In my previous article, I mentioned that the Central Government's currency reforms would likely focus on movements in the real exchange rate. Nothing has changed since then.

With rising wages and the devaluation of other currencies driving up prices in the country, the government is expected to hold its nose and countenance a higher inflation target. This will give rise to further real appreciation of the yuan against other currencies.

Exchange rate variations and rising incomes will lead to greater demand for imported goods, helping lower the country's trade surplus.

Rising operating costs will be the strongest headwind facing exporters. Domestic demand is likely to remain strong, but external demand for Chinese manufactured products will slow due to a smaller price advantage against products from other countries. As a result, export growth will likely decelerate.

In July 2005, the People's Bank of China announced that the yuan would no longer be pegged to the US dollar. Since then, the currency has appreciated markedly against the greenback.

As the currency gains in strength against the US dollar and other currencies, the country's exports become more expensive. Imported products, on the other hand, become more affordable in yuan terms. This phenomenon will shrink the country's trade balance, which is expected to reach $140 billion in 2011.

Meanwhile, incomes of Chinese citizens are growing rapidly. The combination of the country's growing affluence and nominal appreciation of the yuan is going to lead to even higher import demand, all of which fits in with the thesis of decelerating export growth.

Furthermore, as the country fills its coffers, it is spreading its investment portfolio to different overseas projects. China has been quietly forming alliances overseas in an effort to secure resources through outbound investment. Once these investments bear fruit, there will be a pickup in import growth as these overseas businesses ship their products back to China, thereby reducing net exports. Such a development would go a long way to redressing the country's trade balance.

It seems that China's best course of action is to grin and bear a reasonable pace of yuan appreciation. It does not seem to have much choice in the matter as the low interest rate environment is attracting cheap money flows into the country. Because of the restrictive policies applied to the country's capital account, the money arrives in the form of foreign direct investment (FDI), a trend that is expected to continue.

The country's reform of its capital account continues unabated. However, given the structural limitation of the capital account currently - specifically the reluctance on the part of the authorities to open it too quickly - capital is not able to flow freely into the country. This explains why the US pursuit of a weak-dollar policy is not necessarily going to be successful even though the interest rate differential between China and the US is unlikely to change. As a result, FDI will continue its strong rising trend.

The author is an associate director and economist at CCB International Securities Ltd. The opinions expressed here are entirely his own.

(HK Edition 12/29/2010 page3)