>The ascension of the Yuan(CNY)

More strength to the CNY
On June 19, China introduced more flexibility into its yuan (CNY) exchange rate policy. Since then, the People’s Bank of China (PBOC) fixing for USD/CNY has fallen from 6.8275 to 6.7768 on July 8. In fixing terms, the CNY has appreciated 0.75% against the USD over this period.

We expect the annual appreciation pace in the CNY to be slower in the next three years compared to the pace seen from 2005 to 2008. The CNY is expected to appreciate against the USD by a total 2% in 2010, followed by 3% in 2011 and 5% in 2012. In the last cycle, the CNY appreciated by 2.6% in 2005, 3.4% in 2006 and 6.9% in 2007. Our end-year targets for USD/CNY are now 6.69 for 2010, 6.50 for 2011 and 6.19 for 2.12.

CNY flexibility is also about monetary policy, not just the exchange rate
When USD/CNY stopped falling in favor of a flattish profile in July 2008, China’s inflation had eased and converged with its US counterpart. Since then, China and US inflation had fluctuated closely with each other, both in direction and momentum. This was an important development that supported its “basically stable” currency emergency measure to safeguard the Chinese economy from the US-led global financial crisis and the Eurozone sovereign debt crisis.

Since March 2010, when both US and China reported the same inflation rate of 2.4% YoY, inflation has risen in China to a 19-month high of 3.1% in May 2010 while falling to 2.0% in the US. Looking ahead, this trend is likely to persist. Between the two countries, China’s labor sector is undoubtedly stronger where wages have increased significantly this year. On the other hand, job creation remains painfully slow in the US.

Looking ahead, we forecast an average inflation rate of 4.0% for China in 2010. This implies that inflation will accelerate by an average 5.1% for the rest of the year from the average 2.5% posted in January-May period. In contrast, US inflation is expected to average 1.8% from June to December, down from the average 2.3% in the first five months (implying full year average inflation of 2.1%).

To read the full report: USD/CNY OUTLOOK