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China to allow modest renminbi appreciation soon, Western Asset says
Over the next few months, Western Asset expects the Chinese leadership to allow a gradual appreciation of the renminbi albeit at a modest pace of 3.0%-3.5% per year
The Asset 11 May 2010
Asian economies, including China, should continue to grow strongly during the rest of 2010 due to supportive domestic and external factors, said Western Asset Management on May 10. 
 
“Asia’s strong fundamentals stand out in stark contrast to many other regions of the world,” says Rajeev De Mello, head of Asian investment at Western Asset Management. “Despite modest tightening of fiscal and monetary policies in the next few months, domestic conditions remain very supportive for further growth. Monetary policy remains very accommodative and the increase in confidence should offset the gradual phasing out of various stimulus programs implemented during the financial crisis.”
 
In addition to the favourable domestic conditions, the external sector should continue to support Asia through multiple channels. The easy monetary policies of the US Federal Reserve, the European Central Bank and the Bank of Japan should continue to encourage capital flows toward Asia as global investors look for better returns. Consumers in the US are increasing their spending and their imports from Asia.
 
Appreciation of Chinese renminbi
 
Western Asset says the dominant theme over the coming quarters will be the eventual appreciation of the Chinese renminbi. Chinese exports have rebounded significantly from the lows seen in late 2008. Inflation is increasing and global pressure is building for some form of appreciation. After starting the year with some stress in bilateral relations, the most recent US diplomatic moves have been more positive toward China.
 
However, international pressure on China is increasing as French, British, Korean and Canadian leaders included foreign exchange policies in a letter to their G20 counterparts on building balanced growth. Many Asian countries are adversely affected by the Chinese renminbi peg as they are forced to intervene in their respective currency markets to avoid losing competitiveness to China.
 
Over the next few months, Western Asset expects the Chinese leadership to compromise and allow a gradual appreciation and slight widening of the currency band. However, the appreciation pace is likely to be kept very modest, around 3.0%-3.5% per year. De Mello does not believe that the Chinese renminbi will be revalued in one large step, and attaches only a small probability that the currency policy would be shifted toward managing the renminbi against a basket rather than just the US dollar.
 
“As the Chinese leadership will not want to show that it is yielding to foreign pressure, any agreement regarding a change in currency policy is more likely to occur between some of the key meeting dates rather than immediately following one,” he said.
 
The regional impact of a change in Chinese currency policy would likely be positive for all Asian currencies, as well as for risky assets in the region, as it would reduce the risk of protectionism and deteriorating bilateral relations between the US and China, says Western Asset.
 
Interest rates to normalize
 
Policy makers are likely to move toward normalizing their policy rates. Inflation in the region should continue to increase, and increases are also being seen in domestic prices, global commodity prices, food prices and property prices. However, in most cases inflation rates remain close to official targets.
 
Western Asset expects that high unemployment rates in Europe, Japan and the US as well as low factory capacity utilization in most manufacturing countries should help keep inflation from rising too rapidly. Most bond markets already priced in a normalization of interest rates, and yield curves in the region are steep due to earlier expectations of government issuance. Thanks to the stronger recovery, most Asian countries should borrow less, thereby making current longer maturity bonds more attractive.
 
“Our strategy over the next few months will be to maintain an overweight exposure to Asian currencies, especially the Chinese renminbi, the Indian rupee, the Korean won, the Indonesian rupiah and the Malaysian ringgit. Our exposure to the Sri Lankan rupee is mainly to capture that country’s higher yields, which should continue to see growth improvements thanks to the end of the war,” says De Mello.
 
Western Asset continues to favour Asian corporate bonds. While spreads have rallied strongly during the quarter, corporate cash flows are improving due to the improved macro backdrop, and issuance is easily matched by investor demand. The firm has kept its allocation to Asian high-yield moderate, as it awaits new issues scheduled for the coming weeks.  
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