China's external imbalances have grown so large that some economists have started to think the unthinkable: that Beijing may have to revalue the yuan again. Their views are a minority and they hold them with no great conviction. After all, Premier Wen Jiabao has firmly ruled out a repeat of the one-off July 2005 revaluation of 2.1 percent.
But China's foreign exchange reserves and trade surplus are expanding so fast that these economists say a policy U-turn, though unlikely, can no longer be dismissed out of hand. Jonathan Anderson, chief Asia economist at UBS, said the logic for a big one-off revaluation is that it would remove, at a stroke, the undervaluation that has been helping to suck speculative capital into China.
But he said hot money is in fact being lured mainly by the prospect of making a killing on Chinese assets, especially stocks. The Shanghai market has more than tripled since the start of 2006. It hit a fresh record on Tuesday.
"If this is the case, then moving the exchange rate would do little to solve the inflows problem. However, to say the probability is low is not the same as saying the probability is zero," Anderson said in a research report.
Anderson's base case has been that China could let the yuan rise by as much as 8 percent a year without attracting unsustainably large capital flows. After currency reserves in the first quarter jumped $136 billion, to a record $1.2 trillion, he said it would seem this assumption no longer holds water.
Qu Hongbin, chief China economist at HSBC, agreed that the key issue for policy makers was how to lower expectations about returns from yuan-denominated assets.
Opening channels to buy overseas shares would let Chinese investors arbitrage the huge valuation gap between domestic and international equities. This would lead to substantial capital outflows and sap overconfidence in the Shanghai market, Qu said.
A second option was to jack up interest rates aggressively to curb asset price inflation. The third option was a one-off revaluation of about 10 percent, he said in a recent note. Such a step was unlikely because it lacks political support. "Potential considerations aside, the main risk is that such a move won't necessarily reduce China's structural trade surplus. Instead, it may invite more speculation of further appreciation and, in turn, even more capital inflows," he said.
Beijing, in short, is damned if it does revalue the yuan and damned if it doesn't.
This leaves most China-watchers predicting more of the same: a measured rate of climb in the yuan, which rose on Tuesday to 7.6942 per dollar, the highest rate since it was cut loose from a dollar peg in July 2005 to float within managed bands. "They prefer not to revalue," said Ben Simpfendorfer, an economist with Royal Bank of Scotland in Hong Kong.
He said the domestic logic for a firmer currency was stronger than ever, but conservatively minded policy makers still had an inbuilt hesitancy to allow the industrial sector to adjust to stronger prices, fearing a swathe of job losses.
"The message I get from exporters is that the steady pace of appreciation has given them breathing space to cut costs. Foreign manufacturers in particular say they've wrung out pretty decent efficiency gains. But they're wondering whether they'll hit a wall at some point," Simpfendorfer said.
The eternal debate about the yuan is gaining new life in part because China's policy mix to date has failed to cap the gusher of liquidity, springing from a record trade surplus, that officials identify as the greatest threat to economic stability.