NEW RENMINBI PRICING MECHANISM MAY LEAD TO LARGER

C O N F I D E N T I A L SECTION 01 OF 02 HONG KONG 000233

SIPDIS

SIPDIS

STATE FOR EAP/CM AND EB
MANILA PASS AMBASSADOR PAUL SPELTZ
TREASURY FOR U/S TADAMS, DAS DLOEVINGER, OASIA-GKOPEKE
USDOC FOR 4420

E.O. 12958: DECL: 01/19/2031
TAGS: ECON EFIN HK CH
SUBJECT: NEW RENMINBI PRICING MECHANISM MAY LEAD TO LARGER
DAY-TO-DAY RATE CHANGES

Classified By: EP CHIEF SIMON SCHUCHAT; REASONS: 1/4 (B/D)

SUMMARY
--------------


1. (C) Hong Kong-based financial strategists note that the
recent change to how China sets the benchmark exchange rate
for the renminbi (RMB) breaks the link between prices on
consecutive days, allowing for potentially quicker and
greater movements in the RMB/USD exchange rate. The new
mechanism has created both the technical basis and
face-saving cover needed for a more rapid upward appreciation
of the RMB relative to the U.S. dollar (USD) should Chinese
officials decide such a move is desirable. There are two
scenarios where this appears potentially applicable. First,
if the USD were to fall suddenly against other global
currencies, China now has the means to let the RMB move
upward quickly (i.e., retain its value against a broader
currency basket) in response. Second, should China decide to
respond to economic imbalances or political pressure from
trade partners by engineering a sudden appreciation of its
currency, the new system allows it do so without violating
day-to-day price change limits that were previously in place.
We have yet to hear predictions of dramatic short-term
changes in store for the RMB, but three of the analysts whose
comments we cover in this message do foresee RMB appreciation
this year of 3-13 percent. END SUMMARY

MORE FLEXIBILITY
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2. (U) On January 4, China changed the mechanism by which the
daily RMB/USD exchange rate is established. Under the
previous system, dating to the breaking of the RMB/USD peg in
July 2005, the RMB value moved fractionally each day relative
to its value against the USD at the close of the previous
day. Pricing was in principle determined against an
unrevealed basket of foreign currencies, but the scope of
variances across days was still capped at /- 0.3 percent
relative to the USD. (Note: The RMB, which now trades at
approximately 8.07 to the USD, was revalued upward by 2.1
percent on July 21, 2005, and has since appreciated an
additional 0.5 percent. End Note.)


3. (SBU) The significance of the new method of setting what
is called the daily central parity rate involves breaking the
link between rates on consecutive days. Fluctuations of the
RMB/USD exchange rate within a trading day are still limited
to /- 0.3 percent, but the connection between the closing
rate on one day and opening rate on the following day has
been eliminated. The central parity rate is now determined
independently each morning as follows: The China Foreign
Exchange Trading System asks for prices from 13 banks (five
of them foreign) known as "market makers," i.e., banks that
are legally compelled to buy and sell according to their
publicly quoted prices. The highest and lowest prices are
thrown out and a computation is made according to an
unrevealed weighted average of the remaining bids.


4. (U) Market observers believe the weightings are heavily
geared towards China's "big four" banks, since those
institutions account for the lion's share of RMB trading.
Another feature of the new system is that banks can trade RMB
over-the-counter (OTC),i.e., with each other. Most trading
was previously conducted between the People's Bank of China
(PBOC) and the respective banks. In the two weeks since the
change to the pricing mechanism was announced, there has been
no apparent impact on RMB trading behavior; the currency has
traded between 8.065 and 8.07 to the USD. In the longer
term, however, there are potential implications for broader
renminbi revaluation, according to our contacts.

POTENTIAL IMPACT
--------------


5. (SBU) Breaking the link with the previous day's pricing
has created a mechanism by which the PBOC can orchestrate
significant changes in the RMB's value without being accused
of determining rates in an arbitrary manner. DBS Bank
Managing Director Andrew Fung suggested to us that if, for
example, the USD tumbles overnight against the basket of
currencies that now determines the RMB's value, the next
day's central parity rate could then be fixed well above the
previous day's close. Fung, whose bank projects a 3-4
percent appreciation for the RMB this year, believes the new

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arrangement will yield a more flexible and market-determined
crawling peg for the currency. (Comment: The USD has slipped
a couple of percentage points against major Asian currencies
so far this year, a trend that many forecasters expect to see
continue. Since the RMB's value is in principle determined
against a currency basket, the USD depreciation should
theoretically make it easier for China to allow for a
market-based appreciation of its currency. End Comment)


6. (C) Goldman Sachs Managing Director Hong Liang used the
occasion of the January 12 visit of US Executive Director to
the Asian Development Bank, Ambassador Paul Speltz, to
comment on the change in the RMB value-setting mechanism.
She said that the new methodology offers China a means to
save face in responding to political pressure by creating a
plausible way to move the currency's value quickly. In her
view, the new method, by breaking the link between two given
days of pricing -- at least in theory, she commented --
serves as a basis for a truly free float. The new
flexibility is more significant than most observers realize,
but much control still remains. Based on trading patterns
that she is aware of, Liang believes the Bank of China's
daily price offerings presently determine 70 to 90 percent of
the value of the new exchange rate each day. In the future,
however, RMB trading flows are likely to shift to other
market makers, so there will less of a role for state banks
in determining the central parity rate.


7. (C) Liang said that China is well aware that its recently
released global trade figures showing a USD 102 billion
surplus in 2005 underscore a need for RMB appreciation. She
predicted that the surplus along with the recent 17 percent
upward revision in GDP would increase calls by trading
partners on China to allow its currency to appreciate,
commenting that members of the U.S. Congress are likely to be
particularly vocal. Liang cautioned that China would be
particularly sensitive about appearing to cave in to foreign
demands, especially with President Hu Jintao expected to
visit the U.S. in the coming months. (Note: Goldman Sachs
forecasts a 9 percent RMB appreciation over the next 12
months. End Note)


8. (SBU) Deutsche Bank Managing Director Jun Ma echoed
Liang's views on the change to currency price-setting. In
Ma's view, the modification of pricing methodology provides a
technical basis for accelerated RMB appreciation, although
the actual pace of the currency's movement will depend much
more on domestic and international politics. JP Morgan
Managing Director Grace Ng assessed the new mechanism as a
more market-based "price finding" system for the determining
daily changes in value. She views the change as a step
beyond last July's break of the RMB/USD peg -- a move towards
laying the groundwork for more RMB flexibility down the road.
(Note: JP Morgan forecasts the RMB will appreciate 13% this
year relative to the USD. End Note.)
Cunningham