>Regional Implications of Renminbi (RMB) appreciation

■ The economic impact of nominal RMB appreciation likely very limited… — There are three major reasons why: 1) Expected pace of RMB appreciation will be very gradual; 2) Other Asian currencies are expected to appreciate alongside it; and, 3) Intra-Asia production linkages would mitigate the impact on China’s export prices, and reduce substitution gains on Asia’s exports.

■ …but medium term RMB real appreciation may be increasingly important — Real appreciation can be realized via combination of nominal appreciation and higher inflation. China’s faster wage growth vis-à-vis productivity is expected to lift China’s trend inflation to above 4% in the coming decade vs. 2% in the previous decade, with further upside inflation risk from future price reforms.

■ Export substitution gains may be highest in India, Pakistan & Thailand — While net export similarity with China is highest for Taiwan and Philippines, this likely exaggerates substitution gains from RMB appreciation given concentration of similarity in electronics where disproportionate amount are exported to China for processing/re-export. Meanwhile, exports of India, Pakistan and Thailand overlap with China across a broader set of export items that are less likely to be vertically integrated, and could thus marginally benefit more from substitution
gains from third party markets via RMB appreciation.

■ Import gains highest for Australia, Indonesia and Vietnam — Relatively stronger RMB vis-à-vis the region would boost China’s purchasing power of imports. We think the impact will be stronger for Chinese imports that are for final demand than for processing/re-exporting, benefiting commodity exporters and low cost manufacturers.

■ Inflation impact to Asia – Hong Kong looks relatively more vulnerable — Rising imported costs on a REER appreciation of RMB is likely to impact inflation of HK more than others in Asia given the HKD peg and sizeable amount of goods comprising HK’s CPI basket that are imported from China.

■ Capital flow impact– Exacerbating inflows? China’s overseas investment — A gradual appreciation of RMB could exacerbate capital inflows to China and rest of Asia, making liquidity management increasingly complicated. We think RMB’s REER appreciation over the longer term will support China’s increased overseas investment, including to Asia, for two reasons: 1) Makes overseas assets cheaper; and 2) Re-configuration of manufacturing production and ancillary investment flows, with lower end manufacturing potentially relocating to South and parts of Southeast Asia (ex-Singapore, Malaysia) – capital deficient countries like Vietnam, India, Pakistan, Sri Lanka and Indonesia should increasingly welcome capital inflows.

To read the full report: RENMINBI APPRECIATION