By Marc ChandlerWhen China first announced on June 19 that it was going to reintroduce flexibility into its exchange rate mechanism, we advised caution. We warned that it may take some time for China to clarify its intentions. The market's euphoric response was quickly unwound as it became clear that China's position was more nuanced than it first might have seemed. When the U.S. and others call for flexibility they mean the Chinese government should remove its controls that prevent the yuan from appreciating. When Chinese officials talk about flexibility they mean greater two-way movement within relatively narrow bands. However, now two weeks after the new policy was announced, China's intentions are becoming clearer. It will accept some currency appreciation as well as greater two-way movement. Ironically, though, it looks like the market is overcorrecting its initial euphoria and now appears to be pricing China cheaply. Currently indicative prices for the 1-month non-deliverable forward (NDF) imply small yuan depreciation over the next month. The 12-month NDF implies about a 1.5% appreciation over the next year. Over the past two weeks, the dollar has slipped 0.8% against the yuan. This pace of 0.4% a week cannot be expected to be sustained for the year or even for a quarter. However, over the next month, some modest appreciation, even if 0.2% a week on average, seems reasonable and is not priced in. Over the next 12 months, we suspect that a modest 3%-5% appreciation is likely. Back in the July 2005-July 2008 period of yuan appreciation, China allowed the yuan to appreciate on average about 7% a year against the dollar. This was during a different set of macroeconomic conditions, including better growth prospects in its biggest export market, Europe. During that previous 3-year yuan appreciation phase, the dollar was generally weak.