VZCZCXRO5574
PP RUEHCN
DE RUEHHK #0233/01 0190816
ZNY CCCCC ZZH
P 190816Z JAN 06
FM AMCONSUL HONG KONG
TO RUEHC/SECSTATE WASHDC PRIORITY 4397
INFO RUEHOO/CHINA POSTS COLLECTIVE
RUEATRS/DEPT OF TREASURY WASHDC
RUCPDOC/USDOC WASHDC

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 
---------------- 
 
¶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 
 
HONG KONG 00000233  002 OF 002 
 
 
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