Tuesday, July 31, 2012

China's currency is not undervalued

After 18 years of an appreciating yuan/dollar exchange rate and a huge, $3.2 trillion accumulation of foreign exchange reserves, China's currency and forex reserves are roughly unchanged over the past year. This is a potentially important development, since it suggests that the yuan is no longer undervalued, and that China may be entering a new phase in its economic development, in which future growth is likely to be slower but more balanced.

In early 1994, China opted for a monetary policy that targets the value of its currency vis a vis the dollar. This is a legitimate policy option, but very different from the monetary policy that all other major central banks have adopted, which is to target short-term interest rates. In order to manage its exchange rate, China's central bank must buy and sell foreign currency depending on the balance of capital inflows and outflows to their country. If there is a net inflow of capital, the BoC must buy whatever excess of foreign currency there happens to be, thus adding to its foreign exchange reserves while at the same time expanding the supply of yuan in the economy; otherwise, the excess of foreign currency would depress the value of the yuan and violate the peg. Conversely, an outflow of capital would require the BoC to sell foreign exchange and shrink the supply of yuan, thus supporting the yuan. In this manner, capital inflows feed directly into an expanding economy and an expanding money supply.


For the past 18 years, China has experienced an almost relentless and massive inflow of capital. The inflow was so massive that the BoC was ultimately forced to revalue the yuan by 37% in several stages, following its initial 8.72 peg, as reflected in the blue line in the chart above. As China deregulated and privatized its economy, allowing the entrepreneurial energies of the world's most populated country to flourish, the world was quick to see the investment opportunities in China. Investment flows followed, and they were huge. This meant that the BoC had no alternative but to make massive forex purchases (red line in the chart above), and that was a good thing because the abundant supply of yuan this created provided the wherewithal for the Chinese economy to grow roughly 10% per year (in nominal terms, the economy increased a mind-boggling tenfold) as foreign investment inflows financed a booming Chinese economy.



By pegging the yuan to the dollar, China effectively "outsourced" its monetary policy to the U.S., and so it is not surprising that inflation in the two countries is virtually identical, especially now that the economy has had many years to adjust to its currency peg.



The chart above makes it clear that the yuan has been a relatively strong currency since the adoption of its dollar peg. Against a basket of currencies, and adjusted for inflation differentials, the BIS calculates that the yuan has appreciated by over 50% since 1994. Interesting factoid: since 1994, the yuan has depreciated by only 10% vis a vis the mighty Swiss franc, and it is unchanged against the franc for the past 8 years.

Moreover, the fact that reserves and the currency have been flat for the past year tells us that China's capital flows have reached a sort of equilibrium. No longer is there relentless upward pressure to revalue the yuan. Indeed, China could now argue that balanced capital flows are proof that the yuan is no longer undervalued against the dollar. The yuan has perhaps appreciated enough.

Presumably, the BoC could have stopped trying to peg the yuan to the dollar once China's forex reserves had reached some invincible number like $1 trillion. But it seems they wanted to go even further in order to convince the world that the yuan, like their economy, was serious, strong, and here to stay. So now, forex reserves total a little over $3 trillion, most of which is held in the form of dollar, euro, and yen-denominated bills, notes and bonds. Think of those reserves as the collateral backing up China's M2 money supply, which today is equivalent to about $12.5 trillion dollars. By comparison, U.S. M2 is only $10 trillion, and that is "collateralized" by the Fed's holdings of $1.6 trillion of notes, bonds, and MBS.


In the future, China should have no problem accommodating more economic growth with its current level of reserves—the lack of growth in reserves over the past year poses no threat at all to China's ability to continue growth. By simply by lowering banks' required deposit reserve requirement ratio, which is currently 20%, China's banking system can create all the cash and currency needed to support an expanding economy for years to come.



As the above chart suggests, China's galloping growth phase seems to have come to an end. To judge from the evidence of the past year—i.e., no increase in forex reserves and no change in the yuan/dollar exchange rate—no longer does the world in aggregate see obvious bargains in China, or excessive growth, or low-hanging investment fruit. This is likely due to a combination of factors: the yuan's strong performance relative to almost all other currencies; weaker growth in other countries, which translates into weaker demand for Chinese exports; and weaker growth in China, which dampens potential investment returns. Capital inflows have come to a halt because China is no longer the most attractive investment destination in the world.

At the same time as capital flows reach a kind of equilibrium and growth cools, the world senses that the yuan is increasingly unlikely to continue appreciating, and this in turn means that speculative excesses are diminishing. If the yuan is going to be more stable in the future, then it makes less sense to speculate by buying the yuan or by buying Chinese assets. Investors increasingly must focus on things that make economic sense, and less on speculation. This takes some of the froth off of growth, and means that future growth is likely to be more balanced. The prospect of a slower-growing China may dampen one's enthusiasm for global growth in general, but that concern is offset by the likelihood that future growth will be more balanced, less speculative, and thus more durable.

Memo to Mitt: stop bashing the Chinese, please!

11 comments:

seekingtraceevidence said...

Excellent explanation!

Dr William J McKibbin said...

I doubt that Mitt Romney will stop "bashing" the Chinese because Romney can't wait to go to war with someone on the Asian continent -- the US defense industry would stand to dramatically increase earnings in the event of war -- that kind of opportunity that appeals to Romney's sense of greed -- Romney is a global bankster, and banksters love war, especially world war -- expect Romney to go out of his way to bash and insult world leaders and other cultures whenever and whereever he can -- World War II will be Romeny's model for the future -- the good news is that Romney's vision of world war will reduce US unemployment dramatically...

Dr William J McKibbin said...

PS: Pres Obama seems eager to start a world war in Asia as well, so there's not stopping that destiny regardless of whom wins the Presidency this Fall...

PPS: I personally hate war...

Ed R said...

If Scott is so sure China's currency is not undervalued why do they keep it pegged??

The only way to know for sure is to let it float and market forces will determine its true value.

My own bet is that it would appreciate vs. the US$.

Scott Grannis said...

Note that although the BoC opted to "peg" the yuan to the dollar, the existence of almost-perpetual capital inflows forced them to reconsider the peg several times. They effectively allowed the yuan to float, and it appreciated. Now that net capital flows are now longer significant, there is no longer an a priori reason to suspect that the yuan is mis-valued at its current level.

Benjamin said...

I don't understand why right-wingers will vilify anything a communist nation does, unless it is China.

The Chinese Communist Party (CCP) runs China on five-year central planning programs. The CCP controls, either through board seats or voting stock, every major company in China, including publicly held companies (this is not often understood in a somewhat naive West).

If anything, political repression is worse today than 10-20 years ago in China.

And they have controlled the exchange rate of their national currency for decades, as a feature of central planning. True, this means we get cheap goods, produced by a non-free labor force. (It's also true, since we have a international reserve currency, all we do is print money and get goods).

For some reason, China has always gotten a pass from the GOP and the right-wing. I assume this was (in the past) due to influential GOP'ers having trade or business ties with China. Now, this ties may be weakening (and this may explain Romney).

Romney is taking a new and strange tack for a GOP'er. Romney's positions on many issues are indecipherable , and can change instantly, like on universal health care or abortion.

Egads, hold your nose and vote. It's 2012!

Unknown said...

Off-topic.

I was noticing a big drop-off in initial claims in January 2006, and wondered if, like this year, there wa a warmer-than-normal winter. Lo and behold, there was.

Looking at the BLS payroll jobs data, I also noticed there was a surge in jobs in the winter of 2005-06, which then led to what was likely a seasonal adjustment correction in May and June (less so in April), which then recovered very nicely in July. Could history be repeating itself this year?

Family Man said...

http://ftalphaville.ft.com/blog/2012/08/01/1081951/chinas-two-way-liquidity-risk-capital-outflows/

Dr William J McKibbin said...

I saw an article today that suggests Romney may promote a US currency debasement -- more at:

http://www.theatlantic.com/business/archive/2012/07/mitt-romneys-big-polish-idea-lets-debase-the-dollar/260550/

Would enjoy hearing everyone's view on Romney trial balloon approach to economic recovery...

NormanB said...

An IKEA sofa costs $1,200 in Beijing but in Palo Alto, CA it costs $750. Yuan properly valued?

jimmy jam said...

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