Economic Observer Online
May 19, 2012
By Guo Hongchao (郭宏超) , editor of the Economic Observer's Market section 
Translated by Song Chunling
Original article: [Chinese]

The yuan’s central parity rate against the dollar – a weighted average of prices given by market makers – finally rose on May 18, after falling in seven successive trading sessions.

However it’s widely expected that the yuan will depreciate against the dollar.

Since last year, when it appreciated by more than four percent, the yuan has weakened in many trading session on the offshore market. Its volatility is clear, and the exchange rate gap between China and the U.S. is also narrowing.

After its strength against the dollar over the last few years, the yuan has reached a level that is satisfactory to the People’s Bank of China. From the perspective of its value and the supply-demand balance for yuan, the current exchange rate is generally reasonable and balanced, which is also good for the movement towards marketization of the exchange rate and internationalizating the yuan.

However, the euro zone’s deteriorating economy and the transition of China’s domestic economy away from overreliance on infrastructure spending will put great pressure on the exchange rate, and we think the yuan is likely to continue depreciating.

The exchange rate is the international price of the yuan and reflects the price of all China’s imports. Therefore we should have a clearer and better understanding of China’s transition economy. Given the transitional state of China’s economy and the bearish world economy, China has to adapt from “cheap labor, cheap natural resources and cheap environmental-violations.” Meanwhile, the principle for setting the yuan exchange rate based on the three “cheaps” will also change. There’s no doubt that China’s exports will also slow down.

On the other hand, China’s economy will certainly be transformed and its growth will depend on domestic demand. Thus China will further expand its domestic market and the focus of its economy will also gradually switch from “Made in China”to “Sold in China.”

During this period, many factors will combine to influence the economy. Exports are slowing down and upward pressures on the yuan are abating. However, given the scale of the “Sold in China” side, i.e. the domestic market, other countries investment in China and profits from this will also increase in the future.

Technological innovation and production efficiency will be key for international competitiveness in the future. If China cannot quickly find a new source for economic growth and achieve the transition of its economy, then the country will slow down in the next economic cycle. We don't think that the Chinese economy will have major problems, but a painful transition is unavoidable. The depreciation of the yuan is very likely to accelerate for a certain period.

Another factor that shouldn’t be neglected is that rising prices and an asset bubble are boosting the price of Chinese goods. If you exclude the cost of labor, many goods in China are more expensive than those in the U.S. Inflation and the current asset bubble will all lead to the depreciation of the yuan. Considering the supply and demand dynamics, factors such as falling exports, lower utilization of foreign capital and the weak real economy will also have a large influence on the exchange rate.

Pressure from abroad for yuan appreciation has been a great worry for China’s central bank in the last few years, but now the direction has changed suddenly and the currency is instead facing the risk of depreciation. When the exchange rate isn’t only moving in one direction, depreciation can be tolerated for a defined period and can also promote exports. However, if the yuan remains weak over a long period time, capital outflows and inflation will ensue and the negative influences on China’s domestic economy will predominate. We should be prepared to see the depreciation of RMB both domestically and internationally for a while longer.

Correction - when the English translation of this story was first published on May 25, it incorrectly stated in the first paragraph that the yuan had traded at the bottom of its two-percent-wide pricing corridor for seven successive sessions.