China Will Allow Yuan Gains to Slow Inflation, Riverfront Says

China may resume the crawling peg as early as next week

By Allen Wan

Nov. 11 (Bloomberg) -- China will allow for faster appreciation of the yuan against the dollar next year as it seeks to curb accelerating inflation, according to Riverfront Investment Group and RBC Capital Markets.

“China can either let the yuan appreciate or allow inflation to accelerate at the risk of causing social unrest,” said Michael Jones, who manages $1.4 billion in stocks, including Chinese equities, at Richmond, Virginia-based Riverfront. “Inflation pressures will push China to allow substantial yuan appreciation.”

The world’s third-biggest economy expanded 8.9 percent in the past quarter, the fastest pace in a year, according to official data. Money supply increased a record 29.4 percent in October from a year earlier, the central bank said today.

“Rapid Chinese money supply growth led to inflation in 2004 and 2008,” Jones said. “It could happen again.”

He predicts the inflation rate may rise as high as 7 percent next year, with food prices double that estimate. Under that worst-case scenario, Chinese policymakers may be forced to revalue the currency by 25 percent, Jones said.

Consumer prices fell 0.5 percent last month, the smallest drop since declines began in February, according to a Bloomberg survey. Prices will rise 2.7 percent in 2010, according to the average of 16 economist estimates compiled by Bloomberg.

“Pressure from the international community to allow yuan appreciation is not that big,” People’s Bank of China Governor Zhou Xiaochuan said Nov. 6.

Economic Stimulus

China’s 4 trillion yuan ($586 billion) stimulus spending and record lending may lead to a pick-up in inflation, prompting the government to allow for an appreciation of the yuan, said RBC’s global head of emerging research Nick Chamie.

“Strong stimulus and very easy liquidity conditions are likely to stoke inflation pressures in the months ahead, suggesting that tighter policy will be needed -- currency appreciation will likely be part of the package,” Chamie wrote in a note to clients.

RBC predicts the yuan may strengthen to 6.50 against the dollar by the end of next year. China has maintained the currency’s value at around 6.83 against the dollar since July 2008, after allowing it to rise 21 percent in the previous three years. Yuan forwards indicated on Nov. 9 that traders expect the currency to resume gains, climbing 3 percent in the next year.

‘Tough Stance’

Policy makers are unlikely to allow the currency to resume its appreciation this year after keeping it almost unchanged since July 2008, Beijing-based Zhu Baoliang, the chief economist at the State Information Center, said in an interview on Nov 9. China will stick with its “tough stance” on the currency until overseas sales rebound, Zhang Ming, a researcher at the Chinese Academy of Social Sciences, said in a separate interview.

The central bank may first allow for a “gradual” appreciation of the yuan by reintroducing a so-called crawling peg that was shelved during last year’s financial crisis, Riverfront’s Jones said. That would allow the yuan to rise against the U.S. dollar and maintain its value against other major currencies such as the euro and yen, he said.

China suspended the crawling peg as the financial crisis sparked aversion to risk and boosted the dollar, Jones said. Since then, major currencies have rebounded, allowing the government to resume its previous approach, he said.

“We believe that as other currencies continue to rally, China will likely resume a crawling peg strategy against the dollar,” Jones said. “Such a shift in policy will likely motivate a rally as global financial markets breathe a collective sigh of relief.”

‘Material Revaluation’

China may resume the crawling peg as early as next week, when U.S. President Barack Obama visits the Asian country, Jones said.

Asian currencies such as the Taiwanese dollar and South Korean won may appreciate further if the yuan gains as governments in the region have been reluctant to risk further gains on concern they may become less competitive, he said.

“A material revaluation of the yuan could potentially unleash substantial domestic consumption in China, be a catalyst for a boom in global trade, and spark a secular bull market in equities,” Jones said.