Chart 1: The appreciation of the RMB against the US dollar since July 2005

Keynotes

• the People’s Bank of China (PBoC) surprisingly decided to proceed with further reform of the RMB exchange rate regime and to increase the RMB exchange rate flexibility.
• Although the stock markets reacted positively, investors might worry that a reform in the early stage of the recovery will have a negative impact on China’s economy.
• The impacts on different sectors is manageable
• Exporters won’t be hurt by an RMB appreciation, but by a reduction in tax rebate!
• We think that the Chinese chose to re-launch its managed floating exchange rate regime with reference to a basket of currencies (which include EURO) at this moment is definitely a good thing. It might also show a signal that the Chinese government is worrying about a further depreciation in the EURO.
• We still believe that the Chinese equities that listed in Hong Kong are trading at a discount now and aggressive investors should increase their exposure to Chinese equity funds.

On 19 June 2010, the People’s Bank of China (PBoC) surprisingly decided to proceed with further reform of the RMB exchange rate regime and to increase the RMB exchange rate flexibility. On the first trading day right after the announcement was made, Hong Kong and China stocks markets reacted positively. The Hang Seng Index and the Hong Kong China Enterprise Index rose 3.1% and 4.4% respectively. In fact, the Shanghai A also rose 2.9% on the same day to welcome the PBoC announcement.

Although the stock markets reacted positively, investors might worry that a reform in the early stage of the recovery will have a negative impact on China’s economy. In this article, we take a closer look at the impact of the RMB exchange rate regime reform.

The development of the RMB exchange rate regime

In July 2005, the People’s Bank of China announced the reform of the RMB exchange rate regime for the first time. The exchange rate of the RMB moved into a managed floating exchange rate regime with reference to a basket of currencies in order to improve its flexibility. The RMB started to appreciate against the USD since 2005. Chart 1 shows the movement of the RMB against the USD since the reform. However, the PBoC re-pegged the RMB to the US Dollar again in the midst of the financial tsunami in July 2008.

Although the reform of the RMB exchange rate regime does not necessary equals to a currency appreciation, most of the investors are expecting that the pace of the RMB appreciation will be similar to its pace in 2005. According to the PBoC, although the government re-activates the RMB reform, it does not involve a one-off exchange revaluation. We believe that it is one of the most important signals to the market. It is because a large fluctuation in currency might bring economical and financial instability in China. Therefore, we think that the RMB is likely to appreciate marginally in 2010.

We focus our analysis on what impact the RMB appreciation will have on China’s corporate earnings.

The impacts on different sectors is manageable

Table 1: Profits Change if the RMB appreciate 5%

Many investors are worrying that the appreciation of the RMB will reduce the competitiveness of the Chinese products. It might affect the overall earnings of Chinese companies.

Before we analyse the impacts of the potential currency appreciation on the earnings, investor should understand that there are two key factors affecting corporate earnings. They are the input cost and the revenue. We have no doubt that an appreciation might affect the sales and lead to a drop in overseas revenue. However, if a company imports most of its raw materials to produce its products, an appreciation in the local currency would help to lower its production cost. Therefore, an appreciation in the local currency does not necessary lead to a drop in corporate profitability. The impact of a local currency appreciation should be measured by the sector’s dependence on imported materials and its overseas sales.

Table 1 shows the impact of the RMB appreciation on the industrial profits in China. According to the China International Capital Corporation Limited, out of 26 main sectors, only 5 of them would see a drop in profit if the RMB is appreciated by 5%. In fact, most of the sectors could potentially benefit from the appreciation in the RMB. For example, the dependence on imported materials of the Electrical Machinery and Equipment sector is more than 50% and therefore, this sector could benefit from the RMB appreciation even if there is a huge pressure on the increasing labour cost.

Does RMB Appreciation have negative impact on the exporters?

Not necessary!

The People’s Bank of China mentioned that since the RMB started to appreciate in 2005 till 2008, China’s export increased by an annual average of 23.4%. In addition, some of exchange rate sensitive industry such as textile and light industries kept growing without any significant losses in the past few years. It proved that if there is an appreciation in the RMB, it does not necessary lead to a drop in exporter’s revenue.

In fact, we think the appreciation of the RMB can help to promote China’s economic reform. A stronger local currency would help to increase domestic purchasing power and boost household spending. We expect to see the increase in the importance of domestic spending to the overall economic growth in the next 5 to 10 years. Furthermore, it can help to ease the import inflation driven by the higher energy prices.

After the unanticipated announcement on the currency reform, we have revised our view on the rate hike schedule. We believe that the first rate hike might postpone to the later period of the third quarter or even the fourth quarter.

Exporters won’t be hurt by an RMB appreciation, but by a reduction in tax rebate!

Right after the announcement of the further RMB reform, the Chinese government announced to remove tax rebate on some export goods. The main purpose is to reduce over-capacity in some of the sectors.

Starting from 15 July 2010, the tax rebate of these export goods will be cancelled:

1. Part of the steel;

2. Some non-ferrous metal processing materials;

3. Silver;

4. Alcohol, corn starch;

5. Some pesticides, pharmaceuticals, chemical products;

6. Some plastic products, rubber products, glass products.

These export goods are enjoying a tax rebate of higher than 11% during the financial crisis. No more tax rebates will directly affect the earnings of these sectors. In fact, the Chinese government already mentioned that they would like to rectify sectors that are “high energy consumption, high pollution and highly resources dependent”. The government is speeding up to eliminate backward production capacity. We might see some industrial consolidation in the above sectors.

Therefore, investors should focus on the tax rebate cutting schedule rather than the reformation of the RMB. We are more cautious towards the impacts on the exporters caused by cutting tax benefits.

Conclusion

We believe that the Chinese government announced the RMB exchange rate reform so as to ease the pressure from the G20’s governments. Although there is no official currency movement in the pipeline, we believe that the RMB is likely to appreciate steady and slowly in 2010. The EURO is one of the major currencies in the target basket. If the EURO continues to weaken, the official rate of the RMB could remain unchanged. Due to the fact that Europe is the biggest Chinese goods buyer, depreciation in the EURO against the US dollar would mean a decrease in competitiveness of Chinese goods in the eurozone. Therefore, we think that the Chinese chose to re-launch its managed floating exchange rate regime with reference to a basket of currencies (which include EURO) at this moment is definitely a good thing. It might also show a signal that the Chinese government is worrying about a further depreciation in the EURO.

To sum up, a slightly appreciation in the RMB will not have a huge negative impact towards the Chinese corporate earnings. We believe that the reduction in tax benefit would be more painful to the Chinese exporters, especially for those companies that are “high energy consumption, high pollution and highly resources dependent”.

The Mainland Shanghai A share market dropped 27.3% (as of 2 July 2010 in local currency terms), the worst performing market among all major emerging markets. The Premier Wen Jiabao said that the severity of the international financial crisis and the difficulties of economy recovery have surpassed people’s expectation. For example, the European debt crisis is likely to hurt demand for Chinese goods and the recovery is still vulnerable to a downturn trade.

In addition, the recent weak performance of the China A share market is mainly due to the worse than expected economic data. The Purchasing Manager Index drops to 52.1 point in June, the lowest since the index rose above 50 point in March 2009. Market worries about a slowdown in China will delay the global recovery. In addition to the sovereign debt crisis, there is a concern about the potential double dip in developed economy. We believe that the mainland A share market will remain weak and sensitive to the latest economic data in short. However, the recent correction makes the A share market become very attractive. As of 2 July 2010, the estimated PE ratio of the Shanghai A share market is at 13.1X for 2010. Estimated earnings growth is at 27.6% for 2010. The current valuation is significantly lower than its historical average of above 20X. 

Chinese companies that listed in Hong Kong will be benefit from the RMB appreciation due to the currency translation gain. The Hang Seng Mainland 100 Index is now trading at 12.7X (2010 forward PE as of 2 July 2010) with an estimated earnings growth of 23% in 2010. Appreciation in the RMB will lead to an increase in earnings that reported in HKD terms and hence, it will further increase the attractiveness of the Chinese equities listed in the Hong Kong Stock Exchange.