By Kevin Yao - Analysis
SINGAPORE (Reuters) - When Singapore surprised the market by revaluing its dollar this month to pre-empt inflation, analysts had to rack their brains to find out how much the currency’s value had actually gone up. Such an obscure system may be just what China needs.
Steering the exchange rate, not interest rates, is the Monetary Authority of Singapore’s key policy tool. The MAS has managed its currency within a secret trade-weighted band to keep the economy on an even keel and shield the island from speculative attacks since the early 1980s.
By contrast, the yuan looks like an easy target for the market as the Chinese authorities come under mounting pressure to abandon a 21-month-old peg to the dollar.
A shift is widely expected as early as this quarter. Intriguingly, chatter in the market is that Beijing might have an eye on Singapore’s track record as it decides what to do next.
China might still opt for a small one-off yuan revaluation to showcase its international responsibility and help soothe tensions with the United States, but many analysts believe Beijing needs to take some major steps to make the yuan flexible.
“You don’t want to sent a message to the market that there is only one-way risk in your currency,” said Tim Condon, head of Asia research at ING in Singapore.
“If you look at the Singapore dollar, it can go up or down against any currency,” he said.
Reverting to a crawling peg to the dollar -- the regime China followed between July 2005 and July 2008 -- might expose the yuan to expectations of further appreciation, fanning hot money inflows and fuelling economic overheating.
China recorded a $7.24 billion trade deficit in March, the first shortfall since April 2004, but its foreign exchange reserves rose by $47.9 billion in the first quarter to $2.447 trillion, suggestive of persistent upward pressure on the yuan.
When China revalued the yuan by 2.1 percent in July 2005 and scrapped a decade-long dollar peg, it said it would henceforth manage the yuan with reference to a basket of currencies.
But the People’s Bank of China (PBOC) never really followed through on its intention. Instead, it kept the yuan on a tight leash against the dollar, limiting its rise or fall to 0.5 percent from a daily mid-point.
Analysts believe the dollar’s slide helped force the PBOC to actually implement a crawling peg, under which the yuan gained a further 19 percent against the U.S. currency until its rise came to a halt in mid-2008 due to the global economic crisis.
Chinese authorities may have learned from the experience that a crawling peg only increased complacency about currency risk among domestic firms and fueled hot money inflows, analysts say.
“Engineering more two-way volatility would help prevent a similar speculative build-up and also give the appearance of a more market-determined exchange rate framework,” analysts at Deutsche Bank said in a research note.
Fan Gang, a former central bank adviser, said recently that China should switch to a basket peg, but the Deutsche analysts believe a reference basket -- a combination of a crawling dollar peg and a basket peg -- would make the yuan more flexible.
“If China were truly allow such a framework, it would be able to create more two-way movement in the dollar/yuan spot rate, and still maintain only a modest appreciation trend and relatively low volatility in its currency,” they said.
A more flexible exchange rate could help the PBOC improve monetary policy to cope with capital flows and external shocks.
Last week, President Hu Jintao shrugged off foreign calls for a stronger yuan but said China was still committed to currency reforms.
Tellingly, the PBOC has been inviting overseas experts to tap their knowledge about Singapore’s currency regime, while several top government think-tanks have been studying plans for possible currency reforms.
Analysts say the dollar’s rebound provides a good opportunity for China to switch to a basket regime as a continued peg to the dollar translates into yuan rises on a trade-weighted basis.
“The dollar/yuan is still pretty much under control, so guiding the basket should be relatively easy,” said Emmanuel Ng, a currency strategist at OCBC Bank in Singapore.
“A shift may actually take some pressure off the yuan, given that the yuan’s nominal effective exchange rate has actually been appreciating.”
Ben Simpfendorfer, China economist at Royal Bank of Scotland in Hong Kong, agreed that a basket-based regime may ease upward pressure on the yuan, but he still forecasts a 5 percent rise in the currency in the next 12 months, including a 3 percent up-front revaluation.
Offshore NDFs on Wednesday were implying a 3.3 percent yuan rise over the next year.
Under Singapore’s “BBC” regime -- band, basket and crawling peg -- the central bank manages the Singapore’s nominal effective exchange rate (NEER) by adjusting the center, slope or width of the band in line with economic performance.
Analysts estimated last week’s move was equivalent to a revaluation of 1.2 percent to 1.4 percent.
Still, they warn that a basket peg would not necessarily relieve the PBOC from the need to intervene to limit yuan gains.
“Even under Singapore’s rigorous framework, ad hoc ‘smoothing’ intervention to suppress currency volatility is fairly common,” the analysts at Deutsche Bank said.
Editing by Alan Wheatley & Kazunori Takada