The suspicion is that China has allowed the currency to continue to rise to ward off higher inflation and prevent capital outflows amid fears over the longevity of the Feds quantitative easing policy. Expectations of RMB appreciation draws capital into China but is a double-edged sword because flows tend to be of the hot money variety. Worse, some exporters have been tempted to inflate sales, or invoice for non-existent orders, to exchange the dollar proceeds for RMB, casting doubt on official trade data. Even so, the central bank is likely to be acting as a drag on RMBs appreciation by continuing to purchase dollars despite the central governments efforts to cut the trade surplus as part of its policy to rebalance the economy in favour of domestic consumption. A stronger RMB should slow export growth because it makes Chinese goods more expensive while at the same time boosting domestic demand through increasing the purchasing power of the currency. The evidence that RMB is overvalued is the deflationary effect it is exerting seen in exporters cutting prices to compete, causing a profits squeeze, which in turn impacts investment. The transition requires careful management because if export- and investment-led growth fall away before domestic consumption is sufficient to fill the void, economic growth could fall sharply. The trade surplus bottomed out at 2.1% of GDP in 2011 rebounding to 2.8% last year, according to official figures. It has continued to widen this year, hitting $20.4 billion in May not so much because exports are surging but because hoped for growth in imports has faltered, in line with a slowdown in consumption growth. Consumption growth government plus household spending slowed to 8% in the first quarter from 12% in the first quarter of 2012, says Qinwei Wang, China economist at Capital Economics. Investment growth for Q1 was just 5%, down 0.3%, indicating rebalancing is taking place but is insufficient to spur a strong rebound in the economy. Wang believes RMB is undervalued and estimates it will continue its upward trajectory, albeit at a slower pace, reaching 6.10 to the dollar by the end of the year, and 6.0 by end-2014. Interestingly, one of the factors the General Administration of Customs attributed to the disappointing trade performance, apart from a slowdown in the domestic economy, was appreciation in the yuans real value. RMB has appreciated by about 1.4% this year and in recent trade the exchange rate was 6.15 yuan to the dollar, down from 6.23 six months earlier. As a managed float, the RMBs value is officially determined by a basket of currencies. In practice, the valuation of RMB is a key tool through which economic policy is implemented, with the currency moving within a trading band set by the central bank, which keeps RMB inside the band by buying and selling dollars. Lombard Street Researchs Hong Kong-based economist Freya Beamish believes the exchange rate is a smokescreen and that RMB could be overvalued by as much as 30%. Because China hasnt been willing to allow the currency to appreciate nominally, its happened through a back-door way of inflation and that has persisted for a number of years, driving up the RMB, she says. Overvaluation of the RMB is now exerting a deflationary force on the economy and thats causing a profits squeeze, which is the main factor curtailing growth. The symptoms are the product price deflation that Chinas facing. If you look back to mid-2011, product prices went from inflation of about 7% annually to deflation of about 2% to 3% and that situation has persisted for the six intervening quarters, which strongly suggests there is some kind of overvaluation force from the RMB. Beamish adds: So you have hefty product price deflation and it also makes sense from the macro story because adjusted unit labour costs of productivity have been inflating at about 11% in dollar terms since 2005 but thats not the case for the major trading partners that China faces. If a currency cant appreciate in nominal terms, it will appreciate in real terms. So either youll have nominal appreciation of the RMB, or youll have prices in China inflating at a far greater rate than in, say, the United States, which is what weve seen. RMB has appreciated much more in real terms than in nominal terms. RMB appreciated at 3.7% a year between July 2005, when the peg to the dollar was lifted, and July 2008 when the global financial crisis hit, according to a regression path plotted by FX Concepts in New York. It then tracked sideways, holding close to 6.83 until June 2010 when it resumed its rise, maintaining a steady 2% to 2.5% annual rate of appreciation. At 6.15 to the dollar, RMB remains just above the regression line, where its plotted value is 5.94 to the dollar, and is therefore undervalued. However, FX Concepts vice-chairman Jonathan Clark notes that this linear-like appreciation reinforces the suspicion that China is managing the rise of its currency according to a pre-determined plan, much like it manages the rest of its monetary system. RMB looks strong because of the weakness in the other Asian currencies, but the RMB is fairly close to appropriate value, or possibly even slightly undervalued, says Clark. Currency valuations only tend to work on a very long-term basis so its tricky to be confident about what an appropriate value is because it can overshoot and it doesnt mean too much. Clark believes the offshore RMB market CNH, CNT and CNS is an important factor that provides China with the ability to access overseas capital when it needs it and shut it down when it doesnt, without having to shift policy on RMB itself. Patrik Safvenblad, partner at London-based macro strategy fund Harmonic Capital, says since the value of RMB is not determined by markets, the currency cant really be said to be over or undervalued: its level is simply a reflection of Chinese policy. It could be said to be undervalued, but only in the sense that the central bank will continue to let it appreciate over time, he says. Economic conditions in China will dictate how far appreciation goes. If growth is strong, I would expect the authorities to let RMB appreciate faster, but if the economy slows, the rate of appreciation will slow. Safvenblad concludes: As RMB strengthens, we should expect it gradually to become not only more flexible, but also more volatile. The Chinese authorities are stuck between a rock and a hard place. A weaker currency would help boost export competitiveness and even help inflate away rising debt burdens, but at the cost of delaying the much-needed rebalancing of the Chinese economy while triggering a domestic and global political backlash.