China may allow its currency, the renminbi (RMB), to gradually appreciate this year with two important objectives: reducing the pressure from strong domestic liquidity and boosting domestic consumption.

The country faces no urgent economic or financial imperatives to revalue its currency. Elsewhere and in the past, undervalued currencies generated or reinforced excess demand to spur inflation in affected economies. In China, however, there are few signs that unsustainable demand growth is rapidly driving up consumer prices.

But many attribute the country's consistently large current account surpluses to an undervalued RMB. In terms of GDP, China's surpluses are actually smaller than those of countries such as Malaysia, Singapore, and Switzerland. But savers in these economies can invest offshore and such capital outflows ease the buildup of domestic liquidity pressure arising from the current account surpluses.

Meanwhile, much of China's savings are kept in the country as its capital account has yet to be liberalized, causing a constant strain on credit growth and asset prices. Policymakers currently rely on direct credit controls and high reserve requirements to contain the effects of strong liquidity pressure. We believe that this reliance increases the risk of policy errors - and this risk becomes more challenging as the economy grows larger and more complex.

A pegged RMB also hinders a rebalancing of the economy toward domestic demand, in our opinion. Its appreciation would reduce the cost of imports, directly increase purchasing power of Chinese consumers and encourage greater spending. A stronger RMB could also indirectly increase consumption by tempering the price increases of domestic goods and services.

The RMB appreciation against the US dollar in 2005-2008 partly eased some concerns, in our opinion. China's central bank bought less foreign exchange than if it had to maintain a constant exchange rate. Consequently, it created fewer RMB deposits and added less to domestic liquidity.

The slower foreign exchange accumulation also reduced balance sheet risks. Foreign assets amounted to 81 percent of the central bank's total assets, backed by mainly RMB-denominated liabilities. The resulting currency mismatch could cause severe losses for the central bank if the major world reserve currencies depreciate sharply against the RMB.

The three-year climb of the yuan may also have slowed the slide in the economic share of domestic consumption. In the three years to 2005, when the RMB was first de-pegged from the US dollar, the share of final consumption in GDP slipped by 7.8 percentage points to 51.8 percent. Over the next three-year period, it fell by a significantly smaller 3.2 percentage points to 48.6 percent in 2008.

Despite these benefits, we believe that concerns about employment losses have halted the RMB's appreciation since July 2008. However, Chinese policymakers likely meant for the hiatus to be temporary. Conditions that may warrant further RMB appreciation remain little changed since 2005. In our view, the resumption of an appreciation trend is only a matter of time. The relevant questions are how soon? How fast and how far?

We believe economic conditions are ripe for resumption of RMB appreciation. After the retrenchments of 2008-2009, manufacturing jobs are growing once again. Indeed, wage pressures have already emerged. A few coastal provinces have had to raise minimum wages at double-digit rates to attract migrant workers.

Political considerations could delay the timing of renewed RMB appreciation, even if the economic case for it is clear. China's main international trade partners and the multilateral financial agencies have made public calls for a stronger Chinese currency. We believe Chinese policymakers are unwilling to appear to yield to such calls. Until external pressure recedes, China is unlikely to allow a stronger RMB, unless economic conditions make it clearly necessary.

We don't believe that a new round of appreciation will signal a significant shift in China's exchange-rate regime, given the fact that China holds large balance-of-payments surpluses. But some policymakers see a likely long-term move to a managed floating exchange rate regime.

We believe that at least two conditions have to be in place before this is possible. First, China's current account surplus must fall to a level that is closer to those of Germany and Japan (averaging 6 percent and 3.9 percent over 2004-2008, respectively). At these levels, China would find its surpluses politically easier to defend vis-a-vis those of major trade partners.

Second, some capital account liberalization would contribute to a more flexible exchange rate, in our view. Allowing residents to invest abroad more easily and granting foreign direct investors the flexibility to tap local capital market financing would help create net capital outflows. This would reduce or even stabilize the balance-of-payment account and the need for the central bank to hold more foreign reserves.

But capital outflows are unlikely to rival inflows until expectations of further RMB appreciation recede. We believe that this change in investor sentiment is likely when China's current account surplus falls to levels that are no longer a political concern. That's why both conditions - a lower current account surplus and capital account liberalization - are necessary, in our view, before China can move to a more flexible exchange rate regime.

China's transition to a managed floating exchange-rate regime is likely to be a long one. In our view, neither of the two conditions that we have identified can be fulfilled easily or quickly. We expect an effective crawling peg of the RMB against the US dollar to remain in place for a number of years yet. The rate of the crawl will probably vary, or even freeze entirely, depending on China's economic circumstances. But short of major negative developments that trigger a prolonged slowdown in China, we believe a reversal is unlikely.

Kim Eng TAN is director of Sovereign &International Public Finance Ratings at Standard & Poor's. The opinions expressed are entirely those of the author.

(HK Edition 04/20/2010 page2)