The market is digesting the fact that the era of a predictable and steady Renminbi (RMB) appreciation is at an end, and even senior Chinese officials have made recent statements that they considered the RMB close to its fair value.
On the economic front, China's current account surplus has dropped sharply and is likely to stay down for the next few years. Between 2003 and 2007, the surplus trebled and reached 10.1 percent of GDP in 2007. Since then, the surplus has shrunk rapidly to 5.1 percent of GDP in 2010 and only 2.7 percent in 2011.
"There is certainly a cyclical element to the drop – global economy first entered into a deep recession and then stayed rather stagnant while China's domestic demand was pushed up by a strong stimulus," UBS economist Tao Wang wrote in a note to clients.
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Meanwhile, external demand is likely to remain depressed as developed economies go through long-drawn structural difficulties, and China will find it increasingly difficult to gain market share given that they are already large.
On the other hand, China's domestic demand will be boosted by various policies; and importantly, China's real exchange rate has appreciated significantly in the past few years.
"Therefore, we expect China's current account surplus to remain below 3% of GDP in the next couple of years," Wang noted.
According to several estimates, China's exchange rate is at its fair value when its current account surplus is between 2.5 percent and 4 percent of its GDP. At the same time, China's current account surplus has dropped below 3 percent of GDP and is likely to stay down, it is difficult to argue that the RMB is undervalued any longer.
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"While the implied RMB depreciation against the USD in the NDF market in Q4 2011 may have reflected the market's belief that China might depreciate the currency to save exports, we think now it is more widely accepted that perhaps fundamentally the RMB is no longer much undervalued," Wang said.
In 2012, the economist said China would allow for a further 2-3 percent RMB appreciation against the USD, given the recession in the euro zone, the election politics in the US, and the threat of a "currency bill" and other potential protectionist measures in the US against Chinese exports.
After that, the government may allow market forces to play a bigger role, and RMB exchange rate is expected to be range bound with increased two-way volatilities in 2013 and 2014.