Material Matters: RMB Revaluation Takes Centre Stage

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By Chris Shaw

Investors and media are increasingly focusing on speculation the Chinese Government is considering revaluing its renminbi (RMB) peg against the US dollar. Analysts at Citi note this speculation comes at the same time as the US Treasury has postponed its currency report and top officials have increased the level of bilateral contact between the two countries.

While this implies the US is trying to offer a time window for China to revalue its currency higher, Citi suggests it may actually force an agreement to be reached within a 3-month period. If no agreement can be reached Citi suggests the odds of the US naming China as a currency manipulator have increased.

Such an outcome would be less friendly than if the US Treasury were to release its report and not name China as a manipulator, with China to then revalue its currency soon after.

In Morgan Stanley's view China will exit the RMB's hard money peg against the US dollar in coming months as there are benefits to China in doing so. In particular, an appreciation in the RMB would help contain near-term inflationary pressures, which are increasing from a rapid increase in international commodity prices.

There would also be political benefits from such a move, as Morgan Stanley notes China's major trading partners consider the RMB to be undervalued, making the hard peg against the US dollar a form of bias in China's foreign trade policy.

Longer-term, a stronger RMB would likely assist in re-balancing the economy in Morgan Stanley's view, as it would cause an adjustment in relative prices between the tradeable and non-tradeable sectors of the economy.

As well, a revaluation of the RMB would help China move towards a more flexible exchange rate agreement, which is required for any move to a more independent monetary policy.

In terms of the timing of any RMB appreciation Citi expects some appreciation in the second quarter of this year, while Morgan Stanley takes the view the most likely window for any such move is early summer or during the third quarter of this year.

Morgan Stanley expects an initial adjustment of 2-3%, to be followed by a more gradual appreciation in subsequent months. JP Morgan suggests any revaluation is likely to be in a range of 2-5%.

For the full year appreciation is likely to be in the order of 4-5% in Morgan Stanley's view and it estimates the US dollar rate against the renminbi will be around 6.54 by the end of this year and 6.17 by the end of 2011.

JP Morgan takes the view any subsequent appreciation of the RMB would be a positive for commodity prices, in particular those commodities where China is a large, high cost producer and a significant consumer.

In JP Morgan's view any change would be particularly meaningful for iron ore prices and to a lesser extent for aluminium prices, as a stronger RMB would raise the marginal cost of Chinese production in US dollar terms. In both industries China is at the upper end of the production cost curve.

In iron ore China accounts for 20% of global production but domestic producers are in the 90th percentile with respect to costs, while in aluminium China accounts for 38% of world output and is also in the 90th percentile in cost terms.

Assuming the RMB is allowed to appreciate, JP Morgan expects the major impact on the iron ore market wold be to accelerate the long-term trend of China increasing its reliance on seaborne imports. This is occurring at the expense of domestic supply and is an obvious benefit for Australian iron ore producers given their position as exporters to China.

In aluminium a stronger RMB would be expected to assist in the progressive marginalisation of China's domestic industry, as it would add upward pressure to the top end of the cost curve. Despite this, JP Morgan doubts China will reduce domestic aluminium production in favour of imports as a stronger RMB implies cheaper raw materials.

JP Morgan suggests the other potential commodity beneficiaries of a stronger RMB could be thermal and coking coal, while a firmer RMB could also offer a boost to manufacturing globally as China's domestic export based manufacturers would become less competitive.

With respect to Rio Tinto ((RIO)) and BHP Billiton ((BHP)), JP Morgan notes Rio has the biggest earnings exposure to RMB-intensive commodities at around 80% of earnings before interest and tax, while BHP's exposure is around 60%.

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