Mainland China s Exchange Rate Reform and Its Impact on Hong Kong

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1 Treasury Division Renminbi Monitor May 2013 Joanne Yim Chief Economist Ryan Lam Economist Mainland China s Exchange Rate Reform and Its Impact on Hong Kong The Chinese renminbi (RMB) exchange rate started this year on a relatively strong note, as mainland China s economy continued to recover from the financial crisis-induced economic slowdown and reflecting strong capital inflows. The official reference rate was fixed at record levels against the US dollar during the past month. Similarly, the onshore spot RMB rate has been hitting 19-year high versus the US currency. Looking ahead, the RMB is likely to maintain a rising trend, but the pace of appreciation will not be significant and there will be more two-way fluctuations. There are two main factors supporting this view. First, the RMB may be close to its equilibrium level, having gained over 30% against the US currency since the July 2005 exchange rate reform. Our analysis based on different approaches found that while the RMB exchange rate was undervalued in 2012, it was by a range of 0.6% to 10.1%. Second, the Mainland s current account surplus is set to narrow, with growth of foreign direct investment likely to slow and that of outward direct investment to increase in the coming years. These changes will lead to diminishing gains for the RMB. Moreover, the country s capital account will be further liberalised, resulting in more two-way fund flows. Our forecast is for the RMB to appreciate only modestly, fluctuating within a narrow range of 6.00 to 6.20 against the US dollar in the coming two years. The pace of RMB appreciation will slow, but efforts to reform the RMB exchange rate will not. The People s Bank of China has expanded the RMB s daily trading band against other major currencies many times before, and further widening is likely. Our forecast is for the daily trading band versus the US dollar to be expanded again this year, to +/-1.5% or more, from the current +/-1%. The Mainland authorities have been lifting restrictions on capital account transactions based on the following principles: liberalising inflows before outflows, long-term flows before short-term flows, direct investment flows before other investment flows, and institutional flows before individual flows. Further reforms will continue along these lines and the RMB could become a fully convertible currency before the end of this decade. Many in Hong Kong are concerned about the impact of a strong RMB on local inflation. However, our estimates suggest that a 10% appreciation in the RMB against the Hong Kong dollar would only cause Hong Kong s consumer price inflation to rise by about 0.5 percentage point, assuming a complete exchange rate pass-through to consumer prices. The effect could be smaller if local shopkeepers opt to absorb part of the rising import costs. The estimated effect may appear to be rather modest compared with the general perception. However, it must be noted that factors other than the RMB exchange rate could be at play to push up prices of retained imports from the Mainland. Examples include rising Mainland wages as well as increasing consumption of selected food items such as meat as Mainland consumers become more affluent.

2 Recent Trends The Chinese renminbi (RMB) exchange rate started this year on a relatively strong note, as Mainland China s economy continued to recover from the financial crisis-induced economic slowdown and reflecting strong capital inflows. The official reference rate was fixed at record levels against the US dollar during the past month. Similarly, the onshore spot RMB rate has been hitting 19-year highs versus the US currency, trading at a premium to the daily fixing, near the maximum 1% divergence allowed by the People s Bank of China (PBOC). The RMB s recent trend was rather different from that of 2012, when it appreciated only modestly versus the US dollar. The Chinese currency also showed more two-way fluctuations against the US dollar in The RMB weakened against the US dollar from May to early September 2012 when there was general fear of a hard landing for the Mainland economy, before resuming an upward trend in the final quarter of the year. For 2012 as a whole, the official reference rate of the RMB only strengthened 0.25% against the US dollar, closing the year at The pace of annual appreciation was the slowest since 2009 when the Mainland authorities kept the RMB exchange rate against the US currency basically stable to help the economy ride through the global financial crisis triggered by the collapse of the US housing market in Last year s movement, however, was the exception rather than the rule as the RMB exchange rate has strengthened steadily and continuously against the US dollar for several years (Exhibit 1). Exhibit 1: USD/RMB Spot Exchange Rate RMB per USD (22/7/2005) Short-term Outlook Looking ahead, the RMB is likely to maintain a rising trend, but the pace of appreciation will not be significant. There are two main factors supporting this view. First, the RMB may be close to its equilibrium level, having gained over 30% against the US currency since Second, expected narrowing of the Mainland s trade surplus and more outward direct investment flows would lead to diminishing gains for the RMB. The RMB is near equilibrium level The relatively modest gain of the RMB exchange rate against the US dollar in 2012 to a large extent reflected the view that the Chinese currency is no longer significantly undervalued after the sharp appreciation over the past several years. On a cumulative basis, the RMB has appreciated about 32% against the US dollar since the July 2005 exchange rate reform (Exhibit 2). The corresponding increases, in terms of the real and nominal effective exchange rates, were 34% and 24% respectively, according to calculations by the Bank for International Settlements (Exhibit 3). Exhibit 2: USD/RMB Exchange Rate (PBOC Mid-Rate) Cumulative End of period USD/RMB RMB appreciation (vs last year) RMB appreciation (vs 21/7/05) /7/ /7/ % 2.1% % 2.5% % 6.0% % 13.3% % 21.1% % 21.2% % 25.0% % 31.4% % 31.7% Sources: Bloomberg, Hang Seng Bank 2

3 Exhibit 3: Mainland Effective Exchange Rate Index Index Exhibit 5: USD/RMB Spot Onshore/Offshore Spread pips Nominal Real Sources: BIS, Reuters EcoWin, Hang Seng Bank Market participants seem to share the view that the RMB is near equilibrium level, as the spread between the onshore and offshore spot RMB rates have narrowed (Exhibits 4 and 5). The onshore RMB (CNY) and the offshore RMB in Hong Kong (known as CNH) are two separate markets. The main feature of the onshore market is that exchange rates involving the RMB are fixed by the PBOC, and movements are limited by daily trading bands. In contrast, the CNH exchange rate is driven by private demand and supply. When the gap between the onshore and offshore markets narrows, it suggests that onshore rates are near or approaching market levels. Exhibit 4: USD/RMB Spot Exchange Rate RMB per USD Is the RMB really close to its fair value? The International Monetary Fund (IMF) estimated that the implied exchange rate for the RMB against the US dollar was in 2012 based on the purchasing power parity (PPP) approach, much stronger than the average USD/RMB spot rate of recorded for the year. The IMF s estimates therefore suggest that the RMB was undervalued by some 33% during The PPP approach, however, has a major drawback in that it only focuses on the tradable sector of the economy while ignoring prices of nontradables such as services. We have attempted to estimate the Chinese currency s equilibrium value based on other approaches, including (1) Enhanced Purchasing Power Parity, (2) Behavioural Equilibrium Exchange Rate, and (3) Fundamental Equilibrium Exchange Rate. Interested readers can refer to the annex for a detailed description of the various methodologies. Enhanced Purchasing Power Parity (Enhanced PPP) Our estimates based on the enhanced PPP approach suggest that the extent of misalignment of the USD/RMB exchange rate in 2012 was much smaller just 5.1% than that suggested by the PPP model. USD/CNY USD/CNH 3

4 Behavioural Equilibrium Exchange Rate (BEER) Other models were utilised to cross-check the results. Another way to estimate the fair value of a currency is establishing the behavioural link between exchange rate and economic factors, or the BEER model. We built an econometric model linking the RMB real effective exchange rate with economic variables such as net exports, trade balance, trade dependency ratios, fiscal balance, real GDP per capita, and real interest rate differentials between the Mainland and the US, Eurozone and Japan. Our analysis based on the BEER approach indicates a mild undervaluation of 2.8% in the USD/RMB exchange rate in 2012 an even smaller gap than the 5.1% undervaluation derived from using enhanced PPP. Fundamental Equilibrium Exchange Rate (FEER) Unlike the other approaches, the FEER model puts more emphasis on the calculation of how much the RMB would have to adjust in order to bring the Mainland s current account balance to a normal level, that is a norm. Results of this exercise vary, depending on what assumptions are made as regards elasticity of imports and exports to the exchange rate, as well as the definition of the norm for the current account balance. Our estimates using the FEER approach showed that the USD/RMB was undervalued by a range of 0.6% to 10.1% in The exercise shows that there is no single best method to measure the exact fair value of any currency given the imprecise nature of the statistics and the technical drawbacks of each economic model. While one should not overly rely on any one indicator, it is equally striking that the different valuation methods reach some coherent conclusions. That is, while the RMB remained undervalued against the US dollar in 2012, the extent of undervaluation was by a range of 0.6% to 10.1%, much smaller than perceived (Exhibit 6). Less pressure on the RMB to appreciate Putting aside the debate about the extent of Exhibit 6: Summary of Estimation Results Undervaluation of the RMB in Estimation approach 2012 Purchasing Power Parity (IMF) 33.2% Enhanced Purchasing Power Parity 5.1% Behavioural Equilibrium Exchange 2.8% Rate Fundamental Equilibrium Exchange 0.6% 10.1% Rate Sources: IMF, World Bank, CEIC, Hang Seng Bank estimates RMB undervaluation, we have also assessed the RMB s short-term outlook based on economic fundamentals. One main reason for the RMB s strength in the past several years was the Mainland s large current account surplus and the inflow of direct investment. These supporting factors may prove less influential in the coming years as: 1. the Mainland s trade surplus is set to narrow; 2. foreign direct investment (FDI) growth will slow while outward direct investment (ODI) will continue to grow; and 3. the Mainland s capital account will be further liberalised, resulting in more twoway fund flows. Mainland s trade surplus to narrow Despite global uncertainties, the Mainland s trade account remains in surplus. However, its relative size has been narrowing, falling from a recent high of 8.6% of GDP in 2007 Q3 to around 3% in 2012 Q4 and further to 2.3% in 2013 Q1 (Exhibit 7). The trade gap is likely to narrow further in coming years as global growth remains modest and the Mainland is determined to shift away from an export and investmentled model to one more focused on consumption-led growth. Our forecast is for the trade surplus to decline to less than 2% of GDP in 2014 (Exhibit 8). 4

5 Exhibit 7: Mainland Trade and Current Account Balance (% of GDP) Exhibit 9: Mainland Foreign Direct Investment and Outward Direct Investment % of GDP USD billion Trade balance Current account balance FDI ODI Exhibit 8: Mainland Trade Surplus USD bn % of GDP % 2013F % 2014F % Note: F: Forecast Sources: CEIC, Hang Seng Bank estimates Inward foreign direct investment growth to slow while outward investment rises The Mainland s productive potential and, more recently, its fast-growing consumer market has been a magnet for foreign investors. FDI inflows amounted to more than USD100 billion in each of the past three years. However, the pace of such inflows has been slowing from growth of 16.8% in 2010 to 9.1% in 2011, followed by a 3.9% contraction in Long-term capital inflows could further slow as FDI inflows, particularly in the manufacturing sector, are expected to ease against a background of rising labour and other costs, which is already prompting some investors to begin shifting their production base out of the Mainland. In contrast, outward direct investment looks set to increase further as Mainland companies go abroad to acquire physical and other assets (Exhibits 9 and 10). Exhibit 10: Mainland Foreign Direct Investment and Outward Direct Investment (% of GDP) % of GDP FDI ODI Further capital account liberalisation While trade, income and direct investment inflows are expected to ease in coming years, the Mainland is likely to see more twoway portfolio flows as the capital account is further liberalised. In fact, restrictions on such flows are already gradually being lifted through developments such as the qualified foreign institutional investor (QFII), RMB QFII (RQFII) and qualified domestic institutional investor (QDII) schemes. By April 2013, 198, 26 and 110 institutions have respectively been granted the QFII, RQFII and QDII licences, of which the approved investment quotas have advanced to USD41.9 billion, CNY76.3 billion and USD85 billion respectively. 5

6 Going forward, the door for portfolio investment will be opened further, not only for institutions but also for individual investors. Starting in April 2013, individuals from Hong Kong, Taiwan and Macau residing or working on the Mainland can now directly participate in the A-share market on the Mainland. With these types of developments, the rate of foreign exchange reserve accumulation will slow, providing less ground for rapid RMB appreciation. By the end of 2012, the Mainland had accumulated a total of USD3,300 billion in foreign exchange reserves, the largest in the world (Exhibit 11). However, the pace of growth slowed to only 4.1% during the year, a far cry from the double-digit pace in previous years (Exhibit 12). Exhibit 11: Mainland Foreign Exchange Reserves USD billion 3,500 3,000 2,500 2,000 1,500 1, Exhibit 12: Mainland Foreign Exchange Reserves (% YoY change) % Reflecting our view that the RMB is close to fair value, the current account is set to narrow and there will be more outward investment, our forecast is for a moderate appreciation of the RMB against the US dollar in the coming years. We expect the PBOC mid-rate to stabilise in a range of 6.00 to 6.20 against the US dollar in the coming two years. Exchange Rate Reform to Persist While the pace of RMB appreciation will slow, efforts to reform the RMB exchange rate regime will not. The RMB is not yet fully convertible, but it has come a long way since the days when the Mainland opened its economy to the outside world and started the long process of economic reform in the late 1970s (Exhibit 13). After more than three decades of currency reform, the RMB is no longer under a fixed exchange rate system, but has moved to a managed floating exchange rate based on market supply and demand with reference to a basket of foreign currencies. While the central authorities have not disclosed details of the currency basket, they have stated that the basket is dominated by the US dollar, euro, Japanese yen and Korean won, with a smaller proportion made up of the British pound, Thai baht, Russian ruble, Australian dollar, Canadian dollar and the Singapore dollar. A brief review of the RMB exchange rate reform showed that the Mainland had a fixed exchange rate system and also a double-track system before The official RMB exchange rate was fixed steadily lower against the US dollar to improve the competitiveness of Mainland exports, from 1.50 in 1980 to per US dollar by the end of Apart from the official rate, the RMB was traded at swap centres at a lower rate of 8.70 per US dollar. The two rates were unified at the prevailing swap market rate of around 8.70 in early This move effectively devalued the official rate of the RMB by about 33%. 6

7 Exhibit 13: Timeline of RMB Exchange Rate Reform 1988 Sets up currency swap centres to allow firms to trade the RMB Jan 1994 Unifies the official and the swap centre exchange rates, officially devaluing the RMB by 33% to 8.7 per US dollar Apr 1994 Sets up its first interbank currency market in Shanghai, the China Foreign Exchange Trade System The RMB strengthens steadily from 8.70 to the US dollar to around Allows the RMB to be convertible under the current account While some Asian countries devalue their currencies during the Asian financial crisis, the RMB remains stable at around 8.28 to the US dollar Dec 2001 The Mainland joins the World Trade Organization and pledges to gradually move towards a flexible currency regime Jul 2005 Revalues the RMB exchange rate by 2.1% against the US dollar, from 8.28 to 8.11, and shifts to a managed floating exchange rate based on market supply and demand with reference to a basket of currencies May 2007 Widens the RMB s daily trading band against the US dollar to 0.5% from 0.3% Jul 2008 The RMB is repegged to the US dollar at 6.83 to help the Mainland economy to ride out the global financial crisis triggered by the collapse of the US housing market Jul 2009 Takes a step towards internationalising the RMB by launching a pilot programme that allows selected Mainland regions to pay for imports and exports in RMB Jun 2010 Resumes reform of the RMB exchange rate, effectively ending the RMB s two-year peg to the US dollar that was enacted during the global financial crisis Apr 2012 Widens the RMB s daily trading band against the US dollar to 1% from 0.5% During the period between 1994 and mid-2005, the RMB was basically pegged to the US dollar. It is therefore not surprising that the Mainland s exchange rate, in terms of the nominal effective exchange rate (NEER), largely tracked the movements of the US dollar during this period (Exhibit 14). Exhibit 14: USD/RMB Spot Exchange Rate RMB per USD The relationship broke down after 2005 when the Mainland authorities shifted from a US dollar to a currency basket peg. The PBOC announced on 21 July 2005 that it would allow a one-off RMB revaluation of 2.1% to 8.11 per US dollar and introduced a managed floating exchange rate regime based on market supply and demand with reference to a basket of currencies. However, the US dollar peg was reinstituted unofficially as the global financial crisis intensified in The PBOC stopped the trend of a strengthening RMB by keeping it basically stable at around 6.83 per US dollar for two years (between July 2008 and June 2010) in order to promote Mainland exports, which were hit hard by plunging world demand. As major world economies slowly emerged from recession, the Mainland authorities released a statement on 19 June 2010 indicating that they would proceed further with reform of the RMB exchange rate regime and increase the RMB exchange rate flexibility. Since that announcement, the RMB exchange rate resumed its trend of appreciation. 7

8 The RMB s daily trading band against other major currencies has also been widened many times. The RMB can currently fluctuate +/- 1% against the PBOC mid-rate against the US dollar, +/-3% against the euro, Japanese yen, British pound, Australian dollar, Canadian dollar and Hong Kong dollar, and +/-5% against the Malaysian ringgit and Russian ruble (Exhibit 15). We expect the daily trading band to widen further this year, to +/-1.5% or more versus the US currency to increase the flexibility of the RMB exchange rate. Exhibit 15: Daily Trading Band RMB vs. Jul 2005 May 2007 Apr 2012 USD +/-0.3% +/-0.5% +/-1.0% EUR, JPY, GBP, AUD, CAD, HKD +/-1.5% +/-3.0% +/-3.0% MYR, RUB - +/-5.0% +/-5.0% The Mainland authorities have been lifting restrictions on capital account transactions based on the following principles: liberalising inflows before outflows, long-term flows before short-term flows, direct investment flows before other investment flows, and institutional flows before individual flows. Further reforms will continue along these lines. The journey towards internationalisation of the RMB has begun. While it will be a long one and there could be obstacles along the way, the process will continue. In fact, all indications show that the pace of RMB reform would accelerate in the years ahead as the Mainland promotes greater use of the RMB offshore, and encourages two-way cross-border fund flows. It is even possible that the RMB could become a fully convertible currency before the end of this decade. Impacts on the Hong Kong Economy There has been growing concern in Hong Kong about the impact of the sharp appreciation of the RMB against the Hong Kong dollar in recent years on local inflation. Such concern is understandable given Hong Kong s heavy reliance on imported goods for local consumption, a proportion of which originate from the Mainland. Hong Kong s consumer price movements have also been closely correlated with import price inflation as well as inflation on the Mainland (Exhibits 16 and 17). Theoretically, RMB appreciation will cause imported inflation in Hong Kong to rise via its direct impact on import prices as well as its indirect impact on supporting aggregate demand and asset prices in Hong Kong. Our analysis will focus mainly on the direct impact. Consumer price inflation Exhibit 16: Mainland and Hong Kong Consumer Price Inflation (% YoY) % Mainland China Hong Kong Exhibit 17: Hong Kong Consumer Price and Import Price Inflation (% YoY) % Retained Import Unit Value Index CPI 8

9 To investigate the impact of the RMB exchange rate changes on imported inflation in Hong Kong, we started with the basics, by first determining how dependent Hong Kong is on goods from the Mainland. Based on trade figures published by Hong Kong s Census and Statistics Department and our assumptions about the re-export margin, the Mainland is not the most important source of retained imports in Hong Kong. In 2012, for example, the Mainland was estimated to be the supplier of 16% of Hong Kong s total retained imports, far below that of other trading partners such as European countries and Singapore which accounted for 26.7% and 20.1% respectively of the city s retained imports (Exhibit 18). Exhibit 18: Hong Kong s Retained Imports from Major Trading Partners in 2012 Imports by origin (HKD Mn) Re-exports by origin (HKD Mn) Re-exports margin Retained imports (HKD Mn) Share in total retained imports Europe 397, ,510 9% 289, % Singapore 246,406 30,952 9% 218, % Mainland China 1,841,760 2,106, % 173, % Japan 312, ,152 9% 103, % US 204, ,570 9% 104, % Others 274, ,433 9% 54, % Taiwan 245, ,715 9% 44, % South Korea 153, ,847 9% 38, % India 82,020 64,972 9% 22, % Malaysia 83,700 70,345 9% 19, % Thailand 72,911 63,066 9% 15, % Total 3,914,913 3,378, % 1,083, % Sources: Census & Statistics Department of HKSAR, Hang Seng Bank estimates These estimates suggest that a 10% appreciation in the RMB against the Hong Kong dollar would cause Hong Kong s consumer price inflation to rise by about 0.5 percentage point 1, assuming a complete exchange rate passthrough to consumer prices. The effect could be smaller if local shopkeepers opt to absorb part of rising import costs. The estimated effect may appear to be rather modest compared with the general perception. However, it must be noted that factors other than the RMB exchange rate could also serve to push up prices of retained imports from the Mainland. Examples include rising Mainland wages as well as increasing consumption of selected food items such as meat as Mainland consumers become more affluent. Hong Kong s inflation has been on a rising trend since 2009, as the local economy gradually recovered from the financial crisis-induced recession. A breakdown of the consumer price index number shows that inflationary pressures in the past years were mainly from housing rental and food, including dining out (Exhibit 19). In 2012, these two components accounted for 3.4 percentage points in Hong Kong s inflation rate of 4.1%. 1 Tradable goods account for about 30% of the consumer price index (CPI) basket and retained imports from the Mainland account for about 16% of retained imports. The effect of a 10% appreciation in the RMB on CPI inflation would be: 10% x 30% x 16% = 0.48 percentage point, if the increase in import prices is fully transferred to consumers. 9

10 Exhibit 19: Contribution to Hong Kong s Inflation (by major component) Annual CPI inflation (%) Housing (percentage point) Food (percentage point) Others (percentage point) Sources: Census & Statistics Department of HKSAR, Hang Seng Bank estimates Trade in goods and services Changes in the RMB exchange rate will not only have an impact on Hong Kong s inflation, but also on the flows of trade in goods and services, asset prices and even the development of Hong Kong as an offshore RMB financial centre. For instance, Hong Kong stands to benefit from larger inflows of Mainland tourists as a stronger RMB will boost their purchasing power. At the same time, Hong Kong residents may spend less during visits to the Mainland. While the net impact on Hong Kong s trade in services in general and the tourist industry in particular is likely to be mildly positive, it is more difficult to determine the effect of a stronger RMB on some other sectors. Take trade in goods as an example. While a stronger RMB may negatively impact the Mainland s trade balance as export growth slows but import growth accelerates, its effect on Hong Kong s export earnings is ambiguous. The city s export earnings could rise if gross trade flows between the Mainland and other economies passing through Hong Kong increase even if the Mainland s net exports decline. Financial industry For Hong Kong s financial industry, it is not the trend of the RMB that matters, but its general rising popularity in the international community. The Central Authorities have been taking steps to expand the use of the RMB outside the Mainland s borders. The RMB is gaining growing acceptance as a global trade settlement currency, as well as an international investment currency. A few countries have started to include the RMB in their foreign exchange reserves. As a Chinese city with special administrative status and a first-mover in the development of offshore RMB financial markets, Hong Kong is strongly positioned to capitalise on the opportunities presented by the increasing internationalisation of the RMB. 10

11 Annex: Estimates of the RMB s Equilibrium Exchange Rate Much of the debate over the Mainland s exchange-rate policy has focused on whether and by how much the RMB is undervalued. We undertook an exercise that used different frameworks for identifying the equilibrium level of the exchange rate and estimating the extent of the undervaluation of the RMB. 1. Purchasing Power Parity (PPP) approach One typical approach to identify equilibrium exchange rate is to find out the exchange rate that leads to PPP. The principle of PPP states that identical products should cost the same in different countries over the long run. The IMF calculates that the implied PPP exchange rate for the RMB was in % stronger than the average USD/RMB spot rate of during the year. 2. Enhanced Purchasing Power Parity approach The PPP approach ignores the fact that the internal productivity growth gap and relative prices between tradable and nontradable goods is greater in more developed countries (Balassa and Samuelson, 1964). To incorporate the Balassa-Samuelson effect, one may determine whether the currency is overvalued or undervalued by the deviation of its market exchange rate to PPP exchange rate ratio from the regression line linking with GDP per capita (Exhibit 20). Based on this enhanced PPP approach, we estimate that the RMB was about 5.1% undervalued versus the US dollar in Behavioural Equilibrium Exchange Rate (BEER) approach The major theoretical shortcoming of estimating equilibrium exchange rate via the enhanced PPP approach is that the US dollar, the anchor currency, can never be overvalued or undervalued. A different approach is to look at the relationship between exchange rate and the fundamental driving variables. Based on studies from MacDonald and Dias (2007) and Lee et al. (2008), we modeled real exchange rate against fundamental factors including net exports, trade balance, trade dependency, fiscal balance, real interest rate differentials with the US, Eurozone and Japan, and real GDP per capita by dynamic ordinary least square. A suitable lag length was selected by minimising the Akaike Information Criteria. Our reduced-form dynamic equilibrium exchange rate model suggests an undervaluation of only 2.8% in the RMB real effective exchange rate (REER) at the end of Fundamental Equilibrium Exchange Rate (FEER) approach The FEER approach aims to search for the exchange rate which is consistent with macroeconomic balance, which is generally interpreted as maintaining the current account balance in a normal position. One can assess the required adjustment of exchange rate to bring the current account balance to its normal position. Exhibit 21 summarises the valuation estimates under different sets of assumptions as regards the elasticity of imports and exports with respect to the exchange rate and the norm of current account balance. The range of estimates of RMB undervaluation was 0.6% to 10.1% in Market exchange rate / PPP exchange rate Exhibit 20: Relationship between Exchange Rate and GDP Per Capita China Log of 2011 GDP per capita (PPP) Exhibit 21: RMB Undervaluation Based on Different Scenarios Current account balance norm Export elasticity: 1.19* Import elasticity: 0.95* Export elasticity: 0.5 # Import elasticity: 0.3^ 0% 3.8% 10.1% 1% 2.2% 5.8% 2% 0.6% 1.5% Notes: * Coudert & Couharde, 2005 # Anderson, 2006 ^ Thorbecke & Smith, 2012 Sources: IMF, CEIC, Hang Seng Bank estimates Sources: IMP, World Bank, Hang Seng Bank estimates 11

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