Friday, February 28, 2014

China does not have a problem

Today's breathless China headline: "Chinese Yuan's Drop Is Largest Since Its 2005 Currency Revaluation." Yesterday's headline was even more breathless: "China Currency Plunges Most In Over 5 Years, Biggest Weekly Loss Ever." Reading these headlines, you'd be tempted to think that China was in trouble, but you'd be very wrong.

Here's the "plunge" in the value of the yuan from a big-picture perspective:

That's right, you can barely see the "plunge" when you look at  a long-term history of the yuan. Since its all-time high of 6.04 in mid-January, it has dropped a mere 1.7%, to 6.1415. The big story in China continues to be the yuan's impressive strength, not its weakness: it's up 42% vis a vis the dollar in the past 20 years.

And it's not just the yuan appreciating against the dollar. It has appreciated against every currency in the world, and in inflation-adjusted terms as well. As the chart above shows, the real value of the yuan against a large basket of currencies has appreciated by a staggering 85% in the past 20 years. Only the yen has a better record of long-term appreciation: it rose 250% against the dollar from 1970 through 1994 (from 350 yen per dollar to 100).

Spectacular gains in Chinese productivity—which have boosted the size of China's economy by 8-10% per year for the past 20 years—are the main reason the yuan has appreciated. Capital has poured into China, eager to finance and profit from China's impressive progress.

To accommodate the huge increase in the size of China's economy, the Chinese central bank had to expand the Chinese money supply by orders of magnitude. They did this in a very prudent fashion, by buying almost $4 trillion of the capital inflows that China has received over the years. These purchases provided a solid foundation (in the form of an expansion of China's foreign reserves—see chart above) for a necessary expansion of the amount yuan in circulation. (Think of the growth of China's foreign exchange reserves as a proxy for net capital inflows.) Yet even though it bought trillions of dollars with newly-created yuan, the central bank allowed the yuan to appreciate. In a sense, they didn't buy enough dollars and euros, and that created an effective shortage of yuan which could only be resolved via a yuan appreciation.

But as the chart above also shows, China's accumulation of reserves has slowed down significantly over the past few years. That's because the central bank has liberalized capital flows, and the strong appreciation of the yuan has brought China's costs more into line with costs overseas, with the result that the economy has cooled off. With capital inflows "tapering" off, there is much less pressure for the yuan to appreciate. The central bank is correct in allowing (and even encouraging) the yuan to trade more freely. The yuan was on a one-way street (appreciating) for the past 8-9 years, and that can't go on forever. Looking ahead, it's likely that the yuan will bounce around in a relatively stable channel, rather than constantly appreciating. This new perception alone could help reduce capital inflows and avoid any unnecessary or unwarranted "overheating" of the economy.

For the past 15 years or so, Chinese inflation has been very similar to U.S. inflation, as the chart above shows. But since the yuan appreciated against the dollar by about 37% over this same period, Chinese prices effectively rose by roughly that amount relative to U.S. prices. This has made China somewhat less competitive, and that has worked to slow its growth on the margin. But it's still growing by at least 7% a year. And the central bank still has almost $4 trillion of reserves, which makes the yuan potentially the most rock-solid currency on the planet. What's not to like about a growing economy and a strong currency and low inflation?


Benjamin said...

Well plenty not to like about China, a repressive state with a powerful but corrupt communist party...add on the Shanghai equity index is off two-thirds since 2007 and still falling...USA stocks have recovered...worrisome is that Chinese banks do not trust each other and are rausing inter-bank lending rates...but worse is the lack of a free business press in China...
The CCP may run the country well and the Chinese central bank is growth oriented---but please don't ask what is not to like...

Hans said...

Oh dear, we are relying on Chicom's statistics as facts!

The end is near for this command and controlled economy, as those well healed and wealthy are taking their Maos' and leaving the country.

Their GNP is on a serious decline and for certain those double digit growth days are over for good...If they can even manage 6% growth, they should consider themselves very fortune.

An economy, which is 40% construction can not continue to grow at it's previous pace nor is that massive size overall health from a long term perspective.

So to is the shadow banking industry, with nearly 800 billion in outstanding loans, many of which are in default...This does not include the billions in bad state loans to state enterprises.

Also a worry, is the cost of labor has risen substantially in the past decade, with more and more Chinese manufactures leaving the mainland for lower cost labor markets.

They may have a huge reserve in gold bars and currency but those in itself will not repair structural deficiencies.

Roy said...


The financial system in China is heavily repressed, so one has to be careful when comparing a market based economy to that of the Chinese.

Because of this repression, the massive monetary expansion caused the inflation to manifest itself mostly on the debtor side of the economy.

As far as the currency, surely productivity also has to be thrown into the equation when comparing.

As far as the reserves, the central bank in China already printed RMB against the foreign currency in order to keep the RMB devalued (a part of the economy repression).

China's pseudo miracle growth is based on investment based model where wealth has been transferred from households to the state sector.

China is near to getting to the end of its debt capacity, its investments for a long time now do not have any real economic benefit. One should review the increase of debt and credit as part of GDP and also the decrease of household consumption rate to GDP. This "growth" is only "growing" now due to massive increase in credit where 1 RMB has to be thrown in just to get a fraction of it back.

There are only two upcoming options: 1. one or two lost decades, and then we'll see what happens. 2. hard-fall, and then we'll see what happens.

Of course it can happen tomorrow or a few years from now and then it will be very bad.

For more, I highly recommend reading Michael Pettis books and blog. He is nothing but amazing and one of the few who really gets what's going on in China.