Should Yuan appreciation be taken for granted?

Exchange rates for the Chinese Yuan has been a contentious issue for some time.Almost everybody other than the Chinese feel that the currency is undervalued. And some feel, by a huge margin.

USA constantly tries to impress upon the Chinese that they need to do more on the exchange rate front and probably to let appreciate Yuan much more and much faster.In fact a bill is being pushed in US Senate to allow USA to impose import duties on countries that undervalue currencies. Cannot think of any other major country, except China, against which this bill can be used, if passed by US and validated by International Law.

Basically its difficult to argue against Yuan appreciation, with all their reserves and trade surpluses across the board.

I am no currency expert, but just trying to put a few points together and see if Yuan appreciation should be taken for granted.

- After the 2008 crisis, Chinese banks, backed by the govt, went on a lending binge, the likes of which have not been seen before.That went onto create a real state bubble, or extend the real estate bubble and money went into projects which probably could not have been justified economically. Inflation came along and wages started to rise.

  Then, starting some time in 2010, they tried to control the bubble and its side effect, putting restrictions on lending, increasing reserve requirements on banks and increasing bank rates.And that is still going on.

  But it looks real estate in China has reached a point, where soft landing is not an option. A crash is more likely.The chickens have come home to roost.

- The low interest rates that are offered to the consumers, has also caused an "informal lending" system to take a stronghold in China. One of the signs of that is that the formal banking system has been seeing its deposit base shrink in the last few months. "Informal lending" offers higher rates to people,but how much of the system is actually legal is not known.

- The Govt has tightened credit through the banking system, for fear of taking the bubble even further. This has only added fuel to fast growing "shadow banking" system. The reserve requirements for banks is at an all time high.Inflation is still to be controlled.

- Given all this if the real estate does suffer a severe downturn, the whole banking system ends up in a huge mess. And the collateral damage on other ancillary industries will also be huge, further adding to the bad assets in the system.

- Lot of local governments in China have been running huge deficits funding questionable projects. some of these deficits are probably of the size same as Portugal or Greece. Local governments earn a significant chunk of the revenue from the real estate industry. Put these two things together, and it smells bad.

- Chinese demographics are turning towards becoming older. Their under-14 population has gone down from 28% in 1990 to 17% in 2010.The flow of new labour to the market has slowed down, one of the structural reasons for the rising wages.The rising wages are causing some other countries like Vietnam or Bangladesh to become relatively competitive. China's scale is not replicable in the near future and thus there is no immediate threat to its place as the world's leading manufacturer. Thus it is very likely that the deflation that China exported over the last 2 decades is unlikely to last.

Moreover with with an aging population, it is not going to be easy to replace export driven growth with domestic consumption driven growth. As is sometimes said "China will become old before it becomes rich".

All this would mean, they have to move towards higher value addition and technology, but that takes time.

- If the US and Europe go through another recession, then Chinese exports will also suffer.

If recession/stagnancy in the developed world combines with a real estate-cum-banking crisis in China, will the government launch another stimulus as it did in 2008?

Given that the present banking system problem and inflation is a result of that stimulus, its very unlikely, though nothing can be ruled out.

Can China be expected to keep appreciating Yuan, which will almost act as an "anti-stimulus"?

Commodities have already come down quite a bit fearing a Chinese slowdown. Thus argument of using currency appreciation as an anti-inflationary tool gets blunted.

Currency appreciation adds to the purchasing power of the domestic consumer, but in the aftermath of a Chinese real estate and banking crisis, a consumption led growth is also unlikely.And so currency appreciation may not serve that purpose as well.

In bad times, trade surpluses will also shrink.

Domestic interest rates are also likely to head down.

If its indeed a big banking bust in China, they might want to print more money and recapitalise the system.

Chinese Yuan is a controlled market, but generally all these factors would add to the depreciation pressure on a currency and not appreciation.

US Dollar and Euro, facing their own issues can get into a money-printing mode, more than what they have already done.Absolutely possible and changes currency dynamics. But then choosing a winner in a currency "race to the bottom" is tough, if not impossible.

I think its time I repeat myself. I am no currency expert. Its just an attempt to look at things with a perspective.

Let me know, if I have missed something very basic.

USDCNY = 6.36 today.