China: Can the RMB Be More Undervalued Today than It Was Last Year?

William Cline and John Williamson published on Vox an interesting piece earlier this month (June 18), titled “Equilibrium Exchange Rates,” in which they try to “estimate a set of medium-run fundamental equilibrium exchange rates compatible with moderating external imbalances” for the 30 largest economies. They assume that a sustainable equilibrium trade balance for the US implies a current account deficit of 3% of GDP (this is conservative – I would have thought “equilibrium” would have been lower), and try to estimate the amount of currency change needed to get there. They also assume that in general not just the US but all “countries should strive to keep imbalances (surpluses and deficits) under 3% of GDP.”

Using early June 2009 exchange rates, they find that six countries – most of whom are primarily commodity exporters, not coincidentally – have overvalued exchange rates relative to the dollar (Australia, New Zealand, South Africa, Brazil, Colombia, Mexico), and twelve, mostly in Europe, have currencies that are marginally undervalued. Of the 30 countries, eleven have currencies that are at least 15% undervalued relative to the US dollar. For convenience sake I include their 2008 GDP and rank them by size. These are:

Country	Billions	Undervaluation
Japan	$4,908	18.1%
China	$4,221	40.3%
Switzerland	$491	19.8%
Sweden	$479	15.3%
Taiwan	$392	29.4%
Argentina	$330	18.4%
Thailand	$273	16.7%
Malaysia	$222	33.2%
Hong Kong	$215	27.9%
Singapore	$182	26.3%
Philippines	$169	18.2%

Economists can, and of course will, dispute the methodology and the extent of any perceived under- or over-valuation, but in my opinion the most valuable aspect of these exercises is not that they indicate the “correct” exchange rate level, whatever that means, but rather that they can indicate trends or signal interesting anomalies in the aggregate. Two things are noteworthy here, I think.

The first, and most obvious, is that eight of the eleven Asian countries within the top thirty economies (the exceptions are India, Indonesia, and Korea, whose currencies are all undervalued by 4-6%) are on the above list of significantly undervalued currencies, and the list is dominated by them (eight Asians out of eleven countries on the list). This simply suggests the not-exactly-controversial thesis that Asian countries have systematically undervalued their currencies as a strategy to generate employment growth. It also suggests that Asian central banks that worry about the impact of dollar weakness on their reserve holdings are in the funny position of having created the dollar overvaluation at the same time they were actively accumulating those overvalued dollars.

The second noteworthy consequence of their exercise, which I found much more interesting, was a finding that the authors seem to find a little surprising. They say:

The main counterpart to the overvalued dollar is the undervaluation of the Chinese renminbi, along with a few of the smaller Asian currencies. We are somewhat nervous because our estimate (based on the figure of RMB 4.88 to the dollar) of Chinese undervaluation is even larger than it was a year ago (RMB 5.81 to the dollar), despite the fact that the RMB rode the dollar up by 14% in effective terms in the intervening year. It may be that our estimate is now too large because the IMF’s projection of the Chinese surplus seems not to have declined despite the RMB’s real appreciation, although the fall in commodity prices in the past year has presumably worked in China’s favour. But all the other potential biases, notably the way of formulating the Chinese current account target as a substantial surplus rather than the deficit suggested by the FDI inflow, are in the direction of minimising estimated undervaluation. Our analysis is one more piece of evidence that the major macroeconomic imbalance in the world today stems from China’s exchange-rate policy.

Leaving aside the fact of their very high estimate of Chinese undervaluation, I think the authors are saying that although the RMB rose 14% from the last time they calculated these equilibrium exchange rates, nonetheless their measure of the adjustment needed to balance trade suggests that the RMB is actually even more undervalued than it had been a year ago.

What’s going on? How can a currency that has risen 14% against the dollar finish even more undervalued against the dollar? Part of the answer could be differential productivity growth rates, and since Chinese productivity is growing faster than US productivity it would imply that the RMB should revalue against the dollar just to maintain equilibrium. But of course there is absolutely no way Chinese productivity grew by even a fraction of the amount necessary during that time to explain this anomaly.

But remember in my June 3rd post I argued that we make a mistake when we think only currency and tariff policies can affect trade? There is a whole list of policies that, by directly subsidizing production or by implicitly or explicitly taxing consumption, will necessarily affect the trade account. Could it be that even as the RMB was nominally revaluing, other policies were implicitly “devaluing” the RMB – i.e. policies that implicitly increased subsidies to production, and/or taxed consumption – so that the net distortionary impact on trade actually increased? That could explain why a revaluing RMB is nonetheless consistent with an even more undervalued RMB in relative terms.

New lending surges

We are getting reports that June lending numbers are up on May. One of the more bizarre pieces of “good news” recently – very popular among the China bulls – were claims that new lending had moderated significantly in the past two months (so don’t worry too much about that credit bubble everyone’s talking about), but this is true only to the extent that new loans in April and May were compared to the astonishing first quarter numbers. In fact net new lending in April and May was around double the equivalent amounts last year and every year in this decade.

In June, it looks like we are retuning to an upward trajectory. According to an article in the current issue of Caijing:

Commercial bank lending in the first half is expected to hit 6.5 trillion yuan, with new loans in June coming in at about 660 billion yuan, the official Shanghai Securities News reported, citing people close to the matter.

Chinese banks lent out a record 4.6 trillion yuan in the first quarter to help start stimulus projects; while there has been a slowdown since April, the central bank says its policy remains “moderately loose.” Experts have warned against lending quality, unauthorized loan diversions, and the re-emergence of bad loans, which may cause banks to be more cautious in lending in the second quarter.

Discussing the impact of all this lending Andy Xie weighs in with another thoughtful and worried piece in the current issue of Caijing. He writes:

China’s credit boom has increased bank lending by more than 6 trillion yuan since December. Many analysts think an economic boom will follow in the second half 2009. They will be disappointed. Much of this lending has not been used to support tangible projects but, instead, has been channeled into asset markets.

Many boom forecasters think asset market speculation will lead to spending growth through the wealth effect. But creating a bubble to support an economy brings, at best, a few short-term benefits along with a lot of long-term pain. Moreover, some of this speculation is actually hurting China’s economy by driving asset prices higher.

The current surge in commodity prices, for example, is being fueled by China’s demand for speculative inventory. Damage to the domestic economy is already significant. If lending doesn’t cool soon, this speculative force will transfer even more Chinese cash overseas and trigger long-term stagflation.

He goes on to say:

The international media has been following reports of record commodity imports by China. The surge is being portrayed as reflecting China’s recovering economy. Indeed, the international financial market is portraying China’s perceived recovery as a harbinger for global recovery. It is a major factor pushing up stock prices around the world.

But China’s imports are mostly for speculative inventories. Bank loans were so cheap and easy to get that many commodity distributors used financing for speculation. The first wave of purchases was to arbitrage the difference between spot and futures prices. That was smart. But now that price curves have flattened for most commodities, these imports are based on speculation that prices will increase. Demand from China’s army of speculators is driving up prices, making their expectations self-fulfilling in the short term.

I usually don’t quote so much from a single source, but I think Andy Xie’s piece is a very good one and well worth reading (there is a lot more). He makes many of the arguments that all of us who worry about China’s continuing failure to adapt to the huge adjustment in the global and US economies. His conclusions:

What is happening in the commodity market is glaring proof that China’s lending surge is hurting the country. Even more serious is that it is leading Chinese companies away from real business and further toward asset speculation – virtual business.

…Many analysts argue GDP growth follows loan growth, and inflation is a problem only when the economy overheats. This is naive. Borrowed money channeled into speculation leads to inflation. And China may face a lasting employment crisis if private companies don’t expand.

This lending surge proves China’s economic problems can’t be resolved with liquidity. China’s growth model is based on government-led investment and foreign enterprise-led export. As exports grew in the past, the government channeled income into investment to support more export growth. Now that the global economy and China’s exports have collapsed, there will be no income growth to support investment growth. The government’s current investment stimulus is tapping a money pool accumulated from past exports. Eventually, the pool will dry up.

If exports remain weak for several years, China’s only chance for returning to high growth will be to shift demand to the domestic household sector. This would require significant rebalancing of wealth and income. A new growth cycle could start by distributing shares of listed SOEs to Chinese households, creating a virtuous cycle that lasts a decade.

Putting money into speculative investments isn’t totally irrational. It’s better than expanding capacity which, without export customers, would surely lead to losses. Businesses currently lack incentive to invest. But many boom forecasters wrongly assume that recent asset appreciation, fueled by speculation, signaled an end to economic problems. That’s an illusion. The lending surge may have created more problems than it resolved.

Comments

[Alan Young:]

Can someone please explain more simply, for us non-economists:
If the recovery of the Chinese economy is as fragile as you suggest, does that mean that the currency is likely to become stronger, or weaker?
The article says that the RNB is undervalued (relative to the dollar); so it should become stronger. I don't understand how stronger currency = weaker economy, as the author seems to suggest. Help, please?

Jun 24 02:30 PM

[Sober Realist:]

China doesn't have any intention of playing by any rules or returning any favors of buying U.S. products. Their talk of creating internal consumption has been just talk.
"The Chinese government has quietly started adopting policies aimed at encouraging exports while curbing imports, even though China, as one of the world’s largest exporters, has aggressively criticized protectionism in other countries.
The government has sharply expanded three programmes to help exporters, giving them larger tax rebates, more generous loans from state-owned banks to finance trade, and more government-paid travel to promote themselves at trade shows around the world.
At the same time, Beijing has banned all local, provincial and national government agencies from buying imported goods except in cases where no local substitute exists."
“China is not only continuing but accelerating many of the protectionist approaches they’ve taken in the past to promote economic development,” said Michael R. Wessel.
“The focus on maintaining export competitiveness to prevent job losses is clearly trumping longer-term considerations of rebalancing growth and reducing reliance on exports,” said Eswar S. Prasad, a senior fellow at the Brookings Institution.
In other moves, Beijing has halted the rise of the renminbi against the dollar by intervening heavily in currency markets, dumping billions in renminbi and buying dollars and other currencies.
Provincial governments also appear to have cut back on their enforcement of counterfeiting laws and other intellectual property protections. Chinese consumers have less need to buy imported goods when they can buy much less expensive copies produced locally."
www.businesstimes.com....

This is the kind of behavior you can expect from a totalitarian regime focused only on staying in power, no matter the cost to its people or other nations.

Jun 25 07:22 AM

[Michael Pettis:]

What drives the value of a currency is the balance of payments flows, so that China, with its massive trade surplus and very large capital account surplus should see its currency revalue, and would if the PBoC didn't counteract those flows by massive purchases of foreign assets. The only reason "strong" economies tend to see appreciating currencies (and they often don't) is that perceptions of strength often encourage investment inflows. In this case, China still has a massive balance of payments surplus, even if the economy is slowing (and by the way a slowing economy would still give it above average growth).

Jun 25 07:25 AM

[Michael Pettis:]

Sober realist, although there are certainly grounds for criticism, I think your last statement is unfair. What China is doing today is not so different from what the US did in 1930-31. Like in most countries, domestic politcal considerations in China trump international obligations until the foreign response forces otherwise.

Jun 25 07:28 AM

[coreopsis:]

OMG this simplification by a 'professor' reminds me of when I was a first-year b-school student and someone in my section made exactly this point in the finance class...he was totally slammed by (i) the professor for oversimplification and not reading the supporting case materials; (ii) another student who had been working on the forex desk at Goldman; and (iii) another student whose father worked for the Chilean finance ministry.

Really outlandish statements from a soi-disant academic who should avoid making puerile statements about a very complex subject. To even suggest there is a fundamental cross-valuation between currencies (particularly a controlled currency) in a patently non-equilibrium year in global trade such as 2009 is incomprehensible. Can't the author contribute to some (say) travel blog, post pictures, and rate restaurants? At least it would have some utility and possibly be somewhat accurate.

Can this writer's observation be even more overrated this year than last?


On Jun 25 07:25 AM Michael Pettis wrote:

> What drives the value of a currency is the balance of payments flows,
> so that China, with its massive trade surplus [snipped]

Jun 25 09:09 AM

[Billy Gee:]

Timorthy Geithner backed off on his currency manipulation of the RMB analysis in deference to credit needs for the massive spending by the Obama administration. He was insulted afterwards while speaking to students at Peking U. by laughter at his serious remarks. It will now be more difficult to be serious about this subject because of the loss of face.

Jun 25 11:33 AM

[Sober Realist:]

I guess we differ in our opinion of the type of rule China has. America was not a dictatorship in 1930-31. Western businesses that deal with China compromise certain principles in their quest for profits. Take Google for instance. They must now make a choice of submitting to Chinese censorship or lose market share there:
The Paris-based media watchdog Reporters Without Borders says Google is being hypocritical and described the launch of Google.cn as "a black day for freedom of expression in China".

"Like its competitors, the company says it has no choice and must obey Chinese laws, but this is a tired argument," said Julien Pain, head of Reporters Without Borders' internet freedom desk.

"Freedom of expression isn't a minor principle that can be pushed aside when dealing with a dictatorship. US firms continue to justify themselves by saying their presence has a long-term benefit yet the internet in China is becoming more and more isolated from the outside world and freedom of expression there is shrinking," he said.



On Jun 25 07:28 AM Michael Pettis wrote:

> Sober realist, although there are certainly grounds for criticism,
> I think your last statement is unfair. What China is doing today
> is not so different fromIf you what the US did in 1930-31. Like in most
> countries, domestic politcal considerations in China trump international
> obligations until the foreign response forces otherwise.

Jun 25 04:06 PM

[Michael Pettis:]

Sober realist, of course I agree that China is not a democracy, and not even close, but when you argue that this is why China favors domestic producers over foreign, then I have to disagree. The US did the same thing in the early 1930s. I think there is much to criticize, but for the criticism to be effective it should also be fair.

Jun 26 03:15 AM

[PeterZack:]

Coreopsis,
If I knew nothing about the subject I would still know from the tone of all your comments to Pettis that your problem with Pettis is psychological, not analytical. Since I know quite a lot about the subject, I have to say either you failed to grasp even the simplest understanding of how currencies move or you completely failed to understand what happened in your class. Try again, and if you want any credibility, pretend to say idiotic things in a respectful way. As it is you are just wasting time, and so far Pettis hasn’t seemed even to notice any of your rants. Don’t even know why I respond, except that I hate the way the internet emboldens anonymous nobodies.

Jun 26 03:44 AM

[Sober Realist:]

That's not really what I'm saying. What I'm saying is that a dictatorship by its very definition and practice will be much much more difficult to work with as far as international law/trade rules than those nations that are democratic and law-based. This isn't to say that we are completely objective and don't act in our own best interest, but as far as China is concerned, human rights and the rule of fair laws are totally meaningless.
To quote George Zhibin Gu:
"China’s healthy social and economic development must be based on turning the government body from self-serving to a service provider. This issue is far from resolved as of today. Its failure would cause more harm, infinitely bigger than the adverse impacts of global financial crisis.
The (Chinese) government is no service provider. As such, there is no way to establish a law-based, fair modern society as well as modern organizations and businesses. In short, people’s power remains weak. What is more, all market deals are turned into bureaucratic dealings.
The most fundamental issue related to sustained economic development inside China is to move decisively toward a law-based market economy, free from the deadly meddling of an unlimited bureaucratic power. The most basic requirement for this end is to have a firm separation of government from the business sphere. In such a way, the government can truly function like a government and the business entities can truly develop to become modern business organizations with a right set of owners, legal protection and governance."

Now I could say that whatever type of rulers China has does not concern me, but this type of attitude would simply be the equivilent of me sticking my head in the sand and becoming, as someone else stated, another Milo Minderbinder. It appears by all accounts that China's rulers are actually consolidating their power and going in the opposite direction of that recommended above. I'd appreciate it if you gave me your opinion on the following article:
www.theaustralian.news...
Where did John Lee get all that information?



On Jun 26 03:15 AM Michael Pettis wrote:

> Sober realist, of course I agree that China is not a democracy, and
> not even close, but when you argue that this is why China favors
> domestic producers over foreign, then I have to disagree. The US
> did the same thing in the early 1930s. I think there is much to criticize,
> but for the criticism to be effective it should also be fair.

Jun 26 08:55 AM

[coreopsis:]

Zack, my simple response is unless you've been a currency trader for a large bank, it's doubtful whether your backing Pettis's simplistic analysis has any merit. You're wrong that Pettis has never responded to my comments. He's responded in the past quite feebly. Eliciting a response is exactly 180 degrees from my goal. I want to expose the kind of jingoistic thinking that Pettis (and others of his ilk) are prancing about the internet and to point out that Pettis's record of prediction is poor -- as would be expected from someone incapable of multivariate analysis.

Your defense of Pettis also misses the point. His reputation in China is what needs defending and you should therefore go and post on his behalf there.


On Jun 26 03:44 AM PeterZack wrote:

> Coreopsis,
> If I knew nothing about the subject I would still know from the tone
> of all your comments to Pettis that your problem with Pettis is psychological,
> not analytical. Since I know quite a lot about the subject, I have
> to say either you failed to grasp even the simplest understanding
> of how currencies move or you completely failed to understand what
> happened in your class. Try again, and if you want any credibility,
> pretend to say idiotic things in a respectful way. As it is you
> are just wasting time, and so far Pettis hasn’t seemed even to notice
> any of your rants. Don’t even know why I respond, except that I hate
> the way the internet emboldens anonymous nobodies.

Jun 26 09:35 AM

[Sober Realist:]

coreopsis,
Why don't you contribute an article to educate everyone with your words of....wisdom? In doing so, maybe you can shed your jackass image.

Jun 26 10:27 AM

[coreopsis:]

Surely your vocabulary spans a magnitude that includes lesser four letter words that you wish to spew? Don't let the fact that many people here genuinely seek information instead gather polemic views and then submit them as fact...this is beyond your world, I understand that. But, please, when you engage in ad hominem attacks, be more creative. They're already made a movie by this name, surely you can 'think' of something racier...come on, get that dictionary of American slang out and look for the words that have the abbreviation 'obs' attached. Good luck and see your around.


On Jun 26 10:27 AM Sober Realist wrote:

> jackass

Jun 28 09:10 AM

[Michael Pettis:]

Sober Realist, in that light I do agree with your comments. For exmaple one of the problems we are seeing here of is that without a better system of enforcing concerns of ordinary households onto the government some of the necessary reforms, including for example liberalizing the banking system so that households aren't so heavily taxed via low deposit rates, are unlikely to happen as long as there are powerful consituencies that benefit from the existing sysytem.

As for your question, much of John Lee's information is (or was) publicly available. The data on the number of incidents of "mass unrest" for example, although probably understated, used to be released by one of the ministries annually until 2005, when the release was discontinued for reasons never explained.

Jun 30 05:02 AM