors are also betting that a change in yuan policy will trigger substantial gains in currencies and markets across East Asia.

Steven Chang, a vice-president at the Hong Kong branch of State Street Bank, said in recent months foreign investors had bought about 1 per cent of the South Korean stock market by capitalisation, and about 2 per cent of Hong Kong's market. 'It's like 1998 in reverse,' he said.

Those flows are only likely to get bigger if China moves to a wider trading band.

'We think that when it happens, even if it is only 3 per cent, it will still be significantly positive for equities around the region,' said Tim Rocks, an equity strategist at Macquarie Securities.

Fresh inflows into Hong Kong after a change in yuan policy will not endanger the Hong Kong dollar's own peg. It is likely that the Hong Kong Monetary Authority will repeat its recent interventions to support the exchange rate close to the peg of $7.80 to the US dollar. But forward rates in the Hong Kong dollar would be pushed to a steep discount to the spot rate, depressing interest rates and boosting the property and stock markets.

The impact on other markets could be more disruptive. Malaysian authorities have already signalled their readiness to revalue the ringgit, pegged at M$3.80 to the US dollar since 1998.

With economists estimating the ringgit is undervalued by 10 per cent to 15 per cent and the offshore forward market implying a revaluation of only 2.5 per cent over next year, one analyst described betting on ringgit appreciation as 'a steal of a trade'.