China is in the early stages of an economic rebalancing act that makes a stronger currency an almost inevitable part of the mix, and a sustained yuan rise may come far sooner than many foreign players are expecting.

Beijing has started taking broad steps to wean itself off exports and promote greater domestic spending while trying to cope with what appears to be a sustained rise in inflation, all of which point to yuan appreciation.

While higher inflation in China compared with major trading partners will lead to a stronger real trade-weighted exchange rate, traders believe that authorities certainly don’t want inflation alone to be the driver—meaning that nominal appreciation is part of the equation.

Several FX traders on the mainland think that this change is just starting to take shape, underscored by the yuan’s march to record highs, and should reaffirm the consensus expectations for 5-6 percent appreciation this year, contrary to the cautious pricing in the dollar/yuan NDFs.

“China has already started a process to adjust its economic structure, and the previous strategy to keep the yuan’s value at a relatively low level so as to help boost exports will gradually phase out,” said a senior trade at a Chinese commercial bank in Shenzhen.

“The yuan will thus increasingly move in line with China’s economic fundamentals, and the most important factor in the fundamentals this year will be high inflation. So the yuan’s exchange rate will be used in the anti-inflation campaign.”

Beyond economics, there is also currency politics.

Traders have become more convinced that the People’s Bank of China will allow more currency strength thanks to calming currency tensions with the United States, especially after the U.S. Treasury declined to name China a currency manipulator in a report last month.

Those currency tensions appear to have prevented China, always loath to be seen bowing to foreign pressure, from allowing as much yuan appreciation as it might have. Now that the hot button yuan has slipped off the diplomatic radar screen, Beijing is more comfortable letting the currency rise.

The PBOC’s own actions have also given traders more confidence that further currency strength is in store, with the central bank guiding the Chinese currency to a slew of record highs this year.

“A new pattern of periodical, progressive and persistent yuan appreciation has clearly been established since late 2010,” said currency strategist Liu Dongliang at China Merchants Bank in Shenzhen. “Such a pattern will ensure the yuan rises at least 5 percent in the next 12 months.”

Spot yuan hit a record 6.5654 last month and was set at a record mid-point of 6.5695 on Thursday. One-year NDFs are at 6.407, pricing in 2.5 percent appreciation.

While traders say the rise of the offshore yuan market in Hong Kong has lured some money away from NDFs for such appreciation bets because market players can now invest in hard assets, such as bonds, they also say hedge funds are still reluctant to build up positions on this trade.

“Positioning in RMB is decent, but it is not too heavy,” said Jens Scharff Hansen, co-head of Asia FX trading and head of short-term interest rate trading at Deutsche Bank in Hong Kong, at the Reuters Future Face of Finance summit this week.

For a chart on the yuan’s performance since the 2005 revaluation, click on:

Inflation or Appreciation?
The market is divided on how much China needs to rely on currency gains to combat high inflation, at 4.9 percent in January from a year earlier against 4.6 percent in December.

Some argue that inflation has already caused a rising real effective exchange rate (REER), at an inflation-adjusted annual pace of about 10 percent to the dollar, making it unnecessary for Beijing to let the yuan rise in nominal value.

While a recent string of record highs is a clear signal the government has chosen to let the yuan’s nominal value rise instead of using inflation to boost real exchange rates, a jump in