The Renminbi's slow move toward equilibrium: don't hold your breath waiting for quick interest rate liberalization and capital account convertibility.

• Author: Lo, Chi

The distortion of the remninbi's valuation will remain a hotly debated issue, especially in this election year in the United States. Many politicians, however, seem to have overlooked the fact that the renminbi's undervaluation has been corrected significantly in recent years, as evident in the steady decline in China's current account surplus. But to be fair, despite China's narrowing external surplus, foreign trade evidence argues that file renminbi is still far from reaching equilibrium. In all attempt to address the economic distortion, China has recently made a move to increase the renminbi's flexibility by widening its daily trading band against the U.S. dollar. This suggests that a renminbi regime shift is underway.

Going forward, renminbi appreciation will not be a one-way bet anymore, as yuan trading volatility will rise. Such a regime shift will have profound implications for the evolution of the offshore renminbi (or CNH) market, and is a step forward towards opening up China's capital account and full renminbi convertibility.

But China's daunting challenges in achieving full currency convertibility mad helping rebalance its economy have just begun, as these will involve changing its diehard monetary control model. The renminbi will only be able to find its equilibrium when interest rates are fully liberalized and the yuan becomes fully convertible.

RENMINBI EQUILIBRIUM, NOW YOU SEE IT...

In theory, an exchange rate reaches equilibrium when its underlying demand and supply forces are balanced so that there are no sustained depreciating or appreciating pressures. China's falling current account surplus is a visible sign for correcting the renminbi's under-valuation and, hence, a trend towards equilibrium. The same narrowing trend is also seen in the surplus of China's basic balance, a broader measure of the external accounts calculated by adding long-term capital inflows (approximated by foreign direct investment in China) to the current account balance. This has led top Chinese officials to argue that the renminbi was reaching "equilibrium" and suggest that Beijing was ready for greater yuan trading flexibility.

Some analysts also argued that the renminbi's real effective exchange rate had been rising since 1994, when Beijing reformed the dual-exchange rate system by devaluing the renminbi over 33 percent against the U.S. dollar. So the distortion to the yuan exchange rate due to the massive devaluation should have been corrected...