By Tim Condon

If unsteady yuan appreciation hasn’t exerted a pull on Asian currencies, it’s implausible that increasing the unsteadiness will increase its pull. More likely, the yuan will behave more like other Asian currencies.

In his post-NPC press conference Prime Minister Wen reinforced what has now become the party line on the yuan: it is close to an equilibrium level. As evidence he cited the 30 percent real effective exchange rate appreciation since 2005 and the yuan being priced in Hong Kong’s non-deliverable forward market for zero appreciation over a one-year horizon. Other top officials have cited the narrowing in the trade surplus. The abrupt drop in an indicator of the People’s Bank’s foreign exchange market intervention is another sign of reduced yuan appreciation pressure.

It is premature to declare that the yuan is fairly valued. Wen’s and the other evidence can be explained by what was happening in global financial markets in the third and fourth quarters of 2011. Panic over the U.S. debt ceiling and Greek debt triggered hot money outflows everywhere including from China. Panic-driven capital outflows, not an abrupt end of undervaluation, explain the reduced yuan appreciation pressure.

The authorities’ response has been to slow the appreciation of the yuan and, through the first 17 trading days of March, to depreciate it, which would not be a first but, in the context of the new party line, could upset expectations. Yuan appreciation has been a fact of life since the authorities adopted the managed float in July 2005. Average annual appreciation has been 3.8 percent since 2005.

The pace of appreciation has been anything but steady. Annual average appreciation has ranged from 0.9 percent in 2010 to 9.5 percent in 2008. Average monthly appreciation has ranged from negative 2.4 percent in August 2008 to 20.7 percent in January 2008.

We think the wide fluctuations in the pace of yuan appreciation reduce its salience for thinking about other Asian currencies. They also may explain the failure of other Asian currencies to move with the yuan.

If unsteady yuan appreciation hasn’t exerted a pull on Asian currencies, it’s implausible that increasing the unsteadiness will increase its pull. More likely, the yuan will behave more like other Asian currencies, which move to offset swings in the U.S. dollar’s exchange value against major currencies.

The strength of the relationship varies across currencies. The correlation between DXY, an index of the U.S. dollar’s exchange value against the Euro, which has a 57.6 percent weight, the Japanese Yen (13.6 percent), the British Pound (11.9 percent), the Canadian Dollar (9.1 percent), the Swedish Krona (4.2 percent) and the Swiss Franc (3.6 percent), and ADXY, a similar index against Asian currencies including the yuan with a 38.08 percent weight (in the most recent calculation), the Korean won (14.45 percent), the Singapore dollar (10.40 percent), the Hong Kong dollar (8.61 percent), the Indian rupee (7.15 percent), the Taiwan dollar (6.64 percent), the Thai baht (5.09 percent), the Malaysian ringgit (4.67 percent), the Indonesian rupiah (3.01 percent) and the Philippine peso (1.90 percent) is 0.83. U.S. dollar strength against major currencies is strongly associated with strength against Asian currencies.

We expect the People’s Bank of China’s shift to an unsteadier pace of yuan appreciation will be effected within the existing framework for managing the exchange rate. The People’s Bank exercises significant discretion in managing the yuan. We consider it, the Bank of Korea, Bank Negara Malaysia, the Monetary Authority of Singapore, the Central Bank of China and the Bank of Thailand as Asia’s heaviest exchange market interveners. Historically the Central Bank of China and the People’s Bank have been the first and second, respectively, among equals.

The IMF classifies the currencies of most of this group as undervalued (Taiwan is not an IMF member but for a variety of reasons we believe the Taiwan Dollar also is undervalued), which suggests the authorities employ discretion to keep their currencies undervalued. We think the undervaluation is an unintended consequence of Asian central banks trying to insulate their exporters from currency fluctuations by “shadowing” the DXY index. The shadowing explains the correlation between DXY and ADXY.

Yuan appreciation pressure has diminished but the abruptness of the pressure drop makes us skeptical of interpreting it as signalling an end to the yuan’s undervaluation. That said, seven years of appreciation have lessened undervaluation and it is reasonable to expect the average pace of appreciation to slow. The leopard doesn’t change its spots and we doubt the People’s Bank will eschew heavy discretion in managing the yuan. However, we think discretion will be directed at shadowing the U.S. dollar index rather than staying on an appreciation path.