With the anniversary of the July 2005 RMB 2.1% revaluation just passed the big buzz is what will China do next.  The conventional wisdom is that:

• China will not do another step revaluation of the RMB: afterall as high as an authority as their Premier Wen Jiabao has recently firmly publicly denied the possibility of a step revaluation
• It will only modestly let the RMB to appreciate at the snail crawl rate (1.5% in the last 12 months) that it has so far.  

I beg to disagree with the Premier and with the market expectation: I will argue that China will make a significant move on the RMB in the next six months, at least a 5% RMB appreciation and that - high officials statements to the contrary - a significant part of that appreciation will occur through another surprise step revaluation of the currency parity. So,  China will surprise again markets and investors (see also my recent WSJ Econoblog).

So, let me explain why China will both move by at least 5% by year end and why part (at least half of such a move will occur through a step revaluation).

First, the Chinese will allow an appreciation of the RMB by year end (at least 5%) because of both external and domestic factors.

External reasons are the protectionist pressures in the U.S. and Europe. China barely avoided being branded as a "currency manipulator" in May but it has gotten only a six-month respite until October or November, when another "manipulation" report is due (unless the Grassley-Baucus bill passes, in which case a similar "fundamental currency misalignment" report will be issued). Many folks in the US Congress are furious about China's not letting the yuan appreciate more; the Graham-Schumer bill threatening 27% tariffs on Chinese goods may still come to a vote, especially if China keeps on stalling by allowing only microscopic moves around an eight-currency value. And given the slowdown in the U.S. economy and the mid-term elections in November, a serious trade war with China cannot be ruled out if China does not move by a meaningful amount. China knows that and it will thus rationally move. 

The domestic reasons are related to the fact that the current Chinese currency peg is causing a dangerous and unsustainable overheating that may lead to high goods/services and asset inflation, a hard landing and financial sector distress.

Note that, maintaining this effective peg, implies that the rate of foreign exchange intervention has accelerated. In 2005 this intervention was about a massive $250 billion and in 2006 the reserve accumulation is as high as in 2005. The Chinese forex reserves, already at $941 billion in June of this year will surely reach the phenomenal level of $1 trillion by the end of the third quarter of 2006.

The implications of this continuation of an effective fixed exchange rate have been to exacerbate the eventually unsustainable overheating of the Chinese economy that was already evident a year ago. Exports are still booming increasing at annualized rates of 30% plus. Net exports are surging. The Chinese trade surplus is reaching unprecedented levels and the unsustainable investment boom is only getting worse.

Indeed, while the China was forecasting an 8% GDP increase for 2006, data for the first and second quarters already show a major overshoot of growth. In the first quarter the economy accelerated to 10.3% and in the second quarter it further accelerated to the record 11.3%, driven by net exports and real investment. As even senior Chinese admitted, this overheating is clearly unsustainable.

The overheating of the Chinese economy is directly and crucially related to its exchange rate policy which prevents China from having an independent monetary policy. China has tried to control the overheating by increasing interest rates and using administrative controls on credit. But this policy has altogether failed as the exchange rate policy prevents being able to have a really independent monetary policy. Increasing the lending rate by a puny 0.27 percentage point as a way to control credit -- after the first quarter growth figures showed serious overheating -- is really a joke.

The crucial point is that, unless China changes its exchange-rate policy, it will be impossible to control this unsustainable monetary, credit and investment boom.

Letting the currency appreciate will allow a soft landing in three ways:

• It will slow down the politically unsustainable growth of exports, as protectionist pressures are surging in the U.S.
• It will lead to less forex intervention and will thus slow down the rate of growth of credit.
• It will allow China to increase interest rates without having to worry that this increase would lead to even more capital inflows. Right now, China can't increase interest rates -- which needed to cool down the economy -- if it keeps its peg because more money creating inflows will occur if rates go up.

The Chinese authorities know all this all too well; and, given the recent data, the reformers in the central bank, finance ministry and academia who have been pushing for a faster appreciation may eventually convince the politicians in the State Council and other high level organs that a faster appreciation is now in China's interest. Chinese authorities could try again - and will try again - to fudge the need for a revaluation and try to use again ineffective administrative controls of credit and minuscule increases in lending rates to control the overheating; but they have tried this approach for three years now and it has clearly failed. So, it is clearly dawning on them that a new approach based on a faster appreciation of the currency is now necessary to restore control of monetary policy.

Then, if we agree that both domestic and external factor will lead Chine to let its currency appreciate in the short run, why will the 5% appreciation in part occur via a surprise step revaluation like the one in July 2005 rather than via a faster rate of crawl alone?

Beacuse it makes total economic sense to have a step appreciation in spite of the official statements of the highest Chinese authorities to the contrary. If the Chinese want a 5% appreciation by year end it does not make any economic sense to do it with a faster rate of crawl between now and December. In fact, as soon as the markets were notice a faster rate of crawl, the speculative inflows of hot money -- that the Chinese are desperately trying to stop -- will accelerate and thus twart their desire to slow down hot money  inflows. Also, creating a little more noise around that faster crawl to create uncertainty and two-sided risk for speculators - like they have done for months with their silly dance of the RMB on the two sided of the 8 parity - will not work once the crawl rate is faster and expected capital gains are thus larger. Noise and two sided risk around a monthly crawl of 0.1% (the average of the last 12 months) can partly deter speculators; but noise around a clear new trend of 1% per month crawl over the next five months to achieve a 5% reval by year would not work: once the faster crawl is clear - however attempts SAFE may do to create uncertainty and noise around it - speculators will have huge incentives to take long RMB positions and hot money inflows would become massive undermining the Chinese objective to slow them down.

So, in order to achieve 5% and avoid another even more massive surge of speculative inflows it is necessary to surprise investors and do a step revaluation, say of 3%, followed by another 2% move via a faster crawl. Given the interest rate differentials between U.S. and China, even an 2% expected crawl (over 5 months until year end) would not be large enough to drive a lot of hot money inflows while an expected 5% crawl would. So, China will soon surprise markets in the next two months and do another step revaluation (say 2-3%) followed by a faster rate of crawl to achieve the desired RMB appreciation by year end; this would be a more effective way to control the amount of hot money inflows rather than a senseless acceleration of the rate of crawl with no step revaluation.

Is this all too sophisticated for the Chinese authorities? Not at all; these folks are not stupid, actually are very smart and they know what they want to achieve and the best ways to achieve it. With their reserves now close to a trillion dollar, the official buzz is now that they want to diversify out of US dollars. Brad Setser and I told them in private and in public as early as March 2005 that it was not a smart thing to pile up forex reserves (mostly US dollars) to the tune of $250 billion plus a year give all the potential capital losses that they would eventually incur and given the risks of overheating through partially sterilized intervention. They also knew all that all along as they are smart and savvy. But until now they tried to control the overheating through failed admnistrative controls that do not make any sense. And they also know that there is no way they can start diversifying their reserves out of dollar without allowing an appreciation of the RMB: this is basic law of macroeconomics: there is a tradeoff between how much you accumulate reserves (and which currency reserves you accumulate) and the stability of your currency value. I.e. you cannot diversify your reserves out of dollar assets - either in new flow or existing stock format - without letting your currency appreciate relative to the US dollar. Cant have your cookie and eat it too. So, the signal of a desire for diversification can only be read - if they are serious about it as they are - as a signal that they  will let the RMB to appreciate relative to the US dollar.

It is thus time for China to move from central planning of the macroeconomy to the use of market tools for macro policy: this means an independent monetary and credit policy that is feasible - given leaky capital controls - only via a more flexible exchange rates. The old Triffin Inconsistent Trinity Dilemma is a basic law of international macroeconomics and you cannot fight forever the basic laws of economics: with leaky and ineffective capital controls, you cannot have both a fixed exchange rate and an independent monetary policy. It is as simple as that. Today China urgently needs an independent monetary and credit policy to avoid an overheating that may end up in the biggest investment bust and NPL surge in human history if not controlled soon. This requires to to give up the effective fixed exchange rate regime and move to a managed float with meaningful RMB appreciation. China has desperately tried to have both a fixed rate and an independent monetary policy by imposing capital controls on inflows (as a way to get out of the Inconsistent Trinity constraints) but since these controls are totally leaky (with hot money inflows being close to an annual rate of $100 both in 2005 and 2006), this strategy has miserably failed. Thus, China effectively faces a degree of capital mobility  that is large enough to prevent to have both fixed exchange rates and an independent monetary policy.

Premier's Wen speech at the State Council today voowing to take strong actions to forcefully cool down the overheated economy is altogether meaningless unless the Chinese authorities realize that such a task is impossible in the absence of a more flexible exchange rate regime. The old style of controls to prevent overheating will fail and create only further distortions in an already highly distorted economy. In an economy growing at a nominal GDP rate of 15% is makes no sense to have lending rates still below 6%; and no meaningful change in deposit and lending rates is feasible under an effective fixed exchange rate regime. Someone in the economic agencies of China should tell this to Premier Wen unless he does not already know it.

Thus, even in a planned economy you cannot defy the basic laws of economics: the Inconsistent Trinity tells that you need to make choices: you cannot achieve three goals - capital mobility, fixed exchange rates, independent monetary policy- at the same time. It is impossible and, for the last few years, China has been trying to fight a futile Don Qujotesque war against this basic economic Trilemma. So, it is time now to accept reality and to act by providing the necessary currency flexibility that will allow the pursuit of a sensible monetary policy aimed at controlling a spiraling and dangerous overheating. Not doing so may end up being a disaster for China.