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Chandler: Spooky Yuan Set To Strengthen

After spooking the market a week ago with a relatively large decline, the Chinese yuan has stabilized. It has gone broadly sideways against the dollar over the last four to five sessions. Indicative prices from the non-deliverable forward market also suggests the market is having second thoughts about a larger devaluation in the coming months.

The focus has shifted from the strategic economic dialogue talks with the US last week and toward the annual three-day high level economic policy meeting among top Chinese officials. Officials have to confront a sharp deterioration in economic conditions. In particular, growth is slowing and set to slow further. The World Bank forecasts growth in 2009 at 7.5 percent, which would be the weakest in 20 years.

The PRC estimates its economy expanded by 9 percent in Q3 08, but forecasts for Q4 are coming in around 6.0 percent-6.5 percent. Because many suspect that Chinese estimates may exaggerate actual growth, many focus on energy consumption as a way to back into better GDP estimates. Thus the decline in China's energy use in Oct was understood as a very ominous sign and corresponded with the slippage of the yuan.

In the coming days, China will report Nov trade figures and producer and consumer prices. The risk is that the data is even worse than economists expect. A news wire consensus has Chinese exports slowing from a 19.2 percent pace less than 15 percent, while imports slow to 12 percent from 15.6 percent. Producer prices are expected to rise by a year-over-year pace of 4.5 percent down from 6.6 percent. Consumer price pressures are expected to moderate to 3.3 percent from 4.0 percent.

Recall that both exports and imports fell in October and, with the latter declining faster than the former, the trade surplus actually expanded a record $35.2 billion. Yet in Nov, economists expect the trade surplus may have shrank to around $32 billion.

Chinese policy makers will likely rely on fiscal and monetary policy to stimulate the economy and not so much on the currency, which is too blunt of a tool to be very effective. Out of the three-day conference, China may announce several new initiatives. There is likely to be more fiscal stimulus forthcoming, part of which could be tax cuts. These could take the form of an increase in the income threshold that is not subject to taxes (from CNY2000 now to CNY3000) a month. There is also some talk increased spending on health care and pensions.

Additional rate cuts and easing of reserve requirements are also likely in the months ahead.

The US Treasury reportedly has pressed China on a number of different issues, though the currency issue acts as a bit of a lightening rod. For its part, outside of trying to score some propaganda points by criticizing US economic policies, China has expressed displeasure over the US $6.5 billion weapon sales to Taiwan. The arms deal with Taiwan, the first in about a year, reportedly will include interceptor missiles.

Chinese officials have sought to reassure US officials that the PRC remains committed to gradual liberalization of the yuan and that market forces will have a primary role. With the dollar's set back in Europe and North America today, the yuan should be expected to strengthen in Beijing tomorrow.

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Marc Chandler is the global head of currency strategy for Brown Brothers Harriman. He has been analyzing, writing and talking about the foreign exchange market for more than 20 years. He is a regular guest on CNBC and his essays have been published in numerous economic and business publications. He previously served as the chief currency strategist for HSBC Bank USA and Mellon Bank.